Lenders and distressed investors beware: key issues regarding payment subordination in Spanish insolvency proceedings

Subordination agreements are very common in financing transactions.  They are generally used by different classes of lenders to establish the priority of repayment rights against the borrowers and their assets, enabling certain lenders to give priority to their debts over the borrowers’ debts with other creditors and to reduce their loss if a borrower defaults.

Subordination agreements are generally included in a global intercreditor agreement (which governs intercreditor relationships during the life of the financing) and typically define the intercreditor payment priority, by establishing that consideration otherwise payable to a subordinated (or junior) creditor must be paid to a senior creditor until that creditor is paid in full. In a typical capital structure where, for example, subordinated lenders enter into an agreement with senior lenders to subordinate and, subsequently, the borrower defaults, and payments are made to all creditors, all payments due to the subordinated lenders will be paid to the senior lenders until these are paid in full.

When entering into this type of contractual arrangements is key for creditors to understand how the terms of these subordination agreements will be treated in the borrower’s insolvency proceeding and, in general, how they will be affected by a potential insolvency filing of the debtor.  With this in mind, when determining priority among creditors of the same class, it must be considered that the insolvency laws of many legal systems worldwide carry less weight than the agreements entered into by the creditors themselves.  For example, section 510(a) of the US Bankruptcy Code codifies the full enforceability of contractual subordination agreements between creditors of the same class.

However, under the Spanish Insolvency Act framework no such provisions codifying the full enforceability of contractual subordination agreements exist.  In fact, section 92.2 of the act when determining which claims should be classified as subordinated claims (the act establishes the automatic—not equitable—subordination of certain classes of claims), include claims that “under a contractual arrangement, are subordinated with regards to all the other claims against the debtor.”  Therefore, in contrast to the US Bankruptcy Code provisions set forth above, the Spanish Insolvency Act establishes that absolute subordination (subordination vis-á-vis all creditors) is fully enforceable in bankruptcy, but not relative subordination (subordination only among creditors of the same ranking).

In practical terms, this means that in Spanish insolvency proceedings, subordination agreements between creditors of the same ranking are not enforceable and, therefore, the additional protection bargained for by senior creditors versus junior creditors is not achieved.  Instead,  when classifying the debtor’s liabilities, the Spanish insolvency courts exclusively apply the classification of claims ranking under the Spanish Insolvency Act (which establishes that insolvency claims can only be classified as privileged—special or general privilege—, ordinary and subordinated) and do not enforce the terms of subordination agreements.  Therefore, junior creditor’s insolvency payment rights remain intact and unaffected by a subordination agreement in the context of the debtor’s insolvency proceedings.

However, the subordination agreement, although not enforceable in the insolvency proceedings, would still be binding for the lenders who would have to honor its terms.  If any party to the subordination agreement were to breach its terms, the affected lenders would be entitled to take legal action (outside of the insolvency court) against the breaching party.  Therefore, if junior creditors were to breach their contractual obligations vis-à-vis senior creditors’ payment priorities (by not delivering to the senior creditors any payments obtained in the context of the insolvency proceedings when the senior creditors have not been paid in full), the senior creditors would be entitled to start legal proceedings against the junior creditors, to have their contractual rights fully enforced. This, of course, can be burdensome and expensive, making subordination agreements practically ineffective when the debtor files for insolvency, forcing lenders to look for alternatives to payment subordination when structuring their financing transactions.

A possible alternative would be for senior creditors to structure transactions where priority is based on liens rather than on payments.  This is accomplished through second-lien loans, which are typically subject to lien subordination rather than payment subordination.  In this scenario, junior creditors would not have access to the proceeds of the shared collateral until the senior creditors are paid in full.  This priority would not apply to unencumbered assets, as the proceeds resulting from those assets would be shared pro rata between the first- and second-lien lenders.  Although “second lien” financing is not common in Spain, we cannot rule out the possibility of this changing in the future, given the current dynamics of the Spanish credit market and that the new financing players (i.e., mezzanine lenders) are expected to have an important role in the future.

In conclusion, lenders (when structuring their transactions) and distressed investors (when defining their position in the debtor’s capital structure and designing their investment strategy) must be aware of the non-enforceability in Spanish insolvency proceedings of payment priorities under subordination agreements, so they can bargain for additional or alternative priorities to payment priority (i.e., lien priorities) or correctly assess this particularity of Spanish insolvency law when pricing the distressed credit instruments in which they intend to invest.

With almost a century of professional practice and an excellent reputation, Cuatrecasas, Gonçalves Pereira provides legal advice in all areas of business law, including advice in connection with financial restructuring processes, advising both debtors and creditors on issues including preliminary analysis of debt to be restructured and the options in a financial distress situation. In this regard, the firm participates in all stages of Spanish and cross-border complex deals involving reorganisations, restructurings, workouts, liquidations and distressed acquisitions. For more information visit www.cuatrecasas.com.

Iñigo Rubio is a partner at Cuatrecasas, Gonçalves Pereira, London.

Mr. Rubio specializes in advising on the financing of infrastructure projects (public private partnerships and private finance initiatives) and real estate projects, whether simple, syndicated or structured (e.g., sale-and-leaseback and off-balance sheet transactions). He also has ample experience in corporate and asset finance, and debt restructuring transactions, having participated in several of the most important and complex refinancing processes in recent years. Since joining Cuatrecasas, Gonçalves Pereira in 2000, Mr. Rubio developed most of his career in the firm’s Madrid office before being transferred to the London office in January 2010.

Mr.Rubiocan be contacted on +442073820400 or by e-mail: inigo.rubio@cuatrecasas.com

Ignacio Buil Aldana is a senior associate at Cuatrecasas, Gonçalves Pereira, Madrid.

Mr. Buil Aldana has extensive experience in debt restructuring operations (both judicial and out-of-court), bankruptcy proceedings and restructuring agreements. Ignacio represents both debtors and creditors and advises financial institutions and private equity funds in refinancing transactions. Additionally, Ignacio has participated in several national and international financing transactions. Ignacio was an associate in the New York office of a leading American law firm where he represented several debtors in their chapter 11 reorganizations.

Mr. Buil Aldana can be contacted on +34915247603 or by e-mail: ignacio.buil@cuatrecasas.com