Subordination Agreements and property ownership

16 helmikuuta 2005

Russell Dellar

Further to a recent High Court decision we comment on the potential importance of subordination agreements in practice and also outline a recent new class of property ownership…

Whither Subordination?

A recent court decision has subjected subordination arrangements to judicial scrutiny[1]. With their validity long queried by some commentators, this article examines why bankers should always consider the need for subordination of other debts before parting with their loan monies and looks at the status of contractual subordination provisions in the light of the recent SSSL case.

A typical funding structure will involve some level of gearing. The owner(s) will contribute their investment by way of equity injection, but very often part of that investment will also be made by way of debt, whether secured or not. Sometimes this fact is later overlooked when a bank is considering lending into the borrowing company. This can leave an unwelcome legacy for the bank down the line. Even where other lending is unsecured, another lender will, unless the matter is otherwise controlled through a subordination arrangement, be at liberty to take all action available to it under its loan documentation or general law. Should there be a dispute between this other lender and the borrower, a demand could be made (assuming the loan is then due) and follow up action taken (perhaps litigation or a petition for winding up on account of the borrower’s alleged insolvency). If the other lender holds security, then the bank will presumably want to prioritise the ranking of its security interests ahead of the other lenders. In the context of real estate, the arrangements will likely identify who has prior fixed charges over the property, security over any accruing rental streams and how ancillary floating charges in competing debentures are to rank. Moreover, the bank will want to be sure that it regulates the circumstances in which the other lender is entitled to enforce its security. Such matters will be addressed in any properly drawn deed of priorities. Priority of security and debt subordination arrangements are usually covered in an all-embracing intercreditor deed.

Such arrangements should limit (or exclude) the leverage any other lender might have with the bank. The concept of subordination has developed as a means to neutralising or, at least, controlling the rights of other lenders (as junior creditors) vis a vis the borrower and the bank (as senior creditor). Whether a contractual subordination arrangement is effective has, however, received limited attention from the courts. The SSSL case represents the latest statement of the court’s position on this and serves to offer useful guidance to bankers and lawyers alike.

The case arose following the Save petrol group’s collapse and the ensuing liquidations. There were substantial inter-company debts owing within the group. A third party creditor (AIG) sought to enforce a pre-insolvency agreement whereby certain of those inter-company debts were contractually subordinated behind payment of monies owing to AIG. AIG’s claim hinged on whether such arrangements would be in breach of a long established principle of English insolvency law concerning the equal treatment of unsecured creditors[2]. It was held that it was open to the group companies to subordinate their payment claims behind those of AIG, that the liquidators were not entitled to question the same and the fact that the group companies could not, as a result, collect in an inter-company debt until AIG had been paid did not disturb the pari passu principle.

SSSL is a timely reminder for banks to carefully assess whether any other lending or debt (present or future) ought to be subordinated to their own. If so, the case provides welcome support for the proposition that carefully drafted subordination arrangements should be valid and effective.

Commonhold – a new concept

Lenders should be aware that a new way to own and manage interdependent buildings such as office blocks, flats, or other commercial or residential developments was introduced on 27 September 2004. Known as “commonhold”, it combines freehold ownership with membership of a limited company, the Commonhold Association, which owns and manages the common parts of the building. In a commonhold scheme, individual ownership will be by way of a freehold rather than a reducing leasehold interest, which may appeal to lenders. Questions are bound to arise however regarding the financing of “flying” freeholds, which banks have traditionally shied away from. Other potential difficulties include a lender in possession having to take over the borrower’s commonhold rights and obligations and the need for safeguards in the commonhold agreement to ensure charges over commonhold areas are enforceable upon a winding up. Time will tell the extent to which commonhold is adopted in a commercial and mixed-use context.

Also published in the APB newsletter.


[1] RE SSSL Realisations (2002) Ltd (formerly Save Service Stations Ltd) (in liquidation) and another company, Manning and others v AIG Europe (UK) Ltd [2004] EWHC 1760 (Ch).

[2] The so-called pari passu principle of distribution of assets was upheld in the leading case of British Eagle International Airlines Ltd [1975] 1 WLR 758. This was decided in light of the statutory order of application of assets now set out in section 107 Insolvency Act 1986 and Rule 4.181 of the Insolvency Rules 1986.