Voting Rights Provisions in Intercreditor Agreements May Not Be Enforceable As ExpectedMay 12, 2021 – Herrick Restructuring Review
The Herrick Restructuring Review provides insights and information related to restructuring and finance litigation. The Herrick team regularly represents official and ad hoc creditor committees, hedge funds, distressed debt investors, bondholders, and other parties in interest, and often serve as conflicts or special counsel for large-scale complex litigation matters.
In an anomalous decision by the Bankruptcy Court in the District of Kansas, the court declined to enforce the voting provisions in subordination agreements that allowed the senior creditor to vote on behalf of a group of subordinated creditors. Reversing a trend of enforcing express voting restrictions in intercreditor agreements, the court invalidated the voting provision at issue, yet ultimately barred the subordinated creditors from participating in the confirmation process entirely. The decision bucks the trend of enforcing intercreditor agreements that limit the voting rights of junior creditors, but nevertheless, holds that such creditors can be precluded from exercising other rights to participate in a chapter 11 case.
The Debtor—Fencepost Productions Inc., a designer and distributor of outdoor clothing, together with its related debtors—filed for chapter 11 in late 2019. In 2018, the Debtors’ principal creditor, Associated Bank, N.A. (“Associated”), made a $14 million secured loan. At the same time, a group of unsecured creditors, BMS Management, Inc. and related individuals (collectively the “BMS Group”), entered into subordination agreements with Associated, under which Associated had the right to vote the claims of the BMS Group.
The Court first addressed whether transferring voting rights in conjunction with subordination and intercreditor agreements is enforceable. The Court found that the Bankruptcy Code’s enforcement of subordination agreements did not extend to transfers of voting rights. The Court reasoned that BMS Group did not appoint Associated as its agent with a fiduciary duty; thus, Associated would be acting for its own benefit, rather than in the interests of BMS Group. The Court looked to an earlier case which “held that § 510(a), providing for the enforcement of subordination agreements, does not allow for waiver of voting rights under § 1126(a) because subordination affects the priority of payment of claims in bankruptcy, not voting rights.”
But although the Court found that BMS retained its voting rights, nevertheless, BMS Group was excluded from participating in the plan confirmation as the Court found it lacked prudential standing because it was unlikely to recover any financial distribution. The Court reasoned that—because the Debtor would not be able to repay its principal creditor’s unsecured claim — “under all conceivable scenarios”—BMS Group would not receive any distribution. “In this case, the BMS Group, if permitted to participate in the Plan confirmation proceedings, would be litigating issues affecting the rights of third parties, not itself.” By blocking the subordinated creditors from participating, the Fencepost court follows Judge Peck’s decision in Ion Media Networks Inc., et al., 419 B. R. 585 (Bankr. S.D.N.Y. 2009), finding the terms of an intercreditor agreement could be enforced per its plain meaning, which resulted in blocking the plan confirmation objections of the dissenting creditor. But it is important to note that because the Court’s decision hinged on its assessment of the economic value of the BMS Group’s position – and not enforcement of the intercreditor agreement per se,one can imagine the court coming to a different result if the BMS Group had been in the money.
In re Fencepost reverses the trend of enforcing express voting restrictions in intercreditor agreements. The Southern District of New York has distinguished express, specific provisions in subordination agreements (like the provision in Fencepost) from broad, general provisions. Specifically, the court in In re MPM Silicones, L.L.C., 596 B.R. 416, 430 (S.D.N.Y. 2019) addressed “the growing consensus is that agreements that seek to limit or waive junior noteholders’ voting rights must contain express language to that effect. . . . Where—as here—there is no express waiver or specific constricting language in the contract, courts are reluctant to read such constraints into broad provisions.”
The case is In re Fencepost Prods., Inc., No. 19-41545 (Bankr. D. Kan. Mar. 31, 2021).
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