In In re Argon Credit, LLC, et al., Case No. 16-39654 (Bankr. N.D. Ill. Jan. 10, 2019), the United States Bankruptcy Court for the Northern District of Illinois recently held that a standby clause in a subordination agreement prevented a subordinated lender from conducting discovery on the senior lender’s claim, pursuant to section 510 of the Bankruptcy Code.
Prepetition, Debtors Argon Credit, LLC and Argon X, LLC (collectively, “Argon”) operated a lending platform providing near-prime consumer installation loans.
In order to fund Argon’s lending platform, a senior secured lender loaned Argon up to $37,500,000.00 (the “Senior Debt”) under a prepetition revolving credit facility, which was subsequently assigned to another lender (the “Senior Lender”).
Certain insiders of Argon (the “Junior Lenders”) had also made loans to Argon prior to the Senior Debt, but they agreed to subordinate their loans pursuant to a subordination agreement with the Senior Lender (the “Subordination Agreement”), which contained a standby clause providing, in relevant part, that:
Notwithstanding any breach or default by the Parent [Argon] or any other Obligor under the Subordinated Loan Documents, the [Junior] 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 the Parent or any other Obligor unless and until the Obligations to the Senior Lender have been fully and indefeasibly paid and satisfied in full.
In Argon’s converted chapter 7 bankruptcy case, the Senior Lender and the chapter 7 trustee (the “Trustee”) negotiated, and entered into, a stipulation (the “Discovery Stipulation”) that provided for parties in interest and the Trustee to coordinate any discovery surrounding the Senior Debt, pursuant to Bankruptcy Rule 2004. Pursuant to the Discovery Stipulation, all such discovery requests were to be served solely by the Trustee, but if a party in interest conferred in good faith with the Trustee and if the Trustee opted out of discovery, then the party in interest could serve and enforce its own discovery without the necessity of filing a separate examination motion under Rule 2004.
In accordance with the Discovery Stipulation, the Trustee served a subpoena on the Senior Lender, requesting a wide range of documents related to the Senior Debt. The Senior Lender moved to quash the subpoena, but one of the Junior Lenders objected to the motion to quash and sought to enforce the Trustee’s subpoena (after receiving approval from the Trustee).
The Junior Lender argued, among other things, that the standby clause in the Subordination Agreement (a) did not bar it from obtaining discovery on behalf of the Trustee or estate, (b) was amended or waived by the Discovery Stipulation and (c) did not bar discovery relating to the Senior Lender’s fraud. Judge Thorne disagreed.
Section 510 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.” 11 U.S.C. § 510(a).
Judge Thorne found that the standby clause in the Subordination Agreement constituted an explicit and express “silent seconds” provision aimed at preventing “obstructionist behavior” and it went above and beyond the mere maintenance of the “hierarchy of lien priorities” in subordination agreements. Citing In re MPM Silicones, L.L.C., No. 15-CV-2280 (NSR), 2019 WL 121003, at *11 (S.D.N.Y. Jan. 4, 2019). This prevented the subordinated Junior Lender from using the bankruptcy process to affirmatively obtain discovery from the Senior Lender regarding the Senior Debt.
In particular, the Court held that the Junior Lender could not use the Discovery Stipulation or Bankruptcy Rule 2004 to obtain discovery against the Senior Lender, because such acts were clearly calculated to enforce the Junior Lenders’ claims against Argon. In this respect, the Court stated that: “It simply cannot be assumed by the court that [the Junior Lender] is asking for discovery for no reason; they cannot be presumed irrational.”
With respect to the Junior Lender’s argument that it pursued discovery on behalf of the estate and with the Trustee’s consent, the Court found that none of the communications between the Junior Lender and the Trustee supported this argument. Rather, the evidence showed that, while the Junior Lender did coordinate its discovery requests with the Trustee, when the Senior Lender refused to produce certain documents, the Trustee informed the Junior Lender that the estate could not afford to press forward with discovery demands but the Trustee did not oppose the Junior Lender’ efforts to pursue further discovery. While the Trustee requested that the Junior Lender share information that it subsequently obtained from the Senior Lender, this request did not constitute a request for the Junior Lender to perform duties on behalf of the Trustee. The Trustee’s reservation of rights to conduct additional discovery from the Senior Lender further indicated that the Junior Lender was not acting as the Trustee’s agent under the Discovery Stipulation.
The Court also dismissed outright the Junior Lender’s argument that the Discovery Stipulation somehow amended or waived the standby clause, because there was no clear indication that (a) the Senior Lender assented to a modification or amendment of the Subordination Agreement through the Discovery Stipulation, which only the Senior Lender and Trustee negotiated and signed, and (b) that the Senior Lender intentionally relinquished its rights under the Subordination Agreement by entering into the Discovery Stipulation, which generally benefitted many parties in interest; not just the Junior Lender.
The Junior Lender further argued that it should be allowed to investigate whether the Senior Lender fraudulently induced Argon to enter into the secured credit facility and related subordination agreements by promising a $75 million line of credit that the Senior Lender never intended to provide.
The Court, however, found that Delaware law (which governed) does not allow the non-enforcement of a bargained-for agreement between sophisticated commercial actors whenever anyone claims that fraud has occurred. The Court also distinguished case law that permitted rescission of a subordination agreement as a remedy under certain circumstances. According to the Court, not only was the Junior Lender not seeking rescission in this case, the Subordination Agreement remained enforceable until a court entered a judgment providing that such agreement was rescinded based on fraud.
On the last point, the Court noted that nothing prevented the Junior Lender from commencing an action against the Senior Lender to rescind the Subordination Agreement. However, the Junior Lender’s discrete attempt to use the Discovery Stipulation to obtain discovery from the Senior Lender constituted an impermissible end-run around the Subordination Agreement.
Accordingly, the Court sustained the Senior Lender’s motion to quash the subpoena as to the Junior Lender and precluded the Junior Lender from obtaining its own discovery from the Senior Lender.
Subordination agreements are generally required to be enforced in bankruptcy, pursuant to section 510(a) of the Code. While courts in other contexts have refrained from enforcing subordination agreements against subordinated lenders based on ambiguity, there was no such ambiguity raised by the Junior Lender in Argon Credit‘s case. Instead, the Junior Lender appeared to have made a strategic decision to rely primarily on the Discovery Stipulation, which was negotiated solely by the Trustee and the Senior Lender. The fundamental problem with the Junior Lender’s position was that the Discovery Stipulation did not clearly amend the Subordination Agreement, which was otherwise deemed enforceable. Notwithstanding the Junior Lender’s clever arguments, the Court was left with no option other than to enforce the Subordination Agreement and prevent the Junior Lender from conducting discovery.