LAW-Lifting the Cloud of Uncertainty

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Lifting the Cloud of Uncertainty

My Chi To and Oh-Yoon Kim

New York Law Journal

03-05-2012


Section 510(a) of the U.S. Bankruptcy Code provides that a subordination agreement is enforceable to the same extent that it is enforceable under applicable non-bankruptcy law.1 While contractual arrangements relating to priority of payment between creditors are respected in bankruptcy, courts are divided as to whether the waiver of a creditor's right to vote on a Chapter 11 plan should be enforced.

Two courts recently sided with the unenforceability camp, adopting the reasoning articulated in In re 203 North LaSalle Street Partnership2 to find that a waiver of voting rights is invalid because it alters substantive rights granted by the Code.3 Although there are a number of decisions going the other way,4 this line of cases has created a cloud of uncertainty over the extent to which intercreditor agreements are enforceable in bankruptcy. In the early Chapter 11 cases where intercreditor agreements governing billions of dollars of second lien debt issued prior to the 2008 downturn were first tested, this uncertainty played in favor of second lien lenders. To the consternation of many first lien lenders, second lien lenders who were supposed to remain silent not only had a seat at the restructuring table but were sometimes also able to extract concessions in bankruptcy.

Over the past few years, however, several bankruptcy courts have given effect to a variety of intercreditor waivers unrelated to voting rights. These decisions—which start from the proposition that an intercreditor agreement, like any other contract, should be enforced in accordance with its terms—provide the backdrop against which 203 North LaSalle Street Partnership and its progeny should be viewed. This article discusses the emerging contours of the principle that unambiguous waivers of rights by junior creditors should be respected in bankruptcy.

General Principle

Unambiguous Waiver Is Enforceable. This principle was eloquently stated in In re ION Media Networks.5 In that case, the only objector to the debtors' proposed plan was a second lien lender who had repeatedly argued during the Chapter 11 proceeding that the debtors' broadcasting licenses were not part of the collateral. Because the debtors could not grant a security interest in the licenses under applicable law, the objecting lender argued that the value of the licenses should be shared pari passu among all first and second lien lenders.

The court found that the intercreditor agreement clearly gave first lien lenders priority as to the economic value of the licenses, regardless of whether the liens were valid. Giving effect to the plain language of the contract, the court ruled that second lien lenders did not have standing to object to the plan. Expressing frustration with the objecting lender's apparent willful breach of express prohibitions in the intercreditor agreement, the court stated that "plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled."6

Two other recent cases—In re Boston Generating and In re Erickson Retirement Communities—illustrate how courts have dealt with ambiguous intercreditor provisions.7

In Boston Generating, second lien lenders objected to a §363 sale that was supported by the first lien lenders. The first lien lenders argued that the objection violated the intercreditor agreement, which provided that the first lien agent had the exclusive right to exercise remedies and make determinations regarding the sale of the collateral without obtaining second lien lenders' consent. Although the court held that second lien lenders had standing to object, the sale was ultimately approved over their objection.

Recognizing at the outset that the intercreditor agreement was not "a model of clarity," the court stated that it "should not and will not interpret it in a way that re-drafts or re-negotiates the Secured Parties' bargained-for rights" and that "if a secured lender seeks to waive its right to object to a 363 sale, it must be clear beyond peradventure that it has done so."8 Although the court believed that the second lien lenders' objection went against the spirit of the agreement, it felt constrained by its terms. The intercreditor agreement did not expressly prohibit second lien lenders from objecting to the sale, unlike many intercreditor agreements in second lien financings.9

In reaching its decision, the court commented that the sale, which covered substantially all of the debtors' assets, would deprive second lien lenders of a meaningful opportunity to vote on a plan. In addition, the court also noted that second lien lenders were on the cusp of recovery and did not engage in obstructionist behavior of the type identified in ION Media Networks.10 However, it is worth noting that these facts, which the court stated were not dispositive, only entered in the analysis because the intercreditor agreement was ambiguous.

In Erickson Retirement Communities, mezzanine lenders filed a motion seeking the appointment of an examiner. Under the subordination agreements at issue, the mezzanine lenders had agreed not to exercise rights or remedies or take actions to enforce their obligations until the senior debt was fully satisfied. Although the court acknowledged that the agreements were "not as specific in their prohibitions or restrictions as is sometimes the case,"11 the court found that the mezzanine lenders were sophisticated parties that had knowingly waived their right to file an examiner motion in the circumstances. Given that fraud or mismanagement had not been alleged in the case, the examiner motion was evidence of obstructionist behavior, "unmistakably aimed at slowing down the confirmation process and gaining leverage to enhance or create recoveries"12 for the mezzanine lenders.

Exceptions to the Rule

1. Waivers of Voting Rights May Not Be Enforceable. As noted above, there is a court split on the enforceability of waivers of voting rights, with some judges enforcing those waivers in accordance with their terms and others finding that voting rights are too important to be bargained away. It is unclear what other rights would fall in the same category as voting rights. In ION Media Networks, the court appeared to draw a line between the right to object to a plan (which was in dispute in that case) and the right to vote on a plan or to appear as an unsecured creditor.13 Arguably, voting on a plan and appearing in a case are basic rights of all creditors that are different from the special statutory rights granted to secured creditors, such as the right to adequate protection or the right to consent to or credit bid in a §363 sale. In practice, however, as noted in dicta in Boston Generating, second lien lenders' right to object to a §363 sale may be as important as their right to vote on a plan given the increasing use of §363 sales.

2. Cramdown Rules May Trump Turnover Requirement. Section 1129(b)(1) of the Code contains what appears to be an exception to the enforceability of intercreditor agreements in the context of the non-consensual confirmation of a Chapter 11 plan. This provision had not received much attention until In re TCI 2 Holdings,14 which held that a plan of reorganization can be confirmed under §1129(b)(1) over the objection of first lien lenders regardless of whether the plan violated the so-called "turnover" provision in an intercreditor agreement.

Under the proposed plan in that case, first lien lenders would be paid in full with a combination of cash, debt and other rights, while second lien lenders would receive equity and subscription rights. The first lien lenders argued that the plan violated the requirement in the intercreditor agreement that proceeds from the disposition of collateral in connection with enforcement actions must be turned over to the first lien lenders until they are paid in full in cash. The court confirmed the plan based on its plain reading of §1129(b)(1), which mandates confirmation of a non-consensual Chapter 11 plan "notwithstanding section 510(a)" if all of the conditions of §1129(a) and (b) are met.15

Given the court's view that any violation of the intercreditor agreement would not have prevented confirmation of the plan, the court did not decide whether the plan in fact violated the intercreditor agreement. The first lien lenders brought an action for damages for breach of contract in state court, which was ultimately settled. TCI 2 Holdings puts the spotlight on the importance, from the standpoint of first lien lenders, of clear and comprehensive turnover language in intercreditor agreements.16

3. Best Interest of the Estate vs. Clear Intercreditor Terms. An interesting issue that has yet to be decided is whether a clear contractual waiver of rights by second lien lenders—such as the right to object to debtor-in-possession financing or to a §363 sale supported by first lien lenders—should be enforced if doing so would not maximize the value of the estate. If second lien lenders are willing to provide financing on better terms than those offered by first lien lenders, a judge may be reluctant to enforce the intercreditor agreement. Similarly, it may be harder to convince a judge to prevent second lien lenders from participating in a §363 sale if their bid provides more value to the estate than the bid supported by first lien lenders. For example, in In re WestPoint Stevens, first lien lenders were outbid by second lien lenders in spite of an apparent waiver of second lien lenders' right to object to the sale. The court approved the sale over the objection of first lien lenders, who unsuccessfully argued that second lien lenders had no standing to participate in the auction.17

Conclusion

In practice, the most likely source of uncertainty as to how intercreditor agreements will be enforced in bankruptcy is ambiguous drafting. Recent cases suggest that, aside from voting right waivers and the risk that turnover provisions may not be enforced in connection with a cramdown plan, express and specific contractual waivers of rights by junior creditors will be respected in bankruptcy. Circumstances matter, but if the waiver is clear, courts have less leeway to stray from the plain language of the contract, except possibly where enforcing the waiver would be at odds with the overarching goal of maximizing the value of the estate. Because intercreditor agreements are typically negotiated when there is no sign of distress, it is not uncommon for these agreements to be less than clear about the parties' rights in bankruptcy. This ambiguity opens the door to objections that some judges will characterize as obstructionist behavior, while others will defend as legitimate exercises of junior creditors' rights.

My Chi To is a partner and Oh-Yoon Kim is an associate in Debevoise & Plimpton's business restructuring and workouts group.

Endnotes:

1. For a detailed discussion of intercreditor agreements in bankruptcy, see My Chi To, "Second-Lien Financings in Bankruptcy: Expectations vs. Reality," 23 Rev. of Banking & Fin. Services 85, Nos. 8-9 (August-September 2007).

2. Bank of America, N.A. v. North LaSalle Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B.R. 325 (Bankr. N.D.Ill. 2000) (citing Beatrice Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski Mfg. Co.), 5 B.R. 734, 736 (Bankr. D.Minn. 1980)).

3. In re Croatan Surf Club, LLC, 2011 WL 5909199 (Bankr. E.D.N.C. Oct. 25, 2011); In re SW Boston Hotel Venture, LLC, et al., 2011 WL 5520928 (Bankr. D.Mass. Nov. 14, 2011).

4. See, e.g., Blue Ridge Investors, II, LP v. Wachovia Bank (In re Aerosol Packaging, LLC), 362 B.R. 43 (Bankr. N.D.Ga. 2006); In re Curtis Center Ltd. Partnership, 192 B.R. 648 (Bankr. E.D.Pa., 1996); Broadcast Capital Inc. v. Davis Broadcasting Inc. (In re Davis Broadcasting Inc.), 169 B.R. 229 (Bankr. M.D.Ga. 1994), rev'd on other grounds, 176 B.R. 290 (Bankr. M.D.Ga. 1994).

5. ION Media Networks Inc. v. Cyrus Select Opportunities Master Fund, Ltd. (In re ION Media Networks Inc.), 419 B.R. 585 (Bankr. S.D.N.Y. 2009); see also In re Musicland Holding Corp., 374 B.R. 113 (Bankr. S.D.N.Y. 2007) (enforcing broad and unambiguous provisions authorizing amendments to first lien revolving credit agreements).

6. ION Media Networks Inc., 419 B.R at 595.

7. Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010); In re Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D.Tex. 2010).

8. In re Boston Generating, LLC, 440 B.R. at 318-19.

9. The parties had also stipulated that there had been no exercise of remedies by the first lien agent, preventing the judge from ruling that the first lien agent's consent to the sale fell within its exclusive right to exercise remedies under the intercreditor agreement.

10. Id. at 320.

11. Erickson Retirement Communities, LLC, 425 B.R. at 315.

12. Id.

13. ION Media Networks Inc., 419 B.R. at 595.

14. In re TCI 2 Holdings, LLC, 428 B.R. 117 (Bankr. D.N.J. 2010).

15. But see In re Consul Restaurant Corp., 146 B.R. 979 (Bankr. D. Minn. 1992) (finding that plan which did not give effect to subordination rights was not fair and equitable under §1129(b)(1)).

16. Intercreditor agreements frequently only require second lien lenders to turn over collateral proceeds received in connection with enforcement actions taken in violation of the intercreditor agreement. This language may not clearly capture proceeds of §363 sales, or distributions under a Chapter 11 plan, or even proceeds of enforcement actions taken by second lien lenders permitted by the intercreditor agreement.

17. In re WestPoint Stevens Inc., Case No. 03-13532 (Bankr. S.D.N.Y. July 8, 2005). The sale order was appealed on other grounds and remanded to the bankruptcy court, after which it was again appealed and reversed in part on other grounds. See Contrarian Funds, LLC v. WestPoint Stevens Inc. (In re WestPoint Stevens Inc.), 333 B.R. 30 (S.D.N.Y. 2005); In re WestPoint Stevens Inc., Case No. 03-13532 (Bankr. S.D.N.Y. April 13, 2006) (implementing district court's changes to sale order on remand), aff'd, In re WestPoint Stevens Inc., 2007 WL 2936212 (S.D.N.Y. Oct. 9, 2007), rev'd in part, aff'd in part, In re WestPoint Stevens Inc., 600 F.3d 231 (2d Cir. 2010) (reversing bankruptcy court's order on remand based on statutory mootness doctrine and affirming bankruptcy court's holding that original distribution to second lien lenders violated intercreditor agreement).


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