Swiss law stipulates that a corporation may only operate as long as it maintains positive equity. Once equity becomes negative and the company enters overindebtedness, the board of directors is generally obligated to notify the court of the overindebtedness. This duty to report to the court primarily serves to protect those who have or may enter into business relationships with the company and aims to prevent current and future creditors from being harmed by the continued existence of a company with negative equity.
The law provides for the following two exceptions to the notification requirement in article 725b(4)(1) and (2) of the Swiss Code of Obligations (CO):
- Subordination Agreement: If one or more creditors agree to subordinate their claims in the event of bankruptcy, insolvency, or liquidation to cover the potential shortfall in satisfying other creditors (i.e., covering the gap for the full satisfaction of other creditors) due to negative equity, the board of directors may temporarily refrain from notifying the court.
- Reasonable Prospect of Eliminating Overindebtedness: If there is a reasonable prospect that (i) the overindebtedness can be resolved within a reasonable period of time, but no later than 90 days after the submission of audited interim financial statements, and (ii) the claims of creditors will not be additionally endangered, the notification to the court may also be waived.
The exception related to the subordination agreement is justified by the fact that in the case of subordination, current and future creditors are protected from the consequences of the company's continued activity. It ensures that, in the event of bankruptcy, insolvency, or liquidation of the company, non-subordinated creditors are treated as if positive equity existed. With a subordination agreement, all losses are borne by the subordinated creditors.
Startups are often financed through convertible loans, which typically contain subordination agreement. If the board of directors identifies a balance sheet overindebtedness after the provision of a loan, it is generally required to notify the court unless the subordination agreement in the loan agreement is valid.
A valid subordination agreement must meet the following minimum requirements:
1. Subordination in Rank
Initially, the creditor must declare their willingness to subordinate their claims to all other creditors in the event of bankruptcy, insolvency, or liquidation. This subordination must apply not only to current creditors but also to all future creditors of the company.
Below is a proposed text based on the model for a subordination agreement by EXPERTsuisse
The claims of the creditor totalling CHF […] (incl. accrued and future interest) are subordinated to all other existing and future claims against the company: in the event of insolvency proceedings (Art. 175, Art. 192 of the Swiss Debt Enforcement and Insolvency Law) or upon initiation of insolvency proceedings due to deficiencies in the organisation (Art. 731b para. 1bis (3) CO) and in the event of a composition agreement with assignment of assets (Art. 317 of the Swiss Debt Enforcement and Insolvency Law), the creditor shall waive the claims to the extent necessary that the claims of all other creditors, and the costs of the liquidation, debt moratorium or insolvency proceedings, are covered in full by the proceeds of the liquidation of the company.
All subordinated claims are equally ranked.
All accrued and future interest on the specified claims is included in the scope of this subordination agreement.
2. Deferral, Offset, and Repayment Prohibition
To ensure that the subordination effectively protects other creditors from a loss of their claims, it must be ensured that the subordinated debt cannot be repaid until the bankruptcy, insolvency, or liquidation of the company (or until the overindebtedness is resolved). Therefore, the subordination must include a deferral of the relevant debt for the duration of the subordination (and thus also a prohibition to offset), as well as a comprehensive prohibition to repay the debt.
Below is a proposed text based on the model for a subordination agreement by EXPERTsuisse:
The claims and interest covered by the subordination agreement are deferred for the duration of this agreement.
None of the claims or interest covered by the subordination may be paid, settled by offsetting or replacement/novation, or newly secured, either in full or in part.
In the case of bankruptcy or debt restructuring liquidation of the Creditor, the company is permitted to offset the subordinated claims and interest against the company’s claims against the Creditor.
3. Creditor's Solvency
Another (often overlooked) element of a subordination agreement is the solvency of the creditor granting the subordination. This pertains to the fact that granting a subordination might be subject to a clawback because granting a subordination generally prejudices the creditors of the subordinating creditor (as it potentially waives a claim).
If the clawback is successful, the subordination might become ineffective. Therefore, before entering into a subordination agreement, the solvency of the subordinating creditor should be investigated or at least considered.
4. Waiver of Security Enforcement
If a debt is secured by the debtor's assets, a subordination does not protect other creditors effectively. Due to the priority associated with the security interest, the subordination is effectively nullified, as the assets used as security remain unavailable to other creditors despite the subordination.
Therefore, the creditor granting the subordination should waive the right to enforce the security for the duration of the subordination.
Below is a proposed text based on the model for a subordination agreement by EXPERTsuisse:
The Creditor has no right to demand satisfaction from this collateral for the duration of this subordination agreement. This does not apply to collateral pledged by third parties for which there is no right of recourse against the company.
5. Extent of Subordination
For the calculation of the necessary amount of subordination, the law refers to the undercapitalization as a reference, meaning that the subordination must be granted at least in the amount of the overindebtedness. However, a margin is typically built in, meaning that the subordination covers a debt amount exceeding the overindebtedness.
6. Duration and Termination of Subordination
The subordination must be concluded for at least the duration of the overindebtedness. This means that the subordination should be structured in such a way that it cannot be unilaterally terminated by the subordinating creditor or mutually by the subordinating creditor and the company until the overindebtedness is resolved.
Accordingly, subordination is typically entered into for an indefinite period, and it is agreed that the subordination can only be terminated if all of the company's liabilities (including the subordinated debt) are fully covered by the company's assets.
What Are the Liability Risks of an Inadequate Subordination?
If a company goes bankrupt, the board of directors may be accused of breach of duty, and attempts may be made to hold the board of directors accountable for the losses suffered through a liability claim under Article 754 CO.
In that context, the board of directors is often accused of violating the duty to notify the court under Article 725b(3) CO due to late or omitted notification and, if that is the case, the board of directors might become liable for the damage suffered by the company. Such damage equals the difference between the negative equity of the company at the time of the violation of the duty to notify and the negative equity at the time of the actual bankruptcy declaration. Any increase of the negative equity is the damage caused by the board of directors.
The liability risk in the case of an inadequate subordination is therefore substantial. Consequently, it is advisable to carefully review the subordination in your loan agreements.
Take-Home Message
Ideally, every subordination agreement should include the following elements:
- There must be a subordination with respect to the debt and accruing interest to the extent of overindebtedness or complete subordination of the relevant claim.
- There also needs to be an explicit deferral of the debt, as well as a prohibition to offset and repay.
- The subordination agreement should also include a aiver of security enforcement and it should be unrestricted.
Disclaimer: The information contained in this article is for general information purposes and does not constitute legal or tax advice. In specific individual cases, the present content cannot replace individual advice from expert persons.
