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The recent explosion in merger activity invites challenges to the enforceability of provisions purporting to transfer voting rights to senior lenders in bankruptcy. Subordination agreements containing these vote-transfer provisions are common among lenders participating in a merger. The ability of the senior lender to vote a junior lender’s claim in bankruptcy often elevates the senior lender’s influence in plan negotiations while usurping the junior lender’s ability to negotiate a meaningful distribution. After all, the senior lender will vote the claims in its best interests that might contradict the interests of the junior lender. There is a dearth of decisions directly addressing whether a creditor’s transfer of its voting rights in bankruptcy is enforceable. Although most of the decisions enforce the transfer, the U.S. Bankruptcy Court for the Northern District of Illinois found palpable support in the Bankruptcy Code for its decision not to enforce a vote-transfer clause contained in a subordination agreement. Bank of America N.A. v. N. LaSalle St. Ltd. Partnership (In re 203 N. LaSalle St. Ltd. Partnership), 246 B.R. 325 (Bankr. N.D. Ill. 2000). This article discusses the enforceability of vote-transfer provisions and analyzes decisions shaping the split in the circuits concerning enforcement. An example of the detrimental effect these provisions can have on both junior lenders and the entire unsecured class of creditors is considered. Finally, suggestions geared toward increasing the likelihood that vote-transfer provisions will be enforced are explored. Decisions enforcing transfers A junior lender’s transfer of its voting rights to the senior lender is commonplace in subordination agreements between the lenders. Legal decisions enforcing vote-transfer provisions offer two main reasons why the transfer of these rights to senior creditors under subordination agreements are enforceable. Alan N. Resnick, “Subordination Agreement Provisions Shifting Chapter 11 Voting Rights: Can the Seniors Disenfranchise the Juniors?,” 118 Banking L.J. 297 (April 2001). The first reason stems from traditional contract law principles and 11 U.S.C. 510(a) (providing that subordination agreements are enforceable in bankruptcy to the same extent such agreements are enforceable under applicable nonbankruptcy law). The second reason is that subordinated creditors have no interest in their claims until the senior creditor is paid in full. A provision contained in a subordination agreement transferring voting rights to the senior lender was deemed enforceable in conjunction with the senior lenders’ motion for relief from the automatic stay in In re Curtis Ctr. Ltd. Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996). In analyzing whether the debtor’s proposed plan of reorganization was potentially confirmable, the court found that the plain and unambiguous language of a subordination agreement authorizing a senior creditor to “prove and vote” the claims of junior creditors was fully enforceable in bankruptcy pursuant to � 510(a) of the Bankruptcy Code. The court concluded that the debtor could not rely on the vote of the impaired junior creditor for confirmation purposes. Rather, the senior creditor’s vote on behalf of the junior creditor must be considered. The assignment and subordination by a junior creditor of its voting rights in bankruptcy to a senior creditor was enforced in In re Inter Urban Broad. of Cincinnati Inc., No. 94-2382, 1994 WL 646176 (E.D. La. Nov. 16, 1994). Relying on a subordination agreement, the senior lender voted both its and the junior lender’s claim in favor of the senior lender’s competing plan, which ultimately was confirmed. The junior lender failed to object to the senior lender casting its vote. The bankruptcy court overruled the debtor’s attempt to disqualify or designate the senior lender’s votes. In the precode decision of In re Itemlab Inc., 197 F. Supp. 1994 (E.D.N.Y. 1961), equitable considerations supported permitting a senior lender to vote the claim of the junior lender. Although the subordination agreement was silent as to the voting of claims in bankruptcy proceedings, the U.S. District Court for the Eastern District of New York reasoned that the vote attaches to the claim. Because the claim was transferred to the senior lender upon the borrower’s insolvency, the senior lender was entitled to vote the junior claim. The clear intent of the parties was that upon the debtor’s insolvency, the senior lender would control the junior claim and the junior lender would have no authority “to collect or any power to revoke.” Id. at 197. See Broad. Cap. Inc. v. Davis Broad. Inc. (In re Davis Broad. Inc.), 169 B.R. 229 (Bankr. M.D. Ga. 1994) rev’d on other grounds, 176 B.R. 290 (M.D. Ga. 1994). Finding that prebankruptcy agreements do not override contrary provisions of the code, the court in In re 203 N. LaSalle St. Ltd. Partnership refused to enforce a vote-transfer provision contained in a subordination agreement. 246 B.R. at 325. In LaSalle, the senior lender sought a declaratory judgment finding, among other things, that it was entitled to vote the claim of the junior lender pursuant to the parties’ subordination agreement. The junior lender contended that it had the right to vote its own claim in the confirmation process. Initially, the LaSalle court found that an adversary proceeding was an appropriate method for determining the rights of the parties under the subordination agreement. The court reasoned that subordination affects the order of priority of payments but not the transfer of voting rights. Furthermore, because � 510(a) does not allow for a waiver of voting rights, the court refused to allow the senior lender to vote the subordinated claim. The court held that prebankruptcy agreements may not override contrary Bankruptcy Code provisions, noting that a debtor’s agreement to “contract away” its right to a discharge would be against public policy. Because the bankruptcy system is designed to distribute assets differently than under nonbankruptcy law, allowing parties to override Bankruptcy Code provisions by contract would “defeat the purpose of the Code.” The court also found that the Federal Rules of Bankruptcy Procedure precluded the senior lender’s voting of the subordinated creditor’s claim because the creditor must sign the ballot. Fed. R. Bankr. P. 3018(c). Also, permitting a subordinated lender to vote its claim assured that the holder of the subordinated claim maintained its role in the negotiation and confirmation of a plan. See generally Beatrice Foods Co. v. Hart Ski Mfg. Co. Inc. (In re Hart Ski Mfg. Co. Inc.), 5 B.R. 734, 735 (Bankr. D. Minn. 1980) (there is no indication that Congress intended creditors to alter through subordination agreements the bankruptcy laws unrelated to distribution of assets) (dicta). Enforceability issues Provisions in subordination agreements purporting to transfer voting rights could be subject to strict scrutiny in the bankruptcy court if the court interprets � 510(a) narrowly or finds that a formal assignment of the voting rights is required. The section provides that subordination agreements are enforceable in bankruptcy to the same extent the agreements are enforceable under applicable nonbankruptcy law. 11 U.S.C. 510(a). Only one code decision, In re Curtis Ltd. Partnership, enforced a vote-transfer provision without an actual assignment of the voting rights. Yet the court’s reliance on � 510(a) might be misplaced. Seemingly, the section does not support enforcement of a vote-transfer agreement because such rights are not enforceable outside of bankruptcy (as they do not exist outside of bankruptcy). Because � 510(a) makes subordination agreements enforceable in bankruptcy only to the same extent they are enforceable “under applicable nonbankruptcy law,” a broad interpretation of that section may not be warranted. Although a portion of the reasoning in LaSalle might be questionable because a debtor is not contracting away its rights when creditors agree to a transfer of voting rights, the court’s interpretations of the code and rules as precluding the transfer of voting rights appear cogent. Indeed, courts are reluctant to emasculate the Bankruptcy Code and the statutory protections afforded both debtors and creditors by permitting parties to contract away their rights. Klingman v. Levinson, 831 F.2d 1292, 1296 n.3 (7th Cir. 1987). Debtors might claim the entire confirmation process is being undermined by permitting senior lenders to control junior claims. In cases involving a fully secured senior lender and a partially secured junior lender, the senior lender can deprive the junior lender of a meaningful distribution. For example, when the collateral is valued at $25 million and a senior lender holds an allowed claim totaling $20 million and a junior lender holds an allowed claim totaling $15 million, the senior lender has little incentive to obtain a significant distribution to the unsecured class because the senior lender is fully secured. Section 506 of the Bankruptcy Code mandates the bifurcation of the junior lender’s claim to a $5 million secured claim and a $10 million unsecured claim. 11 U.S.C. 506(a). The senior lender likely will vote both its claim and the junior lender’s bifurcated claims to accept a plan providing for the full payment of the senior lender’s claim even though the plan provides for a minuscule distribution to the unsecured creditors. The junior creditor desiring to reject the plan’s treatment of its undersecured claim will be at odds with the senior lender that controls the junior lender’s vote. The junior lender’s hardship engulfs the other unsecured creditors in cases where its claim represents at least two-thirds of the dollar amount of the allowed unsecured class of claims. In those cases, the senior lender’s vote of the junior claim will determine the treatment of the entire class of unsecured creditors. 11 U.S.C. 1126 (a plan is deemed accepted by a class of unsecured creditors if the plan is accepted by creditors holding at least two-thirds of the dollar amount of the allowed claims in the class). Finally, as demonstrated in In re Inter Urban Broad. of Cincinnati Inc., when the senior lender is the proponent of a plan, it might dominate the confirmation process by voting the junior lender’s claim in favor of the plan. In sum, there is no clear precedent controlling whether bankruptcy courts should enforce provisions providing for the transfer of voting rights. A decision not to enforce the transfer finds support in the language of the Bankruptcy Code and rules. Yet a broad interpretation of � 510(a) and deference to the creditors’ contractual rights support enforcement. Senior lenders should not rely solely on the blanket terms of a subordination agreement. Rather, senior lenders always should attempt to obtain an assignment of the junior lender’s voting rights. Furthermore, senior lenders should obtain a security interest in the junior lender’s claim and voting rights and properly perfect those interests, thereby increasing the likelihood that a vote-transfer provision will be enforced. Joanne Gelfand is of counsel to the Fort Lauderdale, Fla., office of Akerman Senterfitt, where she concentrates her practice in bankruptcy and creditors’ rights. She can be contacted via e-mail at [email protected].

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