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	Murdoch University Electronic Journal of Law

Subordinated Debt and the Effect of Adding Section 563c to the Australian Corporations Act

Author:	Eric Tse B Com, LLB University of New South Wales Faculty of Law
Issue:	Volume 9, Number 4 (December 2002)

Contents:

• Introduction
• Usage of Subordinated Debt
• Classification and Mechanism of Subordinated Debt
• S563C's Effect on Pre-Existing Problems
• Uncertainty as to whether Parties Can Contract Out of the Pari Passu Principle (s555)
• English Position
• New Zealand Position
• Australian Position
• Privity of Contract (enforcement of third party's rights)
• S563C's Effect on the Commercial World
• Conclusion
• Bibliography
• Notes

Introduction

1. Subordinated debt is a popular financing tool in today's commercial transactions. This is a simple concept but there is no easy way to implement it effectively. [1] It involves a complex package of rights held by the senior creditors, limitations imposed on the subordinated creditors (or junior creditors) and undertakings of the borrower."[2] The difficulty is that there is no clear legislative framework to facilitate the use of subordinated debt. The introduction of s563C into the Corporations Law (today's Corporations Act 2001) has a clarifying effect; nevertheless many issues such as privity problems have yet to be resolved.

2. The predominant feature of a subordinated debt is that it is a debt that will rank behind other debts but before equity. Although subordinated debt is a form of debt financing, it is in effect a hybrid of both debt and equity. Subordinated debt is often considered as quasi-equity because it shares many characteristics of equity.[3] This hybrid form of financing allows the debtor company to reap the financial benefits of equity together with the taxation and other benefits of debt finance.[4] In fact, it serves as a capital base by providing funds from which the borrower can meet the financial costs of its other debts.[5]

3. Subordination is a transaction whereby the subordinated/junior creditor agrees not to be paid by the debtor until another creditor (the senior creditor) has been paid. In effect, the junior creditor has agreed to defer wholly or partially his right to repayment. The agreement may be inherent in the debt transaction or may be agreed to after the creation of the debt. Where the obligation is initially generated as a subordinated debt, neither the creditor nor the debtor would have changed its position as a result of the subordination. On the other hand, if the debt is subordinated after its creation, both the subordinated creditor and debtor will alter their position potentially to the advantage of third parties.[6]

4. The fundamental object of subordination is to be successful on insolvency. This is due to the fact that subordination concerns the ranking of the unsecured debt of a company and is relevant only if the debtor is insolvent.

   Usage of Subordinated Debt

5. Equity has a higher risk attached to it than debt finance. Subordinated debt is popular because it offers a mechanism interposing a level of funding with a risk greater than that of simple unsecured debt but less than that associated with share capital.[7] It allows companies to fund their capital base with low and flexible cost funds.[8] It has been suggested that the subordinated creditor will benefit on a fixed return on capital with a right to repayment that is higher than that of a shareholder's.[9] Hence, subordinated debt is beneficial to both debtor and creditors.

6. The primary objective of most debt subordinations is the ranking of unsecured debt upon insolvency. Analogies had been drawn with the ranking system between preference shares and ordinary shares.[10] Such an agreement between creditors and debtor company could act as a form of 'cushion or security' for the senior debt. This will be the case when the senior creditor imposes restrictions and limitations upon debtor's repayment of the subordinated debt prior to repayment of the senior debt.[11]

7. In addition, the identification of the subordinated creditor could often enhance security and investor's confidence in the company. For example, if Australia's most famous billionaire or successful company agree to be Company A's subordinated creditor, investors' confidence will increase and they will be more willing to lend money to Company A.

8. Subordinated debt is often used for advances required by investors, sponsors or guarantors to cover construction costs, overruns or other payments necessary to maintain debt to equity ratio.

   Classification and Mechanism of Subordinated Debt

9. There are many different classification of subordinated debt. The two basic types are complete and inchoate subordination. Complete subordination occurs where no payments may be made on the subordinated debt until the senior debt has been repaid in full, eg directors' debts are often subject to complete subordination.[12] In inchoate subordination, junior creditor will be entitled to certain payment until a stipulated event occurs.[13] Such an event could be the repayment to senior creditor or breach by the debtor in agreed financial ratio.

10. Some commentators differentiate subordinated debt as general or specific subordination. General subordination refers to cases where the debt is subordinated to all other debts, whereas specific subordination subordinates the debt to specific debts of the borrower.[14]

11. There are three principal means of achieving a subordination of debt. They are contingent debt subordination, subordination trust and contractual debt subordination.

12. Contingent debt subordination (like inchoate subordination) is a method of subordination so that the subordinated creditor's right to repayment is conditional upon the full repayment to the senior creditor.

13. It is also possible for the subordinated creditor to agree to claim his debt when it matures or on liquidation and to hold the receipts on trust for the senior creditor.[15] Arguably, contingent and trust subordinations are formed to achieve the ranking of unsecured debt upon insolvency while overcoming the problem (as explain below) in the British Eagle[16] case.

14. Contractual debt subordination involves only the concept of contracts. This method is the focus of this essay and it is in fact more contentious because the British Eagle[17] case is perceived to prevent debt subordination that involves "contracting out" of the pari passu provisions[18] upon the insolvency of the debtor company.

    S563C's Effect on Pre-Existing Problems

15. Despite the advantageous usage of subordinated debt, many investors and lawyers had cast doubt upon its applications in commercial transactions. As shown below, the implementation and legal position of subordinated debt had always been problematic in Australia, for example, there had been great uncertainties in relation to the pari passu provisions and privity of contract.

16. The insertion of s563C was made by s102 of the Corporate Law Reform Act 1992 and the section provides that in the context of a company winding up, an agreement for the postponement of a debt in favour of another debt is not rendered unlawful or unenforceable by inter alia s555. This is of course subject to a condition that no disadvantage is caused to any creditor who is not a party to the agreement. The section reads as follows:

    563C Debt subordination

    (1) Nothing in this Division renders a debt subordination by a creditor of a company unlawful or unenforceable, except so far as the debt subordination would disadvantage any creditor of the company who was not a party to, or otherwise concerned in, the debt subordination.

    (2) In this section:

    debt subordination means an agreement or declaration by a creditor of a company, however expressed, to the effect that, in specified circumstances:
    (a) a specified debt that the company owes the creditor; or
    (b) a specified part of such a debt;

    will not be repaid until other specified debts that the company owes are repaid to a specified extent.

    Uncertainty as to whether Parties Can Contract Out of the Pari Passu Principle (s555)

17. The Australian Law Reform Commissions in its Harmer Report[19] suggested that Australian case law provided no firm guide as to whether terms of a subordinated debt contract will or should prevail over the clear mandate of the pari passu provisions (s555 of the today's Corporations Act 2001).

18. There were in fact no clear authorities in this area of law. As shown below, courts in Australia, New Zealand and United Kingdom had different approaches towards subordinated debts. In fact, some had internal conflicts within their jurisdictions.

19. In fact, most of these uncertainties had been added by the fact that s555 did not provide any unexceptional principle. Hence, it was difficult to assess whether to any extent they permit individuals to, in either form or substance, alter the effect of the provisions. As a result, the question was left open for arguments and there were abundant authorities for both sides.

20. Re Walker Construction Co Ltd (in Liq)[20] was one of the early cases that considered whether the statutory rule of pari passu distribution was absolute and thus overrode the agreement by the creditors to defer their debts. The case considered it to be grossly inequitable if the creditors were entitled to pari passu distribution in contravention of the agreement to deter their debts.[21] Hence, this case established that a creditor would waive its right to pari passu distribution. However, it should be noted that such a waiver did not establish a priority in favour of such creditor.

    English Position

21. On the other hand, the House of Lords in the Halesowen[22] case held that parties could not contract out of statutory set-off rules in the UK Bankruptcy Act 1914. The rules were held to be mandatory. The case did not refer to or contradict the Walker Construction[23] case. It simply held that parties could not contract, (either before or after an act of bankruptcy had occurred), to have the bankruptcy administered otherwise than in accordance with such statutory set-off provisions.

22. The United Kingdom decision of British Eagle[24] was decided after the above cases. The judgement ignored the Halesowen[25] Yet, the decision was so contentious that there were two different interpretations of the judgement.

23. The narrow view of the British Eagle[26] case was that the case did not prevent a contractual debt subordination arrangement from being effective. It was not to avoid all contracts that deal with assets contrary to the pari passu provisions. It had been suggested that the principle "is to avoid only those contracts which prevent the whole of the debtor's estate from being available for distribution to all creditors (subject only to security interests and 'flawed assets')."[27] However, this "narrow view" was not widely accepted amongst legal practitioners.[28]

24. A "more popular and wider" view was expressed by Gibson J in Carrera Rothmans v Freemans Mathews Treasure Ltd[29] He regarded the British Eagle[30] principle as avoiding (on public policy ground) any agreements that intended to 'contract out' of the then equivalent of s555. This was to disregard whether contract was entered into for consideration and for bona fide commercial reasons.

25. Despite the above authorities, in 1993, Vinelott J in Re Maxwell Communications Corp (No 3)[31] upheld a subordinated agreement that contracts out of the pari passu distribution. However, it should be noted that this was only a one-judge decision made at first instance.

    New Zealand Position

26. In Re Orion Sound Ltd[32] there was an agreement between creditors to the effect of prioritising certain subsequent creditors. Mahon J rejected the previous New Zealand authority - the Walker's case[33] and characterised the pari passu provisions as a public right that could not be waived or renounced.

    Australian Position

27. Despite such diverging line of authorities, the Australian courts had not followed the British Eagle[34] case. In fact, those Australian cases[35] that had referred to British Eagle[36] case had either distinguished it or ruled it as not relevant to their case. Needham J's obiter dicta in Re Industrial Welding Co Pty Ltd[37] had expressly stated that he believed that the HOL did not lay down a principle that a creditor could not defer his claims to be paid to the claim of others.

28. Sounthwell J in Horne v Chester & Fein[38] distinguished British Eagle[39] on its fact but ruled that liquidators may distribute assets in accordance with an agreement between the parties but where to do so could not adversely affect any creditor not a party to the agreement.

29. In conclusion, at common law, there were two lines of conflicting authorities in all three jurisdictions. The reasoning in Re Walker Construction,[40] Re Industrial Welding,[41] Re Maxwell[42] and Horne v Chester[43] suggested that a liquidator could recognise a subordination agreement. On the other hand, British Eagle[44] and Re Orion Sound[45] suggested the opposite.

30. It was shown above that no Australian case had applied British Eagle[46] to invalidate contractual debt subordination in a winding-up and there was a strong tendency (indicated by Industrial Welding[47] and Horne v Chester & Fein[48] ) to give effect to contractual debt subordination in such a context.[49]

31. It should be noted that there remained considerable doubts as to the potential effect of British Eagle.[50] This is largely due to the fact that before the introduction of s563C, Australian courts had not expressly reject the case. Throughout the Australian's legal history, English decisions had always and are now still highly persuasive to Australia. More uncertainties were contributed by the conflicts between decisions in the English and New Zealand jurisdictions. Hence, it was necessary for some firm clarifications.

32. S563C has explicitly cleared the above common law uncertainties by confirming the position of cases such as Horne v Chester and rendering British Eagle[51] inapplicable in Australia. The section did not vary but simply clarify the law.[52]

33. In addition, it should be noted that s563C has defined the concept of "debt subordination". The Parliament had decided not to leave it to the courts to define and adopt the courts' own meaning. This would also prevent the courts from encompassing new techniques as they develop in the marketplace.[53] Such express definition will run the risk that some forms of subordination might not be 'caught' by the definition where it should be.

    Privity of Contract (enforcement of third party's rights)

34. In many debt subordinations, senior creditors have enforcement problems because they are not party to the subordination agreement. In Australia, the doctrine of privity doesn't allow a third party (senior creditor) to enforce the subordination provisions or to prevent the subordination provisions from being amended.

35. Despite recent dissatisfaction with the privity doctrine and Mason J's effort in Trident General Insurance Co Ltd v McNiece Bros Pty Ltd[54] the doctrine of privity remains strong and contentious in Australian law. In the Trident's case, the parties' attempt to alter the privity principle concentrated only around trust principles and besides, it was only obiter dicta.

36. The insertion of s563C did not expressly address the above problem. However, it could be argued that the statutory recognition of subordinated debt would have impliedly allowed the senior creditor to enforce the subordination provisions. This is because if a senior creditor (third party) could not enforce the contract, then the "cushion or security" effect of subordinated debt would be gone and the use of subordinated debt could be rendered meaningless. It is in fact logical and fundamental that the senior creditor should be allowed to enjoy his rights by enforcing and preventing debtor or junior creditor from amending the provisions.

37. As a result, the formal statutory recognition of subordinated debt in s563C might influence the court to allow the senior creditor to enforce the subordination provisions. However, this line of arguments is not likely to succeed in court because the idea was not expressly provided in s563C and the doctrine of privity is strong in Australia. However, other common law principles such as the promissory estoppel in Waltons Stores[55] could be further developed to allow a senior creditor as a third party to enforce a debt-subordinated contract.

38. The insertion of s563C did not overcome such inherent weakness of contractual debt subordination. Hence, the Parliament should amend the Corporations Act to allow parties to overcome the doctrine of privity.[56] In addition, it should be noted that trust subordination and subordinated debt agreement that are entered into by all three parties (ie debtor, junior and senior creditor) would not have the above privity problem.

    S563C's Effect on the Commercial World

39. In view of the previous uncertainty in this area of law, many Australian lawyers took the view that Australian Courts may well follow the British Eagle[57] line of authority. Hence, before the introduction of s563C, many Australians structured their subordination arrangements to overcome the British Eagle[58] problem. Some preferred artificial methods (alternatives to contractual debt subordination) such as contingent debts and subordination trusts to achieve their objectives.

40. The introduction of s563C assured that British Eagle[59] is not good law in Australia and the section authorises the use of subordinated debt provided that no third party to the agreement would be adversely affected. Now that the position is clear and certain, many Australians will be more confident and willing to utilise subordinated debt. Legal practitioners will rely more on contractual subordinated debt as their mechanism. Mechanisms such as contingent and trust subordination will no longer be used solely for the purpose of overcoming s555. The amendment has enhanced the basic subordination structure.

41. In addition, s563C improves the legal system's efficiency to facilitate the requirements of commercial enterprise. The system is more prepared to recognise the inherent efficiency of private commercial arrangements.[60] This is clearly advantageous to the development of commerce.

    Conclusion

42. The introduction of s563C has a positive impact on an ambiguous issue in the subordinated debt field. Due to conflicts and inconsistencies between and within jurisdictions, common law has proven to be not very helpful in resolving subordinated debt issues. Despite unsolved problems such as privity of contract, statutory reforms are more appropriate and effective.

Bibliography

Nicolaides CM, "Priorities for Subordinated Debt" [1989] Butterworths Journal of International Banking and Finance Law 247

Foster R, "Implications of Quasi-equity in Project Financing" (2001) June 12 Journal of Banking and Finance Law and Practice 97

Jones P, "Developments in Contractual Subordination: Unsecured Lending" 1989 Aug 5(2) Banking Law Bulletin 129

Everatt D, "Debt Subordination in Insolvency" (1992) 8(5) Australian Banking Law Bulletin 35

Johnson B, "Contractual Debt Subordination and Legislative Reform 1991" (1991) Journal of Business Law 225 at 227

Johnston B, "Debt Subordination: the Australian Perspective" (1987) Apr Australian Business Law Review 80 at 82

Johnson B, "Does 'British Eagle' Prevent Debt Subordination" 3 Banking Law Bulletin 24

Wood PR, "Debt Subordination under English Law" [1985] International Financial Law Review 11

Bourke G, "The effectiveness in Australia of contractual debt subordination where the debtor becomes insolvent" (1996) June 7(2) Journal of Banking and Finance Law and Practice 107

Jarvis J, "Debt Subordination: The Saga Continues" (1993) Dec Journal of Banking and Finance Law and Practice 316

Kluyver M, "Contractual Subordination in Schemes of Arrangement" (2001) 9(2) Insolvency Law Journal 60

Kang J, "Debt Subordination Survives the Double Dividend Rule" (1995) 9(4) Commercial Law Quarterly 4

Kang J, "Insolvency" (1993) Sep 7(3) Commercial Law Quarterly 4

Christie S, "Subordination of debt in insolvency" (1993) Aug 9(2) Australian Banking Law Bulletin 17

Taylor L, "What a company charge does not reveal: the financier's perspective" (1992) Dec 10(6) Company and Securities Law Journal 396

Grantham RB, "Legal imperialism and debt subordination" (1989) Jun New Zealand Law Journal 224

Grantham R, "New Hope for Debt Subordination" (1991) Feb New Zealand Law Journal 39

Australian Law Reform Commission (the Harmer Report)- General Insolvency Inquiry (Report No 45)

Explanatory Memorandum to Corporate Law Reform Bill 1992

Second Reading Speech to Corporate Law Reform Bill 1992

Wood P, The Law of Subordinated Debt, 1990 London Sweet & Maxwell

Ford's Principles of Corporation Law

Australian Corporation Law - Principles and Practice

Halsbury Laws of Australia

The Laws of Australia

Notes

[1] Debt subordination attracts problems such as privity of contract, estoppel, perpetuities and the potential for unenforceability in insolvency.

[2] Nicolaides CM, "Priorities for Subordinated Debt" [1989] Butterworths Journal of International Banking and Finance Law 247

[3] Foster R, "Implications of Quasi-equity in Project Financing" (2001) June 12 Journal of Banking and Finance Law and Practice 97

[4] Jones P, "Developments in Contractual Subordination: Unsecured Lending" 1989 Aug 5(2) Banking Law Bulletin 129

[5] Subordination enables a company to increase quasi-capital without diluting control. Everatt D, "Debt Subordination in Insolvency" (1992) 8(5) Australian Banking Law Bulletin 35

[6] Everatt D, "Debt Subordination in Insolvency" (1992) 8(5) Australian Banking Law Bulletin 35

[7] Wood PR, The Law of Subordinated Debt, 1990, London Sweet & Maxwell p3

[8] Everatt D, "Debt Subordination in Insolvency" (1992) 8(5) Australian Banking Law Bulletin 35

[9] Wood PR, The Law of Subordinated Debt, 1990, London Sweet & Maxwell p3

[10] Johnson B, "Contractual Debt Subordination and Legislative Reform 1991" (1991) Journal of Business Law 225 at 227

[11] Johnson B, "Contractual Debt Subordination and Legislative Reform 1991" (1991) Journal of Business Law 225 at 227

[12] Johnston B, "Debt Subordination: the Australian Perspective" (1987) Apr Australian Business Law Review 80 at 82

[13] Jones P, "Developments in Contractual Subordination: Unsecured Lending" 1989 Aug 5(2) Banking Law Bulletin 129

[14] Johnston B, "Debt Subordination: the Australian Perspective" (1987) Apr Australian Business Law Review 80 at 83

[15] Wood PR, "Debt Subordination under English Law" [1985] International Financial Law Review 11

[16] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[17] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[18] S555 - (Debts and claims proved to rank equally except as otherwise) provided that except as otherwise provided by the Corporations Act, all debts and claims proved in a winding up rank equally and, if the property of the company is insufficient to meet them in full, they must be paid proportionately.

[19] Australian Law Reform Commission, General Insolvency Inquiry (Report No 45)

[20] Re Walker Construction Co Ltd (in Liq) [1960] NZLR 523

[21] This was particularly the case as many new creditors had sold goods to the company on the basis that their debts would rank before the deferred debts.

[22] National Westminster Bank Ltd v Halesowen Presswork & Assemblies Ltd [1972] A C 785

[23] Re Walker Construction Co Ltd (in Liq) [1960] NZLR 523.

[24] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[25] National Westminster Bank Ltd v Halesowen Presswork & Assemblies Ltd [1972] A C 785

[26] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[27] Johnson B, "Contractual Debt Subordination and Legislative Reform 1991" (1991) Journal of Business Law 225 at 231

[28] Johnson B, "Contractual Debt Subordination and Legislative Reform 1991" (1991) Journal of Business Law 225 at 231

[29] In this case, there was no "contracting out" of the pari passu provisions but the judges summarised the British Eagle principle. Carreras Rothmans v Freemans Mathews Treasure Ltd [1984] 1 WLR 1016

[30] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[31] Re Maxwell Communications Corporation (No 3) [1993] BCC 369

[32] Re Orion Sound Ltd (1979) 2 NZLR 514

[33] Re Walker Construction Co Ltd (in Liq) [1960] NZLR 523

[34] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[35] For example, Re Marlborough Concrete Constructions Pty Ltd [1977] QR 37 and Re Industrial Welding Co Pty Ltd [1977-1978] ACLC 30

[36] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[37] Re Industrial Welding Co Pty Ltd [1977-1978] ACLC 30 at 168

[38] Horne v Chester & Fein Property Developments Pty Ltd (1987) 5 ACLC 245

[39] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[40] Re Walker Construction Co Ltd (in Liq) [1960] NZLR 523

[41] Re Industrial Welding Co Pty Ltd [1977-1978] ACLC 30 at 168

[42] Re Maxwell Communications Corporation (No 3) [1993] BCC 369

[43] Horne v Chester & Fein Property Developments Pty Ltd (1987) 5 ACLC 245

[44] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[45] Re Orion Sound Ltd (1979) 2 NZLR 514

[46] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[47] Re Industrial Welding Co Pty Ltd [1977-1978] ACLC 30 at 168

[48] Horne v Chester & Fein Property Developments Pty Ltd (1987) 5 ACLC 245

[49] Bourke G, "The effectiveness in Australia of contractual debt subordination where the debtor becomes insolvent" (1996) June 7(2) Journal of Banking and Finance Law and Practice 107

[50] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[51] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[52] Santow J, Re NIAA Corporation Ltd (in liq) (1993) 12 ACSR 141

[53] Bourke G, "The effectiveness in Australia of contractual debt subordination where the debtor becomes insolvent" (1996) June 7(2) Journal of Banking and Finance Law and Practice 107 at 136

[54] Trident General Insurance Co Ltd v McNiece Bros Pty Ltd (1988) 62 ALJR 508

[55] Walton Stores (Interstate) Ltd v Maher (1988) 62 ALJR 110

[56] In fact, some statutory modification to the privity principle has been made in Queensland and Western Australia, eg. S55 of the Property Law Act 1974-78 (Qld) and s11 of the Property Law Act 1969-73 (WA). However, these modifications were not relevant to subordinated debt.

[57] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[58] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[59] British Eagle International Airlines Ltd v Compagnie National Air France [1975] 1 WLR 758

[60] United States Trust Co of New York v Australia & New Zealand Banking Group Ltd (1993) 11 ACLC 707