The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A bankruptcy court in Illinois has held that a “silent second” clause contained in a subordination agreement barred a junior creditor from conducting discovery in aid of a bankruptcy trustee’s objection to a senior creditor’s claim against the debtor. [In re Argon Credit, LLC, 2019 Westlaw 169315 (Bankr. N.D. Ill.).]
Facts: A consumer lending company borrowed money from a commercial bank. Other “insider” parties affiliated with the borrower also extended credit to it, subject to a subordination agreement between the senior lender and the insiders. The subordination agreement contained a “silent second” provision:
Notwithstanding any breach or default by the Parent or any other Obligor under the Subordinated Loan Documents, the Subordinated Lender shall not at any time or in any manner foreclose upon, take possession of, or attempt to realize on any Collateral, or proceed in any way to enforce any claims it has or may have against the Parent or any other Obligor unless and until the Obligations to the Senior Lender have been fully and indefeasibly paid and satisfied in full.
Following the borrower’s bankruptcy filing, its trustee began examining the circumstances surrounding the senior lender’s claim, in preparation for a possible objection to the claim. The trustee and the senior lender entered into a stipulation regarding the coordination of discovery, which provided that all discovery requests were to be served by the trustee; but if a party in interest had conferred in good faith with the trustee and if the trustee were not going to proceed with a discovery request, then that party could serve and enforce its own discovery on a separate track.
After the trustee served a subpoena on the senior lender, the lender moved to quash. With the trustee’s approval, one of the subordinated creditors sought to enforce the subpoena against the senior lender directly. The senior lender argued that the subordinated creditor could not obtain discovery because of the “silent second” provisions contained in the subordination agreement.
Reasoning: The court ruled in favor of the senior lender, based on the language of the subordination agreement:
[T]his standby limitation constitutes an explicit and express “silent seconds” provision aimed at preventing “obstructionist behavior”; it goes above and beyond the mere maintenance of the “hierarchy of lien priorities.” . . . . It prevents [the subordinated creditor] from using the bankruptcy process to affirmatively obtain discovery from [the senior lender] respecting [the senior’s] claim against [the debtor].
Author’s Comment: This would seem to be a fairly straightforward issue, but it isn’t. Many courts have declined to enforce these “silent second” provisions, making life difficult for senior creditors. Frankly, I think that the language of the subordination agreement could have been even stronger than it was. Recall that the junior creditor was forbidden to “proceed in any way to enforce any claims it has or may have against the [borrower] unless and until the Obligations to the Senior Lender have been fully and indefeasibly paid and satisfied in full.”
Arguably, the behavior of the subordinated creditor in this case was not an effort to enforce its own claims against the borrower; instead, it was an effort to interfere with the senior creditor’s claims. Perhaps the clause could have been drafted to provide that the junior creditor was were forbidden to “proceed in any way to enforce any claims it has or may have against the borrower, including without limitation appearing as a party in interest in the borrower’s bankruptcy case, unless and until the Obligations to the Senior Lender have been fully and indefeasibly paid and satisfied in full.”
“Silent second” clauses are sometimes called “gag” clauses or “no action” clauses. I would like to propose a new label: a well-drafted subordination agreement should contain a “gag and handcuff” clause, so that the junior creditors are fully apprised of the rights that they are surrendering.
For discussions of cases involving related issues, see:
- 2018-51 Comm. Fin. News. NL 102, Junior Creditors’ Support for Cramdown Plan Did Not Breach Intercreditor Agreement Because They Held Both Secured and Unsecured Claims.
- 2013-36 Comm. Fin. News. NL 73, Bondholders Waived Right to Participate in Bankruptcy Proceedings Under “No Action” Clauses, Even Though Clauses Do Not Mention Bankruptcy.
- 2012 Comm. Fin. News. 68, Junior Lender Retains Right to Seek Receiver Because Subordination Agreement Does Not Expressly Negate Remedies.
- 2012 Comm. Fin. News. 28, Acquisition of Senior Debt By Borrower’s Insiders Is Not Forbidden By Subordination And Standstill Agreement, But Junior Creditor’s Enforcement Actions Against Guarantors Are Permissible.
- 2011 Comm. Fin. News. 32, Intercreditor Agreement Expressly Empowers Borrower to Block Junior Creditor’s Suit Due to Failure to Obtain Consent of Senior Creditors.
- 2010 Comm. Fin. News. 81, Standstill Provisions in Subordination Agreement May Be Strictly Enforced by Senior Creditor to Prohibit Junior Creditor from Taking Any Action against Debtor.
- 2010 Comm. Fin. News. 23, Subordinated Creditors Lacked Standing to Seek Appointment of Bankruptcy Examiner Because Subordination Agreement Prohibits Junior Creditors from Exercising Remedies Without Senior Lender’s Consent.
- 2010 Comm. Fin. News. 15, Debtor May Prevent Subordinated Creditors from Bringing Suit When Subordination Agreement Requires Prior Consent by Senior Lienholder.
- 2009 Comm. Fin. News. 99, “Gag Clause” in Intercreditor Agreement Prohibits Assignee of Junior Claim from Contesting Validity and Priority of Senior Liens.
- 2008 Comm. Fin. News. 08, Junior Creditors May Appear as “Parties in Interest” Despite “No Action” Clause, but “X-Clause” in Subordination Agreement Prohibits Distribution of Securities in Debtor’s Reorganization.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.