Subordination Agreements, What Solvent Restructures Live or Die On

Multi-layered financing structures depend on some creditors ranking behind others. Subordination agreements are the legal instrument that makes the ranking work. A well-drafted subordination agreement holds under stress; a poorly-drafted one produces disputes at exactly the moment when the parties have no bandwidth to resolve them.

This piece sits under the m3 pillar on corporate restructuring versus business rescue. It sets out the three main forms of subordination, the drafting features that matter, and where subordination arrangements typically fail during restructuring execution.

Three forms of subordination

South African practice recognises three distinct forms of subordination, each with its own legal basis and its own vulnerabilities (Cassim et al., 2021).

Contractual subordination. The subordinated creditor agrees, in a written agreement, to rank behind the senior creditor. The subordination is enforceable as a contract; the senior creditor can enforce the subordination against the subordinated creditor as a counterparty. This is the most common form for shareholder loans, intra-group loans, and similar arrangements.

Structural subordination. The subordinated debt is at a different corporate level from the senior debt. Shareholder loans to a holding company are structurally subordinated to operating company debt because the operating company's cash flows have to service its own debt before any surplus reaches the holding company. Structural subordination does not require a contract between the senior and subordinated parties; it works through the corporate structure.

Subordination on insolvency. The subordination applies only in insolvency proceedings, and specifically only in the distribution of the insolvent estate. Under the Insolvency Act 24 of 1936 (Republic of South Africa, 1936), the parties can (subject to limitations) agree that certain claims rank behind others in the priority order that applies on liquidation. This form is common in mezzanine and hybrid instruments.

The three forms have different mechanics and different vulnerabilities. Well-designed subordination arrangements typically use a combination of the three: contractual subordination for the ongoing relationship, structural subordination for the corporate architecture, and subordination on insolvency as a backstop for the distribution outcome if the restructure fails.

What contractual subordination actually controls

A contractual subordination agreement can control four distinct behaviours:

Payment blockage. The subordinated creditor cannot receive payment while defined conditions apply to the senior creditor (a covenant breach, an event of default, or defined enforcement actions). Payment blockage keeps the cash flow protecting the senior position when the borrower is under stress.

Standstill. The subordinated creditor cannot enforce their claim, accelerate their debt, or take defined actions against the borrower while the senior creditor is engaged in enforcement or workout activity. Standstill periods are typically 90 to 180 days.

Turnover. Where the subordinated creditor receives payment in breach of the subordination, they hold the payment on trust for the senior creditor and turn it over. This is the mechanism that gives the subordination teeth even where a payment is made in error.

Voting. In an insolvency or restructuring proceeding, the subordinated creditor may agree to vote in support of defined outcomes, or to abstain from voting against defined outcomes. Voting subordination is common in mezzanine financings where the senior lender wants to prevent the mezzanine from opposing a restructure the senior supports.

Each of these behaviours has to be drafted explicitly. Subordination agreements that address only "ranking" without specifying the operational mechanics produce disputes during stress.

Where subordination arrangements fail

Three failure modes recur in South African restructuring practice.

Ambiguity about triggering conditions. A payment blockage that triggers on "material adverse change" is more vulnerable than one that triggers on defined events (a payment default, a covenant breach above a threshold, a formal notice from the senior). Subordinated creditors and their advisors will contest ambiguous triggers; the senior creditor's enforcement is delayed while the ambiguity is resolved.

Inadequate turnover mechanics. A subordination agreement that says the subordinated creditor "will turn over" a payment in breach does not specify who holds the money in the interim, what happens if the subordinated creditor becomes insolvent between receipt and turnover, or what the sanction is for failure to turn over. Detailed turnover mechanics (payment into an identified escrow, deemed trust arrangements, security over the turnover obligation) reduce the vulnerability.

Interaction with statutory subordination. Some claims are subordinated by statute regardless of the contractual arrangements: the Companies Act 71 of 2008 (Republic of South Africa, 2008) provides treatment for post-commencement finance under section 135 in business rescue, which can rank ahead of arrangements that appeared senior before commencement. Subordination agreements that do not address the interaction with the statutory framework can produce priority positions in restructuring or rescue that differ from what the parties intended.

Subordination in solvent restructures

In solvent restructures, subordination arrangements are typically the currency of the restructure. Existing lenders may accept subordination of a portion of their claim in exchange for new lending or refinanced terms on the remainder. Existing shareholders may accept structural subordination of their shareholder loans to enable new senior debt to close on acceptable terms. Mezzanine investors may accept contractual subordination to senior debt in exchange for the equity return upside.

The drafting of these subordination arrangements is where the restructure's execution succeeds or fails. Sponsors and boards should engage specialist counsel for the subordination drafting; general commercial counsel are often not the right resource for the technical detail.

Cross-border subordination

Cross-border corporate groups add complexity to subordination arrangements. The subordination that appears effective under South African law may not be recognised in the same terms in another jurisdiction where the borrower has assets or where a creditor initiates proceedings.

Well-drafted cross-border subordination arrangements typically include: express choice of law for the subordination, express choice of forum for disputes, provisions for recognition of the subordination in named other jurisdictions, and coordination provisions where multiple insolvency regimes might apply. The UNCITRAL Model Law on Cross-Border Insolvency (UNCITRAL, 1997) provides a framework for recognition of foreign subordination arrangements in insolvency but does not directly govern subordination outside insolvency.

The banking convention

South African commercial banks have well-developed subordination conventions that emerged through repeated large-transaction practice. Facilities documents for senior secured facilities typically include subordination requirements for shareholder loans, intra-group loans, and other subordinated positions. Sponsors negotiating senior facilities should expect to encounter these subordination requirements and should prepare for them from the outset rather than treating them as late-stage negotiation points.

What good looks like

A well-drafted subordination arrangement holds under stress because it addresses the behaviours the parties actually want to control (payment blockage, standstill, turnover, voting), uses defined triggering conditions rather than vague standards, includes explicit mechanics for turnover and enforcement, and coordinates with the statutory framework rather than assuming it will not apply.

Subordination arrangements that do these things well are almost invisible in normal operation. Subordination arrangements that do these things poorly produce disputes at exactly the moment when the parties have no bandwidth to resolve them, and the underlying restructure often fails during execution as a consequence.

The CentraSolve Corporate Restructuring module supports the subordination drafting workflow through the priority-stack modelling and the interaction with the m4 Business Rescue module for testing the subordination position under rescue scenarios.

References

Primary legislation

Republic of South Africa. (2008). Companies Act 71 of 2008, especially section 135 (Post-commencement finance). Pretoria: Government Printer.

Republic of South Africa. (1936). Insolvency Act 24 of 1936, Part V (Ranking of Creditors' Claims). Pretoria: Government Printer.

Textbook and practitioner sources

Cassim, F. H. I., Cassim, M. F., Cassim, R., Jooste, R., Shev, J., and Yeats, J. (2021). Contemporary company law (3rd ed.). Cape Town: Juta.

Comparative and international sources

United Nations Commission on International Trade Law (UNCITRAL). (1997). Model Law on Cross-Border Insolvency, with guide to enactment and interpretation. Vienna: UNCITRAL.