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 Delaware has held that the “waterfall” provisions contained in an intercreditor agreement barred all distributions to a group of junior lienholders in a Chapter 11 case until the senior lender had been paid in full. [In re La Paloma Generating Co., 2018 Westlaw 6022271 (Bankr. D. Del.).]
Facts: A senior lender held a blanket security interest in all of the assets of a large commercial borrower. A group of junior creditors held a subordinated interest in the same assets; the parties’ relative priorities were governed by an intercreditor agreement. Prior to the borrowers’ Chapter 11 filing, one of the financing statements perfecting some of the senior lender’s security interests lapsed.
Following the borrowers’ Chapter 11 filing, the debtors entered into a settlement with the senior lender. Under the terms of that settlement, most of the claims held by the senior lender were to be paid. However, a portion of its liens on certain assets were released. The assets of the debtors were liquidated, and the proceeds were held by a collateral agent.
Some of the money from that pool of proceeds theoretically would have gone to the junior creditors, on account of their unsecured claim. However, the funds were held by the collateral agent, pending a determination as to whether the junior creditors were entitled to any distribution at all, in light of the wording of the parties’ intercreditor agreement.
The senior lender argued that the junior creditors were not entitled to receive anything from the collateral agent because the senior creditor had not yet been paid in full. The junior creditors claimed that because some of the senior lender’s security interests were unperfected due to the prepetition lapse of the financing statement, any money held by the collateral agent had to be distributed in accordance with the terms of the plan of reorganization, which included a distribution to the junior lenders in their capacities as unsecured claimants. Both sides filed motions, seeking a determination by the bankruptcy court.
Reasoning: The court ruled in favor of the senior lender, based on the language of the intercreditor agreement. The court first noted that the agreement contained a provision stating, in essence, that as long as the senior lender had not yet been paid in full, any funds that would have gone to the junior creditors “in connection with the exercise of any right or remedy . . . relating to the Collateral in contravention of this Agreement shall be segregated and held in trust and forthwith paid over . . . (for the benefit of the First-Lien Claimholders) . . . .” The court reasoned that this paragraph contained four separate conditions:
i. The distribution must be “Collateral or proceeds thereof;”
ii. The distribution must be received “in connection with the exercise of any right or remedy” by the [junior creditors];
iii. Any such exercise of a right or remedy must “relat[e] to the Collateral;” and
iv. The exercise of such right or remedy must be “in contravention of this [Intercreditor] Agreement.”
The court then held that all four of those conditions had been satisfied. First, the assets held by the collateral agent were indisputably proceeds of the original collateral. Second, the filing of the proof of claim by the junior creditors constituted the exercise of a remedy. Third, the remedy obviously related to the collateral or its proceeds. Finally, although the exercise of that remedy (the filing of a proof of claim) was not itself in contravention of the intercreditor agreement, the receipt of funds by the junior creditors would have been a violation of the intercreditor agreement.
The court observed that the junior creditors were probably without standing to challenge the senior lender’s position: “Even if the First-Liens’ UCC filings lapsed prior to the Petition Date, they are valid as to the Second-Lien Lenders who entered into an Intercreditor Agreement acknowledging the First-Liens. . . .”
The junior creditors next argued that the intercreditor agreement contemplated “lien subordination” but not “payment subordination.” The court disagreed, holding that the “waterfall” provisions of the agreement were controlling. The court concluded by quoting with approval from In re Ion Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009): “Affirming the legal efficacy of unambiguous intercreditor agreements leads to more predictable and efficient commercial outcomes and minimizes the potential for wasteful and vexatious litigation.”
Author’s Comment: Although the senior lender ultimately prevailed, the drafting of the intercreditor agreement could have been better. Apparently, under the terms of the agreement, the junior creditors were still entitled to file a proof of claim. It would have been preferable if they had been handcuffed under a “standstill” provision, barred from filing anything unless and until the senior creditor had been paid in full, including interest, fees, and costs.
The agreement also could have stated expressly that it involved not only lien subordination but also debt subordination and payment subordination. Although those provisions sound similar, they are not the same.
Finally, although the junior creditors expressly acknowledged the existence and priority of the senior liens, the agreement also could have included a severe “gag clause,” prohibiting the junior creditors from even contesting the validity or priority of the senior liens.
For discussions of cases dealing with related issues, see:
- 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. 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.
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.