Subordination agreement and insolvency proceedings: protecting the creditor's ranking

A lending institution grants senior financing to a holding company, while a shareholder or a mezzanine lender provides junior debt. The structure holds as long as the debtor meets its payments. But when the debtor tips into safeguard proceedings (sauvegarde), judicial reorganisation (redressement judiciaire) or judicial liquidation (liquidation judiciaire), the question becomes stark: does the subordination agreement signed beforehand continue to produce its effects, or do the insolvency proceedings (procédure collective) reshuffle the cards according to their own order of priority? This analysis examines the fate of contractual subordination when insolvency proceedings are opened and sets out the drafting techniques that make it possible to preserve the senior creditor's ranking against the competing claims of the other creditors.

What a subordination agreement covers

Contractual subordination is the agreement by which a creditor, referred to as junior or subordinated, accepts that payment of its claim will rank behind payment of another creditor, referred to as senior. It organises by contract a hierarchy between creditors who, in the absence of such an agreement, would be treated solely according to the statutory rules of priority.

This contractual subordination must be distinguished from so-called structural subordination, which results from the architecture of the group (debt placed at the level of an operating subsidiary naturally ranks ahead, through the upstreaming of cash flows, of debt carried by the holding company). Structural subordination rests on no undertaking: it flows from the creditors' position in the group's organisation chart. Contractual subordination, by contrast, arises from a contract and therefore requires the express consent of the junior creditor.

Subordination of ranking and subordination of payment

Two techniques coexist, often combined in a single subordination agreement.

Subordination of ranking organises the order in which claims will be settled: the junior agrees to be paid only after the senior has been paid in full. This technique shifts the cursor of the ranking but runs up against a major limit, because the statutory order of payments in insolvency proceedings cannot be freely negotiated between private creditors.

Subordination of payment, which is more robust, prohibits the junior from receiving any payment until the senior has been repaid in full. It is generally coupled with an obligation to pay over, known as a turnover clause: if the junior nonetheless receives a sum, it undertakes to pay it over to the senior up to the amount still owed to the latter. This mechanism shifts the debate from the ground of enforceability against third parties to that of the contractual obligation between the two creditors, ground on which subordination retains its full force.

A contractual basis and its relative effect

The subordination agreement draws its force from Article 1103 of the French Civil Code, under which contracts lawfully formed take the place of law for those who have made them. Between the senior and the junior, the undertaking binds with the same authority as a private law.

But this binding force runs up against Article 1199 of the French Civil Code, which lays down the relative effect of contracts: a contract creates obligations only between the parties. A subordination agreement therefore binds, in principle, only those who signed it. It cannot be enforced against a debtor that is not a party to it, nor against the creditors' representative (mandataire judiciaire), nor against the debtor's other creditors. This limit is the heart of the problem when insolvency proceedings occur: the creditor ranking organised by contract does not automatically bind the general body of creditors or the organs of the proceedings.

The effect of insolvency proceedings on contractual subordination

The opening of insolvency proceedings subjects creditors to a mandatory regime that neutralises part of their contractual freedom. Understanding this regime is essential to gauge what survives of the subordination agreement and what is paralysed.

The primacy of the statutory order of payments

In judicial liquidation, the distribution of the proceeds of the assets follows a statutory order set in particular by Article L.643-8 of the French Commercial Code. That order involves creditors holding specific security, then claims benefiting from preferences, then unsecured creditors (chirographaires) sharing pari passu. This order is mandatory: two creditors cannot, by a private agreement, compel the liquidator to alter the statutory ranking of security to the detriment or benefit of either. The order in which creditors are paid out of the proceeds of the assets is detailed in our article on the order and ranking of payment in judicial liquidation.

In other words, subordination of ranking, understood as a change to the creditor's place in the statutory order of distribution, cannot be enforced against the liquidator. If the junior benefits from security in rem ranking better than the senior's unsecured claim, the liquidator will pay the junior according to its statutory ranking, regardless of the subordination agreement to which the liquidator is not a party.

It is precisely for this reason that the pay-over clause takes on its full importance. Subordination does not change what the liquidator pays to the junior, but it contractually obliges the junior to pay over to the senior the sums thus received. The subordination agreement regains its effectiveness, not against the proceedings, but in the relationship between the two creditors.

The stay of proceedings and the prohibition on payments

The judgment opening the proceedings has two effects that bear on subordination. First, Article L.622-21 of the French Commercial Code stays individual enforcement actions: the senior and the junior alike lose the ability to bring individual claims for payment against the debtor. Second, Article L.622-7 prohibits the debtor from paying any claim arising before the opening judgment.

This prohibition freezes cash flows. The debtor can no longer, on its own initiative, pay either the senior or the junior according to a contractual repayment schedule. The question of creditor ranking will arise only at the stage of distribution or performance of a plan. In this phase, subordination has no immediate effect on payments since no payment is authorised. It nevertheless prepares the treatment of the flows that will occur when the proceedings end.

Enforceability against the organs of the proceedings

The creditors' representative, the administrator and the liquidator are not parties to the subordination agreement. They apply the law, not the contract concluded between the senior and the junior. A subordination agreement therefore cannot require them to follow an order of payment different from the statutory order.

A practical consequence follows: the senior creditor cannot rely directly on subordination to challenge a distribution that the liquidator makes in favour of the junior in accordance with its statutory ranking. Its only route is to proceed against the junior on the basis of the subordination agreement, in order to obtain payment over of the sums received. The quality of the drafting of the pay-over clause therefore entirely determines the effectiveness of the protection.

Subordination tested by classes of affected parties

The transposition into French law of Directive (EU) 2019/1023 of 20 June 2019, carried out by Order No. 2021-1193 of 15 September 2021, has profoundly renewed the question of creditor ranking in safeguard and reorganisation proceedings for businesses above a certain size.

The mechanism of classes of affected parties

Articles L.626-29 et seq. of the French Commercial Code provide, above certain thresholds, for the formation of classes of affected parties called on to vote on the plan. The division of creditors into classes must reflect a sufficient community of economic interest and respect the ranking of security and preferences.

Article L.626-30 provides that the formation of classes takes account of the existence of subordination agreements concluded before the opening of the proceedings. This is a notable advance: the legislature expressly recognises that contractual subordination is intended to structure the treatment of creditors when the plan is drawn up. The senior creditor and the junior creditor are no longer necessarily lumped into a single undifferentiated mass. On the division of creditors into classes and the resulting blocking power, see our analysis of the prepack sale and classes of affected parties.

The senior creditor's ranking in the vote and in the distribution

Respect for creditor ranking pervades the rules on the adoption of the plan. The so-called best interests of creditors test and the cross-class cram-down mechanisms, provided for in Article L.626-32 of the French Commercial Code, require that value be distributed having regard to the order of priority. A senior creditor cannot, in principle, be treated less favourably than a junior creditor of lower rank without its agreement.

Taking the subordination agreement into account at the stage of forming the classes does not, however, relieve the drafter of the need to anticipate difficulties. The statutory recognition applies to agreements concluded before the opening of the proceedings: a later agreement, or an agreement whose content is ambiguous as to its scope in the event of insolvency proceedings, would be exposed to a restrictive reading. The senior creditor's security is therefore, here again, decided at the time of drafting.

Drafting techniques to secure the senior creditor's ranking

The foregoing analysis leads to an operational conclusion: contractual subordination protects the senior creditor effectively in insolvency proceedings only if it is drafted to survive the opening of the proceedings and to operate through obligations between creditors, and not through any claim to impose an order on the liquidator.

Stipulating a complete pay-over clause

The key element is the pay-over clause, or turnover. It must provide that any sum received by the junior creditor in respect of its subordinated claim, whatever its origin (payment by the debtor, distribution in the proceedings, enforcement of security, plan dividend), is received on behalf of the senior and must be paid over to it up to the unpaid balance of the senior debt.

Several details reinforce this clause:

• the allocation of the sums received, by providing that the junior holds them on a fiduciary basis or on behalf of the senior, in order to limit the risk of commingling in its own assets
• the obligation to inform the senior immediately where a payment is received or insolvency proceedings are opened against the debtor
• the prohibition on the junior setting off its subordinated claim against a debt that it owes to the debtor, since set-off can empty subordination of its substance
• the extension of the pay-over obligation to indirect payments, such as payments in kind (dations en paiement) or disguised assignments of claims

Regulating the junior creditor's rights in the proceedings

A robust subordination agreement also regulates the junior's conduct in relation to the insolvency proceedings. It may stipulate that the junior undertakes to file its claim but refrains from any act likely to harm the senior, for example by undertaking not to vote on the plan in a manner contrary to the senior's interests where the law allows, or by giving the senior a mandate to exercise certain rights.

The drafting must remain compatible with the public policy of insolvency proceedings. A clause that purely and simply deprived the junior of its right to file its claim or to vote within its class would risk being held ineffective. The aim is to steer the junior's conduct through contractual undertakings enforceable between the parties, not to strip it of rights founded on public policy.

Distinguishing subordination of the claim from subordination of security

A well-constructed subordination agreement specifies whether it covers only the claim or also the security that secures it. Subordination of the ranking of security follows a different logic: it often requires a ranking agreement, enforceable on the conditions specific to each security, and sometimes publicity formalities.

The senior creditor has an interest in combining subordination of the junior claim with a ranking agreement covering security in rem, whenever the two creditors share security over the same assets. Failing that, the junior could enforce better-ranking security and receive priority payment, leaving the senior reduced to claiming pay-over, with the risk of the junior's own insolvency.

Anticipating the opening of proceedings in the body of the agreement

Article L.626-30 of the French Commercial Code takes into account only subordination agreements concluded before the opening of the proceedings. The drafter must therefore date and document the agreement, and expressly stipulate that subordination survives the opening of safeguard, reorganisation or liquidation proceedings and continues to produce its effects throughout the proceedings and the performance of the plan.

It is prudent to specify that subordination applies in the event of proceedings opened against the principal debtor as well as, where applicable, against the guarantors and the group companies involved in the financing. The consistency of the whole structure, including sureties and first-demand guarantees (garanties autonomes), determines the senior's real protection.

Providing for the fate of subordination on assignment or novation

Finally, the agreement must anticipate the circulation of claims. A clause usefully stipulates that any assignment of the junior claim, any transfer or any novation remains subject to subordination, and that the assignee is deemed to adhere to it. Without this precaution, the sale of the subordinated debt to an uninformed third party could weaken the enforceability of the subordination agreement and compromise the creditor ranking that the senior believed to be secure. The fate of the assignment of a claim in the face of the debtor's insolvency proceedings is dealt with separately in our article on protecting creditor ranking.

Key takeaways

Contractual subordination remains a solid tool, but it does not work where one would spontaneously expect. It does not require the liquidator to alter the statutory order of payments and does not of itself bind the general body of creditors. Its strength lies in the obligations it creates between the senior and the junior, obligations that insolvency proceedings do not neutralise. A senior creditor relying on a mere subordination of ranking, without a pay-over clause, without a ranking agreement on security and without a stipulation of survival on the opening of proceedings, risks seeing its advantage evaporate at the first competing claim.

The reform of 15 September 2021 strengthened the reach of the subordination agreement by requiring it to be taken into account when forming the classes of affected parties, but this recognition benefits only agreements that pre-date the opening and are clearly drafted. The security of the senior creditor's ranking is therefore decided entirely at the stage of negotiation and drafting, well before the debtor's difficulty materialises. Before putting any structured financing in place, have the subordination agreement audited by a practitioner in commercial litigation and insolvency law, with a precise objective: to verify that the protection holds in judicial liquidation, and not only on paper in the in bonis period.

Frequently asked questions

Is a subordination agreement enforceable against the liquidator?

No, not directly as regards the order of payments. The liquidator applies the statutory order of distribution set in particular by Article L.643-8 of the French Commercial Code, and is not a party to the subordination agreement. The agreement therefore cannot require the liquidator to pay the senior before the junior by altering the statutory ranking of security. By contrast, the agreement remains fully enforceable between the senior creditor and the junior creditor, which founds the obligation to pay over the sums that the junior would receive.

What is the difference between subordination of ranking and subordination of payment?

Subordination of ranking organises the theoretical order in which claims are paid, the junior coming after the senior. Subordination of payment prohibits the junior from receiving any payment until the senior has been repaid in full, and is accompanied by a pay-over clause. In insolvency proceedings, subordination of payment is markedly more effective, because it produces its effects through obligations between creditors, independently of the statutory order applied by the organs of the proceedings.

Is a turnover clause valid under French law?

The pay-over clause, or turnover, rests on freedom of contract and the binding force of agreements enshrined in Article 1103 of the French Civil Code. It obliges the junior creditor to pay over to the senior the sums it would receive in respect of its subordinated claim. Its validity in principle is accepted provided that it does not conflict with a mandatory provision of insolvency law and that it is drafted with precision as to its basis and its terms.

Did the 2021 reform strengthen the senior creditor's protection?

Yes. Order No. 2021-1193 of 15 September 2021, transposing Directive (EU) 2019/1023, provides in Article L.626-30 of the French Commercial Code that the formation of classes of affected parties takes account of subordination agreements concluded before the opening of the proceedings. Creditor ranking organised by contract is thus recognised at the stage of drawing up the plan. This recognition nevertheless presupposes an agreement that pre-dates the opening and is drafted without ambiguity as to its scope in insolvency proceedings.

Can the junior creditor still file its claim and vote on the plan?

Yes. The right to file one's claim and, where applicable, to vote within one's class is among the prerogatives that a subordination agreement cannot simply remove. A clause that deprived the junior of these rights founded on public policy would risk being held ineffective. In practice, the agreement steers the junior's conduct through contractual undertakings enforceable between the parties, rather than stripping it of these prerogatives.

Should subordination of the claim be combined with a ranking agreement on security?

This is strongly recommended where the senior and the junior share security over the same assets. Subordination of the claim is not enough if the junior holds better-ranking security in rem enabling it to receive priority payment. A ranking agreement covering the security, enforceable under the rules specific to each guarantee and registered where applicable, usefully complements the subordination agreement and reduces the risk of having to make do with a pay-over claim against a potentially insolvent junior.

Does subordination survive an assignment of the junior claim?

Only if the agreement expressly so provides. Without a clause transmitting subordination, the assignment of the junior debt to an uninformed third party could weaken the enforceability of the agreement. Protective drafting stipulates that any assignment, transfer or novation of the junior claim remains subject to subordination and that the assignee is deemed to adhere to it, which preserves the senior creditor's ranking in all circumstances.