An Illinois Court's Lesson For Senior Lenders
On April 27, 2017, in Bowling Green Sports Center v. GAG LLC, an Illinois appellate court, adopting the reasoning of courts in Missouri, New York and Massachusetts, held that, in the absence of an intercreditor agreement stating otherwise: (1) if a senior lender modifies the terms of an underlying note or mortgage without the consent of the junior lender, the senior lender will relinquish its priority with respect to the additional loaned amounts and (2) if the modification substantially impairs the junior lender’s security interest, “a court will wholly divest the senior lender of its priority and elevate the junior lender to a position of superiority.”
In Bowling Green, defendant GAG borrowed $3.4 million from Gold Coast Bank and $405,000 from Bowling Green to finance the purchase of a bowling alley in West Chicago. Gold Coast Bank and Bowling Green entered into an intercreditor agreement identifying Gold Coast Bank as the senior lender and Bowling Green as the junior lender. The agreement generally provided that: (1) Bowling Green would not sue to recover money from GAG until GAG had repaid Gold Coast Bank in full, and (2) Gold Coast Bank would not increase its loan to GAG without first receiving Bowling Green’s consent. Months later, without notifying Bowling Green, GAG and Gold Coast Bank executed a modification agreement increasing the loan by $51,000.
In 2015, Bowling Green sued GAG for breach of contract. Gold Coast Bank intervened in the proceedings and sought to have Bowling Green’s complaint dismissed based on the intercreditor agreement. Gold Coast Bank argued that, pursuant to the intercreditor agreement, Bowling Green could not sue to recover its debt until Gold Coast Bank’s senior indebtedness had been paid in full. The trial court agreed and dismissed the complaint.
On appeal, the court held that “a senior lender’s failure to obtain a junior lender’s consent results in the modification being ineffective as to the junior lender and the senior lender relinquishing to the junior lender its priority with respect to the modified terms,” but that Gold Coast Bank did not relinquish its priority with respect to the original amount. The court noted that this was consistent with other states’ holdings and the Restatement (Third) of Property. 
The court, additionally, made clear that where a modification is found to “substantially impair the junior lender’s security interest or effectively destroy its equity,” it will “wholly divest the senior lender of its priority and elevate the junior lender to a position of superiority.” In other words, if the modification is drastic enough, a court will negate the senior lender’s priority even with regard to the original loan amount.
This begs the question: When does a modification “substantially impair” a junior lender’s priority?
While not adopting a bright-line rule to answer this question, the court offered examples where it would find “substantial impairment”: (1) where the senior lender increased its loan to the borrowers from $2.2 million to $20 million and (2) where the modification reduced the principal amount, but raised the interest rate from 6 1/4 percent to 10 percent and shortened the maturity of the note from 30 years to 10 months with a balloon payment at the end. The court added that the 1.5 percent increase in Gold Coast Bank’s loan (by $51,000) was “not materially significant in the defendants’ inability to repay Bowling Green [such that it would substantially impair Bowling Green], because the defendants still owed Gold Coast Bank over $1.9 million when Bowling Green filed its complaint.” That being said, “substantial impairment” is based on the facts and circumstances and will be determined on a case-by-case basis.
Given the ambiguity of the “substantial impairment” concept, and the lack of a bright-line rule, it is difficult to assess exactly when a modification will “substantially impair” the junior lender (and as a result, when a senior lender may lose its priority status entirely). One thing is for certain, however; junior lenders will claim “substantial impairment” where given the opportunity to better their litigation position or negotiating leverage.
Taking note of the risks to which the senior lender exposed itself in Bowling Green, other lenders can better protect themselves in the future. Bowling Green demonstrates that where a senior lender can prevent the inclusion of a junior lender in the capital stack of a deal, it should. Once a junior lender has a seat at the table, the senior lender is clearly exposed to challenges to its priority position that risk negating its priority position, increasing its exposure, and adding to its litigation spend. Where the involvement of junior lenders cannot be avoided, however, senior lenders should take full advantage of their bargaining position and include, among other things, provisions that clearly and explicitly: (1) subordinate the junior creditor and (2) enumerate the categories of loan and mortgage modifications that may be completed without the consent of the junior creditor, e.g., the senior lender can increase the loan amount by 15 percent without the consent of the junior creditor, and such increase shall be senior to the junior creditor’s loan. In hindsight, such a provision would have eliminated the senior lender’s risk in Bowling Green.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 2017 IL App. (2d) 160656, ¶ 13.
 Id. at ¶ 13.
 Id. (citing Burney v. McLaughlin, 63 S.W. 3d 223, 229-34 (Mo. Ct. App. 2001); Shultis v. Woodstock Land Development Associaties, 594 N.Y.S.3d 890, 892 (N.Y. App. Div. 1993); Shane v. Winter Hill Federal Savings & Loan Ass’n, 492 N.E. 2d 92, 95 (Mass 1986); (Third) of Prop.: Mortgages § 7.3 cmt. b (1997)).
 Koloff v. Reston Corp., No. Civ. A. 12281, 1993 WL 106062 (Del. Ch. Mar. 26, 1993).
 Gluskin v. Atlantic Savings & Loan Ass’n, 108 Cal. Rptr. 318, 321-25 (Cal. App. 1973).
 Bowling Green Sports Center, 2017 IL App (2d) at ¶ 18.