Bankruptcy law seeks to equitably distribute a debtor’s remaining assets among creditors. However, prior to bankruptcy, creditors can contract around their pro rata equitable distribution by executing inter-creditor agreements. Inter-creditor agreements are executed to delegate the rights and priorities of creditors as to a common borrower in the event the borrower defaults. Subordination agreements are a type of inter-creditor agreement, where junior creditors consent to senior creditors having their loans repaid in full before junior creditors receive their payment. Bankruptcy courts enforce subordination agreements through section 510(a) of title 11 of the United States Code (the “Bankruptcy Code”), which states that a “subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable non-bankruptcy law.”
The Rule of Explicitness is a canon of construction that courts apply in interpreting post-petition interest payment priority in subordination agreements. Under the Rule of Explicitness, senior creditors can recover post-petition interest from junior creditors, if such payment priority is explicitly stated in the subordination agreement. The Rule of Explicitness allows creditors to contract around section 502(b)(2) of the Bankruptcy Code, which prohibits collection of post-petition interest.
After enactment of section 510(a) to the Bankruptcy Code, a circuit split developed over whether section 510(a) abrogates use of the Rule of Explicitness when interpreting subordination agreements. The issue turns on whether courts characterize the Rule of Explicitness as a bankruptcy-specific rule of equity or as a tool of state contract law. The First and Eleventh Circuits hold that enactment of section 510(a) abrogated the Rule of Explicitness because the rule is a bankruptcy-specific rule of equity. However, lower courts in the Second Circuit, and the New York Court of Appeals continue to apply the Rule of Explicitness as a tool of state contract law. This memorandum explores this circuit split in two parts. Part I examines the First, Second, and Eleventh Circuits’ stance on whether section 510(a) abrogated the Rule of Explicitness. Part II discusses the significance of the circuit split, and the issues the split raises.