Indiana Adopts “Partial Subordination” Approach To Priority Disputes Arising Out Of Subordination Agreements

 

The Indiana Court of Appeals in Co-Alliance v. Monticello Farm Service, 7 N.E.3d 355 (Ind. Ct. App. 2014) discusses subordination agreements, generally, and lien priority disputes arising out of them, specifically.

Three lenders.  Co-Alliance dealt with three lenders, each of which financed the borrower’s farming operations.  Lender 1 had the senior lien on the borrower’s assets, and Lender 2 and Lender 3 held the second and third position liens, respectively.  In 2010, Lender 1 agreed to subordinate part of its senior lien in favor of Lender 3, thereby reducing the extent of Lender 1’s first position.  The subordination agreement was borne out of Lender 3’s stipulation to finance the borrower’s crops for that year.  In turn, Lender 1 agreed to subordinate its interests in the 2010 crops to Lender 3’s interests in them.  Lender 2 was not a party to the subordination agreement.

Subordination agreements, generally.  I touched upon subordination agreements in my September 18, 2013 post.  The Court in Co-Alliance noted that subordination agreements “are nothing more than contractual modifications of lien priorities.”  These types of agreements can “accelerate the flow of cash to troubled projects, providing financial relief that promotes the development of assets that are then used to secure payments to all lienholders.”

Contentions.  The Co-Alliance case was a dispute between Lender 2 and Lender 3.  Lender 2 basically asserted that it jumped into first position and theorized that “subordinate” necessarily means “to move a right or claim to a lower rank.”  Lender 2 took the position that the subordination agreement completely reduced Lender 1’s security interest in the 2010 crops such that that Lender 1’s position dropped to the last (or third) position.  The law commonly refers to this as “complete subordination,” and some states follow this rule.  Lender 3 argued that the subordination agreement “merely allowed [Lender 3] to momentarily step into the [Lender 1’s] first priority status.”  This is commonly referred to as “partial subordination.”  The Indiana Court of Appeals preferred this result.

Intent.  In Co-Alliance, the language of the subordination agreement showed that the parties’ intent was for Lender 1 to assign to Lender 3 a portion of any crop proceeds received by Lender 1 based upon its status as the senior lienholder.  In essence, Lender 1 induced Lender 3 to make a loan by guaranteeing it the right of first payment.  Again, Lender 2 claimed that the subordination agreement moved Lender 1 (and, by extension, Lender 3) to the back of the line, to the full extent of the security.  Yet, Lender 2 was not a party to the agreement and, according to the Court, “should not be entitled to a windfall.”  The Court illustrated the intent of the subordination agreement and how it would work:

Thus, [3,] by virtue of the subordination agreement, is paid first, but only to the amount of [1’s] claim, to which [2] was in any event junior.  [2] receives what it had expected to receive, the fund less [1’s] prior claim.  If [1’s] claim is smaller than [3’s], [3] will collect the balance of its claim, in its own right, only after [2] has been paid in full.  [1,] the subordinator, receives nothing until [2] and [3] have been paid except to the extent that its claim, entitled to first priority, exceeds the amount of [2’s] claim, which, under its agreement, is to be first paid. 

Lender 2 loses.  In Co-Alliance, the evidence showed that the amount of the crop proceeds in question did not exceed either the amount of Lender 1’s lien or the amount that Lender 1 was subordinated to Lender 3.  There was no evidence that Lender 2 was burdened by or benefited from the subordination agreement.  “Rather, [Lender 2] was unaffected.”  Accordingly, the Court held that the trial court properly found the subordination agreement gave Lender 3 a first-priority in the subject proceeds.