Are You Sure You Know The Priority Of Your Debt?

In Monty Python and the Holy Grail, some villagers claim to have found a witch, which they would like burn at the stake. They ask Sir Vladimir for permission to burn her, but he wants to know how the villagers know the woman before him is a witch before he consents to her burning. After a bit of prodding, the villagers admit the dressed the woman up like a witch and made her wear a fake nose. But they insist she does have a wart.

A bit of “scientific reasoning” then takes place, and it is determined that the woman weighs the same as a duck, so she can float on water, and thus is made of wood, which we all know is what witches are composed of since they burn.

We were reminded of this scene when reading a recent bankruptcy opinion from the 2nd Circuit Court of Appeals. There is a lot of other stuff going on in the case, but since we frequently work with creditors, what struck a chord with us was the court’s discussion of debt priority.

When a company declares bankruptcy, the court must figure out who gets what when any remaining assets are distributed. Debts are prioritized, and the higher the priority a debt is, the more likely it gets paid back. For example, first-lien secured bonds are superior to second-lien secured bonds, are superior to senior unsecured bonds, are superior to subordinated unsecured bonds, are superior to preferred stock, are superior to common stock, etc.

One cannot come in claiming that the title at the top of a document completely determines what type of debt it is and what priority it gets during a bankruptcy. That is like the villagers dressing up the woman as a witch to make their case against her stronger. It is necessary to do a closer examination of the details of the agreement to determine what exactly it is.

However, the court went a bit overboard in deciding that the terms of the subordinated notes in the case at hand were basically ambiguous. Parties need to have some certainty that their intentions about the priority of debt be respected. Wiggle room is not necessarily something lenders or debtors want in this area of the law.