On December 27, 2018, the United States Bankruptcy Court for the District of Delaware issued an opinion in In re La Paloma Generating Co., Case No. 16-12700 (Bankr. D. Del. Dec. 27, 2018) [Docket No. 1274], that should raise substantial concerns for junior secured creditors.
In particular, the La Paloma opinion determined that:
A proof of claim filed on behalf of second lien creditors constituted an “exercise of remedies” with respect to collateral under the specific terms of the intercreditor agreement at issue;
Any distribution that might be received by second lien creditors from the chapter 11 estate would be subject to the turnover provisions arising under that intercreditor agreement; and
Perhaps most significantly, a payment waterfall nominally governing the distribution of collateral proceeds resulted in de facto claim subordination (in addition to lien subordination) — even though claim subordination1 was not specifically provided by that intercreditor agreement.
La Paloma is presently subject to appeal.2 But, if affirmed, La Paloma has material implications for market participants by supporting the broad-based subordination of junior claims even without a specific subordination provision to that effect. La Paloma may then shift substantial leverage to senior secured creditors by minimizing (or even eliminating) junior secured creditors’ rights or remedies with respect to unencumbered value where senior secured creditors are not otherwise paid in full.
Obviously, much will depend on the specific language of an intercreditor agreement at issue. But market participants should read their own security documents and intercreditor agreements with La Paloma, its lessons, its implications and its risks squarely in mind.
La Paloma Generating Company, LLC and certain of its affiliates (collectively, the “Debtors”) commenced chapter 11 cases on December 6, 2017. The Debtors’ primary operating asset consisted of a gas-fired electric power plant. The Debtors did not have any employees or undertake material operations; rather, plant operations and maintenance were subcontracted to various third parties.
Relevant here, the Debtors were obligors with respect to approximately $327 million of first lien debt (including obligations outstanding on a $35 million working capital facility) and a $110 million second lien term loan as of that bankruptcy filing. The relative rights and obligations of the Debtors’ first lien lenders and second lien lenders were set forth by a certain Collateral Agency and Intercreditor Agreement dated as of August 16, 2005 (the “Intercreditor Agreement”).3
The Debtors subsequently proposed and then consummated a chapter 11 plan in December 2017. The plan provided that first lien lenders would, among other things, (i) credit bid and acquire substantially all the Debtors’ assets, and (ii) and waive liens on certain collateral to facilitate distributions to unsecured creditors. First lien creditors were projected to receive 62 to 63 cents on the dollar under the plan, and second lien creditors were projected to be wholly unsecured.4
Second lien creditors were provided with a distribution under the plan on a ratable basis with general unsecured creditors. Significantly, such distributions were expressly (i) subject to the rights or remedies arising under the Intercreditor Agreement and (ii) “paid to the Collateral Agent” to be “held in reserve” pending a determination as to how, if at all, those distributions were governed by the Intercreditor Agreement.5
LNV Corporation (“LNV”), a large first lien creditor, and an ad hoc group of second lien creditors (the “Ad Hoc Second Lien Group”) filed dueling motions to enforce the Intercreditor Agreement in connection with the Debtors’ plan during October 2017.6
The Intercreditor Agreement And The Parties’ Arguments
The Intercreditor Agreement was, in large part, a standard agreement that will be generally familiar to investors, issuers, or their advisors. Among other things, the Intercreditor Agreement provided for:
Pursuant to Section 2.1, standard stipulations as to the relative priority of liens securing first lien debt and second lien debt with respect to collateral;
Pursuant to Section 3.1, agreements by or on behalf of second lien creditors (through their collateral agent) limiting the exercise of remedies and by which second lien creditors agreed to not challenge or dispute the priority or perfection of liens securing first lien debt;
Pursuant to Section 4.1, a payment waterfall governing the disposition of proceeds of collateral subject to the intercreditor agreement. In particular, Section 4.1 applied to “any money collected or to be applied by the Collateral Agent pursuant to this Agreement and the Collateral Document . . . .” (emphasis added); and
Pursuant to Section 4.2, a turnover provision providing that any “Collateral or proceeds thereof” received by second lien creditors from an exercise of remedies would be turned over to first lien creditors until first lien creditors were paid in full.
The Intercreditor Agreement did permit the filing of a proof of claim on account of second lien debt as a specific exception to the general prohibition on the exercise of remedies. (Intercreditor Agreement § 3.1(k).) Additionally, the Intercreditor Agreement provided that second lien creditors could “exercise rights and remedies as though they [were] unsecured creditors against La Paloma or any other Grantor” — although that provision was not addressed by the La Paloma opinion. (Id. § 3.1(e).)
In its motion to enforce the intercreditor agreement, LNV argued in relevant part that (i) the Intercreditor Agreement’s payment waterfall applied literally to “any money” received by the appointed collateral agent — not just proceeds of collateral, and (ii) the breadth of “Collateral,” as that term was defined by the Intercreditor Agreement, otherwise captured all assets available for distribution in in any event.7
For its part, the Ad Hoc Second Lien Group argued, inter alia, (i) the Intercreditor Agreement provided only for lien subordination (not claim subordination), and (ii) any distributions provided under the Debtors’ plan did not result from “the exercise of remedies” on account of collateral that would otherwise trigger application of the Intercreditor Agreement’s turnover provisions.
The La Paloma Opinion
The La Paloma court flatly rejected the Ad Hoc Second Lien Group’s arguments. In particular, the court found that:
“Collateral” as defined by the Intercreditor Agreement did, in fact, apply to all of the Debtors’ assets, La Paloma, slip op. p.10;
The proof of claim filed on account of second lien claims constituted an “exercise of remedies” subject to the Intercreditor Agreement, id. at p.13; and
Any distribution to second lien creditors otherwise occurring under the Debtors’ plan would necessarily constitute “proceeds of Collateral” resulting from an exercise of remedies subject to the Intercreditor Agreement, id.
More fundamentally, La Paloma further determined that such turnover and subordination provisions, coupled with the Intercreditor Agreement’s payment waterfall, demonstrated the parties’ “intent” to subordinate second lien claims in their entirety. See id. at p.17.
In this regard, La Paloma acknowledged that the Intercreditor Agreement did not explicitly subordinate second lien lenders’ right of payment. Id. at p.18. Instead, the court determined that “[r]eading the Intercreditor Agreement as a whole,” id. at p.17, required such a conclusion, citing the waterfall provisions as compelling evidence that “the parties intended for the First-Lien Obligations to be paid in full before the Second-Lien Lenders are allowed to receive any recovery on behalf of the Second Lien Obligations,” id. (emphasis added).
The La Paloma opinion does not clearly explain how a waterfall governing the disposition of collateral proceeds by a “Collateral Agent” specifically compels such a broad-based subordination of second lien claims (as opposed to rights in collateral). Rather, La Paloma seems to turn on a general reading of the various lien subordination and turnover provisions found in the Intercreditor Agreement to conclude that “[s]ophisticated parties negotiated and entered into this Intercreditor Agreement with the intention to subordinate the Second-Lien Lenders to the liens of the First Lien Lenders,” id. at p.19.8
Here, the La Paloma court may have been persuaded by LNV’s argument, noted above, that literally any asset held by the “Collateral Agent” was automatically subject to the waterfall mechanic provided by Section 4.1 — regardless of whether or not such asset (or the proceeds thereof) might otherwise constitute “Collateral.”9 On this argument, then, the distinction between claim subordination and lien subordination would be a moot since all assets available for distribution would, of course, be subject to the waterfall provision applicable to collateral proceeds.
Key Takeaways from La Paloma
La Paloma, if affirmed, has substantial implications beyond the particular facts and intercreditor agreement at issue there. The opinion suggests that the terms and conditions of an otherwise standard intercreditor agreement can be read to create claim subordination by implication or by reference to “the parties’ intent” — an outcome that would have profound effects on junior secured creditors in any restructuring scenario.
On the other hand, La Paloma may be confined to its facts. Namely, La Paloma involved what was, in effect, a single asset bankruptcy. Therefore, La Paloma did not necessarily need to address questions that might arise where a collateral grant does not clearly extend to “all assets” of a debtor, such as where a debtor owns material, unencumbered property. Nor was there any evidence presented that such unencumbered assets actually existed in the Debtors’ estates — a fact scrupulously noted in the La Paloma opinion. See id. at p.10 (“The Second Lien Lenders assert, without argument that there has to be unencumbered assets.”). La Paloma’s construction of a payment waterfall as supporting de facto claim subordination may then be limited to the case where all assets are, in fact, “Collateral” and, therefore, no meaningful distinction between lien subordination and claim subordination exists. In other words, La Paloma may have limited application outside the context of a single asset case.
At the same time, La Paloma’s broad assertion that “the Intercreditor Agreement states that the First Lien Obligation shall be satisfied in full prior to the payment of the Second-Lien Obligations,” id. at p.18, without any “Collateral-specific” limitation — and without any explicit claim subordination in the Intercreditor Agreement — suggest that La Paloma’s import may go well beyond a single asset collateral package. Namely, that otherwise standard lien subordination provisions could be used to conclusively establish “the parties’ intention” to trigger claim subordination in all instances.
Market participants, and junior secured creditors in particular, should therefore be mindful that an otherwise “vanilla” intercreditor agreement may result claim subordination even where the agreement is silent to that effect.
1. Generally, “claim subordination” (or “payment subordination”) refers to a provision barring a junior creditor from receiving any payment on its claim unless or until the senior creditor is paid in full. By comparison, “lien subordination” refers to a provision where the junior creditor’s lien is subordinated to the senior creditor’s lien, but the junior creditor remains eligible to receive payment on its claim from unencumbered value — even where the senior creditor is not otherwise paid in full.
2. See In re La Paloma Gen. Co., Case No. 16-12700 (Bankr. D. Del. Jan 4, 2019) [Docket No. 1276] (notice of appeal).
3. The Intercreditor Agreement was publicly filed on the La Paloma docket at [Docket No. 696] and is available upon request to Weil, Gotshal & Manges LLP.
4. See Disclosure Statement for the Joint Chapter 11 Plan of La Paloma Generating Co., LLC, In re La Paloma Gen. Co., Case No. 16-12700 (Bankr. D. Del. Sept. 29, 2017), p.9 [Docket No. 676] (identifying first lien recoveries).
5. See Joint Chapter 11 Plan of La Paloma Generating Co., LLC, In re La Paloma Gen. Co., Case No. 16-12700 (Bankr. D. Del. Nov. 6, 2017), p.19 [Docket No. 869] (identifying second lien treatment).
6. See Motion of LNV Corporation to Enforce Intercreditor Agreement, In re La Paloma Gen. Co., Case No. 16-12700 (Bankr. D. Del. Oct. 16, 2017) [Docket No. 739] (the “LNV Motion”); [Ad Hoc Second Lien Group] Motion to Enforce Intercreditor Agreement, In re La Paloma Gen. Co.<, Case No. 16-12700 (Bankr. D. Del. Oct. 5, 2017) [Docket No. 695].
7. See LNV Motion ¶ 16 (“[A]ll of the assets of the Debtors constitute Collateral under the Intercreditor Agreement.”).
8. The La Paloma opinion further provides that: “[T]he Intercreditor Agreement states that the First-Lien Obligations shall be satisfied in full prior to the payment of Second-Lien Obligations,” citing the general provisions of Section 2.1 (Relative Priorities) and Section 3.1 (Exercise of Remedies). The opinion’s general citation does not clearly answer the question insofar as none of Section 2.1 or Section 3.1 expressly subordinates junior claims (as opposed to junior liens).
9. This argument appears somewhat circular. As a general matter, the Intercreditor Agreement does not clearly provide that any asset received by the Collateral Agent constitutes “Collateral” subject to the Intercreditor Agreement’s waterfall and turnover provisions simply because it passes into the Collateral Agent’s hands. As a technical matter, the “Collateral Agent” by definition refers to the entity acting in the capacity “as collateral agent for the Secured Parties.” (Intercreditor Agreement p.1 (recitals; defining “Collateral Agent”).) As a result, it is at least unclear as to whether the “Collateral Agent,” acting (by definition) in its capacity as such, could ever hold cash proceeds or assets for distribution subject to the Intercreditor Agreement on account of something “other than Collateral” unless every asset held by the Collateral Agent is assumed to become “Collateral” as a result.