Is it possible for a debtor company to issue debt (such as bonds) and contractually agree for that debt to rank lower in priority than debts owed by a company to other unsecured creditors? This article examines the commercial uses of subordinated debt agreements, and considers how courts in the offshore jurisdictions of the British Virgin Islands, the Cayman Islands and Bermuda would treat a subordinated debt agreement in a winding-up.

Distressed companies may wish to raise financing under subordinated debt agreements for several reasons. First, issuing subordinated debt has the potential advantage of allowing a debtor company to avoid contravening covenants with existing creditors which restrict its ability to issue new debt ranking above or pari passu with its other creditors. Second, although it would be open to a company to obtain financing by issuing new shares, this may dilute the stakes of the company’s existing shareholders. Raising financing by way of subordinated debt has the benefit of allowing the company to preserve the weighting of the company’s constituent shareholders. In return, investors may be tempted to purchase subordinated debt (with a lower priority to that of unsecured creditors) in exchange for agreeing a higher rate of interest payable by the debtor.

The general position in most common law jurisdictions is that agreements which seek to displace or alter the statutory “waterfall” provisions are void. In the context of an insolvency, subordinated debt agreements appear, at least at first glance, to conflict with the pari passu principle which requires that all creditors of the same class are repaid equally out of the assets of the company in proportion to the debts owed to them. In National Westminster Bank Ltd,1the House of Lords held that it is not possible to contract out of the “waterfall” statutory provisions in a compulsory liquidation. Similarly, in British Eagle International Airlines,2 it was held that giving certain creditors priority over other creditors of the debtor is void on the grounds that it is an attempt to avoid the pari passu principle.

Re Maxwell Communications3 clarifies that debt subordination agreements do not undermine the principle of pari passu or the mandatory insolvency set-off rules. The facts of Re Maxwell Communications arose in the context of a scheme of arrangement. The administrators of the debtor company sought a direction from the Court that they could exclude bondholders who had agreed to subordinate the debts owed to them from participation in a scheme of arrangement until all other unsecured creditors are paid in full. Vinelott J held that the subordination agreement was enforceable and noted that his decision to uphold the validity of the debt subordination agreement was in line with the law of other common law jurisdictions, including Australia and the United States. Importantly, the Court noted that the subordination agreement offered no advantage to the creditor and thus did not offend the public policy considerations discussed in National Westminster Bank.

In the event that a creditor disputes a subordination agreement between themselves and the debtor company, case law suggests that contractual subordination provisions are valid on the insolvency of the debtor and are enforceable against the debtor company. In Re SSL Realisations, the judge noted the commercial importance for companies entering into subordination agreements with their creditors while solvent be held to the bargain they struck, including upon the company’s liquidation.4

At the time of writing, there is no reported decision in which the overall effectiveness of debt subordination agreements has been tested in the British Virgin Islands, the Cayman Islands or Bermuda. The decisions of the courts of England and Wales are nonetheless highly persuasive and Re Maxwell Communications and Re SSSL Realisations are likely to be applied in a winding-up.

1[1972] 1 All ER 641.
2[1975] 1 All ER 390.
31993 1 W.L.R 1402.
4[2006] EWCA Civ 7.

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