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Kurak v. Dura Automotive Sys., Inc.

January 3, 2008

On December 7, 2007, in Kurak v. Dura Automotive Sys., Inc., the Delaware Bankruptcy Court issued a written opinion in which the Court considered what is commonly referred to as an “X-Clause,” a provision in a subordinated note indenture which defines an exception to the basic subordination promise of a subordinated note holder in the event of a bankruptcy or similar proceeding of the issuing debtor, and permits a distribution to such holders in certain circumstances. The Court granted the defendant/debtors’ motion for summary judgment and held, inter alia, that the X-Clause at issue did not relieve the subordinated note holders of their basic contractual promise to subordinate their right to payment or distribution from the debtors until after the debtors’ senior note holders were paid in full.

The Court’s opinion was issued in an adversary proceeding brought by certain of the debtors’ subordinated note holders (the “Subordinated Holders”). The Subordinated Holders’ complaint sought, inter alia, a declaratory judgment that: (i) the X-Clause did not subordinate their right to receive payment or distribution from the debtors under a proposed plan which provided distributions through an equity-rights offering; and (ii) in any event, the debtors’ proposed plan unfairly discriminated against the Subordinated Holders under Section 1129 of the Bankruptcy Code because it transferred the benefit of the Subordinated Holders’ distribution and other rights to the senior note holders (the “Senior Holders”). According to the Subordinated Holders, the X-Clause at issue excepted “Permitted Junior Securities” (as defined in the subordinated note indenture) from their subordination promise even where the Senior Holders were not paid in full, and the debtors’ proposed equity offering constituted the distribution of “Permitted Junior Securities.” The debtors (and the intervening Senior Holders) moved for summary judgment on the grounds, inter alia, that the X-Clause did not affect the basic subordination promise inherent in the subordinated note indenture and required subordination because the Senior Holders were not being paid in full under the debtors’ proposed plan.

The Court’s opinion is notable for several reasons. First, while observing that the X-Clause lacked “utter clarity,” the Court nevertheless agreed with the parties that the X-Clause was not ambiguous. The Court also agreed with the debtors (and other courts which have considered X-Clauses) that the Court may consider other sources, such as the model indenture provisions and commentaries, when construing the X-Clause.

Second, the Court found that applicable New York law required the Court to consider the X-Clause within the overall purpose of the indenture and not in isolation. In the Court’s words, the X-Clause “must be read in context” and, as such, the Court rejected an analysis (proffered by the Subordinated Holders) which focused on “grammatical structure alone.” Further, the Court accepted the proposition that an X-Clause is intended to create only a limited exception to the basic subordination promise and must be construed narrowly.

Third, according to the Court, the subordinated note indenture as a whole supported the conclusion that the Subordinated Holders were not expected to receive any payment or distribution from the debtors (a) until the Senior Holders were paid in full or (b) unless the Senior Holders consented to such distribution. As such, the Court rejected the Subordinated Holders’ grammatically-based argument that the debtors’ anticipated equity-rights offering constituted “Permitted Junior Securities,” because the Subordinated Holders’ argument would “eviscerate the purpose of the subordination provisions” in the subordinated note indenture. Indeed, the Court noted that the Subordinated Holders’ argument defied “explanation and logic” because a “senior creditor simply would not agree to a subordination agreement in which its priority depended upon the form of consideration chosen by the debtor.”

Fourth, although the Court did not reach the Subordinated Holders’ Section 1129 arguments, the Court also noted that generally a plan which proposes disparate treatment of creditors with the same priority level “based upon subordination rights is viewed as fair.” Finally, the Court did agree with the Subordinated Holders’ proposition that “each x-clause is different and must be considered only in the specific context of the applicable contract.” Accordingly, while the Court’s opinion provides persuasive authority for the meaning, purpose and interpretation of an X-Clause, it also suggests that other courts may analyze the provisions of an X-Clause on their own terms.

We believe that the Court’s December 7, 2007 opinion is important as it decided the issue consistent with the expectations of the credit markets, thus providing greater comfort to financial institutions investing in both senior and subordinated debt. Further, we believe that the Court’s ruling is consistent with prevailing Third Circuit precedent and decisions from and within other Circuits which have applied X-Clauses in bankruptcy proceedings.

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