Subordinated debt

What it means

Subordinated debt is a liability that in bankruptcy or liquidation is repaid only after other creditors. The lender of such debt gets money back only if something is left after ordinary and secured creditors have been satisfied.

Subordination can arise by agreement, when the lender contractually accepts ranking behind others, or directly by law. A typical example is a shareholder loan granted while the company is in crisis, which the law moves to the end of the queue in bankruptcy.

For the lender, subordinated debt is riskier and therefore more expensive than an ordinary loan. Banks often treat it almost as equity, because if problems arise it protects their own claims. Mezzanine financing, sitting between debt and equity, plays a similar role.

How it works in practice

Shareholders often fund the company with a loan instead of increasing registered capital, because a loan can later be repaid more flexibly. When lending to the company, however, a bank usually requires the shareholder to subordinate the loan to the bank and not to repay it until the bank loan has been paid off.

In loan agreements, subordinated shareholder loans are often counted as equity when calculating covenants such as leverage ratios. The company can thus improve its ratios without changing its registered capital or filing changes in the commercial register.

In the accounts, a subordinated loan remains a liability and its interest is an expense. With shareholder loans, however, transfer pricing, thin capitalisation rules and limits on deducting interest for tax must be considered, as they can increase the tax burden.

What to watch out for

If the company is in crisis, a shareholder may not be repaid a contribution that substitutes for equity. If the director repays the loan at such a time, the company can claim it back and the director may be liable, which matters especially in bankruptcy.

Subordination protects creditors only when it is clearly and demonstrably agreed. Contracts should define precisely to whom and on what terms the debt is subordinated and when it may be repaid, otherwise disputes between creditors and challenges to payments by the insolvency trustee may follow.