Once upon a time, under the Bankruptcy Act of 1898, subordination agreements entered into outside bankruptcy were generally enforced by bankruptcy courts, but the issue was left to the discretion of the courts to be determined on a case-by-case basis. Since 1979, when the current Bankruptcy Code came into effect, however, the treatment of subordination agreements in bankruptcy has been governed by statute: "A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." 11 U.S.C. § 510(a).
Since a bankruptcy court is supposed to enforce a subordination agreement that is enforceable under applicable nonbankruptcy law, section 510(a) closes the door on the exercise of case-by-case discretion by bankruptcy courts, but the statute nevertheless opens up a series of other issues that the courts have been grappling with for over 35 years now. What constitutes a "subordination agreement"? Must a bankruptcy court enforce all the provisions of a "subordination agreement"? What about rights of the parties that are not spelled out in the agreement (including rights that are derived from equitable principles) or that are dealt with in the agreement in ambiguous terms? How are the answers to such questions affected by section 510(a)'s mandate that "subordination agreements" should be enforced in bankruptcy cases?
The Bankruptcy Code does not define either the term "subordination" or "subordination agreement," but it is generally accepted that there are two types of subordination and subordination agreements: debt subordination and lien subordination.1
In a debt subordination agreement, creditors of a common debtor agree between themselves that the debts of the common debtor to one of the creditors will be "subordinated" to the debtor's obligations to the other creditor. This is generally understood to mean that any payments from the common debtor to one of the contracting creditors are to be applied to "subordinated" debt only after the "senior" debt is paid in full.
Some subordination agreements include the debtor as a party,2 and, in those agreements, the parties commonly agree that the debtor is not to make, and the subordinated creditor is not to receive, any payments until the senior is paid in full; if somehow, despite this, the subordinated creditor receives any payments, per the agreement among the debtor and the creditors, those payments are deemed to have been made on account of the senior debt and the subordinated creditor is required to hold them "in trust" for the senior.
Sometimes, however, the debtor is not a party to the subordination agreement, and the agreement merely constitutes an arrangement between the two creditors. In those cases, getting payments into the hands of the "senior" creditor may involve a little more complexity since the creditors can't themselves agree that a payment by the debtor to one creditor actually constitutes a payment by the debtor to the other. Where the debtor is not a party, payments to the subordinated creditor generally must be credited to the subordinated debt—the creditors don't have the right to redirect the payment from one to the other without the debtor's consent, but, under the subordination agreement, the subordinated creditor has agreed to turn the payments over to the senior creditor until the senior has received, from the debtor and the subordinated creditor, the full amount of the senior obligations.3 In this situation, to the extent that the senior debt is paid out of amounts turned over by the subordinated creditor, the debtor has not discharged its obligations to the senior. The subordinated creditor is, therefore, "subrogated" (see discussion below) to the remaining rights of the senior to receive payments from the debtor and, after the senior has received the full amount it is sue, the subordinated creditor the amounts it has turned over to the senior by receiving all payments from the debtor on account of the amount of the senior debt the debtor did not pay itself.
So, for example, say the debtor D owes $100 to senior Creditor A and $50 to subordinated Creditor B. D pays $50 to A and $50 to B. If there is a three-party subordination agreement, the payment to B will be deemed, in accordance with the agreement, a payment to A. B will be deemed to have received the payment "in trust" for A so that A will have received $100 from D, and B will still be owed $50. If, however, A and B entered into a subordination agreement to which D is not a party, then B will have been paid $50 but will be required, by the bi-lateral subordination agreement, to turn that $50 over to A. A will then have received $100 but only $50 of it directly from D. D will, therefore, still owe $50 to A. When and if D pays the $50 outstanding on its debt to A, B will recover the $50 it turned over to A by being "subrogated" to A's rights to receive the remaining $50 from the debtor.
A Note on Subrogation
In the second example above, the subordinated creditor was said to be "subrogated" to the rights of the senior. Subrogation4 developed as an equitable doctrine to prevent unjust enrichment when one person satisfies the obligations of another. Subrogation allows the person who pays the debt of another to stand in the shoes of the recipient creditor—subrogation has sometimes been described as the equivalent of substitution—and to enforce the rights the creditor has against the debtor. To prevent unjust enrichment, the principle of equitable subrogation applies automatically, whether or not it is provided for in a contract; however, because the doctrine of equitable subrogation places restrictions on the rights of subrogation and because courts have discretion in determining how (and even whether) the doctrine of equitable subordination is applied, contracting parties, such as the parties to a subordination agreement, frequently choose not to rely solely upon their equitable rights and instead to spell out the terms of the subrogation arrangement as a contractual remedy.5
It is worth noting that, where there is a court involved—for example, where the common debtor is the subject of bankruptcy proceedings, even when the subordination agreement is bilateral, if the senior creditor can get the court to enforce the subordination agreement, the senior will be able to obviate the risks inherent in allowing payments to go to the subordinated creditor, who will then have to turn them over to the senior creditor and seek to recover by way of subrogation.
Lien subordination agreements are similar to debt subordination agreements except that, instead of subordinating debt to debt, lien subordination agreements, as the name suggests, involve the subordination of lien to lien.6 A true lien subordination agreement would involve the contractual subordination of an otherwise senior lien to one that would otherwise be junior in priority or, potentially, of a lien to another lien of equal priority. For example, the holder of a first priority security interest could agree to contractually subordinate its lien to that of the holder of a junior security interest. As against third parties, the first would still be first, but, between the parties, it would be agreed that the proceeds of collateral, when distributed, would go first to the junior lienor. Arguably, since the proceeds would go to satisfy the debt secured by the contractually senior lien before the proceeds are applied to the debt secured by the contractually junior lien (liens don't have amounts; they secure amounts), a true lien subordination agreement is really just a special kind of debt subordination agreement.
What are often called lien subordination agreements are really just inter-creditor agreements that involve neither debt nor lien subordination but involve primarily restrictions on the exercise of contractual and statutory remedies of a legally junior lienholder for the benefit of the legally senior lienholder. In these inter-creditor agreements, such restrictions are the heart of the agreement. In true subordination agreements, the subordination of debt to debt or lien to lien is the heart of the agreement, and restrictions on the rights of the junior creditor are commonly described as "ancillary remedies."
Ancillary Contractual Remedies
Such "ancillary remedies" commonly include one or another variation of the following:
- Acknowledgment by the subordinated creditor of the validity, enforceability, perfection and priority of the senior's debt and lien and agreement not to contest or challenge the senior's debt or lien.
- Agreement by the subordinated creditor not to extend further credit to, or make equity investments in, the debtor without the consent of the senior creditor.
- Agreement by the subordinated creditor that it will not exercise any default remedies without the consent of the senior creditor or during a contractually defined standstill period.
- Agreement by the subordinated creditor not to file or support the filing of an involuntary bankruptcy petition, or commencement of any similar proceeding, against the debtor.
- Waiver by the subordinated creditor of any "marshaling rights" (that is, any rights to require the senior to proceed first against collateral in which the junior does not have an interest before proceeding against common collateral).
- Agreement by the subordinated creditor that in any bankruptcy case or similar proceeding involving the debtor the subordinated creditor will:
- Permit the senior creditor to file or amend proofs of claim on behalf of the subordinated creditor.
- Not seek relief from the automatic stay without the consent of the senior creditor.
- Not seek "adequate protection" without the consent of the senior creditor.
- Not oppose any authorization for use of collateral, including cash collateral, approved by the senior creditor.
- Not oppose any sale of collateral approved by the senior creditor.
- Not oppose any post-petition financing offered by the senior creditor to the bankruptcy estate and not offer to provide such financing itself, whether or not the senior agrees to provide it.
- Not seek or support the appointment of a trustee or examiner without the consent of the senior creditor or vote for any trustee candidate not supported by the senior.
- Not seek to have a chapter 11 case dismissed or converted to chapter 7 without the consent of the senior creditor.
- Not exercise the so-called "1111(b) election" (that is, the election, under section 111(b) of the Bankruptcy Code, to have non-recourse debt treated as recourse), without the consent of the senior.
- Not vote for, or support the confirmation of, any plan that is rejected by, or the confirmation of which is not supported by the senior (or, alternatively, allow the senior creditor to cast the vote of the subordinated creditor).
- Not vote to reject, or oppose the confirmation of, any plan the confirmation of which is supported by the senior (or, alternatively, allow the senior creditor to cast the vote of the subordinated creditor).
The list above is not exhaustive, but it is illustrative of the type of restrictions that can be put on the junior creditor (and sometimes on the senior creditor) in a subordination agreement. Many of the provisions, for logical reasons—subordination agreements are, arguably, tested most strenuously when the creditors' common debtor is insolvent—deal with what the creditors can and cannot do in a bankruptcy case.
Even if the parties have agreed on such protocols, and even though section 510(a) of the Bankruptcy Code generally mandates the enforcement of subordination agreements, bankruptcy courts are not entirely consistent in ruling on the enforceability of such "ancillary" remedies built into a subordination agreement. Some courts have enforced subordination agreements in their entirety.7 Some have been strict in their interpretation of such agreements and refused to enforce those they deem ambiguous or unclear.8; a few have taken an arguably even stricter view that only the actual subordination provisions of a "subordination agreement" should be enforced and that ancillary rights and remedies built into such an agreement do not fall within the mandate of section 510(a).9
Other Bankruptcy-specific Issues
As should appear from the discussion above, many of the issues involving subordination agreements arise or, at least, take on a special urgency, in the bankruptcy context. Two such issues, in particular, have generated considerable comment and litigation.
The first of these issues involves the right of a senior creditor to collect post-petition interest from amounts that would otherwise go to the subordinated creditor. This issue arises from the fact that, under section 506(b) of the Bankruptcy Code, an "allowed secured claim" includes interest and "reasonable fee, costs or charges" to the extent that that value of the collateral, after any permitted surcharge by the bankruptcy estate, exceeds the otherwise allowed amount of the claim. If, however, the creditor is unsecured or undersecured, then, under section 502(b)(2) of the Bankruptcy Code, the allowed amount of the creditor's claim may not include post-petition interest. The question then arises: if the creditor cannot recover post-petition interest as part of its "allowed claim" from the bankruptcy estate, may the creditor still recover that interest, pursuant to a subordination agreement, from bankruptcy distributions that would otherwise go to the subordinated creditor?
As on so many bankruptcy issues, the courts are not in agreement on the answer to that question. Some courts adhere to a principle that predates the enactment of the Bankruptcy Code—the so-called "Rule of Explicitness," pursuant to which a senior creditor is allowed to recover post-petition interest from a subordinated creditor only if the subordination agreement is absolutely explicit in mandating that result.10 Others have taken the position that, as a matter of Federal common law, the Rule of Explicitness did not survive the enactment of the Bankruptcy Code, but this leaves the matter to be resolved under applicable non-bankruptcy (usually state) law.11 Some states, notably New York, however, continue to employ the Rule of Explicitness as a matter of contract interpretation,12 while others do not.13 Accordingly, not only must the parties be clear about their intentions in the subordination agreement, but they must also consider carefully the selection of a choice of governing state law.
Another bankruptcy-specific about which there has been much comment and some litigation involves the right of the subordinated creditor to receive and retain notes or stock or other so-called "reorganization securities" under a chapter 11 plan. Say, for example, that, under a plan, the reorganized debtor issues notes to both the senior creditors and the junior creditors, but the notes issued to the junior creditors are clearly made subordinate to the notes to the senior creditors. Or suppose that a plan provides to pay the senior creditors in full over time but the subordinated credited creditors are to receive stock in the reorganized debtor in satisfaction of their claims. Do the "turnover" and related provisions of a subordination agreement require the junior creditors to deliver the "reorganization securities" (the subordinated notes in the first scenario or the stock in the second) to the senior creditors if the seniors have not been paid in full?
To address these questions, many indentures and intercreditor agreements contain what has been called an "X-clause," which is a provision that "allows the subordinated note holder to retain its securities only if the securities given to the senior note holder have higher priority to future distributions and dividends (up to the full amount of the senior notes)."14 Although the X-clause is generally viewed as a "carve-out" or exception to subordination that permits subordinated creditors to retain a reorganization security where the chapter 11 plan provides for the senior creditors to be paid in full, albeit over time, drafting an X-clause that actually accomplishes that result has sometimes proved to be an elusive goal for subordinated creditors. 15
Accordingly, the cases involving interpretation of an X-clause, like those involving the Rule of Explicitness, illustrate a principle that applies to the enforcement of subordination agreements in general and quite specifically to the enforcement of subordination agreements in bankruptcy: it never hurts for the agreement to spell out clearly exactly what the parties intended.
1 Koback v. National City Bank (In re Koback), 280 B.R. 164 (Bankr. S.D. Ohio 2002).
2 The Sumitomo Trust and Banking Co., Ltd. v. Holly's, Inc., 160 B.R. 643, 667-668 (Bankr. W.D. Mich. 1992).
3 Id. at 668.
4 Calligar, "Subordination Agreements," 70 Yale L.J. 376, 400 (1961).
5 Quinn, "Subrogation, Restitution and Indemnity," 74 Tex. L. Rev. 1361, 1388-90 (1996).
6 See, generally, "Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force," 65 Bus. Law 809 (2010).
7 See, e.g. In re Erickson Retirement Communities LLC, 425 B.R. 309, 316 (Bankr. N.D. Tex. 2010) (subordinated creditors had no standing to move for appointment of a receiver because they were "sophisticated commercial entities who knowingly waived all legal and statutory rights that would be in conflict with their obligation to 'standstill'" under subordination agreement).
8 See, e.g., In re Boston Generating LLC, 440 B.R. 302, 319 (Bankr. S.D.N.Y. 2010) (subordinated creditors permitted to object to sale of all bankruptcy estate assets because subordination agreement was "poorly drafted" and not "clear beyond peradventure" regarding waiver of rights).
9 See, e.g., Beatrice Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski Mfg. Co., 5 B.R. 734 (Bankr. D. Minn. 1989) rights and remedies that do not deal strictly with "contractual priority of payment" do not have to enforced, even if they are embodied in a subordination agreement).
10 In re Kingsboro Mortgage Corp., 514 F.2d 400 (2d Cir. 1975); In re Ionosphere Clubs, Inc., 134 Br. 528 (Bankr. S.D.N.Y. 1991).
11 Chemical Bank v. First Trust of New York, N.A. (In re Southeast Banking Corp.), 179 F.3d 1307 (11th Cir. 1999).
12 In re Boston Generating, LLC, 400 B.R. 302 (Bankr. S.D.N.Y. 2010).
13 See, e.g., In re Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex. 2010).
14 Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005).
15 Id. See, also, In re Envirodyne Industries, Inc., 29 F.3d 301 (7th Cir. 1994); In re PWS Holding Corp., 228 F.3d 224 (3d Cir. 2000); Durak v. Dura Automotive Systems, Inc. (In re Dura Automotive Systems, Inc.), 379 B.R. 257 (Bankr. D.Del. 2007).
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