When a debtor becomes insolvent, how will its creditors (persons who are owed money by the debtor) be paid out from the available assets of the debtor? What are subordinated debts?
General Principles on Priority
The general rule in insolvency is that all debts are to be treated equally, with rateable distribution of the available funds between all creditors, known as the pari passu principle. However, there are principles and rules about ranking or priority of debt. That is, which creditors can get paid out from the debtor’s available assets before others? If a creditor is down the line in priority, there’s a higher likelihood he will not be paid at all.
A general list of priority of debts and creditors is as follows (see s 203 of the Singapore Insolvency, Restructuring and Dissolution Act 2018 (“IRDA”) which has yet to come into force at the time of this article):
(1) Fixed charge / secured creditors—e.g. mortgagees;
(2) Expenses, fees, costs, of the insolvency proceedings;
(3) Preferential creditors—employees;
(4) Floating charge creditors;
(5) Unsecured provable debts;
Under s 204 of the IRDA, creditors who help fund or provide an indemnity for costs of litigation by an insolvent company to recover assets can apply for a court order that the assets recovered are distributed to them in priority to other creditors. This is to take into account their contribution or risk in supporting the litigation.
Under 67 of the IRDA, lenders or ‘white knights’ who provide rescue financing to distressed companies may receive super-priority in terms of their debts. The Singapore High Court (Re Attilan Group Ltd  SGHC 283 (deciding on s 211E of the Singapore Companies Act (Cap. 50), which will be replaced by s 67 of the IRDA) once the IRDA comes into force) has held that a rescue financier may stipulate conditions in the grant of its rescue finance, that the conditions of the debt must be fulfilled: (a) it is necessary for the survival of the relevant company seeking the “rescue financing” (or the whole or any part of the undertaking of that company) as a going concern; or (b) it is necessary to achieve a more advantageous realisation of the assets of the relevant company seeking the “rescue financing”, than on a winding up of that company. It must be shown that reasonable efforts were employed and that it would not have been able to obtain rescue financing from any person without special priority status, although the debtor does not have to show that it has sought credit from “every possible source”.
However, it is established law that, by contract, a creditor’s rights can be subordinated to other creditors’. This has particular relevance to the capital adequacy of banks and other credit institutions under the regulatory regime applying to them, but it is also used widely in relation to investors and other financiers. There is also a separate rule that if a guarantor has paid part, but not all, of the guaranteed debt to the creditor, it cannot claim in the insolvency of the principal debtor until the creditor has been paid in full.
The following extract from Manning & Ors v AIG Europe (UK) Ltd & Ors  EWHC 1760 (Ch) (affirmed on appeal: Re SSSL Realisations (2002) Ltd  Ch 610, C.A.) at - explains the law on subordinated loans clearly:
“22. The validity of subordinated debt arrangements has been considered in two English cases and a number of Commonwealth cases. The earliest case I need to consider is Horne v. Chester & Fein Property Developments Pty Ltd (1987) 5 ACLC 245, a decision of Southwell J in the Supreme Court of Victoria. In that case three persons had entered into an agreement in relation to a company which was not a party to the agreement, and may not even have been incorporated by then. The agreement provided that the three were to advance to the company, in equal amounts, the money needed for its establishment, and these loans were to rank equally, but that if any of the three lent further money to the company afterwards, those additional loans were to be repaid in full before the other loans made by any of the three. Two of them did make further loans. The company went into insolvent liquidation, and the question arose whether the agreement for prior repayment of the further loans was valid. There were other creditors of the company, and it was accepted that they were to be paid pari passu with the creditors in respect of the further loans. The judge considered a number of cases, including British Eagle, to which I will refer later. He held that the agreement was valid and effective. He said that the principle of insolvency law that the whole of the debtor’s estate should be available for distribution to all creditors, and that no one creditor or group of creditors can lawfully contract in such a manner as to defeat other creditors not party to the contract, did not mean that effect could and should not be given to an agreement between parties which does not adversely affect the entitlement of persons who are not parties, such as he was considering in that case.
23. In Re British & Commonwealth Holdings plc (No 3)  1 WLR 672, the first of two English decisions about subordinated debt, both decided by Vinelott J, the judge had to consider the rights of the holders of convertible subordinated unsecured loan stock as compared with those of other creditors of the company, in relation to a proposal for a scheme of arrangement under section 425 of the Companies Act 1985. The dispute was between the administrators on the one hand and the trustee of the loan stock on the other. The judge held that the rights of the loan stock holders in a winding-up would be subordinated to those of other creditors. It was not contended that the subordination was ineffective in a winding-up.
24. The following year, in Re Maxwell Communications Corporation plc  1 WLR 1402 the judge had to decide a similar question in a case where the contractual subordination was not supported, as it had been in the earlier case, by trust provisions. It was argued that the pari passu distribution of assets among unsecured creditors was a general rule of insolvency law from which it was not possible to contract out, even to one’s own disadvantage, particularly by analogy with cases on set-off in insolvency. The judge decided that this was not the law. He said that there was no reason why a particular creditor should not waive his right to prove altogether, or save to the extent of assets remaining after another creditor is satisfied, and that he could do this either in the insolvency or in advance of it. He considered the British Eagle case, and other authorities, and held that they did not force him to hold that a contract between a company and a creditor, providing for the debt due to the creditor to be subordinated in the insolvent winding-up of the company to other unsecured debt, is rendered void by the insolvency legislation (see p. 1416F). He held that such an agreement could be valid, and that in the case before him it was.
25. Mr Randall Q.C., … identified three distinct types of transaction, which he said could have different consequences. The true subordinated debt, he submitted, is one where the terms on which the debt is incurred, by agreement between the creditor and the debtor, provide for repayment to be subordinated to other payments to be made by the debtor, as in the two cases before Vinelott J. He contrasted this with a priorities agreement, namely a contract between two or more creditors of the same debtor by which they agree to alter the priority in which they would otherwise receive payment as between themselves. He submitted that in the case of a priorities agreement, persons who are not parties to the contract and have not agreed to its terms should not be prejudiced by it, especially as creditors in a later insolvency. He characterised this as no more than a contractual obligation binding on the particular parties to the contract. Subject to the question whether any security or other proprietary right is conferred over a particular asset of the debtor, this is a fair comment, but it does not seem to me that it leads to any particular consequence or conclusion relevant to the debate. He identified a third type of transaction, a trust arrangement, whereby one creditor, A, agrees to hold on trust moneys received from a common debtor for the purpose of paying or securing payment of another creditor, B. He said that there was nothing inherently wrong with such a transaction, which does confer proprietary rights, but that if A later became insolvent, the arrangement was likely to be a charge over its book debts, and accordingly void against other creditors unless registered.
26. Another distinction can also be drawn between two different types of subordinated debt agreement. There are those by which the debts owed to one creditor or group of creditors are subordinated to those of others, leaving all others to compete equally between themselves, pari passu. The alternative approach, sometimes called “turnover subordination”, is one whereby one creditor agrees with another to hold on trust for the other all dividends or other payments received in respect of his own debt (or at any rate the amount required to pay the other creditor in full), unless and until the other is paid in full. The latter approach would only arise in the context of an agreement between creditors, whereas the former could apply either in an agreement between creditors or in the terms of the issue of subordinated debt as between debtor and creditor. As regards the interest of the creditor seeking to be preferred over another, depending on the likely competition from other creditors not party to the agreement, the latter may well be a more beneficial arrangement than the former, because the former limits the competition, but gives the advantage of that to all the creditors who are not subordinated.
27. Professor Goode, in Commercial Law, 2nd ed. at page 665, and in Legal Problems of Credit and Security, 3rd ed. at page 316, observes that the former type of arrangement is not in the best interests of the non-subordinated creditor, because the latter is so much more advantageous.”
Subordinated Bonds and Notes
It is not uncommon to find subordination in debenture bonds and notes, especially perpetual bonds. Clauses such as these are common in subordinated bonds (extracted from Re Kaupthing Singer & Friedlander Ltd  EWHC 316 (Ch)):
“”Liabilities” means in respect of any person, all present and future sums, liabilities and obligations payable or owing by it in respect of indebtedness (whether actual or contingent, jointly or severally, or otherwise howsoever)
“Senior Liabilities” means all Liabilities except Subordinated Liabilities and Excluded Liabilities
“Subordinated Liabilities” means the Bonds and all other Liabilities of the Issuer in respect of indebtedness which is both unsecured and subordinated by its terms in right of payment to any other Liabilities in any Insolvency of the Issuer
“Insolvency” means the winding-up (in England but not elsewhere) of the relevant company
“Excluded liabilities” means Junior Subordinated Debt and any other Liabilities which are expressed to rank or, in the opinion of the Insolvency Officer of the Issuer, would or do rank junior to the claims of Bondholders in respect of the Bonds in the Insolvency of the Issuer
“Junior Subordinated Debt” means all Indebtedness of the Issuer the terms of which provide that the obligations there under are subordinated in right of payment to all Senior Liabilities and holders of the Bonds
“Indebtedness” means (i) moneys borrowed and (ii) any notes, bonds, debentures, debenture stocks, loan stock or other securities offered, issued or distributed whether by way of public offer, private placing, acquisition consideration or otherwise and whether issued for cash or in whole or in part for a consideration other than cash.
“(a) The Bonds and Coupons shall constitute direct, unsecured and subordinated obligations of the Issuer and the rights of the Bondholders against the Issuer rank pari passu without any preference among themselves. The rights and claims of the Bondholders will, in the event of the winding up of the Issuer, be subordinated in right of payment in the manner provided in the Trust Deed to all Senior Liabilities (as defined in Condition 16) of the Issuer. Accordingly, payment of any amount (whether principal, premium (if any), interest or otherwise) in respect of the Bonds in such winding up is conditional upon, at the time of payment by the Issuer and immediately thereafter, the Issuer being solvent and, accordingly, no such amount which would otherwise fall due for payment shall be payable except to the extent that the Issuer could make such payment and still be solvent immediately thereafter.”
Disputes and legal issues which arise in relation these subordinated bonds often fall on contractual interpretation.
Trickier would be situations where there are multiple subordinated debts and the issue arises as to the priority among these subordinated debts.