In In re Fencepost Productions Inc., 2021 WL 1259691 (Bankr. D. Kan. Mar. 31, 2021), the U.S. Bankruptcy Court for the District of Kansas recently addressed the enforceability of a provision in a pre-bankruptcy subordination agreement under which a subordinated creditor assigned to a senior creditor its right to vote on any chapter 11 plan proposed for the borrower. The bankruptcy court ruled that such a provision is not enforceable because it conflicts with the Bankruptcy Code. In a twist, however, the court concluded that the subordinated creditor lacked "prudential standing" to participate in the confirmation process because it was extremely out-of-the-money and therefore had no stake in the outcome of the case, but was attempting to assert the rights of third parties.
"Standing" is the legal capacity to commence litigation in a court of law. It is a threshold issue—a court must determine whether a litigant has the legal capacity to pursue claims before the court can adjudicate the dispute. In order to establish "constitutional" or "Article III" standing, a plaintiff must have a personal stake in litigation sufficient to make out a concrete "case" or "controversy" to which the federal judicial power may extend under Article III, section 2, of the U.S. Constitution. See Pershing Park Villas Homeowners Ass'n v. United Pac. Ins. Co., 219 F.3d 895, 899 (9th Cir. 2000).
In bankruptcy cases, various provisions of the Bankruptcy Code confer another type of standing on various entities (e.g., the debtor, the debtor-in-possession ("DIP"), a bankruptcy trustee, creditors, equity interest holders, official committees, or indenture trustees) to, among other things, participate generally in a bankruptcy case or commence litigation involving causes of action or claims that either belonged to the debtor prior to filing for bankruptcy or are created by the Bankruptcy Code. For example, in a chapter 11 case, section 1109 of the Bankruptcy Code provides that any "party in interest," including the debtor, the trustee, a committee of creditors or equity interest holders, a creditor, an equity security holder, or an indenture trustee "may raise and may appear and be heard on any issue" in a chapter 11 case.
This "bankruptcy" or "statutory" standing is distinct from constitutional standing, which is jurisdictional—if a potential litigant lacks constitutional standing, the court lacks jurisdiction to adjudicate the dispute. The distinction between constitutional and bankruptcy standing was recently examined by the U.S. Court of Appeals for the Third Circuit in In re Wilton Armetale, Inc., 968 F.3d 273 (3d Cir. 2020), in which the court of appeals held that the ability of a creditor to sue in bankruptcy is not a question of constitutional standing (because the risk of loss creates standing) but, rather, an issue of statutory authority because creditors may lose authority to pursue claims under the Bankruptcy Code. The Third Circuit explained that, in accordance with the U.S. Supreme Court's decision in Lexmark Int'l, Inc. v. Static Control Components, Inc., 572 U.S. 118, 125 (2014), constitutional standing has only three elements: (i) there must be "a concrete and particularized injury in fact"; (ii) the injury must be "fairly traceable" to the defendant's conduct; and (iii) "a favorable judicial decision" would likely redress the injury. 572 U.S. at 125. Once a plaintiff satisfies those elements, the action "presents a case or controversy that is properly within federal courts' Article III jurisdiction." Id.
Finally, the judicially created concept of "prudential" or "zone of interests" standing examines whether: (i) the plaintiff's grievance falls within the zone of interests protected by a statute; (ii) the complaint raises abstract questions or a generalized grievance more properly addressed by the legislature; and (iii) the plaintiff is asserting his legal rights and interests or those of third parties. However, Congress can modify or even abrogate prudential standing requirements by statute. St. Paul Fire & Marine Ins. Co. v. Labuzan, 579 F.3d 533, 539 (5th Cir. 2009) (considering whether lawmakers intended to abrogate prudential standing requirements in section 362(k) of the Bankruptcy Code, which authorizes the recovery of damages for a willful violation of the automatic stay).
Voting on a Chapter 11 Plan
Generally, holders of allowed claims and interests have the right to vote to accept or reject a chapter 11 plan. See 11 U.S.C. § 1126(a). Claimants or interest holders whose claims or interests are not "impaired" under the plan (as defined in 11 U.S.C. § 1124), however, are deemed conclusively to accept the plan, and stakeholders who would receive nothing under the plan are deemed to reject it. See 11 U.S.C. §§ 1126(f) and (g). Any holder of a claim or interest to which an objection has been filed does not have the right to vote the portion of the claim or interest objected to, unless the holder obtains an order temporarily allowing the claim or interest for voting purposes pending resolution of the merits of the objection. Unliquidated or contingent claims may be estimated for purposes of voting on a plan. See 11 U.S.C. § 502(c).
Voting rights can have a significant impact on the ultimate fate of a chapter 11 plan. If a creditor holds a significant bloc of claims in a single class under a plan, it may be able to prevent confirmation of the plan or force the plan proponent to comply with the Bankruptcy Code's "cram down" requirements to achieve confirmation. Creditors holding a blocking position or having sufficient influence to create one through dealmaking with other creditors commonly use the resulting leverage to maximize their recoveries under the plan, sometimes at the expense of creditors who lack the same negotiating power. In some cases, the accumulation of claims and voting power can even be an effective means of gaining control of a company through chapter 11, since many chapter 11 plans involve debt-for-equity swaps.
For this reason, creditors sometimes bargain to obtain greater bankruptcy voting rights by means of pre-bankruptcy intercreditor or subordination agreements.
Intercreditor and Subordination Agreements
An intercreditor agreement is an agreement between or among creditors specifying in advance how their competing claims against the borrower will be dealt with in terms of priority, receipt of payment, recourse to assets, and other related rights. Such agreements typically include a "waterfall" provision specifying the order in which the parties will receive payments from a pool of the borrower's assets upon the occurrence of default or another specified event, and subordinating the liens or rights to payment of junior creditors to the liens or payment rights of senior creditors.
In the event of the borrower's bankruptcy, an intercreditor agreement may include, among other things, provisions that: (i) restrict the junior creditors' right to vote on a chapter 11 plan to maximize senior creditors' control over the plan process and enhance their ability to obtain confirmation of a plan they support; (ii) waive the junior creditors' right to challenge the validity, priority, perfection, and enforceability of the senior creditors' liens or the validity of their debt (and vice versa); (iii) give junior creditors advance consent to any DIP financing to be provided by senior creditors or any use of cash collateral approved by the senior creditors; (iv) waive junior creditors' right to seek relief from the automatic stay without the prior written consent of senior creditors and provide that junior creditors will not oppose any stay relief requested by senior creditors; and (v) waive junior creditors' right to object to any sale of the debtor's assets or to any credit bid submitted in connection with the sale by senior creditors.
To the extent that an intercreditor agreement provides for subordination of debt or security, the agreement will generally be enforced in a bankruptcy case pursuant to section 510(a) of the Bankruptcy Code, which provides that a subordination agreement is enforceable in a bankruptcy case "to the same extent that such agreement is enforceable under applicable nonbankruptcy law."
In construing the validity, enforceability, and application of a subordination agreement, section 510(a) directs the bankruptcy court to look to applicable nonbankruptcy law—generally state law—as well as the terms of the agreement itself. See Collier on Bankruptcy ("Collier") ¶ 510.03 (16th ed. 2021). If there is ambiguity in the agreement concerning the terms or extent of the subordination, a bankruptcy court may refuse to enforce it. See In re Bank of New England Corp., 364 F.3d 355, 367 (1st Cir. 2004) (remanding case to bankruptcy court to determine under New York law whether subordination agreement actually provided for payment of postpetition interest on senior debt prior to any payment on junior debt), on remand, 404 B.R. 17 (Bankr. D. Mass. 2009) (finding that parties did not intend to subordinate claims for postpetition interest), aff'd, 426 B.R. 1 (D. Mass. 2010), aff'd, 646 F.3d 90 (1st Cir. 2011).
Moreover, a chapter 11 plan need not necessarily give effect to the explicit terms of a subordination agreement in providing for the treatment of creditor claims. See In re Tribune Media Co., 587 B.R. 606, 614 (D. Del. 2018) (because section 510(a) is expressly excepted from section 1129(b)(1) of the Bankruptcy Code, a nonconsensual chapter 11 plan that does not fully enforce a subordination agreement may be confirmed as long as "the plan does not discriminate unfairly, and is fair and equitable"); see generally Collier at ¶ 510.03.
Enforcement of Chapter 11 Voting Right Assignments
As noted, section 1126(a) gives the holder of a claim or interest the right to vote on a chapter 11 plan. Courts disagree over whether an assignment of plan voting rights in an intercreditor or subordination agreement is enforceable. Some courts have concluded that they are not. See, e.g., In re 203 N. LaSalle St. P'ship, 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000) ("Subordination … affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights."); In re SW Hotel Venture LLC, 460 B.R. 4 (Bankr. D. Mass. 2011) (assignment of voting rights in a subordination agreement was unenforceable), aff'd in part, rev'd in part, 479 B.R. 210 (B.A.P. 1st Cir. 2012), vacated on other grounds, 748 F. 3d 393 (1st Cir. 2014); In re Croatan Surf Club, LLC, 2011 WL 5909199, *2 (Bankr. E.D.N.C. Oct. 25, 2011); In re Hart Ski Mfg. Co., 5 B.R. 734, 736 (Bankr. D. Minn. 1980).
Other courts have enforced such assignments of voting rights. See, e.g., In re Coastal Broad. Sys., Inc., 2013 WL 3285936, at *5–6 (D.N.J. June 28, 2013), aff'd, 570 Fed. Appx. 188 (3d Cir. 2014); In re Avondale Gateway Ctr. Entitlement, LLC, 2011 WL 1376997, *4 (D. Ariz. Apr. 12, 2011); In re Erickson Ret. Cmtys., LLC, 425 B.R. 309, 316 (Bankr. N.D. Tex. 2010); In re Aerosol Packaging, LLC, 362 B.R. 43, 47 (Bankr. N.D. Ga. 2006).
For example, in LaSalle, an intercreditor agreement provided that the debtor's senior secured creditor had the right to vote the subordinated secured creditor's claim in any bankruptcy. The bankruptcy court refused to enforce the assignment, ruling that sections 510(a) and 1126(a) of the Bankruptcy Code, rather than the provisions of the intercreditor agreement, controlled voting rights.
In particular, the court reasoned that: (i) the subordinated creditor's agreement that the senior creditor could vote on its behalf was not controlling because "prebankruptcy agreements do not override contrary provisions of the Bankruptcy Code"; (ii) section 510(a) does not permit a waiver of voting rights under section 1126(a) because subordination affects the priority of payment of claims in bankruptcy rather than voting rights; (iii) Rule 3018(c) of the Federal Rules of Bankruptcy Procedure ("Bankruptcy Rules"), which provides that acceptance or rejection of a plan must be signed by "the creditor or equity security holder or an authorized agent," does not provide a mechanism for enforcing vote relinquishment; and (iv) the conclusion that section 1126(a) controls is "completely consistent with reasonable bankruptcy policy," which "assures that the holder of a subordinated claim has a potential role in negotiation and confirmation of a plan, a role that would be eliminated by enforcing contractual transfers of Chapter 11 voting rights." LaSalle, 246 B.R. at 331.
By contrast, in Aerosol Packaging, a junior lender and the borrower signed a subordination agreement under which the junior lender agreed to refrain from taking any action to collect on its debt until the senior lender was paid in full, and to permit the senior lender, among other things, to vote on any chapter 11 plan proposed for the borrower in bankruptcy. After the borrower filed for bankruptcy, the junior lender voted to reject the debtor's plan even though the senior lender voted to accept the plan on the junior lender's behalf. The bankruptcy court, rejecting LaSalle, ruled that the subordination agreement appeared to be enforceable under state law and unequivocally provided that the junior lender assigned its right to vote on the plan. It also reasoned that section 1126(a) "does not expressly or implicitly prevent that right from being delegated or bargained away" and that Bankruptcy Rules 3018 and 9010 (the latter of which governs representation, appearances, and powers of attorney in bankruptcy cases) "explicitly permit agents and other representatives to take actions, including voting, on behalf of parties." Aerosol Packaging, 362 B.R. at 47.
Regardless of the particular approach adopted by a court on this issue, the growing consensus is that agreements that seek to limit or waive junior creditors' voting rights must contain express language to that effect. See In re MPM Silicones, L.L.C., 596 B.R. 416 , 430 (S.D.N.Y. 2019) (junior lienholders did not breach an intercreditor agreement by voting in favor of a chapter 11 plan to which senior lienholders objected and which ultimately provided the senior lienholders with replacement notes allegedly worth less than their oversecured claims, absent an express voting rights waiver).
Fencepost Production, Inc. and its affiliates (collectively, "debtors") filed for chapter 11 protection on December 18, 2019, in Kansas. Prior to the bankruptcy filing, Associated Bank, N.A. ("Associated") agreed to loan the debtors up to $14 million on a secured basis. In 2018, Associated and another lender, BMS Management, Inc. (together with related individuals, "BMS Group"), entered into a subordination agreement providing that payment of the debtors' liability to BMS Group would be subordinated to payment in full of the debtors' obligations to Associated. It also provided that, in any bankruptcy: (i) Associated would file a claim on behalf of both lenders; (ii) Associated, at its sole discretion, had the right "to vote or consent to any … proceeding with respect to, any claims of [BMS Group] relating to [the debtors' obligations to BMS Group]"; and (iii) BMS Group would not take any position contrary to the terms of the agreement.
Associated filed a proof of claim in the debtors' bankruptcy for approximately $7.7 million, of which approximately $5.3 million (representing BMS Group's portion of the total debt) was unsecured. BMS Group separately filed a proof of claim for approximately $5.3 million. The debtors proposed a chapter 11 plan under which: (i) the secured claim of Associated would be paid from the proceeds of the liquidation of its collateral; (ii) holders of general unsecured claims (including any deficiency claim held by Associated) would recover 15% of their claims; (iii) BMS Group would be allocated $120,000 in respect of its separately classified, subordinated claim, but the funds would be distributed to Associated; and (iv) equity holders would retain their interests. The disclosure statement accompanying the plan stated that, if the debtors were liquidated in chapter 7, unsecured creditors would receive nothing and all assets would be distributed to secured and priority creditors.
Associated voted to accept the plan on behalf of itself and BMS Group. BMS Group separately voted to reject the plan. It also objected to approval of the debtors' disclosure statement and opposed confirmation of the plan.
The debtors objected to BMS Group's claim, arguing that it was barred by the subordination agreement. In addition, they filed a motion, also based on the express terms of the agreement, to disqualify BMS Group's vote and to strike its objection to the disclosure statement. BMS Group countered that although the other provisions of the subordination agreement were valid, assignment of its voting rights under the agreement was unenforceable.
The Bankruptcy Court's Ruling
Initially, Chief U.S. Bankruptcy Judge Dale L. Somers noted that, as exemplified by LaSalle and Aerosol Packaging, bankruptcy courts have reached different conclusions regarding the enforceability of chapter 11 plan voting right assignments in subordination agreements. He also explained that the issue has been commented upon extensively, and the ABI Commission to Study the Reform of Chapter 11 recommended in its 2014 final report that "[t]he contractual assignment of voting rights in favor of senior creditors under an intercreditor agreement, subordination, or similar agreement should not be enforced." See Final Report and Recommendations of the ABI Commission to Study the Reform of Chapter 11 (2014) p. 261.
According to Judge Somers, the reasoning of LaSalle is more persuasive. He accordingly held that BMS Group's assignment of its right to vote on the debtors' chapter 11 plan was unenforceable. In so ruling, he found that BMS Group did not appoint Associated as its agent under the subordination agreement.
Next, Judge Somers overruled the debtors' objection to BMS Group's claim. He reasoned that, notwithstanding the express terms of the subordination agreement, "subordination does not involve transfer of the subordinated creditor's legal interest." That interest, Judge Somers explained, is protected under the Bankruptcy Code's cramdown confirmation requirements in section 1129(b)(1) of the Bankruptcy Code, which provides that a nonconsensual plan may be confirmed "[n]otwithstanding section 510(a)." In other words, he wrote, "[t]his means that § 1129(b)(1) overrides § 510(a)."
However, Judge Somers concluded that BMS Group lacked standing to participate in the plan confirmation process.
He explained that BMS Group had statutory authority to participate under section 1109(b), section 1126(a) and section 1128(b) (providing that "[a] party in interest may object to confirmation of a plan."). Judge Somers declined to decide whether BMS Group had constitutional standing, "since it is not necessary in the present circumstances."
However, Judge Somers concluded that BMS Group lacked prudential standing to participate in the confirmation process because BMS Group was an out-of-the-money subordinated creditor with no financial stake in the outcome of the case. According to the judge, if permitted to participate, BMS Group "would be litigating issues affecting the rights of third parties, not itself," such as whether the plan violated the "absolute priority rule" by preserving equity interests without paying creditors in full.
The ruling in Fencepost regarding the unenforceability of chapter 11 voting rights assignments in subordination agreements adds yet another chapter to the ongoing debate on this issue. That aspect of the court's decision is unremarkable and emblematic of the exacting scrutiny recently directed by many bankruptcy courts toward bankruptcy-related rights assignments and waivers in such agreements.
The Fencepost court's conclusion that BMS Group lacked prudential standing is more complicated. In part, it would appear to be driven by the facts of the case, which involved a subordinated, clearly out-of-the-money creditor intent upon impeding an otherwise consensual reorganization.
The Bankruptcy Code, however, expressly provides to the contrary by, among other things, giving every party in interest (including creditors and interest holders, without making an exception in cases where there is no value available for distribution to them), the right to appear and be heard "on any issue" in a chapter 11 case (section 1109(b)), the right to vote on a chapter 11 plan (section 1126(a)), and the right to object to confirmation of a plan (section 1128(b)). These provisions arguably indicate that Congress intended to modify or abrogate prudential standing requirements when it enacted the Bankruptcy Code. Moreover, the "rights" any out-of-the-money creditor or shareholder would be seeking to enforce by participating in the confirmation process are arguably their own, rather than the rights of third parties.
A logical extension of the rationale articulated in Fencepost is that clearly out-of-the-money creditors or shareholders of an insolvent corporation would never have prudential standing to participate in the chapter 11 plan confirmation process. That approach would be contrary to court rulings and general practice in many chapter 11 cases.
A version of this article is being published in Lexis Practical Guidance. It has been published here with permission.