A U.S. District Court recently issued an opinion holding that a provision in an intercreditor agreement subrogating a senior lender to the rights of a junior lender extends to the right of such junior lender to vote on a Chapter 11 plan of reorganization in the borrower’s bankruptcy case.
It is a general principle of U.S. bankruptcy law that a party that succeeds to all of a creditor’s rights with respect to a claim may also succeed to the creditor’s voting rights.
Junior lenders wishing to preserve rights under the U.S. Bankruptcy Code in the event of a borrower’s bankruptcy should expressly carve out or reserve such rights in intercreditor agreements or other applicable documents if they are otherwise being required to agree to subrogation.
By comparison, while English law would typically permit enforcement of Avondale style subrogation provisions, an argument can be made that, with respect to a scheme of arrangement, a senior creditor’s voting of a junior creditor’s claim pursuant to such a provision should be discounted to the extent that it is not representative of the bona fide interests of the junior creditor.
The U.S. District Court for the District of Arizona recently issued an opinion in the bankruptcy case of Avondale Gateway Center Entitlement (the debtor) affirming a bankruptcy court decision holding that the contractual subrogation, through a subordination agreement, of a senior secured lender to the rights of a junior secured lender authorized the senior lender to vote on the debtor’s Chapter 11 plan of reorganization on behalf of the junior lender. See Avondale Gateway Ctr Entitlement, LLC v Nat’l Bank of Ariz (In re Avondale Gateway Ctr Entitlement, LLC), No CV10-1772-PHX-DGC, 2011 WL 1376997 (D Ariz, 12 April 2011).
Specifically, the district court held that: under the contractual subrogation clause at issue, the senior lender ‘step[ped] into the shoes’ of the junior lender with respect to its claims against the debtor and acquired all of the junior lender’s rights with respect to those claims; and because the right to vote on a plan of reorganization flows from a creditor’s claim in bankruptcy (and because the right to vote may be assigned), the senior lender succeeded to that right as the effective holder of the junior lender’s claims and was entitled to vote the junior lender’s claims.
Prior to its bankruptcy, the debtor borrowed $30.7 million from the National Bank of Arizona (NBA) secured by a first lien mortgage on a parcel of vacant land, and $18 million from MMA Realty Capital, LLC (MMA), secured by a second lien mortgage on the same land. In connection with this financing, the debtor, NBA and MMA entered into a Subordination and Intercreditor Agreement (the subordination agreement). The subordination agreement contained a subrogation clause that read, in relevant part:
“[MMA] agrees that [NBA] shall be subrogated to [MMA] with respect to [MMA’s] claims against borrower [i.e., the debtor] and [MMA’s] rights, liens and security interests, if any, in any of the borrower’s assets and the proceeds thereof … until the senior debt shall have been paid in full, in cash.”
The debtor subsequently filed for reorganization under Chapter 11 of the Bankruptcy Code and proposed a Chapter 11 plan of reorganization. MMA voted to accept the plan. NBA, on the other hand, cast two votes — one for itself and, based on the subrogation clause, one on behalf of MMA — rejecting the plan. The debtor challenged NBA’s right to vote on behalf of MMA. The bankruptcy court held that the subrogation clause authorized NBA to do so, struck MMA’s ballot, and accepted NBA’s ballot with two votes against the plan thereby leading to a rejection of the proposed Chapter 11 plan.
Effect of Subrogation on Plan Voting Rights
The subrogation clause did not expressly assign MMA’s voting rights to NBA, unlike in other cases where the right to vote itself was expressly transferred. Nonetheless, the district court held that the right to vote is a derivative right possessed by the holder of a claim in bankruptcy. Subrogation is the wholesale substitution of one party (the subrogee) in place of another (the subrogor) with respect to a claim. Because a subrogree succeeds to all of the subrogor’s rights under a claim, under the subrogation clause, NBA expressly succeeded to all of MMA’s rights with respect to MMA’s claims against the debtor. The district court thus held that, because MMA’s right to vote on the plan was derivative of MMA’s claims against the Debtor, NBA succeeded to those rights as subrogee of MMA and became the effective holder of MMA’s claims.
Timing of Subrogation
The debtor argued that NBA’s right to subrogation would not arise until NBA paid MMA’s claims. Under Arizona law, the right to subrogation can arise by contract (“conventional” subrogation) or by the payment of the subrogor’s claim by the subrogee (“equitable” subrogation). In cases of conventional subrogation, the language of the contract controls when subrogation is triggered. The district court found that the subrogation clause did not contractually condition subrogation on payment of MMA’s claims, but expressly made subrogation effective from the execution of the subordination agreement until NBA’s claims were paid in full.
Enforceability of Subrogation in Bankruptcy
The debtor also argued that the subrogation clause was not enforceable with respect to the right to vote on a plan of reorganization. The debtor primarily relied on case law standing for the proposition that “subordination” does not allow for the waiver of voting rights in bankruptcy because subordination affects only the order of priority of payment of claims in bankruptcy and not the transfer of voting rights. The district court found such case law to be inapposite in the case of subrogation, which involves not merely a reordering of the priority of claims, but rather one party stepping into the shoes of another party and succeeding to all of the latter party’s rights.
Further, the district court held that, while a subrogation agreement is not enforceable under Arizona law with respect to non-assignable rights, bankruptcy law permits plan voting rights to be assigned, so the subrogation clause was enforceable with respect to such rights. The district court cited several decisions in which courts held that voting rights may be assigned independently of the claims to which they relate. At least one other court has reached a contrary conclusion. As noted above, however, subrogation does not involve merely the assignment of a creditor’s voting rights, but rather the substitution of the subrogee in place of the creditor-subrogor with respect to a claim. Courts have consistently held that the right to vote a claim may be transferred to a purchaser of the claim, and similarly, a subrogee succeeds to all of the subrogor’s rights under the claim.
Implications of Avondale
The district court’s opinion in Avondale gives significant powers in bankruptcy to senior lenders, which, by virtue of rights granted to them in intercreditor agreements, can succeed, as subrogees, to the rights of junior lenders. Subrogation to all of the rights of another lender with respect to that lender’s claims against a borrower necessarily embraces all applicable rights, including voting rights, that such lender has as a creditor under the Bankruptcy Code when the borrower files for bankruptcy.
The specific implication of Avondale is that a senior lender will automatically obtain the rights of a junior lender to vote on a Chapter 11 plan of reorganization when the senior lender has obtained all of the junior lender’s rights with respect to the junior lender’s claims against the borrower, regardless of whether the intercreditor agreement expressly assigns such voting rights to the senior lender. This suggests that, when a junior lender wishes to preserve its rights under the Bankruptcy Code to vote on a borrower’s plan of reorganization, it should expressly carve out or reserve such rights in the intercreditor agreement or other applicable documents if it is otherwise being required to agree to subrogation.
It is important to note that, with subrogation, a junior lender would also lose the rights it typically would have as an unsecured creditor because it loses all of its rights to the subrogee. A junior lender that is a subrogor therefore arguably would have no rights at all to appear before a bankruptcy court on even the simplest of issues until all of the senior lender’s obligations have been satisfied in full. Subrogation of the type provided for in the subrogation clause has thus far been atypical in the intercreditor arrangements usually found in syndicated leveraged financings, but it is possible that Avondale may make such subrogation more common in corporate credits. On the other hand, such subrogation has been more typically found in real estate related financings.
Comparison With English Practice
The closest English law analogue to a Chapter 11 plan is a scheme of arrangement. Classes of affected creditors are entitled to vote to approve the scheme with a required approval threshold of 75% in amount and 50% in number of the claims in each class held by the creditors that actually vote. On its face, if a subrogation clause of the sort considered in Avondale applied in the context of an English law scheme, that provision should operate similarly in the relevant class vote structure as it would under the U.S. Chapter 11 plan process.
Under English market practice, however, as exemplified by form documentation of the Loan Market Association, standard intercreditor agreements do not provide senior lenders with subrogation rights like those at issue in Avondale. It is not surprising, therefore, that no English court appears to have opined on the issue. Accordingly, it is difficult to predict whether an English court would permit a senior creditor to vote the claims of a junior creditor under such an arrangement.
On the one hand, English courts will generally uphold contracts freely entered into by competent parties. See Printing and Numerical Registering Company v Sampson  LR 19 Eq. 462 (Ch) at 465, which said: “[C]ontracts when entered into freely and voluntarily shall be held sacred and shall be enforced by courts of justice.” Exceptions to the general principle of contract enforceability exist for contracts that off end public policy. Chitty on Contracts 30th Ed., Volume 1 – General Principles, at 16-005.
There are five categories of contract that will be invalidated on public policy grounds: 1.) contracts that are illegal by common law or legislation; 2.) contracts injurious to good government with respect to domestic or foreign affairs; 3.) contracts that interfere with the proper working of the machinery of justice; 4.) contracts injurious to marriage and morality; and 5.) contracts against the public economic interest. Id. The contractual subrogation provision at issue in Avondale would not likely fall within any of these exceptions to enforceability.
On the other hand, an argument could be made that an Avondale-style subrogation provision should not be enforced in the context of scheme voting. In deciding whether to sanction a scheme of arrangement, an English court will first consider whether the scheme meeting was properly convened, the scheme classes were properly constituted and the requisite majorities were met. See In re Rodenstock GmbH  EWHC 1104 (Ch). Assuming those criteria are met, the court must determine whether to exercise its discretion to sanction the scheme “as being one that has been voted for by creditors acting bona fide in their interests and without coercion of the minority, and a scheme, which, objectively, an intelligent and honest creditor acting in its own interests as such might reasonably approve.” Id.
In evaluating whether this standard has been met, the court may consider, among other things, the level of support for the scheme, the nature of the negotiations that led to the scheme, the competing alternatives and the level of support enjoyed by such alternatives, how dissenting creditors would likely fare outside the scheme, and whether the parties supporting the scheme “have been motivated in reaching a decision to support the scheme by anything other than an independent and prudent perception of their own commercial interests.” Id.
Importantly, this last element refers to supporting creditors voting in the “commercial interests” of the holders of the claims being voted. An argument could be made that, in the context of a scheme vote cast by a senior creditor on behalf of a junior creditor’s claim in support of the senior creditor’s own interest, a court should really look to the interests of the junior creditors themselves and, in so doing, reject an attempt by a senior creditor to vote a junior creditor’s rights under a scheme.
Wilbur Foster is a partner in Milbank’s Financial Restructuring Group. He is based in New York. He joined the firm in 1987 and has been a partner since 1994. Foster’s bankruptcy practice focuses primarily on representation of creditors and creditors’ committees in bankruptcy cases, most recently in the bankruptcy cases of Lehman Brothers, New Century, Refco, Enron, United Airlines, and US Airways. He also has extensive experience in structuring, and providing bankruptcy and insolvency advice on, complex financial transactions, including structured finance, derivatives, aircraft leasing and finance, and other financial market transactions involving U.S. banks, non-U.S. banks, insurance companies, broker-dealers, bankruptcy-remote entities, and other participants. In bankruptcy cases he also has litigated issues in connection with such transactions. Foster has written articles and lectured on various aspects of bankruptcy practice. He served as an editor of the New York University Law Review and was a member of the Order of the Coif. From 1982 to 1986, he was an officer in the United States Army Judge Advocate General’s Corps, serving first as a prosecutor and then as a defense counsel, in the First Armored Division, Bavaria, Germany. He is proficient in German and Spanish. He graduated with a B.S. and B.A. from the University of Pennsylvania and received his J.D. from New York University.
Abhilash M. Raval has been a partner at Milbank since 2007. He is a member of the firm’s Financial Restructuring Group, based in New York office. He has extensive experience representing debtors, statutory or official committees, creditors and other stakeholders in all aspects of reorganization cases, liquidation cases and out-of-court workouts. Raval also regularly represents private equity funds and hedge funds in all aspects of acquiring control positions in financially distressed companies, whether through a Chapter 11 process or otherwise. He covers a broad range of industries and also regularly represents prospective lenders in structuring high-risk rescue financings and Chapter 11 DIP and exit financings. Raval has been listed in Chambers USA (2009, 2010 and 2011) for Bankruptcy/Restructuring and in Turnaround & Workouts as an Outstanding Young Restructuring Lawyer. He is also recognized as a leading lawyer for restructuring and insolvency in IFLR 1000. Raval received a J.D. from Harvard Law School, cum laude, in 1997 and an A.B. in Economics from Dartmouth College, summa cum laude, in 1994.
Peter K. Newman is an associate, based in the firm’s London office. He received a B.A. from the University of Maryland and earned his J.D. from New York University School of Law.
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This article was originally published in Butterworths Journal of International Banking and Financial Law.