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Court Enforces Powers Given Senior Real Estate Lender by Subordination Agreement
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August 20, 2007
(This article first appeared in the July 18, 2007, New York Law Journal.)
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By Jeffrey B. Steiner
Thelen Reid Brown Raysman & Steiner LLP
When negotiating the terms of a subordinated real estate loan, it is fairly common for the senior lender to require that the subordinated lender enter into an agreement defining the rights and priorities of the lenders in the event of, among other things, a default by the borrower. The primary purpose of such an agreement - often referred to as a "subordination" agreement - is to make clear that the subordinated lender has very limited, if any, rights to pursue the stated collateral or collect the outstanding subordinated indebtedness from the borrower until and unless the senior lender is paid in full.
While a subordination agreement usually is presented by counsel for the senior lender to counsel for the subordinated lender as a "take it or leave it" document, subordinated lenders nevertheless should appreciate the consequences of these agreements, including provisions in which the subordinated lender assigns its right to vote its subordinated claim in the borrower's Chapter 11 bankruptcy case (11 USC §§101 et. seq.) to the senior lender or otherwise agrees not to vote its claim without the permission of the senior lender.
Bankruptcy Code §510(a)
Bankruptcy Code §510(a) provides that "[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable non-bankruptcy law."
It is well-settled that, pursuant to §510(a), a subordination agreement will be enforced by a Bankruptcy Court even if the senior lender used its bargaining position to improve the status of its existing claims unless the agreement lacks consideration or any other essential element for a binding contract under New York law (or other applicable law) or the subordinated lender proves the existence of inequitable conduct that harmed the junior creditor, such as a subsequent fraudulent transfer. See, e.g., In re Best Products Co., Inc., 168 B.R. 35 (Bankr. S.D.N.Y. 1994).
Indeed, according to Best Products, a "bankruptcy court, in order to effectuate its duty to do equity, must enforce lawful subordination agreements according to their terms and prevent junior creditors from receiving funds where they have explicitly agreed not to accept them."
While a Bankruptcy Court will enforce a subordination agreement under which a subordinated lender agrees to subordinate its claims to the payment of the claims of the senior lender, subordination agreements utilized in most sophisticated commercial finance transactions these days go much further and often contain provisions restricting a subordinated lender's right to vote its claim in a bankruptcy case of the borrower, such as:
Senior Lender is hereby authorized and empowered but shall have no obligation to demand, sue for, collect and receive every payment or distribution of any kind (whether in cash, property or securities) that otherwise would be payable or deliverable upon or with respect to Subordinated Obligations in any case, including a Bankruptcy Proceeding, and shall have the further right to file all claims and proofs of claim and take such other action, including voting the claims arising from the Subordinated Obligations in any Bankruptcy Proceeding, as it may deem necessary or advisable for the exercise or enforcement of any of the rights or interests of the Senior Lender.
Similar provisions contained in subordination agreements provide as follows:
In any case commenced by or against the borrower or a general partner of borrower under chapter 11 of the Bankruptcy Code or any similar provision thereof or any similar federal or state statute (a "Reorganization Proceeding"), the Senior Mortgagee shall have the exclusive right to exercise any voting rights in respect of the Senior Mortgage and the other Senior Loan Documents, and the Subordinate Mortgagee shall have the exclusive right to exercise any voting rights in respect of its claims against the Borrower or a general partner of the Borrower, except that the Subordinate Mortgagee shall not have the right to, and may not, vote affirmatively in favor of any plan of reorganization unless the Senior Mortgagee grants its permission thereto or the Senior Mortgagee votes to accept such plan.
Given that voting plays an integral part of a Chapter 11 bankruptcy case in which the debtor may be attempting to utilize provisions of the Bankruptcy Code to, among other things, restructure a secured obligation over the objection of the secured creditor (i.e., a "cram down" plan), it often is in the interest of the senior lender to have the ability to control the claim of the subordinated lender. The senior lender would want such control so that the subordinated lender cannot "team up" with the debtor to confirm a plan that is not acceptable to the senior lender. The question remains whether provisions contained in a subordination agreement granting the senior lender control over the voting rights of the subordinated lender will be enforced by the Bankruptcy Courts.
The Aerosol Decision
While there is little case law addressing this question, a recent bankruptcy case should provide senior lenders with a degree of comfort that they will receive the benefit of their bargain from a subordination agreement designed to control the claims of subordinated lenders. In re Aerosol Packaging, LLC, 362 B.R. 43 (Bankr. N.D. Ga. 2006).
In Aerosol, Blue Ridge Investors II Limited Partnership, which had invested in Aerosol Packaging, LLC, the debtor, entered into a broadly worded subordination agreement with a predecessor of Wachovia Bank NA, a lender that refinanced the debtor's then-existing working capital facility. The subordination agreement provided that Wachovia was authorized and empowered to, among other things, vote the claims of Blue Ridge in any bankruptcy proceeding of the debtor; demand, sue, collect or receive any distribution of any assets of the debtor; and recover any amounts due on the Blue Ridge claims until such time as the Wachovia claims were paid in full in cash.
Aerosol subsequently filed for bankruptcy under Chapter 11 and reached an agreement with Wachovia to restructure Wachovia's $2.4 million senior claim under its plan of reorganization. In contrast, Aerosol's plan proposed to treat Blue Ridge's $3.5 million subordinated claim as a no-interest, unsecured cash-flow note in the maximum amount of $400,000 upon Blue Ridge's acceptance of the plan or as a bifurcated claim based on a court-determined valuation in the event Blue Ridge declined to accept the plan. Wachovia voted both its claim and Blue Ridge's in favor of Aerosol's plan. Blue Ridge declined to accept the plan, casting a "no" ballot on its behalf and filed a motion to determine who was entitled to vote its claim. The court then was confronted with the question of which of the two ballots was valid.
Blue Ridge argued that Wachovia's right under the subordination agreement to vote on behalf of Blue Ridge in the debtor's bankruptcy proceeding was unenforceable, relying primarily on an earlier decision, In re 203 N. LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000). The LaSalle decision was the only published decision that directly confronted the voting issue before Aerosol. The subordination agreement in the LaSalle case provided:
[North LaSalle] hereby irrevocably agrees that the Bank may, at its sole discretion, in the name of [North LaSalle] or otherwise, demand, sue for, collect, receive and receipt for any and all such payments or distributions and file, prove, and vote and consent in any such proceedings with respect to, any and all claims of [North LaSalle] relating to the Junior Liabilities.
In holding that the senior lender did not have the authority to vote the claim of the subordinated lender, the LaSalle court reasoned that: (i) Bankruptcy Code §510(a) only requires that the Bankruptcy Court recognize that the subordinated lender's claims is "ranked" lower than the senior lender's claim; (ii) under Bankruptcy Code §1126(a) only a "holder" may vote its claim, and the holder in this case was the subordinated lender, not the senior lender; and (iii) a senior creditor is not an "agent" permitted to vote on behalf of a junior creditor for purposes of Federal Rules of Bankruptcy Procedure Rule 3018(c) and, regardless, an "agent" must comply with the wishes of the principal. 1/
Despite the LaSalle decision, the Aerosol court held that the subordination agreement at issue altering the voting rights of the parties was enforceable, reasoning as follows:
|  | Although Bankruptcy Code §1126(a) grants the right to vote to a "holder" of a claim, it is silent as to the holder's ability to delegate or bargain away such voting rights.
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| | Bankruptcy Code §510(a) renders a subordination agreement enforceable to the extent enforceable under applicable non-bankruptcy law, and the pertinent state law does not prevent enforcement of voting rights in the instant case.
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| | Federal Rules of Bankruptcy Procedure Rules 3018(c) and 9010(c) expressly authorize "agents" and other representatives to take actions, including voting, on behalf of principals, such actions need not comply with the direction of the principal. 2/
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Significantly, regarding the agency issue, the Aerosol court stated:
In this case, Wachovia is acting as a duly authorized agent of Blue Ridge, similar to the actions of a real estate lender acting as an agent for the borrower in executing a deed under power of a sale in Georgia to convey title to foreclosed property at a foreclosure sale (i.e., as an agent having a power coupled with an interest). In both instances, the agent acts in its own interests, and not in those of the purported principal.
The Aerosol court concluded by noting that the subordinated lender is not left without a remedy as a result of a delegation of its voting rights because the subordinated lender always has the option of making a full cash payment to the senior lender, thereby reclaiming its voting rights.
Conclusion
While the LaSalle and Aerosol courts reached different conclusions, the reasoning utilized by the Aerosol court in support of its holding that Wachovia could, consistent with the terms of the subordination agreement, vote the claims of Blue Ridge under the plan appears well-grounded. Simply put, the subordination agreement in Aerosol authorized Wachovia to act as the agent of Blue Ridge, having a power coupled with an interest. While the consequences of granting such control to a senior lender eventually could prove detrimental to the subordinated lender because the senior lender likely will act in its own interests when voting, subordinated lenders should at least recognize that such a scenario is possible and that they may not have the proverbial "seat at the table" in a Chapter 11 bankruptcy case.
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For more information about the issues covered in this report, please contact Jeffrey Steiner in our New York office at 212-603-2260 or at jsteiner@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
ENDNOTES
| 1/ | Bankruptcy Code §1126(a) provides that the "holder of a claim or interest allowed under section 502 of this title may accept or reject a plan...." Federal Rule of Bankruptcy Procedure Rule 3018(c) provides that an "acceptance or rejection shall be in writing, identify the plan or plans accepted or rejected, be signed by the creditor or equity security holder or an authorized agent, and conform to the appropriate Official Form...."
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| 2/ | Federal Rules of Bankruptcy Procedure Rule 9010(c) provides that the "authority of any agent, attorney, in fact, or proxy to represent a creditor for any purpose other than the execution and filing of a proof of claim or the acceptance or rejection of a plan shall be evidenced by a power of attorney conforming substantially to the appropriate Official Form...."
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(Reprinted and excerpted with permission from the July 18, 2007, edition of the New York Law Journal. ©2007 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.)
©2007 Thelen Reid Brown Raysman & Steiner LLP
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