Due to the complexity of multi-tranche financing in today's lending transactions, inter-creditor subordination agreements, which provide for priority in debt and/or collateral, are common. Indeed, a commercial debtor with a single lender is more the exception than the rule. Congress has recognized this fact by enacting 11 U.S.C. §510(a), which recognizes subordination agreements and gives due deference thereto.

Certain subordination agreements, however, seek to control more than the priority of debt and/or collateral. In fact, a recent trend has seen the use of subordination agreements to control voting rights in connection with a chapter 11 reorganization plan. Such agreements may seem innocuous upon execution, but when a proposed plan unfairly impairs the rights of the subordinated creditor in favor of the senior creditor, such agreements can be very detrimental and seemingly contradictory to the Bankruptcy Code.

In fact, certain courts have held that subordination agreements that transfer voting rights impermissibly violate the Bankruptcy Code and, therefore, are not enforceable. This recent trend is important due to implications often not foreseen at execution, not to mention the voting of claims of a fragmented bank group.

Subordination Agreements

Pursuant to §510(a), "a subordination agreement is enforceable in a case under this title to the same extent that such an agreement is enforceable under applicable non-bankruptcy law." Based on the express language of §510(a), courts have generally held that a subordination agreement affecting a subordinated creditor's voting rights is fully enforceable in bankruptcy, thereby allowing the senior creditor to vote the subordinated creditor's vote. See In re Curtis Center Limited Partnership, 192 B.R. 648, 658-59 (Bankr. E.D. Pa. 1996); In re Inter Urban Broadcasting of Cincinnati Inc., 1994 WL 646176, at *2 (E.D. La. Nov. 16, 1994).

In both Curtis Center and Inter Urban, however, the debtor/plan proponent raised the objection to the senior creditor voting the subordinated creditor's claim. In fact, in neither Curtis Center or Inter Urban did the subordinated creditor object, thereby fully acquiescing to the senior creditor. Based partially on the lack of such an objection, both cases were summarily decided without considering the underlying policy of voting under the Bankruptcy Code.

Recently, however, the bankruptcy court for the Northern District of Illinois considered this very argument and held that a senior creditor is not entitled to vote a subordinated claim, despite provisions in the agreement that allow the senior creditor to do so. In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000).

203 North LaSalle's Holding

In 203 North LaSalle, the intercreditor subordination agreement provided that the senior creditor could "vote or consent in any [chapter 11] proceedings with respect to any and all claims relating to the junior indebtedness." Prior to confirmation, the senior creditor sought a declaratory judgment action seeking a declaration that it was entitled to vote the subordinated creditor's claim in the forthcoming confirmation proceeding.

In determining the propriety of the subordination of voting rights, the court examined the unambiguous language of the subordination agreement, along with §510(a)'s language, and opined that 11 U.S.C. §1126(a) governs the determination of voting rights.

Section 1126(a) states that the holder of a claim may vote to accept or reject a plan under chapter 11, which is not disregarded by a subordination agreement because pre-bankruptcy agreements do not override contrary provisions of the Bankruptcy Code. 203 North LaSalle, 246 B.R. at 331; citing Klingman v. Levinson, 831 F.2d 1292, 1296 n. 6 (7th Cir. 1987) (where the court refused to enforce a pre-bankruptcy provision controlling the dischargeability of certain debts). The court further reasoned that "since bankruptcy is designed to produce a system of reorganization and distribution different from what would [be] obtain[ed] under non-bankruptcy law, it would defeat the purpose of the Bankruptcy Code to allow parties to provide by contract that the provisions of the Bankruptcy Code should not apply." 203 North LaSalle, 246 B.R. at 331.

The court further stated that §510(a) does not allow for the waiver of voting rights because, inter alia, the definition of "subordination" is "the act or process by which a person's rights or claims are ranked below those of others." Id.; citing Nolan, Joseph R., and Nolan-Haley, Jacqueline M., Black's Law Dictionary 1426 (6th ed. 1990). The court reasoned, therefore, that subordination does not affect the transfer of voting rights, as the concepts are by definition exclusive. Id., citing Beatrice Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski Mfg. Co.), 5 B.R. 734, 736 (Bankr. D. Minn. 1980) (which stated, in dicta, that the Code guarantees each secured creditor certain rights, regardless of subordination including the right to participate in the voting for confirmation or rejection of any plan of reorganization).

The court found further support for its holding in Federal Rule of Bankruptcy Procedure 3018(c), which provides that an acceptance or rejection of a chapter 11 plan must be signed by the creditor or an authorized agent. 203 North LaSalle, 246 B.R. at 331. The court noted that an "agent" acts at the direction of a principal. 203 North LaSalle, 246 B.R. at 331-32; citing In re Brunswick Leasing Corp. v. Wisconsin Central Ltd., 136 F.3d 521, 526 (7th Cir. 1998) (where the court stated that the test of agency is the existence of the right to control the method or manner of accomplishing a task by the alleged agent). Since the senior creditor in 203 North LaSalle acted in its own interests, as opposed to the interests or at direction of the subordinated creditor, no agency relationship existed. 203 North LaSalle, 246 B.R. at 331-32. And, since no agency relationship existed, the senior creditor could not vote the subordinated creditor's claim. Id.

The court's decision not to enforce the transfer of the voting rights provisions of the subordination agreement was based largely on underlying policy and the express language of §1126(a) and rule 3018. Considering 203 North LaSalle's agency holding, it may find future application to a fragmented bank group (i.e., where domestic banks, foreign banks and private investment funds, all of whom answer to different regulatory authority, are participants). Although bank groups typically execute an agency agreement, the agent of a fragmented bank group is not always acting in the best interests, or at the direction of the entire bank group. Indeed, most bank group agency agreements provide for a majority vote, not a unanimous vote.

When an agent in such a situation votes the claims of its constituents, a dissenting participant may very well object based on §1126(a), Rule 3018, and 203 North LaSalle's reasoning. After all, the dissenting participant has a claim against the debtor, and the agent is no longer acting at its direction. Such a holding could cause great disruption when bank groups are involved in a bankruptcy because of the potential for additional litigation arising from such issues, not to mention a potential confirmation objection based on the gerrymandering of diverse bank group interests into one or more classes.

Conclusion

Prior to the execution of future subordination agreements, the senior creditor should consider revamping its provisions regarding voting rights so that an agency relationship is created, as opposed to the mere transfer of a voting right. While such language may be interpreted as a transparent attempt around 203 North LaSalle, it may create enough differences to allow the senior creditor the ability to vote on the subordinated claim.