Subordinated Creditors Beware: Subordination Clauses Don’t Trump the Statute of Limitations
When two lenders make loans to a debtor at the same time, it is common for the loan documents to include agreements between the lenders as to the relative priority and rights of each lender vis a vis the other. These so called intercreditor agreements may include subordination provisions by which one lender’s lien on the debtor’s collateral is made secondary to that of the other lender, provisions limiting one lender’s right to receive payments in the event of a default, and even terms by which one lender agrees that payments on its loan will not begin until some date after payments to the first lender either start or conclude.
One question that arises in this context is the effect of such intercreditor arrangements on a lender’s rights vis a vis the debtor. For example, does a junior lender’s agreement to pay over any amounts it receives from the debtor to the senior lender while the senior loan is outstanding mean that it has to or can wait to sue the debtor in the event of a failure to pay the junior loan? Does the junior lender run the risk of waiving its claim, and possibly even having its claim be barred by the statute of limitations, if it doesn’t bring suit to enforce its right to payment even when it’s required to turn over any proceeds of such a suit to the senior lender? Depending on what the documents say, junior lenders run exactly that risk confirmed the New York Appellate Division, First Department in its recent decision in Nordberg v. South Street Seaport Corporation, 43 A.D.3d 774, 843 N.Y.S.2d 20, 2007 WL 2791662 (1st Dep’t Sept. 27, 2007).
A Case With Extreme Circumstances
In Nordberg, the plaintiff brought suit to recover the principal and interest due with respect to the junior of two promissory notes issued by the South Street Seaport Museum1 in June 1973 in connection with the restructuring of a mortgage on the property on which the museum was built. Under the terms of the senior note, monthly interest payments at the rate of 3 percent per annum would be payable beginning on June 1, 1976, with the $2.5 million and any unpaid principal due at maturity on May 31, 1998. The principal amount of the junior note was $2.9 million, with 3 percent per annum interest payments due monthly beginning in 1980. As in the case of the senior note, the junior note matured on May 31, 1998.
The junior note also contained the following “intercreditor” provision:
Notwithstanding any other provisions of this [junior] Note or any agreement under which this [junior] Note is outstanding (i) no payment on account of principal of, or interest on, this [junior] Note shall be made, nor shall any property or assets of the Museum be applied to the purchase or other acquisition or retirement of this [junior] Note, unless full payment of the principal amount of, and all accrued interest on, the [senior] Note ... has been made or duly provided for in money or money’s worth, and (ii) in the event of any dissolution, winding up, liquidation or other similar proceedings relative to the Museum, its property or its operations ... then all principals of, and interest on the [senior Note] shall be paid in full before the holder of this [junior] Note shall be entitled to retain any payment or distribution in respect of principal of, or interest on this [junior] Note ...
The foregoing provisions regarding subordination are and are intended solely for the purpose of defining the relative rights of the holder of the [senior Note] on the one hand and the holder of this [junior] Note on the other hand. Such provisions are for the benefit of the holder of the [senior Note] and shall be enforceable by it directly against the holder of this [junior] Note, and the holder of the [senior Note] shall not be prejudiced in its right to enforce subordination of this [junior] Note by any act or failure to act by the Museum or anyone in custody of its assets or property. Nothing contained in this [junior] Note or any agreement under which this [junior] Note is outstanding is intended to or shall impair, as between the Museum and the holder of this [junior] Note, the obligation of the Museum, which is unconditional and absolute, to pay the holder of this [junior] Note the principal of, and interest on, this [junior] Note as and when the same shall become due in accordance with its terms, nor shall anything herein affect the negotiability, right to transfer or right to assign this [junior] Note, ... nor shall anything herein prevent the holder of this [junior] Note from exercising all remedies otherwise permitted by applicable law upon default under this [junior] Note or any agreement under which this [junior] Note is outstanding, subject, however, to the rights under the foregoing paragraphs of the holder of the [senior Note].
As it turned out, no payments on either the senior or junior note ever were made and neither note holder commenced an action within six years after the notes matured on May 31, 1998. Rather, the plaintiff waited until Fall 2005 to file suit.
Defendants moved to dismiss on the ground that, inter alia, any suit on the note was barred by New York’s six-year statue of limitations. See N.Y. C.P.L.R. § 213. In response, the plaintiff argued that the above-quoted intercreditor provision barred any suit to enforce the junior note while the obligation on the senior note remained outstanding. Given that no payments had ever been made on the senior note, the plaintiff asserted that his claim under the note did not accrue until the limitations period on the senior note had run, on June 1, 2004. As such, the suit was timely.
The First Department disagreed. It found that the above-quoted intercreditor provision may have limited the junior noteholder’s right to keep payments while the senior note was outstanding, but did not limit the lender’s rights vis a vis the debtor.
While those provisions require that that the senior debt be satisfied before the subordinated debt is paid, they expressly state that they are intended solely for the purpose of defining the relative rights of the senior and subordinate note holders; that they do not impair the obligations of the obligor to the holder to pay the principal and interest on the subordinated note when it became due in accordance with its terms; and that nothing would prevent the holder of the subordinated note from exercising all remedies otherwise permitted by applicable law upon default under the note, subject however to the rights of the holder of the senior note.
43 A.D.3d at 774, 843 N.Y.S.2d at 21, 2007 WL 2791662 at *1. Under the circumstances, the junior noteholder’s claim accrued when the junior note matured on May 31, 1998, and any suit to enforce payment brought more than six years after that date was time barred. Id.
Admittedly, the facts presented in Nordberg are extreme – unsecured promissory notes with 35-year terms are not the norm, and in most cases, a senior lender would have called a default much sooner and/or brought its own suit for non-payment. That being said, there are myriad circumstances that might induce a senior lender to forebear from either calling a default or from pursuing an action for payment. In that case, junior lenders in New York, and possibly elsewhere, should act to preserve their own claims even if doing so means that senior claims will be paid first, or the junior lenders risk losing their claims forever. Junior lenders’ claims can be preserved most easily by building protections into their loan documents at the outset. In any case, however, junior lenders should be vigilant about asserting their rights even when the senior lender chooses not to do so, or risk the consequences.
1 By later agreement of all parties, the museum was released and its obligations under both notes were assigned to an affiliate, the South Street Seaport Corporation, but the other relevant terms of the notes remained unchanged.
By later agreement of all parties, the museum was released and its obligations under both notes were assigned to an affiliate, the South Street Seaport Corporation, but the other relevant terms of the notes remained unchanged.By later agreement of all parties, the museum was released and its obligations under both notes were assigned to an affiliate, the South Street Seaport Corporation, but the other relevant terms of the notes remained unchanged.