In a decision recently issued by the U.S. Bankruptcy Court for the Northern District of Illinois, In re Argon Credit, No.16-bk-39654 (Bankr. N.D. Ill. Jan. 10, 2019), the court held that standby limitation provisions in subordination agreements prevented the subordinated lenders from pursuing discovery on the senior lender's claim, as the subordination agreement in question was enforceable under 11 U.S.C. Section 510(a) and applicable nonbankruptcy law.

Background

Argon Credit and Argon X (Argon) each filed voluntary Chapter 11 bankruptcy petitions in December 2016. Their jointly-administered cases were converted to ones under Chapter 7 just one month later, upon the motion of Fund Recovery Services (FRS), a secured creditor.

Before the petition date, Argon was an originator and servicer of near-prime consumer installment loans. In May 2015, Fintech Financial (Fintech) loaned money to Argon under a revolving credit facility in the original principal amount of up to $20 million. To secure repayment of the loan, Argon granted Fintech a security interest in all of its then-existing and after-acquired real and personal property. In connection with the loan, Margon, an insider of Argon that had lent money to Argon prior to the closing of the loan, entered into a Subordination Agreement with Fintech and Argon containing the following “standby limitation” provision:

“Notwithstanding any breach or default by [Argon] or any other obligor under the subordinated loan documents, the subordinated lender shall not at any time or in any manner foreclose upon, take possession of, or attempt to realize on any collateral, or proceed in any way to enforce any claims it has or may have against [Argon] or any other obligor unless and until the obligations to the senior lender have been fully and indefeasibly paid and satisfied in full.”

In February 2016, Fintech increased the Argon line of credit to $37.5 million. In connection with the increase in the loan amount, Margon entered into an amended and restated subordination agreement, and two related trusts—also both insiders that had loaned Argon money—executed Subordination Agreements, all of which contained “standby limitation” provisions identical to the one set forth in the original agreement with Margon.

The revolving credit facility was assigned by Fintech to FRS in December 2016, after Argon defaulted on the loan and shortly before the petition date.

FRS filed a proof of claim against Argon in the amount of $37,291,193.98. Subsequently, the bankruptcy court entered a stipulation and agreed order by and between FRS and the Chapter 7 trustee that provided, inter alia, for all parties-in-interest in the case to coordinate with the trustee regarding discovery concerning FRS's claim. Under the Stipulation and agreed order, the Chapter 7 trustee was to serve discovery requests upon FRS. However, if a party-in-interest had conferred with the trustee and the trustee determined not to move forward with a discovery request, the party could then proceed to serve and enforce its own discovery requests pursuant to Rule 2004 of the Federal Rules of Bankruptcy Procedure.

The Chapter 7 trustee served FRS with a subpoena seeking production responsive to 55 document requests. FRS moved to quash the subpoena in July 2017. No action was taken on FRS's motion to quash for more than a year until late 2018, when Margon and the related trusts filed an opposition thereto and sought to enforce the chapter 7 trustee's subpoena.

FRS challenged Margon's and the trusts' standing to oppose the motion to quash by virtue of the Standby Limitation provisions in the subordination agreements, which it argued were fully enforceable under Section 510(a) of the Bankruptcy Code. Margon, on the other hand, argued that it was acting on behalf of the estate and therefore should not be subject to the Standby Limitation provisions contained in the subordination agreements.

Enforceable Under Section 510(a)

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 non bankruptcy law.” The parties agreed that the “applicable nonbankruptcy law” here was Delaware contract law, which governed the subordination agreements.

The bankruptcy court found that a subordination agreement is a contract under Delaware law, which requires that an unambiguous writing be interpreted in accordance with its plain meaning. The plain text of the standby limitation provisions prevented Margon and the trusts from “proceeding in any way to enforce any claims” against Argon, until FRS's claims were paid in full. The bankruptcy court further found that the plain and unambiguous language of the Standby Limitation provisions prevented Margon and the trusts from pursuing discovery under Rule 2004, “because any act to obtain Rule 2004 discovery in this bankruptcy case is a calculated, if intermediate, act to enforce the claims they have against Argon.” By seeking to discover grounds for objecting to FRS's claim against their common borrower, Margon and the trusts were seeking to obtain a greater recovery on their claims in direct contravention of the standby limitation provisions.

The court also noted that even though Margon was an equity holder in at least one Argon entity, that fact in and of itself did not confer independent standing upon Margon to pursue discovery: absent a showing that Margon would likely receive distributions from the Argon estate as an equity owner, Margon would not be deemed a party-in-interest other than as a creditor of the debtors.

Margon and the trusts also asserted that, pursuant to the stipulation and agreed order, they were acting on behalf of the estate and that the discovery they were pursuing was in furtherance of an investigation into claims belonging to the estate. Thus, they argued, their conduct did not fall within the scope of conduct barred by the subordination agreements.

The bankruptcy court acknowledged that, if Margon and the trusts could establish that they were pursuing discovery on behalf of the bankruptcy estate, their actions might not be barred by the standby limitation provisions contained in the subordination agreements. However, the court concluded that the stipulation and agreed order were only intended to streamline the discovery process with respect to FRS's claim, rather than to permit an interested party to step into the shoes of the Chapter 7 trustee. The court noted that the Chapter 7 trustee and Margon were direct adversaries in a separate adversary proceeding, a circumstance that further weighed against Margon's and the trusts' argument that they were acting on behalf of the Chapter 7 trustee. Additionally, the court observed that the Chapter 7 trustee had explicitly reserved its right to pursue discovery at a later date: were the court to permit Margon and the trusts to take discovery now, then the Chapter 7 trustee's reservation of rights to take the same discovery down the road didn't make sense and was inconsistent with Margon's claim that it was acting on behalf of the estate.

Finally, in considering Margon's and the trusts' argument that “fraud was afoot” and that their investigation into fraudulent activity surrounding the execution of the loan documents could not be barred by the subordination agreements, the court again looked to applicable nonbankruptcy law. The bankruptcy court noted that, under Delaware law, a fraudulently induced contract is voidable at the election of the innocent party, but not void. Therefore, the court reasoned, unless and until the subordination agreements were actually voided, the court was required to enforce them pursuant to Section 510(a).

The bankruptcy court also rejected additional challenges to its subject matter jurisdiction and statutory authority, the prepetition assignment of the subordination agreement, and a cursory argument that the stipulation and agreed order modified or amended the subordination agreements, which are not discussed in this article.

Conclusion

Section 510(a) requires bankruptcy courts to enforce the bargained-for rights and restrictions of parties to a subordination agreement. Thus, while recognizing they may not have much leverage in a transaction that requires them to subordinate their position to a senior lender, junior lenders should attempt to avoid bargaining away their standing to be heard in a later bankruptcy case.

Rudolph J. Di Massa Jr., is a partner at Duane Morris. He is a member of the business reorganization and financial restructuring practice group and concentrates his practice in the areas of commercial litigation and creditors' rights.

Keri L. Wintle, an associate at Duane Morris, practices in the area of business reorganization and financial restructuring with a focus on bankruptcy and creditors' rights. Wintle represents trustees, corporate debtors, creditors and creditor committees in Chapter 7 and 11 cases.