June 01, 2011
Bankruptcy Law Alert
Author(s): Dennis J. Drebsky
Our latest alert discusses a recent U.S. District Court decision that may be of interest to anyone drafting or negotiating an intercreditor or subordination agreement. The decision, In re Avondale Gateway Center Entitlement, LLC, 2011 U.S. Dist LEXIS 41450 (D. Ariz. April 11, 2011), held that a junior creditor’s right to vote on a bankruptcy plan can be transferred to a senior creditor pursuant to a “subrogation clause” contained within an intercreditor agreement. Under the right conditions, senior creditors who are interested in obtaining the right to vote junior creditors’ claims may consider negotiating for the inclusion of subrogation language similar to the one used in Avondale.
In a recent opinion, In re Avondale Gateway Center Entitlement, LLC, 2011 U.S. Dist LEXIS 41450 (D. Ariz. April 11, 2011), U.S. District Court for the District of Arizona (the “District Court”) affirmed a bankruptcy court decision which held that a “subrogation” language contained in an intercreditor agreement authorized the first lien lender to vote the second lien lender’s claim with respect to the plan of reorganization of the chapter 11 debtor (the “Debtor”).
While other cases have addressed the enforceability of voting rights language in intercreditor agreements—and reached conflicting decisions, Avondale is the first one addressing the enforceability of a subrogation provision with respect to plan voting rights. Accordingly, Avondale may be of interest to anyone drafting or negotiating an intercreditor or subordination agreement.
Avondale Gateway Center Entitlement, LLC, the Debtor, borrowed $30.7 million from the National Bank of Arizona secured by a senior lien on vacant land and $18 million from MMA Realty Capital, LLC secured by a junior lien on the same land.
The two secured lenders entered into an intercreditor agreement (the “Intercreditor Agreement”) which provided that the liens of the National Bank of Arizona would have priority over that of the liens of MMA Realty Capital, LLC. The Intercreditor Agreement contained the following subrogation language:
Subrogation. [Second Lien Creditor] agrees that [First Lien Creditor] shall be subrogated to [Second Lien Creditor] with respect to [Second Lien Creditor’s] claims against Borrower and [Second Lien Creditor’s] rights, liens, and security interests, if any, in any of the Borrower’s assets and the proceeds thereof (excluding, however, [Second Lien Creditor’s] rights under any pledge of Borrower’s membership interests made under the Subordinate Debt Documents) until the Senior Debt shall have been paid in full, in cash.
When the Debtor filed a bankruptcy petition and later submitted a chapter 11 plan, MMA Realty Capital, LLC cast a vote in favor of confirmation. However, National Bank of Arizona cast two votes against confirmation: one vote on its own behalf as the holder of the claim secured by the senior lien on the vacant land, and a second vote as the holder by subrogation of the claim secured by the junior lien on the vacant land.
The Debtor challenged the senior lender’s right to cast a vote on behalf of the junior lender. The Bankruptcy Court ruled against the Debtor, holding that the Subrogation Clause authorized National Bank of Arizona to vote MMA Realty Capital, LLC’s claim. The Debtor appealed the Bankruptcy Court’s ruling, but the District Court affirmed.
The legal discussion in the district court opinion
After recognizing that Section 510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable in a bankruptcy case to the same extent that it is enforceable under applicable nonbankruptcy law, the District Court agreed with the Bankruptcy Court that the Subrogation Clause contained in the Intercreditor Agreement permitted the senior lender to vote the junior lender’s claim. It used the following reasoning:
Nature of subrogation under Arizona law
Under Arizona Law, subrogation is “the wholesale substitution of one party (i.e., the ‘subrogee’) in place of another (the ‘subrogor’) with respect to a claim.” As such, the District Court explained, “the subrogee succeeds to all of the subrogor’s rights with respect to the claim” (emphasis added).
Here, “all of the subrogor’s rights” included the right to vote on the Debtor’s chapter 11 plan. Accordingly, National Bank of Arizona, as the subrogee, stepped into the shoes of and acquired all of the rights associated with the subordinated claim, including the right to vote the subordinated claim.
Subrogation vs. subordination clauses and enforceability in bankruptcy
The Debtor argued that a Subrogation Clause is not enforceable in bankruptcy, citing to In re 203 North LaSalle St. P’Ship, 246 B.R. 325 (Bankr. N.D. 2000) (subordination agreement with an assignment of plan voting rights is not enforceable as against public policy) and In re Hart Ski Mfg. Co., 5 B.R. 734 (Bankr. D. Minn. 1980) (subordination agreement waiving a junior lender’s right to seek adequate protection is not enforceable as against public policy). The District Court distinguished these cases because the disputes there were over the enforceability of “subordination clauses” not “subrogation clauses.” In the District Court’s view, the policy reason at play in the 203 N. LaSalle and Hart Ski cases—permitting subordinated creditors to protect their claims because “[s]ubordination affects only priority of payment, not the right to payment” —was simply not applicable to the Avondale case because, unlike a creditor who enjoys the benefit of subordination and the assignment of only the voting rights, a subrogee “steps into the shoes of the subrogor” and “acquires all of [the subrogor’s] rights.”
The District Court also explained that while a subordination agreement is not enforceable under Arizona law with respect to “non-assignable rights” such as legal malpractice claims, bankruptcy voting rights can be assigned. Cases coming to that conclusion include: Aerosol Packaging, 362 B.R. 43 (Bankr. D. Ga. 2006); In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 U.S. Dist. LEXIS 16546, 1994 WL 646176, *1 (E.D. La. 1994); and In re Erickson Ret. Cmtys., LLC, 425 B.R. 309, 316 (Bankr. N.D. Tex. 2010). Even language in the 203 N. LaSalle decision would lend support to the notion that an actual assignment of the subordinated claim, as opposed to the naked assignment of plan voting rights, would permit the senior lender to vote the subordinated claim.
Analysis and take-away
Limited applicability to existing intercreditor agreements
As far as the authors are aware, intercreditor agreements typically used in first lien/second lien financing rarely provide for the senior lender to be subrogated to the junior creditor’s rights. For example, the American Bar Associations’ Model First Lien/Second Lien Task Force form of Intercreditor Agreement published in May 2010 does not contain language similar to the Subrogation Clause present in Avondale or otherwise provide for subrogation beyond the simple situation where the subordinate lender is subrogated to the senior lender’s position to the extent that the subordinate lender turned over money or property to the senior lender. Nor is a subrogation clause like the one in Avondale likely at play in mezzanine financing documents common in real estate lending. Subrogation clauses may be more likely to appear in sponsor or seller financing transactions. As such, the Avondale decision likely provides no guidance as to the enforceability of voting rights provisions under most existing non-insider intercreditor agreements.
As a practical matter, second lien lenders have generally been successful in refusing to accept an assignment of voting rights clause in the negotiation of a first lien/second lien intercreditor agreement. For those situations where the clause has been successfully inserted by the senior lenders, parties seeking to exclude a senior lender’s vote of the junior lender’s claim will argue that the court should follow either Aerosol Packaging or 203 North LaSalle, depending on which side is making the argument. Unfortunately, there are no Supreme Court or circuit court level decisions on this issue to provide guidance and, while there appears to be a trend in favor of enforcing a clearly worded intercreditor agreement, lower court decisions on the assignability of plan voting rights are in conflict.
Relevance to future negotiations
To the extent that a senior creditor has the leverage in negotiations over an intercreditor agreement to pressure a junior creditor into agreeing to the subrogation of its rights, the senior creditor may want to consider inserting the Avondale subrogation language into future intercreditor agreements. There is a strong argument that a subrogation clause, assuming enforceability under whichever state law governs the intercreditor agreement, should be enforceable with respect to plan voting rights. However, the best way to ensure that the argument will be successful is to make sure that the subrogee succeeds in all of the subrogor’s rights as a holder of the claim in a bankruptcy case.
Specifically, 203 North LaSalle, the major decision that refused to enforce a contractual assignment of the junior lender’s right to vote on a plan, reasoned that the junior lender’s plan voting rights could not be assigned to the senior lender because (i) section 1126 of the Bankruptcy Code provides that only “the holder of a claim” may vote to accept or reject a plan and (ii) under the subordination agreements at play in 203 N. LaSalle, only plan voting rights were assigned to the senior creditor such that the junior creditor remained the holder of its own claim. If a subrogee acquires all of a subrogor’s rights under applicable state law, the subrogee may then become the “holder of the [subrogor’s] claim.” Then, even under the 203 North LaSalle court’s interpretation of section 1126, the transfer of plan voting rights would be effective.
The wholesale nature of subrogation may make junior lenders reluctant to agree to the inclusion of the Avondale subrogation language. It is certainly not consistent with the fact that first lien/second lien financing assumes only lien subordination and not payment subordination. Subrogation clauses that go into effect only on the borrower’s bankruptcy filing have not yet been tested in bankruptcy courts. That type of drafting will remain subject to the argument employed in both 203 N. LaSalle and Hart Ski to the effect that the bankruptcy laws present a complex and delicately interwoven system that should not be altered by pre-bankruptcy agreements. Moreover, there may still be an argument that, if an intercreditor agreement provides that subrogation is in effect “until the [s]enior [d]ebt is paid in full,” the junior creditor’s rights to receive payment after full payment of the senior debt would render the junior creditor the holder of its own claim despite the subrogation language. See Avondale, 2011 U.S. Dist LEXIS 42450 at *5. Nonetheless, it is worth senior lenders considering the inclusion of a subrogation provision as a way to bolster the enforceability of plan voting rights provisions to the extent that they do not conflict with the business deal among the parties.
We are available to discuss any of the concepts touched upon in this Bankruptcy Alert, to assist in the negotiation of intercreditor agreements, the workouts of loans, or in bankruptcy cases.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.