by Patrick E. Mears
In commercial real estate transactions among two lenders and a common debtor, the lenders will often enter into subordination agreements between themselves concerning repayment of their respective loans and the priority of their liens in real estate collateral. For example, the current mortgage lender may be unable or unwilling to advance additional funds to the owner to finance improvements to an existing real estate project. A new lender is willing to make these advances. The new lender demands, however, that the new loan be repaid within a certain time and that this debt be secured by a first priority mortgage lien and security interests in the same property that secures the preexisting mortgage debt. In this situation, the lenders and the common debtor will normally enter into debt and lien subordination agreements defining how the two loans will be repaid and what the priorities of the lenders' respective liens will be. Courts often apply different theories about the legal status and enforceability of subordination agreements, as evidenced by the following statement from In re Holly's, Inc., 140 B.R. 643, 669 (Bankr. W.D. Mich. 1992):
This court believes that the better view is to generally analyze subordination agreements under a contract theory after reviewing the governing language of a given agreement in each instance, but recognizing that in some debt subordination instances an assignment analysis may be warranted if intended by the parties.
Parties and their counsel must therefore be as careful and precise as possible in drafting subordination agreements.
This article first addresses the various types of subordination agreements affecting real estate transactions. The differences between "inchoate" and "complete" subordination agreements are described, along with the various attributes of "debt" and "lien" subordination agreements. The key provisions that must be negotiated between and among the lenders and the debtor in debt and lien subordination agreements are then highlighted.
Inchoate and Complete Subordination Agreements
Most subordination agreements between lenders in real estate lending transactions will be characterized as "inchoate." These agreements will not become enforceable unless and until the owner of the project becomes the subject of a bankruptcy case, becomes insolvent or defaults on its obligations under the senior loan documents. In the absence of these conditions, the debtor may make regular payments to the subordinated creditor.
If the debtor defaults, files for bankruptcy or becomes insolvent, however, an inchoate subordination agreement will prohibit the debtor from paying the subordinated creditor. If the debtor nevertheless continues to make these payments, the senior creditor may recover them from the junior creditor. If the common debtor is in a bankruptcy case, inchoate subordination agreements will typically permit the senior creditor to receive "double dividends." Until the senior debt is paid in full, the senior creditor will be entitled to receive not only the dividends paid on its own claim but also all distributions made in the bankruptcy case on the claim of the junior creditor.
"Complete" subordination agreements prohibit the debtor from making any payments of principal and interest on the subordinated debt until all senior debt has been paid. These agreements are not common when the two lenders are unrelated to the common debtor. Complete subordination agreements are often used when one of the lenders is affiliated with the debtor, such as being its parent company or a controlling shareholder. A complete subordination in this situation will require the affiliated lender to forego receiving loan repayments until the senior debt is repaid in its entirety.
Debt Versus Lien Subordinations
Distinctions also exist between agreements that subordinate the repayment of debt and those that subordinate the priority of liens. A debt subordination agreement is a contract in which the junior creditor agrees that, under certain circumstances, its claims against the common debtor
will not be paid until all senior in-debtedness is repaid. By contrast, lien subordination agreements modify the priorities of liens in common collateral. Subordination agreements often incorporate the important aspects of both of these agreements.
In a lien subordination agreement, two secured creditors will agree on the relative priorities of their respective liens and security interests in some or all of the debtor's assets. If a transaction involves two or more creditors with security interests in the same collateral, an intercreditor agreement that provides for lien subordination will enable those creditors to avoid future disputes over the priorities of their security interests. Secured creditors also may use these agreements to alter their lien priorities, giving higher priority to a creditor that would otherwise have junior status. Creditors may also employ these agreements to modify enforcement rights without affecting their relative lien priorities.
Theories of Enforcement
Subordination agreements have historically been enforced by the courts under four separate legal theories: equitable liens, constructive trusts, equitable assignments and express contracts. The majority of cases and the current trend in case law enforces subordination agreements as a matter of contract law. In interpreting subordination agreements, these decisions primarily focus on the language of the contract and the expressed intent of the parties. Bankruptcy Code § 510(a) directs bankruptcy courts to enforce subordination agreements to the extent that those agreements are enforceable under applicable nonbankruptcy law. 11 U.S.C. § 510(a).
Negotiating Key Provisions
When representing a lender in a real estate transaction involving another lender, counsel must be prepared to negotiate certain key provisions in debt and lien subordination agreements. The following is a brief discussion of those important contractual provisions and certain strategies in negotiating those provisions.
Debt Subordination Agreements
Payment maturities. A subordination agreement will often prohibit the junior creditor from receiving payments on its claim and collecting on the junior debt until the senior debt is paid in full. The senior creditor will seek to include a provision prohibiting the debtor from creating relationships between itself and the junior creditor (especially an insider) that could result in the junior creditor's receiving cash or other property from the debtor. To that end, the senior creditor should negotiate for a provision prohibiting the junior creditor from receiving any property from the debtor, whether through loans, dividends or the like.
Payment rights. A debt subordination agreement should also require that senior debt be paid in full before any payments may be made on subordinated debt in the context of reorganization, liquidation or dissolution of the debtor. Normally, all liquidation and other proceeds otherwise due to the junior creditor should first be paid over to the senior creditor.
Bankruptcy clauses. To fully protect the senior creditor, the debt subordination agreement should contain provisions authorizing the senior creditor to exercise a degree of control over the subordinated creditor and its claim in the bankruptcy case of the common debtor. The agreement should specifically address the following issues.
Description of proceedings. A subordination agreement should provide a broad description of a potential bankruptcy case and related proceedings, including various definitions of other insolvency proceedings, such as assignments for the benefit of creditors, receiverships and the like.
Filing proofs of claim. A subordination agreement should permit the senior creditor to file a proof of claim for the subordinated debt after the debtor's bankruptcy case is commenced or at a later date if the junior creditor fails to do so within a specified period of time. The authorization to file a proof of claim is generally coupled with an irrevocable power of attorney granted by the junior creditor to the senior creditor.
Voting junior debt. Certain votes taken in a Chapter 11 case, such as the election of a trustee or the acceptance or rejection of a reorganization plan, will strongly influence the direction of the case and the amount and timing of payments made to the debtor's creditors. The ability of the senior creditor to vote the subordinated debt on these matters will be extremely important to the senior creditor. Also, the Bankruptcy Code mandates that every plan separate the claims and interests into classes and that a Chapter 11 plan may not be confirmed unless each class of impaired creditors votes to accept the plan (in the absence of cramdown). 11 U.S.C. 1122, 1126 & 1129. The vote of the subordinated debt may determine whether the class of which it is a member accepts or rejects the plan. Unless the senior creditor is authorized to vote the claim of the subordinated creditor, a Chapter 11 plan favored by the senior creditor could be denied confirmation on account of the junior creditor's rejection of the plan.
Collecting post-petition interest. Unless all pre-petition claims of a debtor in bankruptcy are paid in their entirety, a creditor holding an unsecured claim may not collect interest accruing on its claim after the debtor commences a bankruptcy case. A holder of a secured claim, on the other hand, is entitled to collect post-petition interest but only to the extent that the value of its collateral exceeds the amounts of that creditor's allowed claim. Id. at § 506. If the junior creditor's claim is oversecured (i.e., if the value of the collateral, taking into account the senior creditor's lien, exceeds the amount of the junior creditor's claim), then the senior creditor presumably would want to receive directly any post-petition interest payments made by the debtor to the junior creditor. To ensure that this occurs, the subordination agreement should specifically require the junior creditor to turn over these payments to the senior creditor immediately on their receipt.
Exercising the § 1111(b) election. The subordination agreement should continue the subordination status of the subordinated debt when the senior secured creditor elects, under Bankruptcy Code § 1111(b), to have its claim treated as being a fully secured claim. This provision will stop the junior creditor from arguing that, by making this election, the senior debt has been paid in full. At least one reported decision rendered under the Bankruptcy Act of 1898 supports the senior creditor's position that these voting provisions in a subordination agreement are enforceable against the junior creditor in a bankruptcy case. In re Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961). In a recent unreported decision, however, a bankruptcy court refused to enforce a similar provision on the ground that the right to vote on a Chapter 11 plan is a substantive right granted by statute that cannot be affected by contract. In re National Gypsum Co., Case Nos. 390-37213-SAF-11 & 390-37214-SAF-11 (Bankr. N.D. Tex. Aug. 24, 1992).
Waiver of marshaling rights. The doctrine of marshaling of assets developed as an equitable principle designed to benefit junior secured creditors. This doctrine is traditionally applied when two or more secured creditors hold claims against one debtor, the senior creditor may collect from two properties or funds held by the common debtor and the junior creditor may recover from only one of those properties or funds. The doctrine of marshaling requires that the senior creditor first satisfy its claim from the property or fund in which the junior creditor has no interest so as to preserve the junior creditor's ability to collect from the common fund. See, e.g., Meyer v. United States, 84 S. Ct. 318 (1963); In re Beacon Distributors, Inc., 441 F.2d 547 (1st Cir. 1971).
If both the subordinated debt and the senior debt are secured in this fashion, the junior creditor may invoke the doctrine of marshaling to compel the senior creditor to liquidate the collateral securing the senior debt before foreclosing on collateral securing the subordinated debt. To avoid this result, the senior creditor should negotiate a provision in the subordination agreement by which the junior creditor waives its marshaling rights. This waiver should also specifically relieve the senior creditor of any responsibility to collect from the assets of any guarantor of the senior debt before seeking recourse against the subordinated debt or the collateral securing it.
Constructive trust. The subordination agreement should also require that any payments on subordinated debt made to a junior creditor in breach of the subordination agreement be held "in trust" for the senior creditor. This provision should facilitate the senior creditor's ability to track and recover these monies in the junior creditor's possession.
Further assurances. A "further assurances" clause in the subordination agreement will often be very important to the senior creditor because debt subordinations may be viewed in some jurisdictions as assignments or pledges of the subordinated debt. The perfection of the senior creditor's "interest"
in the junior debt (e.g., by the filing of a financing statement listing the junior debt as collateral) may assist the senior creditor in defending against a claim asserted in the common debtor's bankruptcy case that the senior creditor's rights in the junior debt under the subordination agreement are unperfected and therefore avoidable under 11 U.S.C. § 544(a). See In re Holly's, Inc., 140 B.R. 643.
Debtor consent. By this provision, the common debtor acknowledges the subordination of its debt owing to the junior creditor in favor of the senior creditor.
Prepayments of subordinated debt. In inchoate subordination agreements, the junior creditor is entitled to receive payments (interest, principal or both) on the subordinated debt until the occurrence of an event of default that triggers the subordination provisions. Absent a default, however, the debtor could prepay all or a part of the subordinated debt before it matures. This prepayment would effectively circumvent the purpose of the sub-ordination agreement by depriving the senior creditor of its benefits. The senior creditor should therefore insist on a provision prohibiting the debtor from making any prepayments on the junior debt.
Secured subordinated debt. If the junior debt is also secured, the senior creditor should insist that any payments made from the common collateral be subject to the subordination agreement. Also, the senior creditor should require that the security agreement for the subordinated debt expressly prohibit the junior creditor from foreclosing or taking any other action concerning its collateral until the senior debt is paid in full.
Lien Subordination Agreements
Collateral description. Lenders must carefully scrutinize the description of the collateral in the loan and security documents. Errors in security agreements and financing statements may foster a challenge to the perfection of a lender's liens and security interests. Lien subordination agreements should be very specific about collateral descriptions. When both the junior creditor and the senior creditor claim priority in the same collateral, the parties should carefully identify their respective interests in that collateral.
Postponement of enforcement rights. A lien subordination agreement should prohibit the junior creditor from enforcing its subordinated rights in the collateral or in any other way interfering with the senior creditor's liens in the collateral until the senior debt is paid in full. This prohibition will permit the senior creditor to control any liquidation of the collateral and also the timing of that liquidation. Despite being subordinated to senior liens, a junior creditor has rights that may be burdensome to the senior creditor. For example, a junior creditor could commence mortgage foreclosure of the common collateral on the debtor's default. Despite the senior creditor's higher priority, the timing of the foreclosure may not be in the senior creditor's best interests. Consequently, the senior creditor should require that the junior creditor waive its rights to marshal assets and agree to postpone any enforcement rights that it may have against the collateral. The senior creditor should also require the junior creditor to agree to release its liens if that release is necessary for the senior creditor to foreclose on and sell its collateral.
Requests for notice. The lien subordination agreement should require the foreclosing senior creditor to give the junior creditor written notice of any sale or other disposition of the collateral. To preserve its liens and interests in the property, the junior creditor may elect to purchase the property at a foreclosure sale or to purchase the senior debt.
Termination, rescission or modification. If one of the parties to the lien subordination agreement later becomes dissatisfied with its credit agreement with the debtor, that creditor could assert that it had been defrauded or misled in some fashion by the debtor in the loan negotiations. The lien subordination agreement should contain a provision requiring the two creditors to be bound, notwithstanding any such claim.
Dollar limitations. A junior creditor may insist on a dollar limitation on the amount to be subordinated. A senior creditor making revolving loans or future advances to the debtor should resist that demand. This limitation would grant the junior creditor influence over the senior creditor's subsequent lending decisions. If the senior creditor desires to dictate which loans to make and which loans to deny the debtor, that creditor does not want to worry about which portion of the loans will be secured by its senior liens and which portion will be unsecured.
Right to terminate. A junior creditor's right to terminate the effectiveness of a lien subordination limits the senior creditor's ability to service the debtor's borrowing needs. By granting the junior creditor the power to determine the date on which liquidation will begin, a termination provision undermines the very purpose for which the senior creditor enters into the lien subordination agreement. The senior creditor should resist any attempt by the junior creditor to include a termination provision in the subordination agreement.
Debtor consent. Because the lien subordination agreement also has an impact on the debtor, the lenders should obtain the debtor's written consent to the document. The debtor's consent is typically contained at the end of the subordination agreement.
Debt and lien subordination agreements among a debtor and its creditors can be useful in avoiding or resolving disputes and in protecting their respective interests. Because the contract is usually enforced, it should clearly express the intent of the parties.
Patrick E. Mears is a senior member of Dykema Gossett, PLLC, in Grand Rapids, Michigan. He is a vice chair of the Real Property Division's Loan Practice and Lender Liability (I-2) Committee and a member of the Workouts, Foreclosure and Bankruptcy (I-7) Committee.
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