Subrogation clause in an intercreditor agreement Nixon Peabody

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JUNE 1, 2011

Subrogation clause in an intercreditor agreement successfully
transferred the right to vote on a bankruptcy plan
By Mark N. Berman, Dennis J. Drebsky, and David H. Lee

In a recent opinion, In re Avondale Gateway Center Entitlement, LLC, 2011 U.S. Dist LEXIS 41450 (D.
Ariz. April 11, 2011), U.S. District Court for the District of Arizona (the “District Court”) affirmed a
bankruptcy court decision which held that a “subrogation” language contained in an intercreditor
agreement authorized the first lien lender to vote the second lien lender’s claim with respect to the
plan of reorganization of the chapter 11 debtor (the “Debtor”).

While other cases have addressed the enforceability of voting rights language in intercreditor
agreements—and reached conflicting decisions,1 Avondale is the first one addressing the enforceability
of a subrogation provision with respect to plan voting rights. Accordingly, Avondale may be of
interest to anyone drafting or negotiating an intercreditor or subordination agreement.

Factual background

Avondale Gateway Center Entitlement, LLC, the Debtor, borrowed $30.7 million from the National
Bank of Arizona secured by a senior lien on vacant land and $18 million from MMA Realty Capital,
LLC secured by a junior lien on the same land.

The two secured lenders entered into an intercreditor agreement (the “Intercreditor Agreement”)
which provided that the liens of the National Bank of Arizona would have priority over that of the
liens of MMA Realty Capital, LLC. The Intercreditor Agreement contained the following subrogation
language:

        Subrogation. [Second Lien Creditor] agrees that [First Lien Creditor] shall be subrogated to
        [Second Lien Creditor] with respect to [Second Lien Creditor’s] claims against Borrower and
        [Second Lien Creditor’s] rights, liens, and security interests, if any, in any of the Borrower’s
        assets and the proceeds thereof (excluding, however, [Second Lien Creditor’s] rights under


1
     Compare In re 203 North LaSalle St. P’Ship, 246 B.R. 325 (Bankr. N.D. 2000) (holding that an
     intercreditor agreement provision which permits the senior creditor to vote the junior creditor’s claim
     was not enforceable) with In re Aerosol Packaging, LLC 362 B.R. 43 (Bankr. N.D. Ga. 2006)
     (holding that such a provision was enforceable).
        any pledge of Borrower’s membership interests made under the Subordinate Debt
        Documents) until the Senior Debt shall have been paid in full, in cash.

When the Debtor filed a bankruptcy petition and later submitted a chapter 11 plan,2 MMA Realty
Capital, LLC cast a vote in favor of confirmation. However, National Bank of Arizona cast two votes
against confirmation: one vote on its own behalf as the holder of the claim secured by the senior lien
on the vacant land, and a second vote as the holder by subrogation of the claim secured by the junior
lien on the vacant land.

The Debtor challenged the senior lender’s right to cast a vote on behalf of the junior lender. The
Bankruptcy Court ruled against the Debtor, holding that the Subrogation Clause authorized National
Bank of Arizona to vote MMA Realty Capital, LLC’s claim. The Debtor appealed the Bankruptcy
Court’s ruling, but the District Court affirmed. 3

The legal discussion in the district court opinion

After recognizing that Section 510(a) of the Bankruptcy Code provides that a subordination
agreement is enforceable in a bankruptcy case to the same extent that it is enforceable under
applicable nonbankruptcy law, the District Court agreed with the Bankruptcy Court that the
Subrogation Clause contained in the Intercreditor Agreement permitted the senior lender to vote the
junior lender’s claim. It used the following reasoning:

        Nature of subrogation under Arizona law

        Under Arizona Law, subrogation is “the wholesale substitution of one party (i.e., the
        ‘subrogee’) in place of another (the ‘subrogor’) with respect to a claim.” As such, the District
        Court explained, “the subrogee succeeds to all of the subrogor’s rights with respect to the claim”
        (emphasis added).

        Here, “all of the subrogor’s rights” included the right to vote on the Debtor’s chapter 11
        plan. Accordingly, National Bank of Arizona, as the subrogee, stepped into the shoes of and
        acquired all of the rights associated with the subordinated claim, including the right to vote
        the subordinated claim.

        Subrogation vs. subordination clauses and enforceability in bankruptcy

        The Debtor argued that a Subrogation Clause is not enforceable in bankruptcy, citing to In re
        203 North LaSalle St. P’Ship, 246 B.R. 325 (Bankr. N.D. 2000) (subordination agreement with

2
     The plan provides for National Bank of Arizona, as holder of the claim secured by a first lien on the
     vacant land, to receive $1.3 million per year for 20 years and for MMA Realty Capital, LLC, as
     holder of the claim secured by a second lien on the same land, to receive an immediate cash payment
     of $900,000.


3
     It’s interesting to note that the Debtor, not MMA Realty Capital, LLC, appealed the bankruptcy
     court’s decision. The District Court ruled that the Debtor had standing to appeal because the
     confirmation of its plan would be impacted by the decision.




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       an assignment of plan voting rights is not enforceable as against public policy) and In re Hart
       Ski Mfg. Co., 5 B.R. 734 (Bankr. D. Minn. 1980) (subordination agreement waiving a junior
       lender’s right to seek adequate protection is not enforceable as against public policy). The
       District Court distinguished these cases because the disputes there were over the
       enforceability of “subordination clauses” not “subrogation clauses.” In the District Court’s
       view, the policy reason at play in the 203 N. LaSalle and Hart Ski cases—permitting
       subordinated creditors to protect their claims because “[s]ubordination affects only priority
       of payment, not the right to payment”4—was simply not applicable to the Avondale case
       because, unlike a creditor who enjoys the benefit of subordination and the assignment of
       only the voting rights, a subrogee “steps into the shoes of the subrogor” and “acquires all of
       [the subrogor’s] rights.”5

       The District Court also explained that while a subordination agreement is not enforceable
       under Arizona law with respect to “non-assignable rights” such as legal malpractice claims,
       bankruptcy voting rights can be assigned. Cases coming to that conclusion include: Aerosol
       Packaging, 362 B.R. 43 (Bankr. D. Ga. 2006); In re Inter Urban Broadcasting of Cincinnati, Inc.,
       1994 U.S. Dist. LEXIS 16546, 1994 WL 646176, *1 (E.D. La. 1994); and In re Erickson Ret.
       Cmtys., LLC, 425 B.R. 309, 316 (Bankr. N.D. Tex. 2010). Even language in the 203 N.
       LaSalle decision would lend support to the notion that an actual assignment of the
       subordinated claim, as opposed to the naked assignment of plan voting rights, would permit
       the senior lender to vote the subordinated claim.

Analysis and take-away

       Limited applicability to existing intercreditor agreements

       As far as the authors are aware, intercreditor agreements typically used in first lien/second
       lien financing rarely provide for the senior lender to be subrogated to the junior creditor’s
       rights. For example, the American Bar Associations’ Model First Lien/Second Lien Task
       Force form of Intercreditor Agreement published in May 2010 does not contain language
       similar to the Subrogation Clause present in Avondale or otherwise provide for subrogation
       beyond the simple situation where the subordinate lender is subrogated to the senior lender’s
       position to the extent that the subordinate lender turned over money or property to the
       senior lender. Nor is a subrogation clause like the one in Avondale likely at play in mezzanine
       financing documents common in real estate lending. Subrogation clauses may be more likely
       to appear in sponsor or seller financing transactions. As such, the Avondale decision likely
       provides no guidance as to the enforceability of voting rights provisions under most existing
       non-insider intercreditor agreements.

       As a practical matter, second lien lenders have generally been successful in refusing to accept
       an assignment of voting rights clause in the negotiation of a first lien/second lien
       intercreditor agreement. For those situations where the clause has been successfully inserted


4
    203 N. LaSalle, 246 B.R. at 332.
5
    Avondale, 2011 U.S. Dist LEXIS 41450 at *9, 12.




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        by the senior lenders, parties seeking to exclude a senior lender’s vote of the junior lender’s
        claim will argue that the court should follow either Aerosol Packaging or 203 North LaSalle,
        depending on which side is making the argument. Unfortunately, there are no Supreme
        Court or circuit court level decisions on this issue to provide guidance and, while there
        appears to be a trend in favor of enforcing a clearly worded intercreditor agreement, lower
        court decisions on the assignability of plan voting rights are in conflict.

        Relevance to future negotiations

        To the extent that a senior creditor has the leverage in negotiations over an intercreditor
        agreement to pressure a junior creditor into agreeing to the subrogation of its rights, the
        senior creditor may want to consider inserting the Avondale subrogation language into future
        intercreditor agreements. There is a strong argument that a subrogation clause, assuming
        enforceability under whichever state law governs the intercreditor agreement, should be
        enforceable with respect to plan voting rights. However, the best way to ensure that the
        argument will be successful is to make sure that the subrogee succeeds in all of the subrogor’s
        rights as a holder of the claim in a bankruptcy case.

        Specifically, 203 North LaSalle, the major decision that refused to enforce a contractual
        assignment of the junior lender’s right to vote on a plan, reasoned that the junior lender’s
        plan voting rights could not be assigned to the senior lender because (i) section 1126 of the
        Bankruptcy Code provides that only “the holder of a claim” may vote to accept or reject a
        plan and (ii) under the subordination agreements at play in 203 N. LaSalle, only plan voting
        rights were assigned to the senior creditor such that the junior creditor remained the holder of
        its own claim. If a subrogee acquires all of a subrogor’s rights under applicable state law, the
        subrogee may then become the “holder of the [subrogor’s] claim.” Then, even under the 203
        North LaSalle court’s interpretation of section 1126, the transfer of plan voting rights would
        be effective.

        The wholesale nature of subrogation may make junior lenders reluctant to agree to the
        inclusion of the Avondale subrogation language. It is certainly not consistent with the fact that
        first lien/second lien financing assumes only lien subordination and not payment
        subordination. Subrogation clauses that go into effect only on the borrower’s bankruptcy
        filing have not yet been tested in bankruptcy courts. That type of drafting will remain subject
        to the argument employed in both 203 N. LaSalle and Hart Ski to the effect that the
        bankruptcy laws present a complex and delicately interwoven system that should not be
        altered by pre-bankruptcy agreements. Moreover, there may still be an argument that, if an
        intercreditor agreement provides that subrogation is in effect “until the [s]enior [d]ebt is paid
        in full,” the junior creditor’s rights to receive payment after full payment of the senior debt
        would render the junior creditor the holder of its own claim despite the subrogation
        language. See Avondale, 2011 U.S. Dist LEXIS 42450 at *5. Nonetheless, it is worth senior
        lenders considering the inclusion of a subrogation provision as a way to bolster the
        enforceability of plan voting rights provisions to the extent that they do not conflict with the
        business deal among the parties.

We are available to discuss any of the concepts touched upon in this Bankruptcy Alert, to assist in
the negotiation of intercreditor agreements, the workouts of loans, or in bankruptcy cases. If you




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have questions, do not hesitate to contact the following members of the Financial Restructuring and
Bankruptcy team:

                 Mark N. Berman, Esq., 617-345-6037 or mberman@nixonpeabody.com

                 Dennis J. Drebsky, Esq., 212-940-3091 or ddrebsky@nixonpeabody.com

                 David H. Lee, Esq., 212-940-3070 or dlee@nixonpeabody.com



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The foregoing has been prepared for the general information of clients and friends of the firm. It is
not meant to provide legal advice with respect to any specific matter and should not be acted upon
without professional counsel. It is always necessary to review specific transaction documents and
identify the parties to the transaction. If you have any questions or require any further information
regarding these or other related matters, please contact your regular Nixon Peabody LLP
representative. This material may be considered advertising under certain rules of professional
conduct.




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