Based on a subordination agreement, senior secured noteholders contended that they were entitled to receive payment of post-petition interest from bankruptcy plan distributions that would otherwise go to junior noteholders. The junior noteholders countered that the senior noteholders were not entitled to the benefit of the subordination provision dealing with post-petition interest.
As background, under Section 502(b)(2) of the Bankruptcy Code a creditor generally is not allowed a claim for post-petition interest. There is an exception for oversecured creditors under Section 506(b). However, the senior noteholders were not oversecured. (Otherwise, they would not have needed to rely on the subordination argument.)
The sequence of financing was as follows:
- 1997 – The debtor had a credit facility through LaSalle Bank consisting of a $22.6 million revolver and a $3.5 million secured term loan. By 2003, this increased to a $40 million revolver, a $20 million supplemental revolver, and ~$12.2 million term debt. By the end of 2004, the total credit facility was $154.6 million.
- 2003 – The debtor issued $200 million of convertible notes. The indenture included subordination provisions and was governed by New York law.
- 2006 – The debtor entered into a new credit facility with a group led by Citibank for an unsecured $320 million revolving line of credit. The LaSalle credit facility was paid off and terminated.
- 2009 – The debtor defaulted under the Citibank credit facility due to adverse regulatory developments. The debtor repaid the facility from cash on hand and the facility was terminated.
- Next followed an 18-month period in which the debtor did not have any financing. (There was a dispute as to whether it could have obtained financing, or simply chose not to do so.)
- 2010 – The debtor obtained a $20 million secured bridge loan, which was refinanced by a larger senior secured debt financing with the same lenders consisting of a $60 million bridge loan and a $120 million multi-draw term loan (which the debtor apparently did not draw).
- 2011 – The debtor issued $225 million of senior secured notes, which were used in part to pay off the prior secured debt financing.
The subordination agreement at issue was included in the 2003 junior note indenture. As a general matter, it provided that the junior notes were “subordinated in right of payment, in cash or cash equivalent, to the extent and in the manner stated in this Article XI to the prior payment in full when due of all existing and future Senior Indebtedness of [the debtor].”
With respect to bankruptcy distributions, it provided that “the holders of all Senior Indebtedness shall first be entitled to receive payment in full, in cash or cash equivalent, of the principal thereof, the interest thereon and any other amounts then due thereon before the [junior notes] are entitled to receive payment on account of the principal of or interest on or any other amounts due on the [junior notes].”
Senior Indebtedness was defined as:
[T]he principal of, premium, if any, interest, including, with respect to the Credit Facility [which was defined by reference to the LaSalle facility], all interest accrued subsequent to the commencement of any bankruptcy or similar proceeding, whether or not a claim for post-petition interest is allowable as a claim in any such proceeding, and rent payable on or in connection with, and all fees, costs, expenses and other amounts accrued or due on or in connection with, [the debtor’s] Indebtedness whether secured or unsecured, absolute or contingent, due or to become due, outstanding on the date of this Indenture or thereafter created, incurred, assumed, guaranteed or in effect guaranteed by the company, including all deferrals, renewals, extensions or refundings of, or amendments, modifications or supplements to, the foregoing [with certain exceptions]. (Emphasis added).
The final piece of the puzzle is the “rule of explicitness.” Various decisions held that a subordination provision had to explicitly reference the senior creditor’s right to post-petition interest in order to be enforceable, given that those claims are generally disallowed in bankruptcy. Thus, the model indenture published by the American Bar Association in 1983 and the revised version adopted in 1999 included language explicitly providing for priority of post-petition interest by including a clause in the definition of Senior Indebtedness: “all interest accrued subsequent to the commencement of any bankruptcy or similar proceeding, whether or not a claim for post-petition interest is allowable as a claim in any such proceeding…”
Given that the Bankruptcy Code added Section 510(a), which provides that a subordination agreement is enforceable to the same extent that it would be under non-bankruptcy law, some argued that the rule of explicitness did not survive adoption of the Bankruptcy Code.
However, even under Section 510, there remains the question of whether a subordination agreement is enforceable under non-bankruptcy law. The 11th Circuit certified the question of whether New York law requires a subordination agreement to specifically address post-petition interest, and the New York Court of Appeals responded by saying that the rule of explicitness should be recognized and specific language was required in order to include post-petition interest as senior debt in order to alert a junior creditor to its risk.
In contrast, the 1st Circuit held that the rule of explicitness was extinguished by the Bankruptcy Code, and the New York court did not have any authority to determine an issue that would apply only in a federal bankruptcy. However, it went on to conclude that the language at issue in the case was ambiguous (since it did not specifically address post-petition interest). Ultimately the bankruptcy court concluded that the indenture did not support including post-petition interest in the senior indebtedness – suggesting that the rule of explicitness may survive as a practical matter even in the 1st Circuit.
As noted by the K-V Discovery Solutions bankruptcy court: “It would appear that in order to avoid much uncertainty and a lengthy trial, the Rule of Explicitness should be followed.”
In this case the question turned on whether the post-petition interest provision benefited only LaSalle (the initial senior creditor), or extended to the senior noteholders. The senior noteholders argued (1) the language was clear, and the reference to “including, with respect to the Credit Facility,” was only illustrative and not limiting; (2) the rule of explicitness had been abolished; and (3) the definition of “Credit Facility” included a “replacement” for the LaSalle facility, and the senior notes were a “functional” replacement.
On the first argument, the bankruptcy court agreed with the junior noteholders that the language was clear, but the clear meaning was that only post-petition interest relating to the “Credit Facility” was covered. The drafting history for the indenture was that (1) initially there was no reference to post-petition interest, (2) a subsequent draft included the ABA model post-petition interest provision, and (3) a further draft inserted the clause “with respect to the Credit Facility.” The court concluded that the result of this negotiation was that protection was given specifically to LaSalle.
In response to the argument that the rule of explicitness was abrogated by adoption of Section 510(a) of the Bankruptcy Code, the court noted this would have been determinative only if the indenture did not include any provision. However, in this case the question was whether the explicit language had limited application.
With respect to the final argument, the question was whether “replacement” meant replacement of the LaSalle facility in a temporal sense (i.e. followed and substituted for the LaSalle facility) or a structural sense (i.e. replaced the LaSalle facility in the debtor’s capital structure). The court concluded that equating “Credit Facility” with senior debt would cause the clause to have no meaning. So, it rejected the senior noteholders’ functional replacement argument and determined that the senior noteholders could not recover post-petition interest from the distribution to the junior noteholders under the subordination provisions.
The bankruptcy court was most receptive to the last argument. If there had been an unbroken chain of refinancings, it is not entirely clear how the court would have come out. However, with the 18-month gap of no financing, arguing that the senior notes were a replacement for the LaSalle facility didn’t fly.
This illustrates yet again that precision in drafting matters, and possible ambiguities are a very important consideration in reviewing documents during due diligence.
Vicki R. Harding, Esq.