How Bankruptcy Courts Interpret Intercreditor Agreements: The Uncertainty of Judicial Perspective

Intercreditor Agreements typically are contractual arrangements among lenders of similar or differing priorities to a single borrower secured by the assets of the borrower, often including real estate assets. These multiple layers of financing create uncertainty regarding the respective rights of the various lenders. To seek to avoid controversy, competing lien claims, extended time frames toward resolution and additional costs, the lenders seek agreements among themselves to establish priority, rights and obligations and procedures for addressing competing claims on assets among the lenders, especially to sort out the priorities of the first and second lien lenders.

Second-lien loans have been a part of leveraged finance markets for a long time, often fueled by the congruence of investors seeking higher returns and borrowers desirous of additions to their capital stack. Intercreditor agreements have played a pivotal role in enabling many of these transactions, delineating the rights and obligations of and among senior and junior creditors and establishing procedures for addressing defaults by borrowers. These agreements typically address issues like lien priority and subordination arrangements and agreements among lenders (whether in pari passu (equal priority) or subordinate priority positions), payment distributions, funding of operational costs and taxes coming due and pre-bankruptcy waivers. Such agreements exist because the various lenders wish to mitigate potential and actual conflicts in lender’s claims and assertion of rights in cases of borrower default, workout or bankruptcy scenarios.

This paper considers the legal framework governing intercreditor agreements, focusing on subordination provisions under the U.S. Bankruptcy Code (the “Code”) and, specifically, Section 510(a) thereof also considers key court decisions that have defined the scope and enforceability of these agreements, in whole or in part, particularly in cases involving contested waivers of statutory rights. Finally, the paper addresses some practical elements for structuring enforceable intercreditor agreements in bankruptcy situations.

Subordination under Bankruptcy Code Section 510

Section 510(a) of the Code provides that subordination agreements are enforceable in bankruptcy to the extent they are valid under applicable non-bankruptcy law. In re Bank of New England Corp., 364 F.3d 355 (2004), In re La Paloma Generating Company, 595 B.R. 466 (2018). Courts generally interpret such agreements under state contract law, focusing on the clarity and intent of the parties and sometimes contradictory provisions of the Code, as the Code does not provide a specific federal statute for interpreting these agreements. In re Bank of New England Corp., 364 F.3d 355 (2004). Intercreditor agreements also typically are enforced pursuant to their terms, and ordinary contract principles apply to their interpretation. In re Air Safety  Intern., L.C., 336 B.R. 843 (2005). Where terms are unambiguous, they govern creditor rights in bankruptcy, but they cannot create a conflict with, or override fundamental protections guaranteed by the Code In re Ion Media Networks, Inc., 419 B.R. 585 (2009).

For example, in In re Best Products Co., Inc., 168 B.R. 35 (Bankr. S.D. N.Y. 1994)[1], the court emphasized that subordination agreements must align with state law principles of enforceability. Ambiguities in such agreements may lead courts to consider extrinsic evidence, including the negotiating history underlying specific executed intercreditor agreements, to ascertain the parties’ intent and match that to coordinate with Code requirements.

Key Court Decisions on Subordination Agreements

Beatrice Foods Co. v. Hart Ski Manufacturing Co. Inc., 5 B.R. 734 (Bankr. D. Minn 1980), is one of the earliest bankruptcy cases addressing intercreditor agreements governing the rights of creditors holding liens on the same collateral. The court limited subordination agreements to the priority of payment, emphasizing that statutory rights under the Code, such as stay relief or claim assertion, are not altered by pre-petition agreements. This decision highlights the principle that bankruptcy law preserves certain creditor rights regardless of contractual subordination provisions to the contrary.

In re 203 N. LaSalle Street Partnership, [2] 246 B.R. 325, 331 (Bankr. N.D. Ill, 2000), dealt with priority of claims and rights of senior and junior creditors, changes to equity and impact of new equity infusions from existing parties. The court invalidated a provision transferring junior creditors’ voting rights to senior creditors, citing Section 1126(a) of the Code, which allows the claim holder to vote. The court reaffirmed that pre-bankruptcy agreements cannot contravene or transfer or assign to a senior lender a junior lender’s statutory voting rights.

In Ion Media Networks, Inc. et. al.,[3] 419 B.R. 585 (Bankr. S.D.N.Y., 2009), the court upheld provisions designed to prevent obstructionist behavior by junior creditors, including restrictions on contesting senior claims. This case illustrates the enforceability of intercreditor agreements that promote efficient bankruptcy proceedings.

In Erickson Retirement Communities, 425 B.R. 309 (Bankr. N.D. Tex. 2010), the court held that subordinated creditors were banned from seeking appointment of an examiner, where the existing agreement expressly stated that they would not “exercise any rights or remedies or take any action or proceeding to collect or enforce any of the subordination obligations without the prior written consent of the agent until the senior secured lenders had been fully satisfied.”

Common Bankruptcy Waivers in Intercreditor Agreements

Intercreditor agreements often require junior creditors to waive certain statutory rights to protect senior creditors’ interests in bankruptcy and allow the senior creditors to assert its priority claims without interference or objection until such claims are resolved or otherwise determined by the court. Common provisions include:

1. Consent to Cash Collateral: Junior creditors may be deemed to have consented to the use of cash collateral by the debtor upon notice of the senior creditors’ consent. In re General Wireless Operations Inc., Not Reported in B.R. Rptr. (2017).
2. Turnover Provisions: Junior creditors may be required to hold any proceeds from the common collateral in trust and pay them to the senior creditors until the senior claims are fully discharged. In re MPM Silicones, L.L.C., 596 B.R. 416 (2019).
3. Prohibition on Challenging Senior Claims: Junior creditors may be expressly prohibited from challenging the priority of the senior creditors’ claims, including on the basis of non-perfection of the senior liens. In re La Paloma Generating Company, 595 B.R. 466 (2018).
4. Restrictions on Objections and Actions: Junior creditors may be restricted from taking actions that hinder the senior creditors’ ability to exercise remedies with respect to the common collateral and may be barred from receiving any part of the common collateral until the senior claims are fully discharged. In re MPM Silicones, L.L.C., 596 B.R. 416 (2019).
5. Waiver of Rights to Grant Liens or Modify Rights: Junior creditors may waive the right to grant or impose liens on the collateral that are in pari passu with or superior to the senior creditors’ liens and may be barred from modifying or impairing or adversely limiting the rights of senior creditors without their prior written consent. In re Broadway 401 LLC, Not Reported in B.R. Rptr. (2011).
6. DIP Financing: Junior creditors generally are restricted from providing or supporting DIP financing that primes senior creditors’ liens unless specific conditions are met, such as the full repayment of senior debt or explicit provisions in intercreditor agreements. In re Vertis Holdings, Inc., Not Reported in B.R. Rptr. (2010).

Junior Creditor’s Voting Rights

The legal basis for disputes arising when senior creditors exercise junior creditors’ voting rights in bankruptcy is governed primarily by the provisions of the Code, particularly 11 U.S.C. § 1126(a), which states that “the holder of a claim” may vote to accept or reject a plan. This statutory provision has been interpreted to mean that voting rights are personal to the claim holder and cannot be waived or transferred through subordination agreements, as such agreements typically govern the priority of payment of claims, not voting rights.

Accordingly, senior creditors cannot control the bankruptcy process by restricting junior creditors’ voting rights or assigning those rights to themselves if such actions conflict with the Code. Courts consistently have refused to enforce provisions in intercreditor agreements that destabilize the reorganization process, violate public policy or otherwise restrict or attempt to transfer junior creditor voting rights.

For example, in In re MPM Silicones, L.L.C., 596 B.R. 416 (2019), the court ruled that pre-bankruptcy agreements cannot override statutory creditor rights, including voting on reorganization plans, without an express waiver. Similarly, in In re Ion Media Networks, Inc., 419 B.R. 585 (2009), the court upheld an intercreditor agreement but emphasized that it did not infringe on the junior creditors’ right to vote or appear as an unsecured creditor.

Moreover, in In re NESV Ice, LLC, 661 B.R. 427 (2024), the court held that a senior lender’s assignee exercising voting rights must act in good faith, as using such rights solely for litigation strategy would subvert the Code. Likewise, in In re Fencepost Productions, Inc., 629 B.R. 289 (2021), the court found that subordination agreements attempting to eliminate junior creditors’ voting rights are generally unenforceable because subordinated creditors retain their right to vote and invoke statutory protections without regard to provisions in an intercreditor agreement to the contrary.

Consequently, while intercreditor agreements may seek to limit junior creditors’ rights, courts will scrutinize such provisions and reject them if they conflict with the Code or undermine public policy.

Best Practices for Structuring Intercreditor Agreements

Drafting intercreditor agreements requires careful consideration of enforceability under both bankruptcy and state contract law. Key recommendations include:

• Clarity and Precision[4]: Ambiguous provisions are more likely to face judicial scrutiny and rejection. Clearly delineate the scope of waivers and restrictions.
• Alignment with the Code: Avoid provisions that directly conflict with or undermine, transfer or limit fundamental bankruptcy rights, such as voting rights under Section 1126(a).
• Innovative Solutions: Incorporate mechanisms like buyout options for junior creditors to reduce litigation risk. For example, courts in Ion Media and Aerosol Packaging highlighted the utility of such provisions.
• Jurisdictional Awareness: Recognize that courts differ in interpreting subordination under Code Section 510(a), with some focusing narrowly on payment priority and others adopting broader interpretations, especially if public policy arguments come into play.

Conclusion

In entering into intercreditor agreements on behalf of lenders, counsel should try to educate clients about these issues in advance of negotiating and executing intercreditor agreements. If not possible, then such attempts definitely should be undertaken before seeking to enforce provisions in existing intercreditor agreements that the courts are less likely to accept as discussed herein.  Assertion of those types of intercreditor agreement provisions may well result in unsuccessful results and simply add to the costs and time spent in bankruptcy court as well as adding to contentiousness of the proceeding.

Ultimately, effective intercreditor agreements balance senior creditors’ need for control priority of their liens with junior creditors’ statutory protections, fostering more cooperative creditor agreements and relationships to foster and encourage efficient and more-timely bankruptcy proceedings and resolutions.

[1] Declined to Extend by In re FiberMark, Inc., Bankr. D. Vt., March 10, 2006. Reorganized Chapter 11 debtors moved to admit into evidence, as expert opinion, the 298-page report compiled by an independent examiner appointed by the court to investigate and address disputed fact questions regarding motives of corporate Chapter 11 debtors’ principals and of members of the [creditors’] committee in connection with certain disputed transactions. The Bankruptcy Court held that only the examiner’s conclusions, and not evidence of his underlying rationale or facts as found by the examiner, could be introduced into evidence over hearsay objection.

[2] Declined to Follow by In re Caesars Entertainment Operating Co., Inc., Bankr. N.D. Ill. May 18, 2016. The Caesars court distinguished between waivers of specific contract rights (state law recourse) and statutory rights. It concluded that LaSalle’s broad invalidation of pre-bankruptcy agreements was not directly applicable because the waiver in Caesars did not explicitly address federal statutory rights.

[3] Distinguished by In re MPM Silicones, L.L.C., S.D.N.Y. January 4, 2019. In Ion Media, junior creditors’ recovery was tied to the same collateral securing senior creditors, triggering Intercreditor Agreement restrictions. Here, junior creditors received stock as part of the reorganization plan, which the court deemed unrelated to the common collateral.

[4] Rule of Explicitness, under which subordination agreement has to provide explicitly for senior creditors’ right to post-petition interest in event that debtor files for bankruptcy in order for the senior creditors’ post-petition priority rights to be enforced, is alive and well following adoption of Bankruptcy Code provision recognizing enforceability of subordination agreements in bankruptcy, and in order to avoid much uncertainty and lengthy trial, parties should follow the Rule of Explicitness in drafting subordination agreements. 11 U.S.C.A. § 510(a). See also In re Bank of New England Corp., 364 F.3d 355 (2004) and In re Caesars Entertainment Operating Co., Inc., 562 B.R. 168 (2016).

This article is intended for general informational purposes only and does not constitute legal advice or a solicitation to provide legal services. The information in this article is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this information without seeking professional legal counsel. The views and opinions expressed herein represent those of the individual authors only and are not necessarily the views of Clark Hill PLC.