Subordination Agreements under question

Banking / Insolvency

Subordination Agreements under question.

More bad news for lenders? Kieran McGarrigle looks at the future of subordination agreements following a decision by the English High Court in SSSL Realisations.

More bad news for lenders?

A banking friend recently described 2005 as a difficult year for lenders. The comment surprised me as many lenders are reporting (for various reasons) a notable increase in lending during 2005, so I enquired why. My friend replied by saying that the law had not been particularly kind to lenders during 2005 as it was interfering with a lender's right to recover its money when its borrower defaults.

This view is arguably an understandable one when you consider some of the recent developments in insolvency law. A lender's traditional means of recovering its debt have been restricted by both the Courts and the Government. A lender can now only hold a valid fixed charge on book debts in very limited and perhaps prohibitive circumstances following the Spectrum Plus case. My article in the previous Update outlined the impact of this case for lenders. Legislation is also being introduced which restricts a lender's ability to appoint an administrative receiver, arguably a lender's most effective method of enforcement.

Subordination

The bad news for leners is that the Courts have now turned their attention to subordination agreements. A subordination agreement is an agreement between two lenders (normally a senior and a junior lender) whereby one lender (normally the junior lender) agrees that its debt will not be discharged until the other lender has been repaid in full. There has been some concern that subordination infringes the principle of parri passu in an insolvency which provides for the equal treatment for creditors of the same rank in an insolvency.

Case Law

The effectiveness of subordination agreements was considered recently by the Courts in SSSL Realisations (2004), part of the Save Petrol Group. There were substantial inter-company debts owing within the group when the companies were placed into liquidation. A third party creditor (AIG) sought to enforce a pre-insolvency agreement whereby certain of those debts were contractually subordinated to the monies owing to AIG. The Courts decided that the subordination agreement was valid and held that an agreement which, in this case, prevented the group companies from collecting inter-company debts until AIG had been paid in full did not disturb the pari passu rule. However, the decision has been appealed to the Court of Appeal.

Turnover Trust

One of the key features of a subordination agreement is a "turnover trust" provision which is essentially an undertaking from the subordinated lender to (i) hand over any funds received by it in breach of the subordination agreement and (ii) hold any monies received in breach of that subordination agreement on trust for the other lender. There has been some concern that this "turnover trust" provision could be construed as a charge on the subordinated creditor's assets which would be void for non-registration if the subordinated creditor becomes insolvent. The Court in SSSL Realisations (2004) concluded that since, as a matter of construction, the trust was limited to those amounts which would be required to repay the debt to AIG, the trust did not constitute a charge.

Appeal

The Court's decision in SSSL Realisations (2004) was welcomed by lenders. It upheld the validity of subordination agreements provided the "turnover trust" provision is limited to the indebtedness of the lender who has the benefit of subordination (something which draftsmen of subordination agreements should bear in mind). However, the Court of Appeal is now considering the appeal and the effectiveness of subordination agreements, in particular the "turnover trust" provision. Many lenders, having invested heavily in the validity of subordination agreements, are anxiously awaiting the Court of Appeal's decision. The decision could have huge implications for lenders where they have entered into, or are entering into, subordination agreements with other lenders or the owners of companies and are assessing their risk on the basis that their standard subordination agreements are valid. For my banking friend, there may be some more bad news to come.

Kieran McGarrigle is an Associate in the firm's Corporate Department specialising in all aspects of corporate recovery and insolvency. He is currently advising the Administrators of Coleraine Football Club.

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