Document Type

Article

Publication Title

Banking Law Journal

Publication Date

2001

Abstract

Subordination agreements among creditors are common in financial transactions. When a company seeks additional credit, the new lender may insist on an agreement with existing creditors which provides that their right to payment will be subordinated to the full payment of the new loan. The existing creditors may be willing to sign such an agreement for the purpose of encouraging the new lender to provide the borrower with liquidity needed to continue the business as a profitable venture, thereby increasing the likelihood that the borrower will meet all future financial obligations. In addition, contractual subordination is used frequently in connection with the issuance of debt securities. The level of priority of the debt securities, whether senior or junior, will directly affect their interest rate and market price.

In general, contractual subordination will be respected in the event the borrower becomes a debtor in a bankruptcy case. Section 510(a) of the Bankruptcy Code provides that “[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.” Unless a bankruptcy court rearranges priorities based on equitable principles, known as equitable subordination, or the class of senior creditors effectively waives the benefits of the subordination agreement by voting to accept a chapter 11 plan in which they give up their rights to junior creditors, the subordination agreement controls the ranking of prebankruptcy claims against the bankruptcy estate.

In addition to using subordination agreements to achieve priority over other creditors with respect to the payment of their claims, senior creditors also use them to obtain other rights from junior creditors. In particular, subordination agreements have included provisions that give the senior creditor the right to cast the junior creditor's vote to either accept or reject a plan of reorganization in the event the borrower is in chapter 11. These provisions effectively give a senior creditor two votes; it may vote with respect to its own claim and may vote again with respect to the subordinated claim. Senior creditors have argued that these provisions should be enforceable as a matter of contract, but junior creditors, wishing to vote on a chapter 11 plan despite the contractual provision, have argued that the enforcement of these provisions would be inconsistent with the provisions of the Bankruptcy Code granting voting rights only to the holders of claims. This article will examine how courts have dealt with these voting rights provisions found in subordination agreements.

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