Intercreditor Agreements

Background

The facts of Southern Fidelity are somewhat convoluted (harkening back to the adage that hard facts make bad law). In 2007, Brooke Capital Advisors, Inc. (“BCA”) loaned over $12 million to its parent entity, Brooke Capital Corp. (“Debtor”). As security for the loan, Debtor granted BCA a security interest in the stock of First Life America Corporation (“FLAC”), another affiliate of Debtor. Supposedly, BCA perfected its security interest in the stock via possession by attorney for Debtor.

After making the loan to Debtor, BCA entered into participation agreements with four separate, unrelated entities for a total of about 89% of the interests in the loan to Debtor. Three of those participation agreements required BCA to repurchase the participation interests at a future date. The fourth participation did not create a repurchase obligation. (Note: while all four participants were the plaintiffs in the Southern Fidelity litigation; we are concerned only with the three participants for the purposes of this article.)

After the consummation of BCA's sale of the participation interests in the loan, Debtor entered into a restructuring of a $9 million loan from Citizens Bank and Trust Company (“Citizens”). As part of the restructuring, Debtor granted Citizens a security interest in the FLAC stock. To perfect its security interest in the FLAC stock, Citizens, along with Debtor and BCA, entered into an escrow agreement with a third-party escrow agent to hold the stock on behalf of Citizens and BCA. In addition, Citizens, Debtor and BCA entered into a “Payments Agreement” whereby the three parties agreed that, if Debtor or BCA became entitled to receive any proceeds from the sale of the FLAC stock, those proceeds would be paid to Citizens and applied to satisfy Debtor's obligations to Citizens. Thus, BCA had subordinated its interest in the FLAC stock to Citizens.

Shortly after finalizing the restructuring of the Citizens loan, Debtor filed for bankruptcy. During the bankruptcy proceedings, Citizens asserted that it has a properly perfected security interest in the FLAC stock and that its security interest had priority over the security interest of BCA in the FLAC stock. The bankruptcy court found that the three participation agreements with repurchase obligations were, in fact, disguised loans and that those three participants had, at best, an unperfected security interest in the FLAC stock. The bankruptcy court agreed with Citizens with respect to those three participants, holding that the Payments Agreement among Citizens, Debtor and BCA effectively subordinated the security interest of BCA in the FLAC stock. With respect to the fourth participant, the bankruptcy court held that the Payments Agreement did not subordinate the security interest of BCA in the FLAC stock because the related participation agreement prohibited BCA from subordinating its security interest in the FLAC stock.

The three participants held to have subordinate interests in the FLAC stock appealed the decision of the bankruptcy court to the United States District Court for the District of Kansas. The participants argued that they held a perfected security interest in the FLAC stock under UCC ' 9 -310(c). Second, they argued that BCA could not subordinate their interests in the FLAC stock without their consent. Finally, they argued that the participation interests should not have been recharacterized as loans.

The District Court Ruling

The district court first ruled that whether or not the participation interests were recharacterized as loans was irrelevant ' the ruling would be the same regardless of whether the participants purchased a participation interest from BCA or made a loan to BCA. The court then held that the participants received a valid assignment of BCA's properly perfected first lien on the FLAC stock under UCC ' 9-310(c). The court held that the participants did not need to make any additional UCC filings to perfect their interest in the FLAC stock because BCA held a properly perfected security interest in the FLAC stock at the time it entered into the participation agreements, i.e., the time of “assignment.”

Furthermore, the district court held that BCA could not consent to Debtor's grant of a lien on the FLAC stock to Citizens or to subordinate its security interest in the FLAC stock because such actions were prohibited by the participation agreements. The participation agreements stated, in part, that BCA “will not, without [participant's] written consent, renew, extend or consent to the revision of the provisions of any note or security documents covered or waive any claim against [Debtor].” Thus, the court held that BCA was contractually prohibited of subordinating the participants' security interest in the FLAC stock. As such, the subordination arrangement among Citizens, Debtor and BCA was not enforceable against the participants.

Analysis

For the time being, we will set aside any debate over whether UCC ' 9-310(c) was applicable and, if so, whether it granted the participants a security interest in the stock or a security interest in a security interest in the stock (a payment intangible, for UCC purposes). Further, we will not consider whether the participations were, in fact participations, in which case the participants would have received a pro-rata interest in the loan to Debtor and the collateral securing such loan, or whether the participations were loans, whereby the participants would have a security interest in BCA's right to repayment from Debtor (a payment intangible, for UCC purposes). Rather, we will focus on the district court's holding that BCA was contractually prohibited of subordinating the participants' security interest in the FLAC stock.

Those who practice in capital markets should be concerned with this ruling. The district court effectively made the participation agreements between BCA and the participants binding on Citizens, even though Citizens was never party to the participation agreements. This is a complete departure from contract law, which could impose an untenable burden of due diligence and risk upon a party seeking a lien subordination from a prior perfected secured creditor.

If BCA was contractually prohibited from subordinating its security interest in the FLAC stock vis ' vis the participants, and if BCA then entered into a subsequent agreement whereby BCA breached such prohibition, then the participants would have a claim against BCA for breach of contract. However, the agreements between BCA and the participants should in no way be binding on the party receiving the benefit of the subordination or otherwise impair the effectiveness of the subordination.

As the participants allowed BCA to act on their behalf, Citizens had no way to know that BCA lacked authority to subordinate its lien on the FLAC stock. At worst, from the perspective of Citizens, BCA had the apparent authority to do so. Absent actual knowledge of Citizens to the contrary, the effectiveness of the subordination should not have been impaired by the participation agreements.

The Southern Fidelity holding would create an unacceptable amount of uncertainty with respect to subordination agreements and intercreditor agreements. A party seeking accommodation under a subordination or intercreditor agreement has little or no way of knowing whether the counterparty has granted a participation interest in (or loan secured by) such counterparty's obligations owed by a debtor and, if so, whether the consent of any participants to the subordination is necessary. As such, there is no guarantee that some proffered participant will not show up at a later date claiming a prior interest in the collateral on which a party thought it held a first lien.

Conclusion

As discussed above, the Southern Fidelity decision creates more problems than it solves. Under Southern Fidelity, a party seeking a lien subordination under an intercreditor agreement will have to conduct additional diligence regarding the obligations secured by the lien for which subordination is sought. Furthermore, counsel should consider adding additional representations, warranties and covenants regarding the obligations secured by the lien for which subordination is sought. And, even if a party does all of those things, there is no guarantee of coming out ahead (or of breaking even, for that matter). Law, much like life, is not fair.

(Note: This case is currently on appeal with the United States Court of Appeals for the Tenth Circuit.)

Sean M. Gillen is a partner in the Omaha, NE, office of Kutak Rock LLP. Gillen is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers in asset acquisitions, dispositions and financings. He can be reached at [email protected].

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

Sometimes, you just cannot win. You can do everything correctly. You can plan, prepare and execute flawlessly. You can have the stars and planets in alignment. And, yet, none of that may matter in the end. Life is not fair. Of course, as one of my former law school professors said, “fair” is a four-letter word, especially in the practice of law.

The case of Southern Fidelity Managing Agency, LLC v. Citizens Bank & Trust Co., 2014 WL 129336 (D. Kan. 2014), illustrates how an intercreditor agreement may not cure all ills facing a secured creditor. In addition, Southern Fidelity allows us the opportunity to view the intersection of intercreditor-related concepts such as syndications, subordinations and participations.

Background

The facts of Southern Fidelity are somewhat convoluted (harkening back to the adage that hard facts make bad law). In 2007, Brooke Capital Advisors, Inc. (“BCA”) loaned over $12 million to its parent entity, Brooke Capital Corp. (“Debtor”). As security for the loan, Debtor granted BCA a security interest in the stock of First Life America Corporation (“FLAC”), another affiliate of Debtor. Supposedly, BCA perfected its security interest in the stock via possession by attorney for Debtor.

After making the loan to Debtor, BCA entered into participation agreements with four separate, unrelated entities for a total of about 89% of the interests in the loan to Debtor. Three of those participation agreements required BCA to repurchase the participation interests at a future date. The fourth participation did not create a repurchase obligation. (Note: while all four participants were the plaintiffs in the Southern Fidelity litigation; we are concerned only with the three participants for the purposes of this article.)

After the consummation of BCA's sale of the participation interests in the loan, Debtor entered into a restructuring of a $9 million loan from Citizens Bank and Trust Company (“Citizens”). As part of the restructuring, Debtor granted Citizens a security interest in the FLAC stock. To perfect its security interest in the FLAC stock, Citizens, along with Debtor and BCA, entered into an escrow agreement with a third-party escrow agent to hold the stock on behalf of Citizens and BCA. In addition, Citizens, Debtor and BCA entered into a “Payments Agreement” whereby the three parties agreed that, if Debtor or BCA became entitled to receive any proceeds from the sale of the FLAC stock, those proceeds would be paid to Citizens and applied to satisfy Debtor's obligations to Citizens. Thus, BCA had subordinated its interest in the FLAC stock to Citizens.

Shortly after finalizing the restructuring of the Citizens loan, Debtor filed for bankruptcy. During the bankruptcy proceedings, Citizens asserted that it has a properly perfected security interest in the FLAC stock and that its security interest had priority over the security interest of BCA in the FLAC stock. The bankruptcy court found that the three participation agreements with repurchase obligations were, in fact, disguised loans and that those three participants had, at best, an unperfected security interest in the FLAC stock. The bankruptcy court agreed with Citizens with respect to those three participants, holding that the Payments Agreement among Citizens, Debtor and BCA effectively subordinated the security interest of BCA in the FLAC stock. With respect to the fourth participant, the bankruptcy court held that the Payments Agreement did not subordinate the security interest of BCA in the FLAC stock because the related participation agreement prohibited BCA from subordinating its security interest in the FLAC stock.

The three participants held to have subordinate interests in the FLAC stock appealed the decision of the bankruptcy court to the United States District Court for the District of Kansas. The participants argued that they held a perfected security interest in the FLAC stock under UCC ' 9 -310(c). Second, they argued that BCA could not subordinate their interests in the FLAC stock without their consent. Finally, they argued that the participation interests should not have been recharacterized as loans.

The District Court Ruling

The district court first ruled that whether or not the participation interests were recharacterized as loans was irrelevant ' the ruling would be the same regardless of whether the participants purchased a participation interest from BCA or made a loan to BCA. The court then held that the participants received a valid assignment of BCA's properly perfected first lien on the FLAC stock under UCC ' 9-310(c). The court held that the participants did not need to make any additional UCC filings to perfect their interest in the FLAC stock because BCA held a properly perfected security interest in the FLAC stock at the time it entered into the participation agreements, i.e., the time of “assignment.”

Furthermore, the district court held that BCA could not consent to Debtor's grant of a lien on the FLAC stock to Citizens or to subordinate its security interest in the FLAC stock because such actions were prohibited by the participation agreements. The participation agreements stated, in part, that BCA “will not, without [participant's] written consent, renew, extend or consent to the revision of the provisions of any note or security documents covered or waive any claim against [Debtor].” Thus, the court held that BCA was contractually prohibited of subordinating the participants' security interest in the FLAC stock. As such, the subordination arrangement among Citizens, Debtor and BCA was not enforceable against the participants.

Analysis

For the time being, we will set aside any debate over whether UCC ' 9-310(c) was applicable and, if so, whether it granted the participants a security interest in the stock or a security interest in a security interest in the stock (a payment intangible, for UCC purposes). Further, we will not consider whether the participations were, in fact participations, in which case the participants would have received a pro-rata interest in the loan to Debtor and the collateral securing such loan, or whether the participations were loans, whereby the participants would have a security interest in BCA's right to repayment from Debtor (a payment intangible, for UCC purposes). Rather, we will focus on the district court's holding that BCA was contractually prohibited of subordinating the participants' security interest in the FLAC stock.

Those who practice in capital markets should be concerned with this ruling. The district court effectively made the participation agreements between BCA and the participants binding on Citizens, even though Citizens was never party to the participation agreements. This is a complete departure from contract law, which could impose an untenable burden of due diligence and risk upon a party seeking a lien subordination from a prior perfected secured creditor.

If BCA was contractually prohibited from subordinating its security interest in the FLAC stock vis ' vis the participants, and if BCA then entered into a subsequent agreement whereby BCA breached such prohibition, then the participants would have a claim against BCA for breach of contract. However, the agreements between BCA and the participants should in no way be binding on the party receiving the benefit of the subordination or otherwise impair the effectiveness of the subordination.

As the participants allowed BCA to act on their behalf, Citizens had no way to know that BCA lacked authority to subordinate its lien on the FLAC stock. At worst, from the perspective of Citizens, BCA had the apparent authority to do so. Absent actual knowledge of Citizens to the contrary, the effectiveness of the subordination should not have been impaired by the participation agreements.

The Southern Fidelity holding would create an unacceptable amount of uncertainty with respect to subordination agreements and intercreditor agreements. A party seeking accommodation under a subordination or intercreditor agreement has little or no way of knowing whether the counterparty has granted a participation interest in (or loan secured by) such counterparty's obligations owed by a debtor and, if so, whether the consent of any participants to the subordination is necessary. As such, there is no guarantee that some proffered participant will not show up at a later date claiming a prior interest in the collateral on which a party thought it held a first lien.

Conclusion

As discussed above, the Southern Fidelity decision creates more problems than it solves. Under Southern Fidelity, a party seeking a lien subordination under an intercreditor agreement will have to conduct additional diligence regarding the obligations secured by the lien for which subordination is sought. Furthermore, counsel should consider adding additional representations, warranties and covenants regarding the obligations secured by the lien for which subordination is sought. And, even if a party does all of those things, there is no guarantee of coming out ahead (or of breaking even, for that matter). Law, much like life, is not fair.

(Note: This case is currently on appeal with the United States Court of Appeals for the Tenth Circuit.)

Sean M. Gillen is a partner in the Omaha, NE, office of Kutak Rock LLP. Gillen is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers in asset acquisitions, dispositions and financings. He can be reached at [email protected].