Must a Senior Creditor Notify a Subordinated Creditor of a Default On Senior Debt to Trigger the Subordinated Creditor's Duty to Remit Payments to the Senior Creditor?
 
July 27, 2004
 
Michael Weissman - Chicago

In PPM Finance, Inc. v. Norandal USA, Inc., 297 F.Supp. 2d 1072 (N.D. Ill. 2004) the issue before the court was whether a subordinated creditor violated a subordination agreement by receiving payments from a common debtor that was in default on senior debt.

Both Jackson Mutual Life Insurance Company (Jackson) and PPM Finance, Inc. (PPM) provided senior financing that enabled Scottsboro Properties, L.L.C. (Scottsboro) to purchase an Alabama aluminum processing plant from Norandal USA, Inc. for $92 million. But the financing totaled only $76.5 so Norandal accepted a promissory note from Scottsboro for $7.8 million. (Presumably, the gap between $92 million and the total financing package was filled by an equity infusion, and/or price adjustments and prorations).

Concurrently with the closing, PPM, for itself and as agent for Jackson, entered into a subordination agreement with Norandal. It stipulated that PPM and Jackson were the senior secured parties and Norandal was the junior secured party. It also provided that Norandal could not receive principal and interest on the Scottsboro note if there were a default on the senior debt; if any such payment were received, Norandal was not to commingle it with its own assets but was instead to hold it in trust for Jackson and PPM.

During the negotiations that preceded the execution of the subordination agreement, counsel for Norandal asked for a provision requiring PPM and Jackson to give Norandal notice of a default on the senior debt. The request was refused. However, the subordination agreement contained a provision calling for Norandal to give PPM and Jackson notice of a default on the subordinated debt.

There was testimony from Scottsboro’s former Chief Financial Officer that Scottsboro was in default on the senior debt from October 1999 until August 1, 2001. Between November 1, 1999 and January 18, 2001 Norandal received subordinated debt payments from Scottsboro totaling $3.7 million. The first time PPM and Jackson notified Norandal of Scottsboro’s default on the senior debt was July 27, 2001.

Jackson and PPM filed an involuntary petition for relief under Chapter 11 against Scottsboro on August 1, 2001, and, thereafter, initiated an adversary proceeding against Norandal seeking recovery of the payments Norandal received in violation of the subordination agreement.

Norandal’s principal defense was that it was entitled to notice from Jackson and PPM of a senior debt default. But the court flatly rejected this, finding nothing in the subordination agreement to support it. The court held that it was the existence of a default rather than actual notice of a default that triggered Norandal’s obligation to remit payments to Jackson and PPM. Indeed, the court went so far as to say that it was Norandal’s duty to inquire of Jackson whether there was a senior debt default when it received payments from Scottsboro. The court also rejected twelve affirmative defenses Norandal asserted.

What’s the point?

When a subordination agreement is the product of negotiation between two sophisticated parties, it will be enforced in accordance with its unambiguous terms.

For more information e-mail Michael L. Weissman at michael.weissman@hklaw.com or call toll free, 1-888-688-8500.