• Effectiveness of a Claims Subordination Agreement in Bankruptcy
  • January 20, 2014
  • Law Firm: BSJP Brockhuis Jurczak Prusak Sp.k. - Warsaw Office
  • Effectiveness of a claims subordination agreement in bankruptcy

    In the banking practice, in order to secure repayment of a bank loan, a frequent condition precedent to the loan disbursement is execution of a claims subordination agreement consisting in subordination of claims of the borrower’s other creditors to the bank’s claims under the loan agreement. Such claims subordination agreement is usually entered into between the lending bank, borrower and the borrower’s shareholders, in particular to subordinate the claims of the latter arising from the inter-company loans granted, dividend distributions, refund of payments to the capital, surcharges, disbursements in connection with reduction in the share capital or reduction in the nominal value of shares, or distribution of assets in the case of company winding-up. Such subordination provides a guarantee that the funds disbursed under the loan will not be allocated to repayment of the subordinated claims, but to the company’s business, and that profits of such business will be allocated to repayment of the debt under the loan.

    On the basis of a claims subordination agreement, the subordinated debtor agrees that its claims (subordinated claims) are subordinated to the bank’s claims under the loan agreement (senior claims) and that any repayment or payment of amounts under the subordinated claims will be made solely in accordance with the  subordination agreement between them. If a facility or loan is granted to an entity which is indebted towards its shareholders (e.g. on account of the loans granted), the creditors usually agree that the subordinated claims may be satisfied solely after the senior claims have been satisfied in full (the so-called total subordination).

    In addition, a subordinated creditor usually undertakes not to claim repayment of the subordinated claims, or to make them payable before the agreed payment date, or to demand establishment of collateral for such claims, or to claim satisfaction from any such collateral. Further, in order to ensure the effectiveness of a claims subordination agreement, the creditor of the subordinated claims undertakes not to transfer, in whole or in part, the subordinated claims to any third party. Moreover, a subordination agreement often contains clauses under which the subordinated creditor undertakes not to apply for or take any action that may result in, appointment of an asset administrator, winding-up or bankruptcy of the borrower.

    If the borrower is declared bankrupt, the senior status of the bank’s claims becomes particularly significant due to the risk in connection with the impossibility to fully recover all claims as, in practice, the bankrupt’s estate is often insufficient to be distributed among all creditors of the bankrupt. Therefore, the answer to the question whether the official receiver is entitled to distribute the bankrupt’s estate in accordance with the claims subordination agreement, thus deviating from the statutory rules of distributing the bankrupt’s estate, is of great practical significance.

    In accordance with the Bankruptcy and Rehabilitation Law Act of 28 February 2003 (unified text of 28 June 2012, Journal of Laws of 2012, item 1112), all financial liabilities of the bankrupt which have not become due yet become due and payable on the date of declaration of bankruptcy. Further, the Act provides for a specific order of satisfying the creditors’ claims by individual satisfaction categories, creditors of the same category being satisfied proportionally. Therefore, it is not quite clear whether the official receiver should distribute the bankrupt’s estate according to the statutory regulation and satisfy the claims of individual creditors of the same satisfaction category according to the  proportionality rule, or take into account the provisions of the claims subordination agreement entered into between the creditors (or some of them) when distributing the bankrupt’s estate among them and satisfy their claims according to such agreement, thus in practice satisfying the subordinated claims solely after the senior claims have been satisfied in full.

    Since the Bankruptcy and Rehabilitation Law Act does not contain any separate provisions governing the issue of satisfying claims in case a  claims subordination agreement is entered into, and as there is no legal basis to make an exception to the general rules for satisfying claims in a bankruptcy procedure, the official receiver will not distribute the estate other than in accordance with the satisfaction rules provided in the Act. The claims subordination agreement will thus only form an obligation of the entities being the parties thereto, and after the bankrupt’s estate has been distributed by the official receiver, the parties are usually obliged to make mutual settlements in accordance with the agreement between them.

    In such case, the grant of the rights to perform any acts in connection with the subordinated claims in a bankruptcy procedure, such as the right to receive payments made by the official receiver against such claims as a result of distribution of the bankrupt’s estate, or the right to recognize such payments against satisfaction of the subordinated claims, as soon as on the basis of the claims subordination agreement might be of particular importance for senior creditors.