Assignment of Voting Rights in Intercreditor Agreements

ASSIGNMENT OF VOTING RIGHTS IN INTERCREDITOR AGREEMENTS

Gregory E. Spitzer[1]

Paul, Hastings, Janofsky & Walker LLP
191 North Wacker Drive
30th Floor
Chicago, Illinois 60606
Ph.: 312.499.6000
Fax: 312.499.6100

I.Introduction

Intercreditor agreements are normally enforced, pursuant to section 510 of the Bankruptcy Code,[2] insofar as they address payment and priority of payment. The enforceability of other types of provisions, however, is less clear.Clauseswaiving or transferring various rights of a junior creditor—to file a proof of claim, to receive adequate protection, or to vote on a plan of reorganization—have met with varying responses from the bankruptcy courts. At the same time, written decisions that touch on intercreditor agreements are less than plentiful, because differences between parties must be settled quickly in the fast-moving bankruptcy process.[3]All of this leaves substantial uncertainty concerning even very common terms in intercreditor agreements.

The assignment of voting rights is one of the issues that courts and commentators continue to disagree over. Whether a provision in a subordination agreement transferring the junior creditor’s voting rights to the senior creditor should be enforced is a question yet to be fully resolved.In an effort to sort out some of the confusion, this paper examines the status of the law on assignability of voting rights, and suggests several possibilities for practitioners looking to ensure enforceability of such provisions.

II.Competing Views on Enforceability

A.Early Cases

One of the earliest decisions on assignability of voting rights wasIn re Itemlab, Inc.,[4] a case decided under the former Bankruptcy Act.Itemlab arose out of an intercreditor agreement between Dutch-American Mercantile Corp. (“Dutch-American”)and Blanmill Realty Corp. (the “Junior Lender”) in connection with loans to the debtor.[5] The agreement contained general provisions subordinatingthe Junior Lender’s claim to that ofDutch-American, butwas“silent as to voting of claims.”[6]Nevertheless, whenthe debtorentered bankruptcy and Dutch-American and the Junior Lender disagreed over a proposed plan of arrangement, the court found that as a “complete subordination agreement” the parties’ agreementgave Dutch-American “complete control over the claim,” including the right to vote.[7]The Itemlab decision thus held that voting rights transfers not only could be enforced, but could even be inferred where an intercreditor agreement did not explicitly address the issue at all. Indeed, in the view of many commentators, it remains “the most far-reaching decision giving a senior creditor the right to vote the claim of a subordinated creditor.”[8]

The first decisions on voting rights following the enactment of the Bankruptcy Code in 1978did not go quite so far as Itemlab, but maintained the general proposition that a voting rights transfer provision in an intercreditor agreement would be enforced. In In re Davis Broadcasting, Inc., a junior lender moved to reopen a chapter 11 case to “correct an error” in the order confirming the plan of reorganization.[9] The plan had been pushed through by the senior lender, relying on the terms of a subordination agreement allowing it to vote both its own and the junior lender’s claims.[10]The junior lender voiced no objection at the time of confirmation, but eight months later filed its motion to modify the plan confirmation order.[11] The court refused, observing that the junior lender “freely entered into the Subordination Agreement that put it into this situation,”and “is now ingeniously attempting to find a new way to appeal the confirmation order.”[12]

Echoing the same sentiment, the court in In re Curtis Center Ltd. Partnership held that a junior creditor that willingly contracted away its voting rights must be held to its bargain.[13]“The language of the subordination agreement is plain and unambiguous,” the court explained, and “the terms of this prepetition agreement are fully enforceable in this Bankruptcy case pursuant to [section 510 of the Bankruptcy Code].”[14]

An alternative rationale for enforcement was articulated in In re Inter Urban Broadcasting of Cincinnati, Inc.[15] In that case, the debtor had borrowed funds from both Barclays Business Credit, Inc. (“Barclays”) and Firstmark Credit Corp. (the “Junior Lender”).[16] In connection with the loans, all three parties executed a subordination agreement giving Barclays the right to vote the Junior Lender’s claim.[17] After the debtor entered chapter 11, Barclays filed a plan of reorganization and voted both its own and the Junior Lender’s claim to accept the plan.[18] The debtor moved to disqualify Barclays’ votes, and the bankruptcy court denied the motion.[19]On appeal, the district court upheld the decision. The courtexplained that under the intercreditor agreement, the Junior Lender “held no claim or interest and could not do so unless and until Barclays was paid in full.”[20] Because Barclays had a superior interest in the Junior Lender’s claim, Barclays could be considered the holder of the claim for voting purposes:“Barclays’ vote of [the Junior Lender’s] claim was proper and in accord with the law.”[21]

Thus, nearly all of the early case authority supports enforceability of voting rights transfer provisions. At least one decision, however, came out the other way. The case In reHart Ski Mfg. Co.asserted (albeit in dicta) that “[t]he Bankruptcy Code guarantees each secured creditor certain rights, regardless of subordination . . . includ[ing] the right to participate in the voting for confirmation or rejection of any plan of reorganization.”[22]In this court’s view, a junior creditor could not waive or transfer its right to vote on a plan, even by express agreement.

B.The 203 North LaSalle Decision

Theenforceability of voting rightstransfer provisionswas dramatically challenged by the2000 caseIn re 203 North LaSalle Street Partnership.[23] The203 North LaSallecase had a considerable impact on the academic discussion of voting rights assignability, and, as at least one commentator has suggested, may also have affected practitioners’ approach to the issue.[24]Because it called into question what had seemed to be more or less settled law surrounding voting rights transfers, 203 North LaSallecaptured the interest—and also some ire—of those in the field.

At issue in 203 North LaSalle was an intercreditor agreement between Bank of America (the “Bank”), which held a $93 million first mortgage on a commercial property in downtown Chicago, and North LaSalle Street LP (the “Junior Lender”), general partner of the debtor and also a secured creditor.[25]In a“Consent and Subordination Agreement,” the Junior Lenderagreed not only to subordinate its debt to the Bank’s, but also to let the Bank vote the Junior Lender’s claim in any bankruptcy reorganization.[26]The agreement provided:

[The Junior Lender] hereby irrevocably agrees that the Bank may, at its sole discretion, in the name of [the Junior Lender] or otherwise, demand, sue for, collect, receive and receipt for any and all . . . payments or distributions and file, prove, and vote or consent in any . . . proceedings with respect to, any and all claims of [the Junior Lender] relating to the Junior Liabilities.[27]

After the debtor filed for bankruptcy, the Bank and the debtor proposed competing plans for reorganization. To have its plan confirmed, the Bank needed both its own and the Junior Lender’s votes, and filed an adversary complaint against the Junior Lenderseeking a declaration of its rights under the intercreditor agreement.

The court in 203 North LaSalle found that “[w]hile the language of the subordination agreements governs the outcome of the Bank’s right to repayment . . . the language of the Bankruptcy Code governs the determination of voting rights in this case.”[28]Because section 1126(a) of the Code provides that “[t]he holder of a claim”[29]—and only the holder of a claim, in the court’s reading—may vote on a plan of reorganization, a junior creditor could not waive or transfer its right to vote.[30] Moreover, while Bankruptcy Rule 3018(c) allows for voting of a claim by a creditor’s “agent,” the Bank could not fairly be characterized as the agent of the Junior Lender when it was acting in its own interests, contrary to those of the Junior Lender.[31]Thus, the court concluded, the voting rights transfer provision was unenforceable, and the Junior Lender was entitled to vote its own claim despite the clear language of the intercreditor agreement to the contrary.

C.Return to Enforcement:Aerosol Packaging

203 North LaSallecast into doubt even the most basic points regarding assignability of voting rights. While speculation was rampant, the following years saw no judicial decisions that put the issue to the test, and the 2005 revision of the Bankruptcy Code did not address the subject. Finally, in late 2006, the Bankruptcy Court for the Northern District of Georgia decided In re Aerosol Packaging, LLC,[32]the first post-LaSalle case to address a voting rights transfer provision.

The Aerosol Packaging case arose out of a subordination agreement executed between Wachovia Bank (“Wachovia”) and Blue Ridge Investors (the “Junior Lender”), a small business investment fund.[33] In connection with the refinancing of Wachovia’s loan to the debtor, the Junior Lender assigned its voting rights to Wachovia:

[T]he Lender is hereby irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor or otherwise), but shall have no obligation, to demand, sue for, collect and receive every payment or distribution referred to in subsection (a) above and give acquittance therefor and to file claims and proofs of claim and take such other action (including without limitation voting the Subordinated Debt or enforcing any security interest or other lien securing payment of the Subordinated Debt) as it may deem necessary or advisable for the exercise or enforcement of any of the rights or interests of the Lender hereunder.[34]

Subsequently, the debtor entered chapter 11, and both Wachovia and the Junior Lender filed ballots to vote the Junior Lender’s claim.[35]Deciding which ballot was valid required the court to rule on the enforceability of the voting rights transfer provision.

On these facts, the court inAerosol Packaging reached a decisionprecisely opposite to that of the 203 North LaSalle case. Indeed, the decision directly attacked the reasoning of 203 North LaSalle, point by point, concluding that courts have not only the power but the obligation to enforce voting rights assignment provisions.

TheAerosol Packaging court began by observing that, while Bankruptcy Code section 1126 grants to “[t]he holder of a claim” a right to vote on restructuring plans, it “says nothing about whether such right may be delegatedor bargained away.”[36]Further, the court continued, Bankruptcy Rule 3018(c) expressly allows for voting of a claim by a creditor’s “agent.”In this regard, the court rejected the argument, suggested in 203 North LaSalle, that to establish an agency relationship requires an alignment of interest between the senior and junior creditors:

In this case, Wachovia is acting as a duly authorized agent of [the Junior Lender], similar to the actions of a real estate lender acting as the agent for the borrower in executing a deed under power of sale . . . to convey title to foreclosed property (i.e., as an agent having a power coupled with an interest). In both instances, the agent acts in its own interests, and not in those of the purported principal.[37]

Thus, theAerosol Packagingopinion concluded, the terms of the subordination agreement, together with applicable sections of the Bankruptcy Code, “compel the conclusion that the right to vote any claim of [the Junior Lender] in Debtor’s bankruptcy proceeding was assigned by [the Junior Lender] to Wachovia.”[38]In the view of the Aerosol Packaging court, the law not only empowered but required it to enforce the voting rights transfer provision as written.

III.Ensuring Enforceability

As the preceding discussion suggests, the law surrounding assignment of voting rights in intercreditor agreements remains unsettled. While most courts faced with the issue have enforced assignment provisions, the 203 North LaSalle decision is enough to cast doubt on any assertion of certainty. Of course, in spite of this state of affairs, or rather because of it, practitioners will wish to take all possible precautions to ensure that the agreements they craft will be enforced as intended. Beyond careful drafting of the basic voting rights transfer language, additional considerations in structuring the agreement may add a measure of security.The following sections examineseveralof these possibilities (and attendant pitfalls) for ensuring that voting rights transfer provisions stand up to judicial scrutiny.

A.Establishing an Agency Relationship

Following the Aerosol Packaging rationale, one possibility for ensuring enforceability of a voting rights transfer may be found in Bankruptcy Rule 3018(c), which provides that a vote on a reorganization plan may be signed by “the creditor or equity security holder or an authorized agent.”[39]This Rule suggests that explicit language designating the senior lender as the agent of the junior lender would require that a voting rights transfer be enforced. Especially in light of the Aerosol Packaging court’s finding that the agency rationale does not require the senior creditor to share or vote in the junior creditor’s interests, Rule 3018(c) provides strong support for this approach. Several commentators have warned, however, that such an approach may be seen as a transparent attempt to avoid203 North LaSalle.[40]

In an effort to resolve this difficulty, it has beensuggested that “a different result [may be] warranted when a direct agency relationship is established by contract rather than seeking a determination by the court that an agency relationship is created based on conduct.”[41]An explicit agency clause in the intercreditor agreement could therefore helpin determining enforceability. This measure may not be necessary—theAerosol Packagingopinion mentions no explicit grant of agency—butit certainly seems advisable. It is difficult to see what a party seeking enforcement would have to lose by including such a provision, and it might well persuade an otherwise unconvinced court to enforce a voting rights transfer provision.

B.Rendering Agency Irrevocable

To even further reinforce the agency rationale for a voting rights transfer, practitioners may also wish to consider a second, complementary approach. This strategy, too,seems to have been anticipated by the Aerosol Packaging court, with its suggestion that in voting the Junior Lender’s claim Wachovia was acting as “an agent having a power coupled with an interest.”[42]An “agency coupled with an interest,” or one given for consideration, is generally irrevocable, and therefore stands a greater chance of holding up in the event of a subsequent dispute.

Under the basic law of agency, a principal ordinarilymay revoke a grant of agency at any time.[43] However, where the agent’s authority is coupled with an interest in the subject matter of the agency, or given for consideration, the principal retains no power to terminate the agency relationship at will.[44]In the intercreditor context, then, an irrevocable agency with respect to voting of claims could theoretically be established in two ways:(i) by having the junior lender grant the senior lender an interest in the junior lender’s claim; or (ii) by having the senior lender pay or give consideration to the junior lender for the authority to act as the junior lender’s agent for voting purposes.

In practice, the first concept is difficult to work out (with none of the cases or commentary suggesting what an attempt might look like). The second possibility, however, appears more promising. One approach, for instance, would be for the senior lender to simply make payment to the junior lender for the authority to act as the junior lender’s agent. This approach, although simple to implement, may lack substance and thus not be effective. Alternatively, consideration might be found in the structure of the agreement itself.Becausea prudent senior lender would be unwilling to enter into a loan transaction without intercreditor concessions from the junior lender,the senior lender’s loan to the debtor could itself be framed as consideration.Accordingly, including a recital of consideration in the junior lender’s grant of agency could make the grant irrevocable; an irrevocable agency relationship, in turn, promises a strong basis for argument should the senior lender be forced to defend a rights transfer in court. Indeed, when coupled with an express declaration that the senior lender, as agent, may act in any manner consistent or inconsistent with the interests of the junior lender, it provides a solid rationale for enforcement.

However, a word of caution is in order here as well. In some states—notably California—the simple payment of consideration may not suffice to render an agency relationship irrevocable.[45]Indeed, even an express declaration that consideration has been paid with the intent of making a grant irrevocable may not be enough.[46]In such circumstances, there appears to be little recoursefor a senior lender seeking to render its agency power irrevocable. While it will not hurt to try, prudence counsels against relying on the use of an irrevocable agency rationale as a panacea.

C.Model Language

The preceding sections have laid out several conceptual approaches to ensure enforceability of voting rights transfer provisions.It remains to be considered, however, what specific language can be used to effect these approaches in practice. To that end, the following paragraphs lay out model language that may be usefulfor practitioners aiming to implement some or all of the suggestions discussed above.

For a simple grant of agency to a senior creditor, the following form language provides a helpful starting point:

The Bank and each of its officers are hereby irrevocably authorized (but not required), as the undersigneds’ agent and attorney, to file for, make claim on, collect, receive, and receipt for, and exercise all votes and consents with respect to, any and all Junior Indebtedness in any . . . insolvency proceeding or liquidation.[47]

A more complex provision, incorporating the concept of an agency coupled with an interest, might read as follows:

To induce the Senior Lender to enter into the refinancing of Debtor’s loans, [and upon payment of ____ dollars ($___)][48] and for other good and valuable consideration the receipt and sufficiency of which is hereby acknowledged, including but not limited to the Senior Lender’s agreement to make the Senior Loans to Debtorthat the Senior Lender would not enter into without the following agency appointment, the Junior Lender hereby irrevocably authorizesand appoints the Senior Lender, as its agent and attorney in fact, to file for, make claim on, collect, receive, and receipt for, and exercise all votes and consents with respect to, any and all Junior Indebtedness in any bankruptcy, winding up, liquidation, or other similar proceeding relating to Debtor or its creditors, with any such duties to be undertaken at the option and discretion of the Senior Lender. The Senior Lender shall actas an agent having a power coupled with an interest, which power is hereby made irrevocable by the exchange of consideration previously recited. The Junior Lender agrees and acknowledges that in this capacity, the Senior Lender may exercise all votes and consents of the Junior Lender in any manner, whether consistent or inconsistent with the interests of the Junior Lender, and without guidance from the Junior Lender.