Intercreditor Agreements

In re Vassau

The case of Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal 2013) illustrates how judicial decisions can require transactional practitioners to re-evaluate their form documents to determine whether the same need to be adapted to overcome potential issues. The facts of the case are nothing out of the ordinary for a Chapter 7 bankruptcy proceeding. The Vassaus owned their principal residence located in Carlsbad, CA. At the time of the Vassaus' bankruptcy petition, July 1, 2009, the home was worth approximately $1,100,000.

The Vassaus' home was pledged as collateral for two separate loans and was encumbered by two liens, one senior and one junior. The senior lien was in favor of Bank of America, N.A., in its capacity as successor in interest to Countrywide Bank (the “Senior Lender”). The junior lien was also in favor of Bank of America, N.A., also in its capacity as successor in interest to Countrywide Bank (the “Junior Lender”). Prior to making the payments at issue in the bankruptcy proceeding, the Vassaus owed approximately $988,000 to Senior Lender and $265,000 to Junior Lender. In light of the $1,100,000 value of the Vassaus' home, the Senior Lender's indebtedness was fully secured, and the Junior Lender's indebtedness was partially secured.

At the time of the Vassaus' Chapter 7 bankruptcy petition, they were behind on their scheduled payments to the Senior Lender.

During the 90 days prior to the date of the Vassaus' Chapter 7 bankruptcy petition (the preference period for non-insiders), the Vassaus made payments to the Senior Lender of approximately $42,000. The Senior Lender applied those payments to interest charges, late fees, an escrow balance shortfall and other charges and fees. The In re Vassau court noted that this amount would have been fully secured by the lien on the Vassaus' home in favor of the Senior Lender. No transfers were made to ' or applied to the balance owed by the Vassaus to ' the Junior Lender during the 90-day preference period.

Trustee Objection

The Chapter 7 trustee (the “Trustee”) objected to the transfers to the Senior Lender made during the 90 days prior to the date of the Vassau's Chapter 7 bankruptcy petition. The Trustee argued that, even though none of the $42,000 in payments during the 90-day preference period were made to the Junior Lender, the payments were, in fact a preference to the Junior Lender. The Trustee's argument was that the effect of the payments to the Senior Lender reduced the amount of (fully) secured indebtedness owed to the Senior Lender by $42,000. As a result of this reduction in the senior secured indebtedness, the amount of equity cushion now available to secure the indebtedness owed to the Junior Lender increased by $42,000 (and the amount of unsecured indebtedness owed to the Junior Lender also decreased, correspondingly, by the same $42,000). Thus, by reducing the Senior Lender's fully secured claim, the secured portion of the Junior Lender's partially-secured claim increased.

The In re Vassau court reviewed the requirements for avoiding a preferential transfer:

(b) Except as provided in subsections (c) and (i) of this section, the trustee may avoid any transfer of an interest of the debtor in property '

” (1) to or for the benefit of a creditor;

” (2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

” (3) made while the debtor was insolvent;

” (4) made '

”” (A) on or within 90 days before the date of the filing of the petition; or

”” (B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

' '(5) that enables such creditor to receive more than such creditor would receive if '

”” (A) the case were a case under chapter 7 of this title;

”” (B) the transfer had not been made; and

”” (C) such creditor received payment of such debt to the extent provided by the provisions of this title.

11 U.S.C. '547(b).

The Junior Lender conceded that transfers were made and that subsections (2), (3) and (4) of ' 547(b) had been satisfied. The Junior Lender argued that subsections (1) and (5) of ' 547(b) were not satisfied. [Note, the Junior Lender also argued ' 547(i) as a defense. The In re Vassau court quickly disposed of this argument as ' 547(i) applied in cases of transfers to insiders made between 90 days and one year prior to the commencement of a bankruptcy proceeding. As In re Vassau did not involve transfers to insiders made between 90 days and one year prior to the commencement of the case, the court held that ' 547(i) did not apply.]

While the Junior Lender agreed that it was a creditor of the Vassaus at the time of the transfers, the Junior Lender asserted that the payments, having been made to the Senior Lender, were not made with the intent to benefit the Junior Lender.

The court held that intent was not relevant to the preferential transfer analysis. All that was required was that the transfer at issue actually benefit the creditor. In this case, the $42,000 paid to the Senior Lender clearly benefited the Junior Lender because such payments increased the amount “equity” in the Vassaus' home available to secure the Junior Lender's indebtedness, thus increasing the amount of the Junior Creditor's secured claim and decreasing the amount of the Junior Creditor's unsecured claim. Accordingly, the In re Vassau court held that the Trustee had satisfied subsection (1) of” 547(b).

'Hypothetical Liquidation'

After wrestling with the semantics of subsection (5) of ' 547(b), the court determined that the facts must be evaluated under a “hypothetical liquidation” paradigm to determine if the creditor at issue received more than it was otherwise entitled had the transfer not been made. Under such analysis, the court found that the Junior Lender clearly satisfied subsection (5) of ' 547(b). Since secured claims are paid in full under a Chapter 7 liquidation, and since unsecured claims are paid ratably in light of the overall amount of unsecured claims, a partially secured creditor benefits whenever the secured portion of its claim increases and the unsecured portion of its claim decreases. One hundred percent of an amount is always more than anything less than 100% of such amount.

The In re Vassau case could have numerous impacts on intercreditor arrangements. As the court noted, the Senior Lender and the Junior Lender were the same entity; however, the In re Vassau court stated that senior and junior lenders would not always be the same entity. Once a court concludes that a transfer is avoidable under ' 547 as a preference, ' 550(a) of the Bankruptcy Code permits a trustee to recover the property (or the value of such property) from either the entity benefited by the transfer (in this case, the Junior Lender) or the immediate transferee of the debtor (in this case, the Senior Lender). 11 U.S.C. ' 550. Thus, if a payment made to a fully secured senior lienholder is deemed to constitute a preferential transfer made to a partially secured junior lienholder under ' 547, a fully secured senior lienholder may be required under
' 550 to disgorge the payment to the bankruptcy trustee.

A Measure of Risk

Many commercial and corporate financings involve senior and junior creditors secured by the same collateral, and many of those transactions have junior creditors which are only partially secured by such collateral. Under the In re Vassau holding, both a senior and a junior lienholder could bear some measure of risk that flows from a ' 547 avoidance action in cases where the junior lienholder is partially secured by the same collateral as the senior lienholder. [Note: The risk visited upon the Senior Lender, i.e., the out-of-pocket payment made in response to the ' 550 recovery, should be only transitory in nature. Section 502(h) of the Bankruptcy Code provides that a claim arising from the recovery of property under ' 550 shall be allowed (assuming it is not otherwise disallowed under other provisions of the Code) "the same as if such claim had arisen before the date of the filing of the petition." 11 U.S.C. ' 502(h). Thus, the Senior Lender would be able to increase its existing claim by the amount recovered by the Trustee under ' 550. Logic suggests that this additional claim to which the Senior Lender would now be entitled (and deemed by the Code as having arisen pre-petition) should also be secured by the first lien held by the Senior Lender (and therefore prior to the Junior Lender), which would be consistent with their relative positions with respect to each other as they existed prior to the preferential transfer.]

Conclusion

Given that many senior/subordinate financing arrangements involve intercreditor agreements (including subordination agreements), lenders will need to consider if changes to their tried-and-true forms are necessary in light of In re Vassau. Lenders will want to consider whether an intercreditor agreement should allocate the risk of a preference recovery among the senior lender and junior lenders and to specify the priorities of all payments or recoveries as among senior lenders and junior lenders, including the result of a preference recovery by a bankruptcy trustee. To the extent possible, the senior lenders would likely prefer to allocate all of the risk of a preference recovery to the junior lenders (though the In re Vassau court did not address how such a provision would have altered the result in the case).

Some senior lenders may want to go so far as to require the junior lenders to indemnify the senior lenders for and hold the senior lenders harmless from any losses resulting from a preference determination, including an obligation to reimburse the senior lenders for any amounts that the senior lenders are required to return as a result of a successful preference action by a bankruptcy trustee (at least to the extent of the value of the junior creditor's lien) and, perhaps more importantly, including any costs, expenses and legal fees incurred by the senior lenders in connection with defending against the preference action. Finally, the senior lenders should require the junior lenders to agree that any payments recovered from the senior lenders by the bankruptcy trustee following a determination that the junior lenders received a preferential transfer will be treated as indebtedness of the borrower subject to the priority lien in favor of the senior lenders (i.e., the respective lenders are restored to their positions immediately prior to the occurrence of the preferential transfer).

In contrast, if junior lenders agree to such provisions, junior lenders will want to limit any indemnity or reimbursement obligations to final and nonappealable rulings and to cap the amounts subject to indemnity or reimbursement to the value of junior lender's lien. Furthermore, junior lenders may want to limit any such indemnity to costs, expenses and legal fees incurred by the senior lenders for actions taken at the express request of the junior lender in support of its defense against the preference avoidance action or to costs, expenses and legal fees incurred by the senior lenders only after the bankruptcy court has ruled that a preferential transfer has occurred and the trustee has elected to pursue the senior lenders for repayment. Alternatively, junior lenders may insist on limiting any such indemnity to situations where the senior lenders are not otherwise made whole under ' 502 of the Bankruptcy Code.

In any case, lenders should be prepared to improvise and adapt their approach to senior/subordinate intercreditor agreements involving common collateral to ensure that they can overcome subsequent preference risk should a borrower declare bankruptcy.

Sean M. Gillen is a partner in the Omaha, NE, office of Kutak Rock LLP. He is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers in asset acquisitions, dispositions and financings, including loan and lease financings, syndications, securitizations, restructurings, workouts and bankruptcies. He can be reached at [email protected]. Mr. Gillen would like to thank Tom Roubidoux, a partner in Kutak Rock's Finance and Restructuring Group specializing in bankruptcy law, for his invaluable input, comments and suggestions with respect to the mechanics of bankruptcy claims and preference actions and the practical bankruptcy implications of In re Vassau.

Editor's Note: This is the third article in a series covering various aspects of intercreditor agreements.'

During my third year of law school, I was convinced that litigation was the game for me. Sure, I never had designs of being Clarence Darrow or Gerry Spence (though I cannot deny dreams of an Atticus Finch moment or two). However, I was convinced that my personality and demeanor (“aggressive,” according to the self-analysis we conducted in our Negotiations course) represented a skill set more suited for the courtroom. Following my Trial Advocacy practical course and a couple of litigation projects while clerking for a private firm, I could not run away from the courthouse quickly enough. Transactional practice would be the life for me. I would never have to worry about litigation or its implications from the safety of the ivory transactional tower.

That being said, my subconscious desire for disillusionment would find continuous opportunities for satisfaction, notwithstanding the perceived bone-white walls and towering heights of transactional practice. Much to my chagrin, I found that courts were deciding cases that impacted my practice on a regular basis. Judicial decisions were not limited to such topics as trusts and estates, torts, family law or securities. What was worse, some of these decisions had the audacity to require modifications to our sacrosanct bank of form documents. To paraphrase the words of one Gunnery Sergeant Thomas “Gunny” Highway, we would need to improvise, adapt and overcome documentation challenges consistently presented by these pesky judicial decisions.

In re Vassau

The case of Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal 2013) illustrates how judicial decisions can require transactional practitioners to re-evaluate their form documents to determine whether the same need to be adapted to overcome potential issues. The facts of the case are nothing out of the ordinary for a Chapter 7 bankruptcy proceeding. The Vassaus owned their principal residence located in Carlsbad, CA. At the time of the Vassaus' bankruptcy petition, July 1, 2009, the home was worth approximately $1,100,000.

The Vassaus' home was pledged as collateral for two separate loans and was encumbered by two liens, one senior and one junior. The senior lien was in favor of Bank of America, N.A., in its capacity as successor in interest to Countrywide Bank (the “Senior Lender”). The junior lien was also in favor of Bank of America, N.A., also in its capacity as successor in interest to Countrywide Bank (the “Junior Lender”). Prior to making the payments at issue in the bankruptcy proceeding, the Vassaus owed approximately $988,000 to Senior Lender and $265,000 to Junior Lender. In light of the $1,100,000 value of the Vassaus' home, the Senior Lender's indebtedness was fully secured, and the Junior Lender's indebtedness was partially secured.

At the time of the Vassaus' Chapter 7 bankruptcy petition, they were behind on their scheduled payments to the Senior Lender.

During the 90 days prior to the date of the Vassaus' Chapter 7 bankruptcy petition (the preference period for non-insiders), the Vassaus made payments to the Senior Lender of approximately $42,000. The Senior Lender applied those payments to interest charges, late fees, an escrow balance shortfall and other charges and fees. The In re Vassau court noted that this amount would have been fully secured by the lien on the Vassaus' home in favor of the Senior Lender. No transfers were made to ' or applied to the balance owed by the Vassaus to ' the Junior Lender during the 90-day preference period.

Trustee Objection

The Chapter 7 trustee (the “Trustee”) objected to the transfers to the Senior Lender made during the 90 days prior to the date of the Vassau's Chapter 7 bankruptcy petition. The Trustee argued that, even though none of the $42,000 in payments during the 90-day preference period were made to the Junior Lender, the payments were, in fact a preference to the Junior Lender. The Trustee's argument was that the effect of the payments to the Senior Lender reduced the amount of (fully) secured indebtedness owed to the Senior Lender by $42,000. As a result of this reduction in the senior secured indebtedness, the amount of equity cushion now available to secure the indebtedness owed to the Junior Lender increased by $42,000 (and the amount of unsecured indebtedness owed to the Junior Lender also decreased, correspondingly, by the same $42,000). Thus, by reducing the Senior Lender's fully secured claim, the secured portion of the Junior Lender's partially-secured claim increased.

The In re Vassau court reviewed the requirements for avoiding a preferential transfer:

(b) Except as provided in subsections (c) and (i) of this section, the trustee may avoid any transfer of an interest of the debtor in property '

” (1) to or for the benefit of a creditor;

” (2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

” (3) made while the debtor was insolvent;

” (4) made '

”” (A) on or within 90 days before the date of the filing of the petition; or

”” (B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

' '(5) that enables such creditor to receive more than such creditor would receive if '

”” (A) the case were a case under chapter 7 of this title;

”” (B) the transfer had not been made; and

”” (C) such creditor received payment of such debt to the extent provided by the provisions of this title.

11 U.S.C. '547(b).

The Junior Lender conceded that transfers were made and that subsections (2), (3) and (4) of ' 547(b) had been satisfied. The Junior Lender argued that subsections (1) and (5) of ' 547(b) were not satisfied. [Note, the Junior Lender also argued ' 547(i) as a defense. The In re Vassau court quickly disposed of this argument as ' 547(i) applied in cases of transfers to insiders made between 90 days and one year prior to the commencement of a bankruptcy proceeding. As In re Vassau did not involve transfers to insiders made between 90 days and one year prior to the commencement of the case, the court held that ' 547(i) did not apply.]

While the Junior Lender agreed that it was a creditor of the Vassaus at the time of the transfers, the Junior Lender asserted that the payments, having been made to the Senior Lender, were not made with the intent to benefit the Junior Lender.

The court held that intent was not relevant to the preferential transfer analysis. All that was required was that the transfer at issue actually benefit the creditor. In this case, the $42,000 paid to the Senior Lender clearly benefited the Junior Lender because such payments increased the amount “equity” in the Vassaus' home available to secure the Junior Lender's indebtedness, thus increasing the amount of the Junior Creditor's secured claim and decreasing the amount of the Junior Creditor's unsecured claim. Accordingly, the In re Vassau court held that the Trustee had satisfied subsection (1) of” 547(b).

'Hypothetical Liquidation'

After wrestling with the semantics of subsection (5) of ' 547(b), the court determined that the facts must be evaluated under a “hypothetical liquidation” paradigm to determine if the creditor at issue received more than it was otherwise entitled had the transfer not been made. Under such analysis, the court found that the Junior Lender clearly satisfied subsection (5) of ' 547(b). Since secured claims are paid in full under a Chapter 7 liquidation, and since unsecured claims are paid ratably in light of the overall amount of unsecured claims, a partially secured creditor benefits whenever the secured portion of its claim increases and the unsecured portion of its claim decreases. One hundred percent of an amount is always more than anything less than 100% of such amount.

The In re Vassau case could have numerous impacts on intercreditor arrangements. As the court noted, the Senior Lender and the Junior Lender were the same entity; however, the In re Vassau court stated that senior and junior lenders would not always be the same entity. Once a court concludes that a transfer is avoidable under ' 547 as a preference, ' 550(a) of the Bankruptcy Code permits a trustee to recover the property (or the value of such property) from either the entity benefited by the transfer (in this case, the Junior Lender) or the immediate transferee of the debtor (in this case, the Senior Lender). 11 U.S.C. ' 550. Thus, if a payment made to a fully secured senior lienholder is deemed to constitute a preferential transfer made to a partially secured junior lienholder under ' 547, a fully secured senior lienholder may be required under
' 550 to disgorge the payment to the bankruptcy trustee.

A Measure of Risk

Many commercial and corporate financings involve senior and junior creditors secured by the same collateral, and many of those transactions have junior creditors which are only partially secured by such collateral. Under the In re Vassau holding, both a senior and a junior lienholder could bear some measure of risk that flows from a ' 547 avoidance action in cases where the junior lienholder is partially secured by the same collateral as the senior lienholder. [Note: The risk visited upon the Senior Lender, i.e., the out-of-pocket payment made in response to the ' 550 recovery, should be only transitory in nature. Section 502(h) of the Bankruptcy Code provides that a claim arising from the recovery of property under ' 550 shall be allowed (assuming it is not otherwise disallowed under other provisions of the Code) "the same as if such claim had arisen before the date of the filing of the petition." 11 U.S.C. ' 502(h). Thus, the Senior Lender would be able to increase its existing claim by the amount recovered by the Trustee under ' 550. Logic suggests that this additional claim to which the Senior Lender would now be entitled (and deemed by the Code as having arisen pre-petition) should also be secured by the first lien held by the Senior Lender (and therefore prior to the Junior Lender), which would be consistent with their relative positions with respect to each other as they existed prior to the preferential transfer.]

Conclusion

Given that many senior/subordinate financing arrangements involve intercreditor agreements (including subordination agreements), lenders will need to consider if changes to their tried-and-true forms are necessary in light of In re Vassau. Lenders will want to consider whether an intercreditor agreement should allocate the risk of a preference recovery among the senior lender and junior lenders and to specify the priorities of all payments or recoveries as among senior lenders and junior lenders, including the result of a preference recovery by a bankruptcy trustee. To the extent possible, the senior lenders would likely prefer to allocate all of the risk of a preference recovery to the junior lenders (though the In re Vassau court did not address how such a provision would have altered the result in the case).

Some senior lenders may want to go so far as to require the junior lenders to indemnify the senior lenders for and hold the senior lenders harmless from any losses resulting from a preference determination, including an obligation to reimburse the senior lenders for any amounts that the senior lenders are required to return as a result of a successful preference action by a bankruptcy trustee (at least to the extent of the value of the junior creditor's lien) and, perhaps more importantly, including any costs, expenses and legal fees incurred by the senior lenders in connection with defending against the preference action. Finally, the senior lenders should require the junior lenders to agree that any payments recovered from the senior lenders by the bankruptcy trustee following a determination that the junior lenders received a preferential transfer will be treated as indebtedness of the borrower subject to the priority lien in favor of the senior lenders (i.e., the respective lenders are restored to their positions immediately prior to the occurrence of the preferential transfer).

In contrast, if junior lenders agree to such provisions, junior lenders will want to limit any indemnity or reimbursement obligations to final and nonappealable rulings and to cap the amounts subject to indemnity or reimbursement to the value of junior lender's lien. Furthermore, junior lenders may want to limit any such indemnity to costs, expenses and legal fees incurred by the senior lenders for actions taken at the express request of the junior lender in support of its defense against the preference avoidance action or to costs, expenses and legal fees incurred by the senior lenders only after the bankruptcy court has ruled that a preferential transfer has occurred and the trustee has elected to pursue the senior lenders for repayment. Alternatively, junior lenders may insist on limiting any such indemnity to situations where the senior lenders are not otherwise made whole under ' 502 of the Bankruptcy Code.

In any case, lenders should be prepared to improvise and adapt their approach to senior/subordinate intercreditor agreements involving common collateral to ensure that they can overcome subsequent preference risk should a borrower declare bankruptcy.

Sean M. Gillen is a partner in the Omaha, NE, office of Kutak Rock LLP. He is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers in asset acquisitions, dispositions and financings, including loan and lease financings, syndications, securitizations, restructurings, workouts and bankruptcies. He can be reached at [email protected]. Mr. Gillen would like to thank Tom Roubidoux, a partner in Kutak Rock's Finance and Restructuring Group specializing in bankruptcy law, for his invaluable input, comments and suggestions with respect to the mechanics of bankruptcy claims and preference actions and the practical bankruptcy implications of In re Vassau.