In a recent decision involving a Boston real estate developer, a federal bankruptcy court in Boston has held that a junior lender’s assignment of bankruptcy voting rights to a senior lender in an intercreditor agreement was unenforceable.
The decision could have a major impact on bankruptcy subordination agreements between lenders, in which junior lenders frequently assign their voting rights to senior lenders.
Lenders simultaneously extending credit to a borrower often enter intercreditor agreements among themselves, determining their relative rights to receive payments from the borrower and to exercise remedies upon default.
Such agreements are sometimes referred to as subordination agreements, because the junior lender subordinates its right to receive payments to the senior lender. The most rigorous subordination agreements prohibit junior lenders from receiving any payments whatsoever, until senior lenders are paid.
More lenient agreements allow junior lenders to receive regular payments, but not prepayments, as long as the borrower does not default with senior lenders. Subordination agreements typically require junior lenders to forbear from collection actions (including filing suit or foreclosure) while the senior debt remains unpaid.
Lenders seek to minimize their loss if the borrower files bankruptcy. A borrower seeking to reorganize under Chapter 11 must present a reorganization plan that addresses the borrower’s secured and unsecured creditors. The Bankruptcy Code allows creditors to vote to accept or reject the borrower’s plan, and the bankruptcy court will not confirm a plan without sufficient favorable votes from creditors whose claims will be impaired. A class of creditors may reject the borrower’s plan if it disadvantages that class. To prevent junior lenders from voting against the senior lenders’ interests, junior lenders are often required to assign their bankruptcy voting rights to the senior lenders.
Section 510(a) of the bankruptcy code validates subordination agreements, to the extent that they are enforceable under applicable non-bankruptcy law. However, judges in the separate federal bankruptcy courts interpret the bankruptcy code differently, and there is conflict among the various courts as to whether assignments of voting rights in intercreditor agreements are enforceable in bankruptcy reorganizations. Some courts have held such assignments unenforceable, and others have upheld them. In November, the Bankruptcy Court for the District of Massachusetts came down on the side holding that such assignments are unenforceable, in In re SW Boston Hotel Venture.
Assignment Of Voting Rights Invalid
The debtor real estate developer in that case proposed a reorganization plan addressing the claims of several classes of creditors. Among these creditors were an insurance company and the City of Boston, both of which held secured claims. The insurance company and the city had entered into an intercreditor agreement, where the city subordinated to the insurance company, and assigned its voting rights in bankruptcy to the insurance company. The insurance company voted to reject the plan, and also cast a ballot for the city rejecting the plan. In spite of the city’s assignment of its voting rights to the insurance company, the city cast its own vote accepting the plan.
The bankruptcy court held that the city’s assignment of voting rights to the insurance company was unenforceable, noting that Section 510 provides that subordination agreements are enforceable, but such agreements cannot nullify provisions of the Bankruptcy Code. In the court’s view, Section 1126(a) allows all creditors holding valid claims to vote on a debtor’s plan.
According to Bankruptcy Judge Joan N. Feeney: “To the extent a provision in a subordination agreement purports to alter substantive rights under the Bankruptcy Code, it is invalid.”
The judge cited a bankruptcy court decision from Illinois in 2000: Bank of America v. 203 North LaSalle St. Partnership. In that case, the court invalidated an assignment of voting rights in a subordination agreement, ruling that the assignment was inconsistent with voting rights granted under Section 1126(a). The court in Illinois also maintained that Section 510(a) only protected the order of priorities under subordination agreements, not assignments of voting rights.
The court in Massachusetts acknowledged an opposing opinion from a U.S. bankruptcy court in Georgia, which held that Section 1126(a) grants a creditor the right to vote, but does not prohibit delegation or assignment of that right.
The Massachusetts court, however, was not persuaded by the Georgia decision, and adopted the reasoning of the court in Illinois.
For now, unless an appellate court renders a contrary decision, the bankruptcy court in Massachusetts is unlikely to enforce a junior lender’s assignment of bankruptcy voting rights to a senior lender under an intercreditor agreement.
Christopher R. Vaccaro is an attorney in Stoneham, concentrating in banking and real estate law.
