Restructuring

Contributed by David G. Litvack
Much to the delight of junior creditors everywhere, the United States Bankruptcy Court for the District of Massachusetts recently held that, while subordination agreements are generally enforceable in bankruptcy, the assignment of voting rights contained in a subordination agreement is unenforceable in a bankruptcy case.
In In re SW Boston Hotel Venture, LLC, the court considered whether to confirm the debtors’ plan of reorganization over the objection of a secured lender.  One of the issues it faced was determining the validity of two sets of ballots, both purportedly cast with respect to the same claim.  The first ballot came from a junior creditor who cast a ballot on its own behalf in favor of the debtors’ plan of reorganization, while the second ballot came from a senior creditor who cast a ballot against the plan of reorganization on behalf of the junior creditor.  The senior creditor asserted it was entitled to cast the ballot on behalf of the junior creditor based upon the provisions of an intercreditor and subordination agreement, which provided that the junior creditor would assign its voting rights to the senior creditor in any bankruptcy case.
Although subordination agreements are generally enforceable in bankruptcy proceedings pursuant to section 510(a) of the Bankruptcy Code, the bankruptcy court noted that to the extent a provision in a subordination agreement attempts to alter a substantive right under the Bankruptcy Code, such provision is invalid.  The court reasoned that a creditor cannot waive its right to vote with respect to a plan of reorganization because such a waiver would allow creditors to alter the substantive provisions of bankruptcy law – something Congress does not permit.  Thus, the court held that the right to vote on a plan of reorganization is a substantive right that cannot be waived.
Even though the court acknowledged the split in authority on whether the assignment of voting rights contained in a subordination agreement is enforceable in bankruptcy, it determined that the better interpretation is that the assignment of voting rights contradicts a substantive right provided by the Bankruptcy Code.  Specifically, section 1126(a) of the Bankruptcy Code provides that “the holder of a claim or interest allowed under section 502 of this title may accept or reject a plan . . . .”  As a result, the court agreed with the holdings of other bankruptcy courts in the Fourth, Seventh, and Eighth Circuits and disagreed with bankruptcy courts in the Third, Fifth, and Eleventh Circuits.
Other courts have given additional justifications as to why the assignment of voting rights in a subordination agreement is prohibited.  For instance, in Bank of America, N.A. v. North LaSalle Limited Partnership (In re 203 North LaSalle Street Partnership), the court found that Federal Bankruptcy Rule 3018(c) provides that an acceptance or rejection of a chapter 11 plan must be signed by “the creditor or equity security holder or an authorized agent.”  Consequently, the LaSalle court determined that a senior creditor was not the “authorized agent” of a junior creditor because the senior creditor was acting in its own interests and not at the direction of its principal – the quintessential test for agency.
Further, in Beatrice Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski Mfg. Co.), the court observed that “subordination” is commonly understood to relate to the order of priority of payment on claims, but not to the transfer of voting rights.  Specifically, the Hart Ski court stated,

The intent of § 510(a) . . . is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy proceedings.  There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.

Although the decision in the SW Boston case arguably further muddies the water as to whether the assignment of voting rights in a subordination agreement is enforceable in bankruptcy, it does, however, give junior creditors an incentive to challenge the deprivation of their voting rights going forward.  The decision also reinforces the idea that properly represented junior creditors in bankruptcy proceedings have many tools in their arsenal to gain a leg up on senior creditors and/or “torpedo” a thought-to-be consensual plan of reorganization.  Oddly enough, in the SW Boston case, the junior creditor actually supported the debtors’ plan, and the senior creditor rejected the plan.