In an action to establish the priority of claims of unsecured trade creditors of a corporation over the indebtedness represented by a convertible debenture issued by the corporation, the judge did not err in considering extrinsic evidence to explain certain ambiguous provisions of a clause in the debenture qualifying the priority given to trade creditors. [127-129]
Where a subordination clause in a debenture contained a clear statement giving priority to the claims of trade creditors over those of the holder of the debenture, as well as certain provisions limiting the priority of trade creditors which were difficult to reconcile with the clear subordination of debt, and where evidence showed that the purpose of the subordination clause was to enable the corporation issuing the debenture to obtain short term financing from trade creditors despite its lack of equity, this court construed the subordination clause as giving priority to the claims of trade creditors. [129-130]
CIVIL ACTION commenced in the Superior Court on December 26, 1976.
The case was heard by Hurd, J.
Carl K. King (Eric I. Zucker with him) for the defendant.
Gerald P. Tishler (John A. Wortmann, Jr., with him) for the plaintiffs.
DREBEN, J. This appeal turns on the construction of a subordination clause in a 1973 convertible debenture issued by Austin Hastings Co., Inc. (the Company), to the defendant, A-H, Inc. A judge of the Superior Court held that the
defendant's claim to the proceeds of a foreclosure sale was subordinated to the claims of unsecured trade creditors represented by the plaintiffs. We affirm.
The 1973 debenture was issued in exchange for an earlier debenture of the Company, given to the defendant in partial payment for the purchase by the Company of the defendant's assets. The debenture matured in July, 1976, and its "payment and performance" were secured by the Company's equipment. After the debenture came due and the Company was unable to meet its obligation, the defendant foreclosed. Because of claims made by representatives of the trade creditors (the plaintiffs), the proceeds of the sale ($204,221.72) were held in escrow pending the outcome of this action. The amount so held is insufficient to pay either the principal and interest due on the debenture or the sums stipulated to be owing the trade creditors ($787,838.20).
The clause in question, Section 9 of the debenture, is set out in the margin. [Note 2] Under the first portion, Section 9.1, the defendant
as holder agreed that "the indebtedness represented by this Debenture" and the payment of principal and interest "shall be subordinate . . . to trade creditors for goods sold and delivered and services rendered (`Senior Debt') to the end that no payment shall be made by the Company on account of the principal . . . or interest . . ., as long as any Senior Debt is outstanding."
If the clause had there ended, the rights of the parties would be beyond question; the plaintiffs would be entitled to the proceeds of the sale. An additional proviso in Section 9.1, together with Section 9.2, has, however, led the parties to divergent conclusions. [Note 3]
The inartful language of Section 9 and the varied interpretations which can be and have been placed on it refute the defendant's contention that there was error "in the admission
of evidence of the facts and circumstances of the transaction . . . for the purpose of . . . explaining any uncertainty or ambiguity . . . ." Robert Indus., Inc. v. Spence, 362 Mass. 751 , 753 (1973). Restatement (Second) of Contracts Section 212, and comment b (1981).
Evidence at trial indicated that the method of financing the Company's purchase of the defendant's assets left the Company without any equity. The purpose of the subordination clause was to induce suppliers to extend credit to the Company. Without it, such credit would not have been forthcoming. [Note 4] The proviso, relied upon by the defendant, permits certain payments by the Company. It does not purport to nullify at maturity the priority given to trade creditors in Section 9.1, and no evidence suggests that such an interpretation was ever contemplated by the parties. [Note 5] Reading the proviso in light of its purpose to enable the Company to obtain short-term financing from trade creditors despite the lack of equity shown on its balance sheet, we conclude that the payments permitted by the clause were not intended to eliminate the plaintiffs' senior status. [Note 6]
We also decline to adopt the defendant's reading of Section 9.2 so as to limit the priority of the trade creditors in Section 9.1 to the defendant's unsecured claims. The equitable considerations underlying the rule that an assignment of debt usually carries with it all liens and security, see 3 Williston, Contracts Section 432A (3d ed. 1960), are applicable here. Where there is a clear subordination of debt as in Section 9.1, we will not deny that provision its practical effect in the absence of specific language that priority in the security is not intended. Subordination agreements are "consistently" construed to afford substantial "practical" benefits to the debt or security interest given priority. Grise v. White, 355 Mass. 698 , 704 (1969).
Such consistent construction might lead us, with some plausibility, to accept the plaintiffs' interpretation of Section 9.2, see note 3, supra. An alternative and perhaps more satisfactory solution is to recognize, as did the trial judge, that the language of Section 9.2 cannot be readily reconciled with Section 9.1. Where as here the "main object to be accomplished is stated in [Section 9.1]," and where "a repugnancy is found between [two clauses, Section 9.1 and Section 9.2,] the one which essentially requires something to be done to effect the general purpose of the contract itself is entitled to greater consideration than the other which tends to defeat a full performance, and repugnant words may be rejected in favor of a construction which makes effectual the evident purpose of the entire instrument." Morrill & Whiton Constr. Co. v. Boston, 186 Mass. 217 , 220 (1904). With this precept in mind, we give greater weight to Section 9.1 than to Section 9.2 and read the latter as meaning that the security interests of the defendant are recognized as prior to claims of creditors except as specifically permitted under certain specified documents and except as provided by Section 9.1 of the debenture. Accordingly, we hold that the plaintiffs are entitled to priority in the proceeds.
[Note 1] Henry Gesmer.
[Note 2] "9. Subordination.
"9.1. The Company covenants and agrees and the Holder hereof likewise covenants and agrees that the indebtedness represented by this Debenture and the payment of the principal hereof, and premium, if any, interest and mandatory prepayments hereon shall be subordinate to all indebtedness of the Company to The National Shawmut Bank of Boston or any other bank indebtedness including that of banks taking the position of, or participating with, said National Shawmut Bank of Boston and to trade creditors for goods sold and delivered and services rendered (herein "Senior Debt") to the end that no payment shall be made by the Company on account of the principal of, or premium, if any, or interest on this Debenture, or as a mandatory prepayment of this Debenture, and this Debenture shall not be purchased either directly or indirectly by the Company as long as any Senior Debt is outstanding; provided, however, the Company may on the stated maturity dates make payments on account of the principal of or premium, if any, or interest on this Debenture, or as a mandatory prepayment of this Debenture, or may either directly or indirectly purchase this Debenture on its stated maturity dates (if this Debenture is declared due and payable by reason of the acceleration hereof, any such event shall not be deemed a stated maturity date), or as an optional prepayment of this Debenture as provided in Section 2.2 hereof [sic], but only if, the Company obtains the written consent of The National Shawmut Bank of Boston in respect of prepayments under said Section 2.2 at any time while the Company is indebted to The National Shawmut Bank of Boston.
"9.2. Nothing contained in this Section 9 shall limit or restrict the right of the Holder hereof to realize upon the security interests and liens which the Holder hereof has perfected under and pursuant to the Pledge Agreement, Security Agreement, and Guaranty as security for all payments due hereunder, said security interests and liens hereby being recognized as prior liens to any claim or rights of any creditor of the Company, except as specifically permitted under said documents and the Purchase Agreement."
[Note 3] The defendant argues that the proviso in Section 9.1 which permits the Company to make payment "on the stated maturity dates" means that payments are only subordinated prior to maturity, but that there is no subordination thereafter. It claims that that even if it is wrong in this interpretation, it is entitled to the proceeds of the security by reason of Section 9.2, as that clause means that only its claims in excess of its security interest are subordinated by Section 9.1 to the trade creditors.
The plaintiffs insist that the defendant's construction of the proviso would nullify the subordination clause since only at maturity would significant payments become due. Moreover, although the proviso permits the Company to make certain limited principal payments, it does not, on the plaintiffs' reading, give the defendant the right to enforce payment while senior debt is outstanding. As to Section 9.2, the plaintiffs argue that the term "realize" means only that the defendant had the right to take possession and sell subject to the rights of the senior creditors. Otherwise Section 9.1 would be rendered nugatory; the importance of priorities only arises when the debtor's assets are insufficient to meet its debts.
[Note 4] The need for current financing is a well recognized purpose of subordinated securities. "[S]ince these issues [subordinated securities] are regarded by senior debt holders as equity capital rather than debt, they furnish an equity base" which enables the issuing corporation to obtain short-term financing. Calligar, Subordination Agreements, 70 Yale. L.J. 376 (1961).
[Note 5] In fact, the evidence is consistent with a contrary conclusion. Each year the financial statements of the Company, which under the provisions of the debenture were required to be given promptly to the defendant, explicitly stated that the debenture was subordinated to trade creditors. None of the annual statements, not even the statement next prior to the debenture's maturity, suggested that the subordination rights of the trade creditors ended on maturity.
[Note 6] We also note that the proviso did not well suit the transaction. Although Section 9.1 speaks of maturity dates, there appears to be only one maturity date in the instrument. The only mandatory prepayment called for is in Section 2.1 which requires a payment of 25% of the original principal amount "on the fourth anniversary of the date of issuance hereof." That date came after maturity, as the date of issue was February 16, 1973, and the date of maturity was July 30, 1976.