In a March 2021 decision in the jointly administered bankruptcy cases of Fencepost Productions, Inc. and certain of its affiliates, Judge Dale L. Somers of the Bankruptcy Court for the District of Kansas declined to enforce a voting restriction in subordination agreements between two of the debtors' creditors, but nonetheless found that the deeply subordinated creditors were barred from voting on the debtors' plan because they lacked prudential standing.1 In declining to enforce the contractual voting restriction, the decision defies a trend toward enforcing subordination and intercreditor agreement terms - so long as they are specific and express - even if such terms may limit a party's statutory rights as a creditor in bankruptcy. Instead, Judge Somers applied a federal court jurisdictional doctrine, the relevance of which can only be determined on a case-by-case basis.
Fencepost Productions, a designer and distributor of outdoor clothing, and two of its affiliates filed for bankruptcy on December 18, 2019. Prior to the bankruptcy, a group of the debtors' unsecured creditors, referred to as the BMS Group, had executed subordination agreements in favor of the debtors' secured lender, Associated Bank, N.A., when Associated Bank agreed to lend the debtors $14 million. The subordination agreements expressly allowed Associated Bank, in any later insolvency proceeding of the debtors, to file a claim on behalf of the BMS Group and to vote such claim on their behalf. When the debtors solicited votes on their plan, Associated Bank - attempting to exercise its rights under the subordination agreements - voted the BMS Group's claim in favor of the plan. In apparent disregard of the subordination agreements, the BMS Group cast competing ballots rejecting the plan.
In deciding which vote to allow, Judge Somers first evaluated to what extent he should give effect to the general rule, under Section 510(a) of the Bankruptcy Code, that subordination agreements are enforceable in bankruptcy when enforcement of such agreements might contradict other provisions of the Bankruptcy Code.2 For example, Section 1126(a) of the Bankruptcy Code states that the "holder of a claim or interest" may vote to accept or reject a plan.3 In a 2000 case from the Northern District of Illinois, In re 203 North LaSalle Street Partnership, the bankruptcy court found that the "plain language" of Section 1126(a) meant that only the subordinated creditor could vote its claim, despite the creditor's agreement in a subordination agreement giving that right to the senior creditor.4 Judge Somers agreed with the 203 North LaSalle court's logic that subordination agreements can only be enforced to the extent that they dictate priority of payments among creditors, but should not be enforced to alter a creditor's rights under Bankruptcy Code provisions unrelated to the distribution of assets.5
This aspect of the decision puts the District of Kansas at odds with the generally prevailing recent trend of other courts which have enforced contractual voting restrictions in bankruptcy. In another recent decision interpreting an intercreditor agreement, for example, a Southern District of New York court distinguished between express, specific provisions in subordination agreements that bargain away bankruptcy rights (which can be enforced) versus broad, general provisions (which should be narrowly interpreted).6 In that case, the court declined to read a general contractual provision as one that prohibited voting, but suggested that it would enforce a specific contractual restriction (such as the one in Fencepost), stating: "The case law thus shows a clear fission in the treatment of contracts with explicit language and designed to prevent obstructionist behavior by junior lenders and contracts with broad language, directed at maintaining the hierarchy of lien priorities."7
In the Fencepost case, having declined to enforce the subordination agreements' voting clause, Judge Somers next turned to three standing doctrines that limit a party's right to seek relief in federal court (and for the court to hear the case) - prudential standing, statutory standing, and constitutional standing. Prudential standing is a judicial doctrine that acts as an exception to the rule that a federal court is obliged to hear a case that falls within its jurisdiction. As Judge Somers noted, the doctrine is "applied on an issue-by-issue basis," and notably, has recently been limited primarily to those cases where a plaintiff may be seeking to raise another person's legal rights.8 In applying the doctrine, Judge Somers accepted the uncontested assertion that the BMS Group would not receive payment under any scenario, including a chapter 7 liquidation, due to the subordination agreements' turnover provisions. Thus, if the BMS Group participated in plan confirmation proceedings, it would be "litigating the rights of third parties, not itself" - i.e., no matter what distributions it might otherwise be entitled to under the debtors' reorganization plan, the BMS Group would be required to turnover such distributions to Associated Bank under the subordination agreements. Because the BMS Group did not itself have a financial interest in the distributions under the plan of reorganization, prudential concerns prevented the BMS Group from "seek[ing] to disturb" such a plan that had been accepted by the debtors' other creditors, including Associated Bank. In the end, Judge Somers disallowed the subordinated creditor group's vote, but not on the basis of the subordination agreements.9
The Fencepost decision leaves murky the question of whether assignments of voting rights in intercreditor agreements will be enforced. It shows that even now, at least some bankruptcy courts may still find 203 North LaSalle to be convincing precedent despite the trend toward enforcing express voting restrictions in intercreditor agreements. And it leaves the door open (if courts decline to enforce voting rights restrictions) to "silent seconds" seeking to vote on plans where they do have an economic interest, which gives less comfort (or certainty) to lenders and their lawyers drafting intercreditor agreements today.
1. In re: Fencepost Prods., Inc. NPB Co., Inc. Old Dominion Apparel Corp. Debtors., No. 19-41542, 2021 WL 1259691 (Bankr. D. Kan. Mar. 31, 2021)
2. 11 U.S.C. § 510(a).
3. 11 U.S.C. § 1126(a).
4. In re 203 N. LaSalle St. P'ship, 246 B.R. 325 (Bankr. N.D. Ill. 2000).
5. See Fencepost, at *14 ("As examined above, subordination merely reorders priorities among creditors. Unlike the circumstances where a claim is assigned to an other [sic] party, subordination does not involve transfer of a subordinated creditor's legal interest.").
6. In re MPM Silicones, L.L.C., 596 B.R. 416 (S.D.N.Y. 2019).
7. Id. at 431.
8. See, generally, Lexmark Int'l, Inc. v. Static Control Components, Inc., 572 U.S. 118 (2014).
9. Judge Somers declined to rule on the BMS Group's constitutional standing, given his dispositive finding on prudential standing, but separately noted that the BMS Group did have statutory standing.
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