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Judge Shannon (Bankr. D. Del.) Holds that a Junior Secured Creditor Was Bound by the Terms of its Prepetition Intercreditor Agreement Barring it from Proceeds “Carved-Out” in an Agreement Between the Trustee and Senior Secured Creditor

Written by: Gregory J. Flasser 

On May 29, 2009, Consolidated Bedding, Inc. and its affiliated debtors (collectively, the “Debtors”) filed a petition for relief under Chapter 7 of the Bankruptcy Code.  In a decision rendered on June 25, 2021, Judge Shannon found that due to the terms of an intercreditor agreement, the Debtors’ junior secured lender was prohibited from obtaining proceeds of collateral that the Debtors’ senior secured lender had carved out in favor of a chapter 7 trustee.

As of the petition date, the Debtors owed approximately $231 million to American Capital Financial Services, Inc. (“American”) and approximately $14.4 million to L&P Financial Services Co. (“L&P”).  The claims of American and L&P were secured, respectively, by senior and junior liens on substantially all of the Debtors’ assets.  Prior to the petition date, L&P and American entered into an Intercreditor Agreement to (i) subordinate L&P’s liens upon the Debtors’ assets to those of American, and (ii) preserve L&P’s position in the collateral as a junior secured creditor behind American.

Because the Chapter 7 Trustee (the “Trustee”) did not have sufficient funds with which to administer the cases, American and the Trustee entered into certain stipulations (the “Stipulations”) to enable the Trustee to monetize and liquidate potentially valuable estate causes of action.  In short, the Stipulations provided that 75% of any proceeds the Trustee recovered would go to American and the remaining 25% of the proceeds would go to the Trustee.  Over the course of a decade, the Trustee prosecuted and settled several claims bringing in over $11.4 million to the Debtors’ estates (approximately $2.3 million of which would go to the Trustee).

On October 25, 2019, the Trustee filed an adversary complaint seeking declaratory relief to (i) find that the split of proceeds negotiated between the Trustee and American was a “carve-out” free and clear of any lien, claim, or interest asserted by L&P, (ii) enforce the prepetition Intercreditor Agreement pursuant to section 510(a) of the Bankruptcy Code and to subordinate L&P’s junior secured debt, and (iii) disallow L&P’s junior secured claim pursuant to section 502(b)(1) of the Bankruptcy Code because L&P was prohibited from accepting any payments on account of its junior debt under the Intercreditor Agreement.  L&P filed a motion for summary judgment alleging that it had a valid and enforceable lien on the Debtors’ assets and that L&P was not bound by the Stipulations because the Trustee failed to provide L&P with adequate notice.

In deciding the “carve-out” issue, Judge Shannon held that a secured creditor may agree to allow a trustee to recover the costs of prosecuting a bankruptcy estate’s claim from the proceeds of the litigation when that claim is subject to the creditor’s lien.  In this case, American did just that by negotiating an agreement with the Trustee allowing the Trustee to keep 25% of the proceeds recovered as part of discharging his duties as the Chapter 7 Trustee.  As Judge Shannon put it, “American enjoyed the right to carve funds out from the proceeds of its collateral to incentivize the Trustee to pursue claims on behalf of the Debtors’ estate.”

Because American had the ability to agree to a “carve-out” funds with the Trustee, Judge Shannon turned to his analysis to the relationship between American and L&P.  It was undisputed that the relationship between American and L&P was governed by the Intercreditor Agreement and that the Intercreditor Agreement was a “subordination agreement” within the meaning of section 510(a) of the Bankruptcy Code.  Section 510(a) 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.”  11 U.S.C. § 510(a).  Looking at its terms, the Intercreditor Agreement granted American broad authority to release liens in any collateral and provided that L&P could not receive payments until American’s senior debt has been paid in full.  As a result, Judge Shannon rejected L&P’s argument that its lien could not be reduced or eliminated.  Finally, although he was troubled by the Trustee’s failure to provide L&P with adequate notice of the Stipulations, Judge Shannon again looked to the terms of the Intercreditor Agreement to hold that L&P waived its right to object to any failure to provide notice.  Accordingly, Judge Shannon denied L&P’s motion for summary judgment and entered judgment in favor of the Trustee.

A copy of the opinion can be found here.


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