Enforcement of Standstill Provisions

by Andrew K. Alper November/December 2010
In the world of second lien lending and seller “carry back” financing, it is not uncommon for the lenders to enter into subordination agreements whereby the second lien subordinates its lien and its right to collect payments or money to the first lien. Onerous standstill provisions in subordination agreements are less common but also not unusual in subordination agreements.

The following constitutes a provision, which is typical in a subordination agreement with a standstill provision:

Payment to subordinated lender (the second lien holder). If, notwithstanding the provisions of this agreement, any payment or distribution of any character (whether in cash, securities or other property) shall be received by subordinated lender out of or in connection with the collateral in contravention of the terms of this agreement, and before the loan shall have been paid in full, such payment, distribution or securities shall not be commingled with any asset of subordinated lender and shall be held in trust for the benefit of, and shall be paid over or delivered and transferred to, senior lender (the first lien) or its representative, for the application to payment of the loan remaining unpaid, until all of the loan shall have been paid in full.

Until such time as the loan shall have been paid in full, together with any and all other amounts, which shall be due and payable under the loan documents, the property that is the subject to senior lender’s lien shall have been reconveyed to borrower and the other collateral released, subordinated lender shall not take any of the following actions with respect to the subordinated indebtedness, without the prior consent of lender: a.) accelerate all or any portion of the subordinated indebtedness or initiate any enforcement action under this subordinated loan documents; b.) exercise any of subordinated lender’s other remedies under the subordinated loan documents or commence any legal proceedings against borrower; c.) consent to any amendment or modification of the subordinated loan documents.

Many subordination agreements with “standstill” provisions will allow the subordinated lender to get monthly payments until there is an event of default. Some subordination agreements do not allow payments. When the subordinated lender is subordinated to the senior lender and there is a default on a loan, the senior lender will invoke the “standstill” provisions to prohibit or even disgorge payments by the borrower to the subordinated lender until the senior lender is paid in full. This puts the subordinated lender in a bad position. Such was the recent case of Grice Engineering, Inc. v. Innovations Engineering, Inc., 2010 Westlaw 3768107 (Wisc. App., District 4).

In this case, Grice Engineering bought the assets of Innovations Engineering, Inc. pursuant to an Asset Purchase Agreement. The total purchase price was $3.15 million. At the closing, Grice Engineering paid Innovations $500,000. Fifth Third Bank financed the $500,000 closing payment pursuant to a loan and security agreement. The remainder of the purchase price, $2.65 million, took the form of a promissory note executed by Grice Engineering and payable to Innovations. The promissory note called for 12 quarterly installments and a final payment of $2,065,770. The $500,000 note was secured by a lien on all assets of Grice Engineering. The promissory note was also secured by stock pledge agreements. Pursuant to the provisions of the promissory note, the Asset Purchase Agreement, and the general Business Security Agreement, Innovations entered into a subordination agreement under which payment of Grice Engineering’s debt to Innovations became subordinated to all indebtedness of Grice Engineering to the bank. So the bank was in the first lien position and Innovations was in the second lien position on the assets acquired by Grice Engineering under the Asset Purchase Agreement.

Grice Engineering then defaulted under the promissory note to Innovations. Disputes and differences arose pursuant to the Asset Purchase Agreement between Grice Engineering and Innovations. The bank was permitted to intervene in their lawsuit and filed a motion to dismiss Innovations’ claims against Grice Engineering on the grounds that the “standstill” clause of the subordination agreement between Innovations and the bank barred Innovations’ claims because the bank’s loan to Grice Engineering had not been paid off. Innovations opposed these motions contending that the subordination agreement was unconscionable if it precluded Innovations from enforcing Grice Engineering’s obligations to it and also contended that the bank breached its duty of good faith and fair dealing implied in the subordination agreement.

Among other rulings, the lower court found that the subordination agreement was unconscionable because of the standstill clause and therefore unenforceable. On appeal, among many other issues, the bank contended that the subordination agreement was not unconscionable. In this case, the standstill clause in the subordination agreement provided that, “Innovations shall not exercise any rights or remedies or take any Enforcement Action available upon the occurrence of a default or an event of default or otherwise under the subordinated loan documents or take any action toward the collection of any subordinated debt until all of the senior debt shall have been indefeasibly paid in full in cash and the senior commitment shall have been terminated.” It was undisputed that Grice Engineering remained obligated to the bank under the terms of the loan agreement between them and the senior debt as defined in the subordination agreement executed by Innovations and the bank was not paid in full.

The choice of law clause in the subordination agreement required the court to use Illinois law to determine this issue. Innovations contended that if the standstill clause covers all of its rights and remedies under the subordinated loan documents then it can do nothing to enforce its right to collect the money due to Innovations until the bank is paid rendering the loan to be a nullity. The Appellate Court stated it was clear from a reading of the subordination agreement that the standstill clause barred Innovations from exercising any rights or remedies available upon default until the subordinated loan documents until the bank was paid. Therefore, this left Innovations having to contend that the subordination agreement was unconscionable.

Under Illinois law, a determination that a contract’s clause is unconscionable may be based on either procedural unconscionability or substantive unconscionability or a combination of both (see Kinkel v. Singular Wireless LLC, 223 Ill.2d 1 (Ill. 2006). The burden of proving unconscionability is on the party alleging unconscionability (see Reuben H. Donnelley Corp. v. Krasny Supply Co., 227 Ill. App.3d 414 (Ill. App. Court 1991). Procedural unconscionability refers to some impropriety during the process of forming the contract depriving a party of a meaningful choice. All circumstances surrounding the transaction are to be considered, including the manner in which a contract was entered into, whether important terms were hidden, and whether each party had a reasonable opportunity to understand the terms. In determining whether a party had a meaningful choice, a court may consider a party’s commercial experience. The disparity in bargaining power between the contract drafter and the party claiming unconscionability is also considered: the inquiry on this point is whether there is a “gross disparity.” However, disparity in bargaining power alone is insufficient for a finding of unconscionability (see Streams Sports Club Ltd. v. Richmond, 99 Ill.2d 182 (Ill. 1982).

Innovations argued that the bank was in a stronger position than it was in when it entered into the subordination agreement because the bank could either loan the money to Grice Engineering or deny the funds necessary to make the sale of the business happen. However, given the lack of evidence produced regarding the superiority of the bargaining position of the bank and the fact that Innovations was a sophisticated commercial actor, the only reasonable inference from the subordination agreement is that Innovations knew what it was doing when it signed the subordination agreement. Innovations also contended that the standstill clause was hidden in the subordination agreement since it was in the same type as the rest of the subordination agreement and not specifically called to its attention. Innovations identified no evidence that it did not have a reasonable opportunity to review and understand the terms of the subordination agreement. Therefore, the court concluded that Innovations was unable to present evidence, which would show it was procedurally unconscionable.

Substantive unconscionability concerns the actual terms of the contract and examines the relative fairness of the obligations assumed (see Hutcherson v. Sears Roebuck & Co., 342 Ill.App.3d 109 (Ill. App. Court 2003). Illinois courts are more reluctant to conclude that negotiated contracts between commercial enterprises are unconscionable than they are where the contract is between a consumer and a business (see Walter E. Heller & Co. v. Convalescent Home of the First Church of Deliverance, 49 Ill.App.3d 213 (Ill. App. Court 1977). In determining whether there was substantive unconscionability, the court discussed the characteristics of subordination agreements between creditors. The subordination agreement between Innovations and the bank did allow Innovations to receive principal and interest payments under its note so long as Grice Engineering was not in default on its debt to the bank. Some subordination agreements provide that the subordinated creditor will accept no payment on its debt until the senior loan is paid in full (see e.g., Sumitomo Trust & Banking, 140 B.R. 643, 668 (Bankr. W.D. Mich. 1992)).

The court also referred to other cases where standstill agreements in subordination agreements were challenged but were enforced by courts in Illinois (see Strosberg v. Brauvin Realty Servs., Inc., 295 Ill.App.3d 17 (Ill. App. Court 1998); Rovak v. Parkside Veterans Home Project, Inc., 8 Ill.App. 310 (Ill. App. Court 1956)). The court then went on to conclude that the subordination agreement was part of the transaction of the sale of Innovations’ business assets to Grice Engineering. As a result of the transaction, Innovations received the $500,000 that the bank lent Grice Engineering thereby giving a benefit to Innovations when the assets were sold. Innovations also contended that Grice Engineering got an unfair benefit by not having to pay Innovations now as a result of the default since its much larger loan did not have to be paid until the bank was paid in full. However, this of course means that there is more money to pay the bank’s loan in full. Therefore, the benefit to the bank is plainly what the subordination agreement provides for, and Innovations was unable to point to any factual submission showing that the subordination agreement was commercially unreasonable. Therefore, there was no showing that the standstill clause was unconscionable and was enforced by the court.

From the senior lender’s perspective, standstill provisions should be used so that the senior lender gets the benefit of its bargain. However, it also makes sense for the senior lender to make that clause conspicuous to avoid the contention that the subordinated lender did not bargain for that provision. From the subordinated lender’s standpoint, if the subordinated lender does not want a standstill provision in the subordination agreement then it should be carefully reading the subordination agreement to make certain that the standstill agreement is not part of the document. Of course, as a practical matter, in seller carry back financing, usually the seller that is the subordinated lender is happy to get paid a substantial part of the purchase price at the time of the sale and therefore does not carefully read or understand the effect of a standstill provision. Whether the senior lender will remove the provision or soften it is a matter of negotiation, but if the subordinated lender plays hard ball with the senior lender, it may lose the loan and the sale. Therefore, these negotiations are part of the business deal that all parties need to understand.

Andrew K. AlperAndrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List. Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.

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