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11 May 2018
In a recent decision,(1) the Supreme Court confirmed the admissibility and validity of qualified subordination agreements included in general terms and conditions and with respect to consumer transactions. Further, the Supreme Court held that qualified subordination agreements – in particular, those relating to loan agreements – create a specific type of contract.
While this decision was taken with a clear sigh of relief by the Austrian crowdfunding community, which largely depends on the admissibility of subordinated loans to be entered into with consumers, it also has a significant impact on standard bank loan transactions – in particular, in restructuring situations.
Austrian legal practice uses a wide range of terms(2) to describe contractual arrangements between a creditor and its debtor in which the creditor subordinates its claims in rank in such a way that the claims must be honoured in case of the debtor's insolvency or its liquidation only if all non-subordinated creditors have been satisfied.(3) Effects of these so-called 'simple' subordination arrangements are materially limited to amending the ranking of creditors in insolvency proceedings.
In contrast, 'qualified subordination agreements' within the meaning of Section 67(3) of the Insolvency Act ensure that a liability subject to such a qualified subordination agreement can be disregarded when assessing the (over)indebtedness status of a debtor. Hence, qualified subordination agreements provide for a very effective instrument to (assist in) re-establishing the financial soundness of a debtor.
Finally, the Federal Act on Alternative Forms of Financing,(4) a specific legal framework that was put in place to provide small and medium-sized enterprises with particular financing models outside of the highly regulated (and supervised) capital market, confirms subordinated loans as an eligible alternative financing form. However, apart from a very limited statutory definition that subordinated loans must not provide the creditor with an unconditional repayment claim,(5) the act provides no indication on how to correctly structure this instrument.
A consumer protection association filed for injunctive relief against the use of certain provisions included in the standard terms and conditions of an Austrian company active in the field of renewable energy and photovoltaics. In order to fund its business operations, the defendant took out qualified subordinated loans. Pursuant to the clause under scrutiny, the lenders' claims were not only subordinated to other creditors' claims in the event of insolvency of the defendant, but also ranked pari passu with the shareholders' claims for repayment of capital. Further, lenders waived their claims for repayment of the principal and interest to the extent that fulfilling these claims would cause the defendant to become over-indebted or insolvent (ie, if fulfilment of such claims would require the defendant to file for insolvency). This waiver was stipulated to be effective as long as the defendant was in a 'financial crisis', which itself was defined in more detail by referring to certain key financial indicators.(6)
The court of appeal confirmed the first-instance court's judgment and held that the subordination agreement included in the terms and conditions used by the defendant were subject to judicial review, as they did not stipulate the main performance obligations under the loan agreement. The court of appeal held these provisions to be void as they were grossly disadvantageous to the lenders (consumers). However, it allowed an appeal to the Supreme Court.
The Supreme Court reversed the court of appeal's decision and held that the qualified subordination clause is a constitutive feature of the specific contract type and is therefore not subject to judicial content control pursuant to Section 879(3) of the Civil Code. The Supreme Court based its decision on the following assessment:
In a standard loan agreement, the provision of capital is the main service provided by the lender (consumer), while the borrower must repay the principal and interest.(7)
The level of satisfaction of the lender's repayment claim determines the nature and quality of the service owed by the borrower, since it depends on whether the loan is to be regarded as debt or mezzanine capital. Unlike, for example, the term of a bond, which the Supreme Court has already held not to be part of the main obligation,(8) the type of capital – at least in the two basic forms of equity and debt – determines the type of transaction. Gradations between equity and debt capital may also be exempt from control under Section 879(3) of the Civil Code – in particular, if "they are not merely variants of the one or the other", but have acquired a certain independence, as is the case with qualified subordinated loans.
The Supreme Court also reverted to the key issue of the statutory definition of 'subordinated loans' in the Federal Act on Alternative Forms of Financing (ie, the fact that such funding instrument does not provide an unconditional right to repayment; whereas an unconditional right to repayment is defined as a right to claim repayment of funds, irrespective of the economic situation of the debtor).
Based on the above, the Supreme Court emphasised that the key element of a subordinated loan is the economic situation of the borrower (ie, whether the borrower is in a financial crisis). The borrower's financial situation is of particular importance for the lender's claim for satisfaction with respect to the level to which the borrower must fulfil such a claim. Accordingly, the subordination clause is part of the 'main subject matter of the contract', as it restricts the borrower's promise to pay agreed interest and repay the principal. The Supreme Court deemed the subordination clause to be the constitutive feature clearly delimiting the subordinated loan from 'standard' types of loan and deposit transaction, as defined in the Civil Code (and referred to in the Banking Act).
This decision – and, in particular, certain Supreme Court findings – will have an impact on Austrian banking practice.
In recent years, Austrian banking practice shows that banks are increasingly prepared to agree to enter into qualified subordination arrangements with their (corporate) debtors in order to assist the debtor in its restructuring efforts. These arrangements are regularly limited to the unsecured parts of the outstanding debt. However, in certain cases – in particular, if banks deem the debtor's business to be promising and reasonably likely to recover – these subordination agreements may also include secured debt.
By holding that a subordination clause is a constitutive feature of a subordinated loan, the Supreme Court also confirmed, by reference to publications by legal scholars to that end, that the subsequent insertion of a qualified subordination clause into an existing loan agreement qualifies as a 'novation' within the meaning of Section 1376 of the Civil Code.
Under Austrian law, a novation – contrary to a mere contractual amendment of the principal obligation(9) – means that the former principal obligation ceases and the new obligation commences simultaneously. Further, unless the participants(10) (ie, the parties to the underlying agreement and any third-party security providers) explicitly agreed otherwise, a novation also extinguishes all ancillary rights relating to the former principal obligation, including (third-party) security instruments (eg, pledges, sureties, security assignments, guarantees and comfort letters) as well as claims for interest, contractual penalties and arbitration clauses.
The fact that collateral ceases to exist by operation of law is in general regarded as an undesirable consequence. Accordingly, there were some – unsuccessful – calls for a change in law and some legal scholars have argued in favour of limiting the applicability of the participation concept of Section 1378 of the Civil Code – in particular, in situations where the position of third-party security providers is not worsened by the novation. These attempts have been disputed by others, who point to the general freedom of contracts. These dissenters argue that a change in the collateralised liability beyond the scope of a mere amendment (Section 1379 of the Civil Code) without the consent of the third-party security provider would not be compatible with the principle that, irrespective of a deterioration of the collateral granted, everybody (including a third-party security provider) has the freedom to decide for itself whether to enter into an agreement.
At first sight, this question could be seen as a non-issue, as parties to the security agreements may validly agree that the security instrument must also secure a new obligation arising from a novation. However, in contrast to a detailed proviso, the effectiveness of which has already been confirmed by the Supreme Court,(11) these continuing security clauses are regularly drafted very broadly and are given in advance without limiting the type of the new obligation to be secured. Thus, these catch-all-style clauses may be inadequate to meet the requirements under Section 1378 of the Civil Code asking for express consent between the parties, particularly in situations where the novated obligation could – at least with respect to certain aspects – worsen the position of the security provider.
Until now, the Supreme Court had not taken a clear position on how to solve the consequences of a novation – in particular, with respect to third-party security instruments. However, the Supreme Court seems to have shown a certain sympathy for a limitation of the participation concept in cases where the third-party security provider's position is not worsened. Future guidance by the Supreme Court will be welcome, as this decision has moved banking practice from the relative safety of the legal concept of 'contractual amendments' to the uncharted waters of the effects of a novation.
For further information on this topic please contact Stephan Schmalzl at Graf & Pitkowitz by telephone (+43 1 401 17 0) or email (email@example.com). The Graf & Pitkowitz website can be accessed at www.gpp.at.
(2) For example, Nachrangabrede, Rangrücktrittserklärung, Forderungsrücktritt, Gläubigerrücktritt, Subordination, Sanierungsabrede, uä; see also Pateter/Pirker, Zur Rechtsnatur der Nachrangabrede, ZIK 2015/275.
(3) For example, "Der Gläubiger tritt im Falle der Liquidation oder der Insolvenz mit seinen Ansprüchen aus diesem Vertrag hinter alle anderen Gläubiger zurück" ("In the event of liquidation or insolvency, the claims of all other creditors shall rank ahead of the claims of the creditor under this contract").
(5) There is a regulatory background to this requirement. The Federal Act on Alternative Forms of Financing creates a legal framework for alternative financing of companies outside of the Austrian Financial Markets Regulator's jurisdiction. In order to ensure that the alternative funding instrument subordinate loan does not contravene with regulated banking activities, the legislature chose to negatively delimit subordinated loans from standard regulated deposit or lending activities under the Banking Act (as defined in Annex 1 to Directive 2013/36/EU) for which an unconditional right to repayment is an inherent part.
(6) This contractual provision materially copied the definition of a 'financial crisis' in Section 2 (3rd alternative) of the Equity Substitution Act (Eigenkapitalersatzgesetz); that is, the waiver should be effective as long as:
(7) See also European Court of Justice (ECJ) April 30 2014, C-26/13 Kásler and Káslerné Rábai and ECJ September 20 2017, C-186/16 Andriciuc. The ECJ confirmed with respect to loan agreements that the 'main subject matter of the contract' within the meaning of Article 4(2) of EU Directive 93/13 must be understood as those terms that lay down the essential obligations of the contract and, as such, characterise it. Further, the ECJ held that it is to the referring court to assess whether a clause constitutes the main subject matter of the contract (eg, by taking into account the type and nature of the contract, all the provisions of the relevant contract as well as its legal and factual context).
(9) 'Schuldänderung' – change of debt pursuant to Section 1379 of the Civil Code. In its decision, the Supreme Court (OGH May 4 2005, 8 Ob 31/05z) applied an extensive interpretation on the scope of a contractual amendment of the debt and held that changes in the interest rate, the reduction of the loan amount and the conversion into a foreign currency loan are mere changes to the debt within the meaning of Section 1379 , which do not affect the existence of a security instrument established to secure such debt. Further, pursuant to settled case law of the Supreme Court, the conversion of a revolving facility into a term loan is a change of the debt and does not constitute a 'novation' within the meaning of Section 1378.
(11) See OGH September 3 1975, 1 Ob 126/75. In this decision, the Supreme Court held that a mortgage did not cease as a result of a novation converting the previously secured loan into a limited partnership contribution. The court reasoned that the parties had specifically agreed in the mortgage deed that in the event of the planned conversion of the loan into a limited partnership contribution, the mortgage debtor would indemnify the creditor for any reduction of this limited partnership contribution and would grant liens to secure all obligations assumed in the deed.
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