Subordination agreements are generally enforced in accordance with applicable non-bankruptcy law in bankruptcy cases. The decision in In re Fencepost Productions, Inc., No. 19-41542, 2021 WL 1259691 (Bankr. D. Kan. Mar. 31, 2021) recognizes limits to this rule. While the subject subordination agreements were generally enforceable, the assignment of Chapter 11 voting rights in such agreements was not.
But the opinion goes farther. While the subordination agreements’ contractual assignment of junior creditor voting rights was not enforceable, the US Bankruptcy Court for the District of Kansas nevertheless found that, where junior creditors did not have a direct pecuniary stake in confirmation, they had no standing to participate in any way in the Debtors’ Chapter 11 confirmation process—they could not vote or object to the proposed plan. This decision expands the prudential standing doctrine and conflicts with well-established principles favoring broad participation in a restructuring process. However, as discussed below, we believe the ruling is principally predicated upon the subordinated creditor’s admission that it would never recover under the Debtors’ economic circumstances and therefore should be limited in its application.
Rarely do creditors (let alone subordinated creditors) admit that they are out-of-the-money under all factual circumstances. Creditors seeking to protect their financial interest always assert some legal or factual basis for recovery and therefore the decision should be distinguishable in future cases. Nonetheless, depending on the issues present in a bankruptcy case, the US Bankruptcy Court in Kansas may become an attractive (or an “avoid at all costs”) jurisdiction to limit participation of junior stakeholders.
Fencepost Production, Inc. and two affiliates (the Debtors) design and distribute licensed and unlicensed outdoor apparel for men, women, and youth under various brand names. Their products are sold at major department stores, sporting goods stores, mass merchant retailers, and national online retailers.
In April 2018, Associated Bank, N.A. (Associated) and the Debtors entered into a revolving loan facility secured by personal property. Contemporaneously, BMS Management, Inc. and related individuals (collectively, the BMS Group) and Associated entered into subordination agreements with the following common provisions:
On December 18, 2019, the Debtors filed their bankruptcy cases. Associated asserted claims totaling $7.7 million and the BMS Group asserted claims of $5.3 million in the aggregate.
The Debtors filed a plan of reorganization that separately classified the BMS Group’s claims and proposed to pay $10,000 per month for one year to satisfy such claims. Pursuant to the subordination agreements, these payments would inure to Associated’s benefit. The Debtors’ asserted, and importantly the BMS Group did not dispute, that “[t]here is no scenario whatsoever which exists to provide any payment to the” BMS Group.
Associated voted the BMS Group’s claims in favor of the plan. The BMS Group submitted competing ballots to reject the plan. The BMS Group also objected to plan confirmation, asserting that the Debtors had not proven that the plan was feasible and that the plan violated the absolute priority rule.
The Bankruptcy Court first addressed whether the assignment of the BMS Group’s plan voting rights to Associated was enforceable. The Bankruptcy Court observed that subordination agreements are generally enforced in accordance with applicable non-bankruptcy law (usually on state law issues, such as relative priorities of payment); however, the court ruled that such enforcement did not extend to rights created in the bankruptcy process, like the right to vote on a Chapter 11 plan.
The court analyzed the two leading (and contradicting) cases on the enforceability of assignments of voting rights in subordination agreements: In re 203 N. LaSalle Street P’ship, 246 B.R. 325 (Bankr. N.D. Ill. 2000) (finding assignment of voting rights in subordination agreement unenforceable), and In re Aerosol Packaging, LLC, 362 B.R. 43 (Bankr. N.D. Ga. 2006) (finding assignment of voting rights in subordination agreement enforceable). The Bankruptcy Court noted that most courts follow Aerosol Packaging and find assignments of voting rights in subordination agreements to be fully enforceable in bankruptcy.
Nevertheless, the Bankruptcy Court followed LaSalle because it found its reasoning was “more persuasive” than Aerosol Packaging. The Bankruptcy Court distinguished LaSalle because the decision was based upon the fact that the junior creditor appointed the senior creditor as its “agent” for bankruptcy voting. The BMS Group did not appoint Associated as its agent. Accordingly, the Bankruptcy Court held that the assignment of BMS Group’s voting rights to Associated was unenforceable to the extent it purported to permit Associated to vote the BMS Group’s claims on the Debtors’ plan.
Despite finding that the subordination agreements’ voting assignment was unenforceable, the Bankruptcy Court also held that the BMS Group had no standing to participate in the confirmation process.
As the predicate for its decision, the Bankruptcy Court accepted the Debtors’ undisputed factual assertion (which the BMS Group did not dispute) that the BMS Group would not recover under any scenario.
The court focused its analysis on the doctrine of prudential standing. According to the court, this doctrine encompasses “the general prohibition on a litigant’s raising of another person’s legal rights.” Quoting the US Court of Appeals for the Second Circuit’s decision in Kane v. Johns-Manville Corp., 843 F.2d 636, 644 (2nd Cir. 1988), the court noted that:
Third-party standing is of special concern in the bankruptcy context where, as here, one constituency before the court seeks to disturb a plan of reorganization based on the rights of third parties who apparently favor the plan. In this context, the courts have been understandably skeptical of the litigant's motives and have often denied standing as to any claim that asserts only third-party rights.
With these doctrinal limitations, the court found that the BMS Group did not have standing to participate in the confirmation process because there was no scenario under which the BMS Group would receive a direct financial benefit. For example, while the BMS Group sought to vote against the plan to require the Debtors to satisfy the cram down requirements for confirmation, the BMS Group would not benefit from enforcement of the strictures of cram down. It would not benefit from forcing the plan to not discriminate or ensuring that the plan satisfied the absolute priority rule. According to the court, other creditors—not the BMS Group—must assert these rights. Accordingly, the court held “that prudential considerations bar the members of the BMS Group from exercising their rights to vote against confirmation and to challenge specific aspects of Debtors’ Plan which do not directly impact their financial interests.”
This decision is notable for two reasons. First, it runs contrary to the current trend of enforcing prepetition subordination agreements in accordance with their terms, including assignments of voting rights. This is an important reminder that, while subordination agreements will generally be enforced in accordance with their terms, the extent to which a subordination agreement will be enforced as to assignments of voting and other fundamental bankruptcy-created rights remains less certain.
Second, the court’s holding that a creditor without a financial stake cannot participate in a Chapter 11 confirmation process is at odds with well-established bankruptcy standing doctrine.
The Bankruptcy Code addresses treatment of creditors that are not entitled to recover under a plan: their claims are impaired, their classes are “deemed to reject” the plan, and solicitation of “deemed rejected” classes is not required. See 11 U.S.C. §§ 1126(a), (f), and (g). But such a plan must still satisfy the cramdown requirements for confirmation and creditors in “deemed rejected” classes have standing to object to confirmation (for example, ensuring that senior creditors are not receiving more than a 100% dividend) and participate in the bankruptcy process.
Courts also recognize that an out-of-the-money creditor may still have standing to object to confirmation. In In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011), the Second Circuit confirmed appellate standing (generally accepted as more restrictive than trial court standing) of Sprint, a creditor that was not entitled to recover anything under the debtor’s plan:
Taking the broader perspective first, we decline to withhold standing merely because the bankruptcy court’s valuation of DBSD put Sprint’s claim under water. By the bankruptcy court’s estimate—which we accept for purposes of this appeal—DBSD is not worth enough to cover even the Second Lien Debt, much less the claims of unsecured creditors like Sprint who stand several rungs lower on the ladder of priority. But none of our prior appellate standing decisions—at least none involving creditors—have turned on estimations of valuation, or on whether a creditor was in the money or out of the money. We have never demanded more to accord a creditor standing than that it has a valid and impaired claim.
Id. at 90. Like in DBSD, there was no dispute that the BMS Group has a valid and impaired claim; its admission that it would not recover under the plan does not change this. It may still have had a sufficient pecuniary interest to object to confirmation. See, e.g., Id. (quoting In re P.R.T.C., Inc., 177 F.3d 774, 778 (9th Cir. 1999) (noting that creditors “have a direct pecuniary interest in a bankruptcy court’s order transferring the assets of the estate”)).
The Fencepost decision is broad: it denied the BMS Group standing to participate in any way with respect to the Debtors’ plan. At the very least with respect to cram down, feasibility, and good faith (principles central to the integrity of the bankruptcy process), Fencepost deviates from precedent.
For example, in Kane v. Johns-Manville Corp., 843 F.2d 636, 650 (2d Cir. 1988) (a decision Fencepost cites favorably), the Second Circuit found that, while the objecting creditor did not have standing to raise direct objections of classes of creditors of which it was not a member, it did have standing to object to ensure the plan was proposed in good faith and was feasible, and that the debtors had satisfied the requirements for cramdown. Id. (The objecting creditor “does have standing to assert his remaining claims regarding . . . compliance with the requirements of section 1129(a) and (b); these claims allege violations of [its] own rights under the Code.”); see also DBSD N. Am., 634 F.3d at 91 (declining to raise the “standing bar so high” as to preclude creditors from appealing a decision “if the bankruptcy court had committed a fundamental error such as not allowing the out-of-the-money creditors to vote or not following another of the numerous requirements of § 1129.”).[1]
The Fencepost decision was clearly driven by the BMS Group’s admission that it would not receive any value under any circumstances. This admission amounts to a waiver of the most fundamental factual issues necessary for the BMS Group to prevail on any confirmation objection. Indeed, Bankruptcy Rule 9011 requires that parties file pleadings in good faith and based on supportable factual premises. The BMS Group could not challenge the Debtors’ good faith while acting in good faith, itself, given that it admitted it could never recover and its challenge to confirmation was driven by non-financial motivations. Thus, while overbroad in its standing ruling, the Bankruptcy Court probably reached the correct ultimate conclusion. Having admitted that it could never recover, the BMS Group may have been left with no practical ability to challenge confirmation, even if it had standing.
There are at least two key takeaways from the Fencepost decision.
First, a subordinated creditor that admits that it will never recover under a plan creates a real risk, as shown here, that a court may find that such creditors do not have an ability to participate in other aspects of the Chapter 11 proceeding. Regardless of whether such a decision is reached as a result of waiver or standing, the practical implications for a creditor of being unable to participate in a bankruptcy case are extraordinary. Accordingly, to the extent possible, creditors should avoid making such an admission (if there is a good faith and legitimate basis to do so) if they hope to retain the ability to participate in the case.
Second, depending on the factual circumstance and the desire to limit junior stakeholder participation, debtors and senior lenders may find the US Bankruptcy Court for the District of Kansas to be an attractive forum for bankruptcy.
[1] These conclusions are consistent with principles announced by the Third Circuit: in bankruptcy cases, congress intended to “confer broad standing at the trial level to continue in the tradition of encouraging and promoting greater participation in reorganization cases[.]” In re Glob. Indus. Techs., Inc., 645 F.3d 201, 211 (3d Cir. 2011) (citations and modifications omitted) (further recognizing that “bankruptcy standing is particularly appropriate [where] the challenges they want to bring implicate the integrity of the bankruptcy process.”).