Definition of terms: Subordinated (Subordination)
Subordinated is a term commonly used in law and business, describing the subordination of a claim, right, or entitlement in comparison to other similar rights or claims. Subordination—also known as subordination agreement or subordination clause—results in a claim being satisfied only after all senior claims have been fully met. The term “subordinated” is especially prevalent in banking, insolvency law, and the issuance of financial instruments, and is of significant legal importance in these fields.
Legal basis of subordination
Areas of application of subordination
Insolvency law
In insolvency proceedings, subordination plays a critical role in the ranking of creditors. Under German insolvency law, subordinated claims are only satisfied according to § 39 of the Insolvency Code (InsO) after all senior claims have been settled. Subordinated claims include, among others, certain interest claims as well as claims arising from subordination, such as in the case of subordinated loans.
Banking and capital markets law
In banking, the term ‘subordinated’ is primarily used for subordinated liabilities or so-called ‘subordinated loans’. These liabilities, in the event of liquidation or insolvency, are served after the claims of all other creditors, in particular senior creditors. This is typical for certain bonds, such as subordinated debentures (subordinated bonds), which are mainly issued by banks to strengthen their regulatory capital.
Legal consequences of subordination
A subordination significantly affects the realizability of the claims involved. Creditors with subordinated claims bear an increased risk of default, as their claims are only met after the full satisfaction of the senior creditors. Accordingly, they often demand higher interest rates or other compensation as a premium for the assumed risk.
Contract design and legal requirements
Subordination agreements
The contractual establishment of subordination is typically achieved through a so-called subordination agreement. In such an agreement, the parties commit to acknowledge the priority of other claims and subordinate their own claim to the ‘subordinated’ rank. In order to be legally effective, a subordination agreement generally requires written form and should clearly stipulate the conditions and extent to which the subordination applies.
Types of subordination
A distinction is made between the simple subordination and the qualified subordination (qualified subordination clause). In simple subordination, subordinated claims are satisfied only after those of senior creditors. Qualified subordination, however, additionally provides by contract that repayment will be entirely suspended for as long as this is necessary to avoid the debtor’s insolvency. According to § 5 para. 2a sentence 1 no. 5 of the Deposit Guarantee and Investor Compensation Act (EAEG), qualified subordinated loans are not considered deposits, which means that increased creditor protection does not apply to these claims.
Subordinated in the context of selected legal areas
Banking and lending industry
In banking, subordinated bonds are classified as a component of the bank’s regulatory capital (Tier 2 Capital) and serve to satisfy regulatory capital requirements. In the event of insolvency, these bonds are fully subordinated in their repayment and typically have a longer maturity than senior liabilities.
Corporate law
Subordination also plays a role in corporate law, particularly in the case of shareholder loans. According to § 39 para. 1 no. 5 InsO, claims from shareholder loans are treated as subordinated in insolvency proceedings. This is intended to prevent shareholders from being favored over third-party creditors in the event of insolvency.
Securities law and bonds
Subordinated bonds are financial instruments whose repayment in the event of insolvency or liquidation occurs only after the repayment of senior liabilities. Investors who purchase such securities accept the increased risk of default and are generally compensated with higher interest rates.
International perspectives
European regulation
In the course of implementing the Capital Requirements Directives and banking reform (CRR/CRD IV, Basel III), the term ‘subordinated’ in European banking supervision law refers to capital instruments intended to provide special creditor protection for senior claims. The specific definition of subordination and the criteria for subordinated instruments are further clarified by the European Central Bank and the European Banking Authority (EBA).
Anglo-Saxon law
In Anglo-American jurisdictions, subordination is regulated both by contract and by statute. ‘Subordination Agreements’ and ‘Intercreditor Agreements’, which expressly establish different classes of creditor ranking, are particularly common.
Significance and risks of subordination
Subordination is a key instrument for managing creditor interests and allocating risk in the event of corporate insolvency or restructuring. Subordinated agreements enable companies to raise subordinated capital, but also increase the risk for the respective capital providers. Clear and precise subordinated arrangements are essential to meet both regulatory and civil law requirements and to avoid future disputes regarding the ranking of claims.
References
- Münchener Commentary on the Insolvency Code, § 39 InsO
- Schwab, Insolvency Law, 13th edition, Munich 2020
- Boos/Fischer/Schulte-Mattler, KWG Commentary, 5th edition
- EBA Regulatory Technical Standards, Subordinated Debt Instruments
- European Central Bank (ECB), Guide to Capital Instruments
Conclusion: The term Subordinated describes the subordination of claims and entitlements in comparison to other rights. The legal structuring of subordination is complex and covers various areas of banking, corporate law, insolvency law, and capital markets law. Understanding the consequences and risks of subordination is essential to configure creditor positions and the allocation of liability in a legally secure and targeted manner.
Frequently Asked Questions
What legal requirements must be met for a liability to be considered ‘subordinated’?
Whether a liability can be classified as ‘subordinated’ essentially depends on statutory requirements and the contractual agreements between creditor and debtor. In legal terms, it is crucial that subordination be explicitly agreed in a form-compliant arrangement (subordination clause). This agreement must expressly stipulate that the claim will only be satisfied in an insolvency or liquidation after the satisfaction of certain other claims (so-called senior creditors). For financial institutions and in the context of bonds, additional regulatory requirements, such as those under the Banking Act (KWG) or the Capital Requirements Regulation (CRR), must be observed. In particular, it is often required that termination or early repayment be excluded or heavily restricted. Courts also frequently require that subordination is documented in a manner that is clear and transparent for lending law purposes to ensure legal clarity in insolvency.
What is the effect of a subordination in insolvency proceedings?
In insolvency proceedings, subordination means that subordinated claims, in accordance with § 39 InsO (Insolvency Code), are legally subordinated to all other non-subordinated claims. They are therefore only served after the full satisfaction of the other insolvency creditors. Legally, this means that the probability of full or partial repayment in insolvency is greatly reduced, as often there are no remaining assets to cover subordinated claims. Creditors of subordinated claims are typically ranked below so-called ‘ordinary insolvency creditors,’ with different levels of subordination possible depending on the agreement. In extreme cases, a claim may even be subordinated to other subordinated claims if this has been expressly agreed.
To what extent is the enforceability of subordinated claims legally restricted?
Enforceability is primarily governed by §§ 39, 38, and 199 InsO. During ongoing insolvency proceedings, the subordinated creditor may assert their claim, but it is treated with lower priority. Direct enforcement against the debtor for the subordinated claim is legally excluded at this stage. Only when all senior claims have been fully satisfied does the subordinated claim come into effect. Even outside insolvency proceedings, subordination can restrict or exclude rights and claims, such as within the framework of individual foreclosure measures.
Can the subordination agreement be revoked or amended retrospectively?
As a rule, a subordination is legally binding if it has been agreed with the consent of all relevant parties and the required formalities are observed. Amendments or revocation therefore require the consent of all contracting parties and must be documented expressly as well. In certain cases, such as avoidance in insolvency law or blatant unconscionability, revocation or modification is possible by law. Furthermore, regulatory requirements, such as for banks or insurance companies, may impose additional requirements or restrictions on amendments or terminations of subordination agreements.
What duties and information requirements exist towards the creditor when entering into a subordination agreement?
Legally, the debtor is obliged to inform the creditor comprehensively about the scope of the subordination agreement. This includes, in particular, the consequences in the event of insolvency or liquidation, the restricted enforceability, and possibly additional limitations, such as the exclusion of default interest. Furthermore, the principle of transparency ensures that the creditor must be made aware of all legal consequences; this is of central importance, especially in the area of consumer protection. Incorrect or insufficient information about the effects and risks of subordination can lead to the clause being invalid or result in liability for damages.
Are there differences in the legal treatment of subordination in bonds versus loan agreements?
Legally, there are indeed differences between subordination in loan relationships and subordination of bonds. While bonds are often subject to capital market or regulatory special regulations, such as the Securities Prospectus Act or the CRR, civil law applies to loan agreements. For bonds, subordination usually requires explicit and transparent disclosure in the prospectus to adequately inform investors and meet regulatory requirements. In the credit sector, subordination is typically arranged in individual contracts and is primarily governed by the rules of the German Civil Code (BGB) and, where applicable, the Insolvency Code (InsO). In both cases, the specific structuring and contractual content are decisive for the legal classification and execution of subordination.
What role do regulatory requirements play in subordination?
Regulatory requirements play a crucial role, particularly in the banking and insurance sector, for the legal recognition of subordination agreements. According to the KWG, CRR, and Solvency II, certain criteria must be met for subordinated liabilities to count as regulatory capital. These include, among others, a minimum maturity, subordination in the event of insolvency and liquidation, and exclusion of early repayment. Compliance with these provisions is regularly monitored by the Federal Financial Supervisory Authority (BaFin) or comparable regulatory authorities. Breaches of these requirements may lead to the loss of the regulatory capital status of the subordinated liability and trigger supervisory measures.
