Businesses exist in perpetuity whilst some are meant to operate for a limited period towards a particular project. Section 102 of the Companies and Other Business Entities Act [Chapter 24:31] require companies to satisfy the Solvency and Liquidity Test at a given time. Financial statements are also prepared on a going concern basis unless there is winding up or a project for which an enterprise was established is coming to an end. Paragraph 26 of International Accounting Standard 1 (IAS 1) requires management to consider factors which might affect the going concern of a business and to disclose such in its financial statements in line with paragraph 25. Net liability, adverse key financial ratios, negative operating cash flows, inability to pay creditors, inability to adhere to loan agreements, loss of key management, loss of major market and failure to meet minimum capital thresholds are indicators of going concern challenges. Subordination agreements may be used to guarantee going concern in circumstances where a business has a debt overhang.
Parties to a subordination agreement
A subordination agreement is done between a business and the creditor, who becomes the subordinated creditor. A subordinated debt will rank lower than other debts, which assumes the rank of senior debt when it comes to payment preference and will usual become due and payable once senior debts are fully paid. The major creditor to a business facing going concern issues should be engaged to consider and agree to the subordination arrangement. All liabilities owing by the business to the subordinated creditor becomes subordinated debt.
Structuring subordination agreements
There is need to identify debts due to the subordinated creditor which are being subordinated and consider the terms and conditions of the subordinated debt as well as the period and/or duration of subordination. Whilst audit firms consider a business's ability to operate for one year following the time of audit, its critical to align the period of debt subordination to the business's capacity to meet going concern requirements, hence the period of subordination may be for a period longer than one year. The creditor agreeing to subordination should undertake not to claim the debt, or receive benefits such as interest, guarantee or indemnity. Subordination should also be limited to identified debts forming the senior debt and there can be provisions to limit further borrowing and/or for business to seek subordinated creditor consent for any new debts.
To protect the subordinated creditor, a subordination agreement may not be amended, waived or released without prior consent of the subordinated creditor and/or in some cases the senior creditor where a number of creditors are party to the agreement. The consent if required to allow for amendments shall not be unreasonably withheld or delayed. Basically, amendments may be done with regards to the period of subordination in view of the business performance and ability to operate sustainably as a going concern.
Enforcement and benefits
Subordination agreements are binding on the parties and remain in force until the discharge date, which is the time when senior debt has been paid off and/or an agreed level of liability has been reached. Parties may choose arbitration and/or subject agreement to the laws of the country and/or any neutral jurisdiction when it comes to international parties. Both the business and the subordinated creditor should benefit from the arrangement in that the business continues as a going concern whilst the creditor is assured of repayment due to improved capacity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.