Turkish Law Blog

Overview of Project Finance and as a Security Device “Subordinated Loans” and its Reflection in Practice under Turkish Law

Yaman Gürsel Yaman Gürsel/ University of Fribourg
Arman Zenginpedük, Associate Arman Zenginpedük, Associate/ GSI Goksu Safi Isik Attorney Partnership
16 September, 2019

Abstract: Smart buildings, large airports, sports stadiums, power plants or in broad sense energy infrastructures that provide renewable energy; these mega constructions permanently require robust finance due to the enormous risk that the project owner bears the whole time. Not only a single company but widespread participation with various finance/banking corporations along with joint venture/s and mostly States must gather to achieve such projects. The subordinated loan comes into the scene in the form of a useful security device in convincing senior lenders. Nevertheless, subordinated loans are not only serving to a purpose of security but as a matter of fact, it is called subordinated debt as a method of financing a project. Although the application of subordinated loan does not seek many conditions to meet on the side of the parties, still its unique nature lays out very extinguished ground rules for the parties to comply.

Additionally, there can be different pathways for parties to choose in carving out a subordination. For instance, the conclusion of a shareholder loan agreement, inserting a subordination clause or even sometimes a contract itself only to clarify parties’ rights and obligations under the new scheme for reimbursement of the senior and junior loan denote to the point illustrate its complexity[1]. Whereas the implementation of such a device is generally dealt in the same manner in the international arena, under Turkish law few diversifications are stemming from the characteristics of the Turkish law. In this respect, we found it quite interesting and valuable to scrutinize the methods that are applied under Turkish law for parties to establish such security in financing a project while providing a broad-and-clear text on the subordinated loans from an international perspective.

1. Introduction

Project finance is an indispensable vehicle to be used by governments and banking corporations to increase their volume and role in the market economy. Especially, when such an issue is contemplated to be carried out in a developing country such as Turkey, not only the domestic government along with financing entities, but also foreign governments might start raising interests through the success of that project. Scrutiny of the devices invoked by the parties in financing projects—mainly for mega buildings requiring constant cash flow with considerably high numbers, since the main risk concerning the project finance in developing countries is the volatility in the economy and the ability of the project to reimburse its financing, becomes a must to discuss to reveal critical points as their differences, advantages/disadvantages, and conditions. By doing so, not only a useful text will be provided to the practitioners, but also theories constituting its fundamentals will be clarified.

To illustrate the main facts of such a case; there is a big-seized project that requires major financing, whereas representing a noteworthy risk to fail-and-success. Due to this risk-driven feature, sponsors which generally consist of parent companies and some other private investors do not keen to carry out the operation by themselves[2]. As a merchant supposed to act commercially reasonable, they look forward to distributing such risk among other leading players as banks. To attain that, they need to render the project profitably-attractive to the outworld. Nevertheless, doing a great job in marketing is not enough to resolve the problem of risk distribution, since these major players, banks are restricted to join the game with certain limits imposed by the supervision agencies. To be more precise, in every country, there are national supervision agencies imposing strict-compliance to the internationally-determined capital ratio standards like Basel III Principles to secure the banking system, especially in the aftermath of the last global financial crisis[3].

Hence, banks, in other words, become obliged to ask for security before letting the project company access to such a significant amount of cash-flow. The subordinated loan comes into the scene at this phase as a safeguard for the banks by looking at the computing capital adequacy of the project company[4]. However, in the background of such transactions, firstly there must be a shareholder loan agreement concluded between the sponsors and the project company. Rather than providing their contribution through an equity subscription, which by the way has differences compared to shareholder loans as pros and cons, the sponsors generate an indebtedness that may be taken as security by the lenders[5]. Also, once they conclude the transaction so-called subordinated loan, sponsors turn out junior creditors against the lenders, and they affirm that they will be paid out only from the excess of money after the senior creditors will be fully paid out[6]. This scenario often occurs when the debtor (project company) goes insolvent due to a failure or material change held in the project. Nevertheless, in simple terms, for example, a parent company as a sponsor of the project company lowers its rank behind the lender’s rank even though they both implement the same transaction as granting of credit[7].

As a road map to describe for this article emphasized with the subordinated loans, we firstly provide a bird’s eye view on the term “project finance” without narrowing our spectrum for a specific country’s legal system. Matters as the importance and primary structure, among other things, essential elements of project finance as a founding legal instrument are laid out before the part in which we attempt to outline the specific risks of a project-financing for security purposes. Subsequently, the article elaborates on the subordinated loan as a type of security and the way of project financing. For us to deploy a coherent assessment within a comparative standpoint, the reflection of subordinated loans to the practice under Turkish law has been engaged in this part. In conclusion, the article is enriched by different legal systems’ way of approaching to the subordinated loans within.

2. Project Finance, its Structure and its Essential Elements along with the Founding Legal Instrument

a. The Concept of Project Finance

As mentioned numerously above, project finance constitutes a crucial ground for today’s economy. Due to the globalization of the economy, now we have cross-border financial transactions to deal with in today’s business structures and such globalization indispensably affected the shape of the project finance. Precisely, in today’s context, it is quite impossible to finance the construction of a mega-airport project in the absence of international players. Indeed, it does not mean bias to undermine the importance of domestic authorities and mechanisms.  All is to say that financing big-sized projects require foreign involvement in our days, and such involvement naturally brings out the concept of international project finance. Project finance includes significant bank financing a project by taking a substantial part of the total risk of failure or success[8].

b. The Essentials and Structure of Project Finance

Fundamentally, carving out the main structure of project finance requires us to touch upon specific points. The nature of these points, in effect, varies among the terms to call some mandatory documents, transactions, parties, and phases. To demonstrate what it has been said, after the sponsors get in charge of the project, a special purpose vehicle—i.e., the single-purpose project company – commonly referred as project company - is firstly established by the sponsors, and its shares often are distributed either via shareholders agreement or through a joint venture agreement between the sponsors of the project. Sponsors could be constituted by a group of legal entities, which in general includes at least one parent company of the special purpose vehicle.

Supposedly, a bank, financial institution or a group of lenders is approached by the sponsors to finance the project company through by concluding a facility agreement or a loan agreement and as mandatory contingency of acting as a prudent merchant creditor (bank—senior creditor) demands security, not only from the project company, but in particular bargains the sponsors to provide a noteworthy amount of security for the repayment of such a massive amount of cash-flow to finance the project. Such banks or group of lenders who grasp the role of a senior creditor will be paid out with the proceeds are targeted to obtain after the completion of the project at hand[9]. Concerning the security amount, the project company is obliged to provide an adequate amount of security as well. Means of security and required security documents to guarantee the loan for each project are decided by the lenders as an outcome of commercial concerns such as bankability. In that regard, what would amount to means of security varies in each project.   Agreements that usually subject in a project finance scheme may be classified in two as the project documents and the finance documents.

Project documents generally include contracts such as the project agreement, joint venture agreement, construction contracts, which generally is in the form of EPC Contract, where the contractor undertakes the Engineering Procurement and Construction (EPC) works and the engineering design of the project, sub-contracts, and operation & maintenance contracts. These can also be regarded as the contracts that the banks or financial institutions are not parties to. As to finance documents, contracts such as loan agreement (sometimes referred as facility agreement), interest hedge agreements, direct agreements, subordination agreement, could be mentioned[10].

In that regard, in addition to the project agreement and the loan agreement, completion of the security documents and agreements such as inter-creditor agreements, share pledge and retention agreements, sponsor support agreements and securities over the project assets and other guarantees from parent companies are also regarded as essential pieces of project financing deals. It should be mentioned that depending on the type of project, essential documents may vary in addition to the contracts mentioned above; e.g. in a privatization project, the transfer of right to operate agreement becomes also prominent or under Public-Private Partnership (PPP) projects, in addition to project and finance document mentioned above, documents subject to tender and concession agreements should be deemed as essential in the structure of the project financing.

3. Subordination and Subordinated Loan/Debt as a Security

a. In General

After all the information stressed above, addressing one of the most useful security devices in project finance, subordinated loan, will be perceived more lucidly. To begin with, McKnight provides us an efficient definition as “subordination is a process through which an unsecured creditor agrees to settle subordinating its right to payment by a debtor, particularly in an insolvency of the debtor, behind the claims of one or more other unsecured creditors”[11]. His definition is essential based on the tips that it gives as to the assessment of the significant concerns. First of all, subordination is a term that denotes the insolvency – as insolvency generally regarded as an event of default in loan agreements, and secondly, it regulates the relationship among the competing creditors. In combination with these, subordination, however, creates security for the lenders when it comes to financing a project.

Speaking of the relationship among the creditors, the subordinated loan has made an important change over the ordinary rule of pari passu distribution of debtor’s assets in insolvency. For a long while, English law was struggling with this rooted practice. To have more profound knowledge on this matter, Sections 107 and 382 (3) of the Insolvency Act 1986 should be examined. At this point, the principle of British Eagle set out under Rule 4.181 of the Insolvency Act 1986 inevitably comes to our attention and it used to render any agreement that disarranges the pari passu distribution void[12].

This principle has been firstly alleged in British Eagle International Airlines Ltd v Cie Nationale Air France[13]. It took English courts 15 years to recognize the validity of subordination agreements; yet, in consequence, they are smoothly functioning as a security device in project financing, roughly speaking. To overcome the principle of British Eagle, the English courts had to realize that such rank-lowering behind the other creditors in case of debtor insolvency was not actually affecting any other creditors’ rights in an adverse manner, but the junior creditor’s itself. For this reason, it was concerning no one but the junior creditor’s own interest, and it didn't amount to any distortion over the pari passu distribution[14].

Re SSSL Realisation Ltd and Manning v AIG Europe Ltd are relatively recent decisions in which the British courts have recognized the validity of the subordination arrangements[15].

b. Parties to a Subordination

In identifying the competing creditors in the combat of priority, creditor subordinates its debt to another creditor, that creditor is referred to as the junior creditor[16] which are generally the sponsors. The one whose claim is prioritized is called as a senior creditor since as banks or financial institutions they extend loan for the project. Hence, we may figure out the parties to subordination by drawing a scheme between three essential players, such as a senior creditor, junior creditor, and debtor as the project company which generally referred also as the borrower in many project finance deals. This junior-senior interaction comes into the scene when the issue passes through indebtedness of these creditors as junior debt and senior debt[17].

Junior debt encompasses all present and future liabilities of the debtor to the junior creditor. These liabilities are supposed to be incurred from the specified junior documents and can be observed as a loan agreement, interest, hedge contract, subscription agreement. As to the width of such debt, it includes insider subordination to its sphere[18]. Thus, regarding the width of junior debt, subordinated debt mostly relates to the loan agreement concluded between the project company and sponsors. The other component of a subordination relationship—senior debt as the latter does, embraces all present and future liabilities of the debtor to the senior creditor. Documentation of such liabilities has to be specified under the senior finance documents and to exemplify such indebtedness, credit agreement, debt securities, interest hedge contract could be mentioned[19].

With regard to the scope of senior debt, there is a critical discussion relating to the junior creditors’ veto rights. Precisely, when the project company leans towards in post-commencement financing, the state of the junior creditor in the relationship inherently becomes interested. Post-commencement financing should be understood as the debtor wants to apply for further advances from the senior creditor because of a situation that does not matter what it is. Nevertheless, such add-on fresh advance could bring some trouble on the junior creditor’s indebtedness due to the subordination agreement under which junior creditor binds himself to be paid out only after the senior creditor will be wholly paid out[20]. For instance, in insider subordination such veto is organically bound to the project company through the junior creditor (parent company) has a notable authority to control the acts of the project company. In such event, junior creditor naturally will be set forth no objection since it will be competent to measure the necessities of an advance and repayment capability of the project company[21].

c. Types of Subordination/Subordinated Loan

There are mainly two types of subordination in practice: subordination via turnover or contractual[22]. In a turnover subordination, junior creditor holds the dividends and distribution of receivables on trust for the senior creditor.  Under a contractual subordination either with the participation of senior creditor or not, the junior creditor and debtor conclude a contract according to which junior creditor is bound to be paid out only after the full-satisfaction of the senior creditor’s claims. Such a covenant is valid against all other creditors.

c.i. Turnover Subordination

First of all, there are two versions of turnover subordination. It might either be turnover subordination trust or a debtor-creditor turnover subordination. They share an essential characteristic, which is primarily concerning the insolvency of the debtor. Once the debtor goes insolvent, the junior creditor agrees to hand on all the receivables incurred from the junior debt to the senior creditor, unless the senior creditor obtains full reimbursement. Such a covenant is available to give for a single senior debt or a class of senior debt, and this could be achieved only through the turnover subordination.

In most of the Anglo-American jurisdictions, the trust points out the transfer of proceeds, which will occur in the future as a proprietary right in rem to claim, and it is recognized as assignment of proceeds under English law and such assignment cannot be prohibited[23]. Nonetheless, under US law, there are court decisions that are treating the transfer of proceeds over the junior debt in favor of the senior creditor as an equitable lien[24], or as an equitable assignment[25].

I. Turnover Subordination Trust

In the event where the parties agreed to conclude a turnover subordination trust, all receivables collected by the junior creditor belong to the senior creditor property. Such a scheme of property is valid until the senior creditor obtains a full-payment as to the senior indebtedness. Needless to say, after stressing the senior creditor’s property rights, the receivables such as payment of premiums or interests incurring from junior indebtedness remain at junior creditor’s disposition on trust[26]. Since such subordination empowers the senior creditor with a proprietary right in rem, it is the most preferred method to resort to in practice[27]. This method can be also attained by via contractual agreement, yet it oftentimes is arranged on trust[28]. The landmark case law to observe how the turnover subordination trust functions are Re British and Commonwealth Holdings Plc. (No 3)[29].

Nevertheless, the term “trust” might be perceived a bit confusing in specific scenarios, given it symbolizes the transfer of proceeds in the form of an assignment. Raison d’être of this term is to confer the senior creditor a super-priority right in case of junior creditor’s bankruptcy. Alternatively, the junior creditor is also entitled to carry out an assignment over the junior debt as a security in favor of the senior creditor[30].

II. Debtor-Creditor Turnover Subordination

Contrary to turnover subordination trust, the senior creditor does not grasp a proprietary interest over the receivables that junior creditor gets in return for junior debt. In this case, the junior creditor agrees to pay the junior debt amount to the senior creditor if the debtor would go insolvent. From a different point of view, junior creditor turns out a debtor to senior creditor as long as the solvency of junior creditor continues. This method can only be applied if the junior creditor stands reliable on not going to bankrupt. Often this preference comes in the prominence, when conventional subordination trust amounts to a security interest, or when the applicable weakens its effectivity at the junior creditor’s insolvency[31].

 III. As a Security Interest “Turnover Subordination”

For a turnover subordination to be regarded as a security interest, it essentially depends on the reception of transfer of proceeds by the host jurisdiction. In other words, if the law of the relevant country characterizes such transfer of proceeds as a security interest in regard to the fact that junior creditor assigns the rights deriving from the junior debt to the senior creditor, then in that case turnover subordination will be treated as a security interest[32].

In addition, when it comes to using invoke subordination as security, under English law, the question of whether such a claim can be registered or not, unveils. Therefore, Section 860 of Companies Act 2006 should be taken into consideration in order to assess whether subordination trust might result as a security interest—i.e., a charge which can be registered in favor of a third party or not. It is crucial to detect that such charge can be registered or not since otherwise, it would not be possible to deem it void in the case where it can be registered but not registered due to the parties’ omission[33]. Under British law, in order for a subordination trust to be registered, pursuant to Section 860 of the Companies Act 2006, it must be either a floating charge, or a charge on a book debt, or a charge to secure an issue of debentures. On the other hand, for instance under Canadian law, they can be registered, yet it is not essential[34]

c.ii. Contractual Subordination

The type of contractual subordination distinguishes from the turnover subordination with few characteristics. Essential differentiation bases on the fact that contractual subordination impacts the junior creditor against all the creditors. In simple terms, the conclusion of a contractual subordination binds the junior creditor to be ranked behind all other creditors in case of debtor’s insolvency[35]. Re Maxwell Communications Corp Plc[36] is a convenient case law to identify how the system of contractual subordination works in practice[37].

Furthermore, contractual subordination is an agreement which is concluded between junior creditor and the debtor. According to the agreement, the debtor goes insolvent or is subjected to dissolution proceedings; the senior creditor will be first paid out. Such an agreement might be challenging with the well-established rule that is enabling unsecured creditors enjoying pari passu distribution over the foreclosure of debtor’s assets[38]. In that regard, contingent as a term may replace the contractual subordination. It merely denotes to the fact that that junior debt will be deemed as contingent in regard to the debtor’s ability to pay the senior debt in full. As regards the amount decreased in debtor’s ability, junior debt will be diminishing proportionally[39].

Considering these two main differences; it is noteworthy to exemplify in a hypothetical situation. So, assuming that the debtor has assets at the value of CHF 6.000.000,00 and we have three categories of debts as senior, junior and others. Each debt is at the amount of CHF 3.500.000,00, so the total debt is CHF 10.500.000,00, and the dividend on each debt is CHF 2.000.000,00. As per these numbers, if the junior creditor and senior creditor would have agreed on a turnover subordination, senior debt will be paid in full as CHF 3.500.000,00 meanwhile junior creditor will be keeping CHF 500.000,00 on his account. However, if the parties had concluded a contractual subordination, then the junior creditor will be receiving nothing given the fact that its covenant will be binding him against all the creditors. Hence, CHF 1.000.000,00 of his total dividend will go to the reimbursement of senior debt, and other million will go to the payment of the other debt. Gradually, the senior creditor obtains a lesser amount than in turnover subordination.

d. Hierarchy of the Claims

As to the ranking in insolvency, necessarily we stick to the ordinary hierarchy among the creditors of an insolvent debtor. Usually, the famous triangle is applied to illustrate the hierarchy, which is divided into three. The top floor is reserved for the senior creditors—lenders, e.g., banks. Below the senior creditors, meaning that after the full-satisfaction of senior creditors' claims, junior creditors are positioning at the middle layer of the triangle. At the bottom of the triangle, there are unsecured creditors consisted of shareholders who expect the return of their equity contribution. In case of turnover subordination, the position of the junior lenders comes down to the bottom of the triangle since the payment for their dividends are subordinated as well. McKnight has opposed the school of thought that alleges shareholder loan might be considered as quasi-equity due to its lowered rank ahead of the shareholders' claims, and we, author of the article, agree to his opinion given his fully-correct reasoning[40].

To list a few of the significant differences between shareholder claims and junior creditors' claim, firstly junior creditors' claim place ahead of the shareholders' claims[41]. Further, subordinated debt is embodied by the contractual rights under which the interest amount is regulated, whereas shareholders can get dividends only if the project company makes a profit that year. Besides, concerning the distributivity of dividends, absolute capital reserves have to be fulfilled[42].

e. Additional Issues of a Subordination Agreement

Moreover, it is beneficial to address the critical elements of a subordination agreement regardless of winding-up debtor’s business. Mainly, there must be provisions to administer the issues such as reception or retainment of the payments of interests, fees, and repayments of principals. To successfully draw a frame around these matters, payments that mature during the project company’s solvency, adequacy of the project company’s reserves to pay out the senior creditors and assessment of actual or anticipated default of the borrower must be taken into consideration within the agreement[43].

In some legal systems, the establishment of subordinated loans can be limited, given the implementation of thin-capitalization rules. Under such circumstances, if the shareholder debt arising from the shareholder loan agreement notably exceeds the amount of equity, then exceeding the part of the shareholder debt is considered as equity to hinder the deductibility of the tax over the profits of the project company. In doing so, exceeds will be subjected to a withholding tax under these regimes[44].

4. Project Finance and Implementation of Subordination in Turkey

a. General Overview of Project Finance in Turkey

When it comes to the financing of investment projects in energy, infrastructure, construction, and telecommunication; Turkey, as a developing country, benefits the high rate of financial support from both international and domestic banks and financial institutions, with a portfolio of borrowings over $1 billion[45]. Over the past decade, in terms of infrastructure investment, Turkey has been home to many big-scale projects such as the Istanbul Grand Tunnel, the third bridge on the Bosphorus, Istanbul’s new airport, Marmaray, the Trans-Anatolian Natural Gas Pipeline and many more. Some of these projects are done by utilizing the Public-Private Partnership (PPP) model and “project financing” becomes prominent as one of the most efficient tools to finance such projects since project financing provides for off-balance-sheet financing of the project, which does not affect the credit of the shareholders or the grantor, and shifts some of the project risk to the lenders in exchange for which the lenders obtain a higher margin than normal for corporate lending[46].   

In that regard, lenders require the sponsors and the project company to provide guarantees to maintain a solid repayment mechanism for such amount of financial support in return for the project risk that the lenders bear. Guarantees include mechanisms such as sponsor support, government guarantees (such as debt assumption), step-in and substitution rights, share pledge and retention and subordination.

Subordination mechanism originated from common law system, is highly referred and applied in project financing in Turkey as a civil law jurisdiction. The implementation of subordination in Turkey requires also the adaptation of such a concept to the juridical system by utilizing the existing mechanisms in the law of obligations as done in many other civil law jurisdictions.  Having said that, the implementation of subordination in practice in Turkey will be dealt with in the following sections.

b. Legal Nature of Subordination under Turkish Law

In general, subordination takes effect after the subordination agreement between the junior lenders and the senior lenders has been completed. The completion of such agreement is effective to prioritize the senior lender’s claim over the junior creditor’s claim whether in relation to project revenues or in the event of insolvency in the jurisdictions that recognize the validity of such agreement to provide priority over the payments.

Under Turkish law, the concept of subordination is not regulated as recognized as under common law and some other civil law jurisdictions. Having said that, the subordination agreement should not be confused with the concept of subrogation which simply takes place when a third party performs the deed of the debtor in a contractual relationship and becomes the new debtor of such contractual relationship. Also, completion of such agreement is not subject to the concept of the third-party beneficiary contract under Turkish law as it is in some other civil law jurisdictions such as France, Belgium, Luxembourg, Greece, Switzerland, and Japan.

Since subordination is not defined or recognized under Turkish law, it would be beneficial to mention the concept of assignment of proceeds as subordination is done subject to the concept of assignment of proceeds. The concept of assignment of proceeds is regulated between the Articles 183-194 of the Code of Obligations (CO)[47]. Assignment of proceeds can be defined as a transaction where the deed is transferred by the assignor to the assignee without having need to address the consent of the debtor. Such transfer can be realized either by an agreement or by a court decision. Assignment by an agreement is the most common way in practice for subordination in project finance deals as will be scrutinized in the following section.

Assignment of proceeds is a legal transaction in which the right to claim is transferred from assignor to assignee thus such legal transaction can be regarded as an act of disposal and contractual and causal transaction. Agreement for such assignment must be done in writing in order to be deemed valid. Such transfer covers the main right to claim as well as with the ancillary rights such as interests and guarantees.  

As a consequence of such procedure, the assignor becomes the creditor of the respective contractual relationship between the assignee and the debtor. Also, the assignor guarantees the debtor’s ability to pay such debt to the assignee. The concept of subordination in project financing becomes prominent at this very point in practice since the sponsors are the shareholders of the debtor at the same time.

c. The Establishment and Practice of Subordination in Project Finance Deals in Turkey

As mentioned previously, the concept of subordination is not regulated under Turkish law and is subject to the concept of assignment of proceeds. As a general rule, the process of subordination becomes valid after the completion of subordination agreement under common law jurisdictions. Whereas according to Turkish law completion of such agreement does not provide seniority over the junior debt ipso facto.

Since Turkish law does not recognize subordination of debts through a subordination agreement, in the event of insolvency or bankruptcy of the project company, the senior lenders’ claim will rank pari passu with the claims of unsecured creditors[48]. In that regard, to give effect to such subordination agreement, junior debtors and senior debtors also make a transfer of subordinated proceeds agreement in which the junior debtors agree to assign their proceeds from the debtor to the senior debtor. Although the debtor’s approval is not required for these agreements to take effect, in practice, parties prefer to involve the debtor to these agreements. In practice, parties may also prefer to give effect to subordination and transfer of subordinated proceeds in one agreement rather than making separate agreements or implement subordination and transfer of subordinated proceeds to the loan agreement. Under Turkish law, priority for the proceeds of the senior debtors over the junior debtors in the ranking system can only be obtained by such assignment since assigned proceeds are deemed concessionary to the unsecured proceeds.

Such transfer of subordinated proceeds can be done by resorting to several mechanisms as senior lenders may collect the receivables for repayment, the receivables may be collected into a reserve account or such assignment make take effect upon an event of default in which the senior lender may claim such receivables upon realization of the circumstance set in the agreement[49]. In practice, the preference made by the parties may differ in each project subject to the commercial concerns particular to the respective project. Parties may prefer to give effect to such transfer upon the realization of an event of default or may agree to utilize such proceeds in the repayment of the loan without having a need to require realization of any contingency.  Also, in practice, the parties agree to keep such amounts in a reserve account.

It has to be mentioned that in that scheme, the transfer of such receivables is subject to the realization of a contractual contingency and in the event that such contingency is not realized which may happen when the project is operated and run smoothly, such transfer of proceeds will not be completed. In this regard, subordination will still be valid since it has been completed under the concept of assignment of proceeds, however, such assignment of proceeds will be a promissory transaction instead of an act of disposal. In order for such assignment to be deemed as an act of disposal, upon the occurrence of such contingency, the senior creditor must also prove the realization of such condition and that it was entitled to such assignment accordingly. In practice, senior creditors generally require the junior creditors to notify the senior creditors immediately in case of an event of default.

5. Advantages of A Subordinated Debt in Comparison with Equity Subscription

Although we already have mentioned a few pros of subordination in brief under the hierarchy of claims, it is worth noting them in a separate part of this article. It is necessary to underline that the advantages of subordination are weighed compared to equity subscription in the event of project finance. Firstly, the debtor is not entitled to deduct dividends payable from its gross income, whereas interest deriving from a subordination remains deductible and is not subject to the withholding tax[50]. Further, the project company is not liable on the issue of loan capital; on the other hand, the capital duty might amount to liability to rise over the debtor. In paying interest on a debt, the debtor is not obliged to obtain profits as if he has to earn to distribute dividends[51].

Besides, payment of interest does not cause a decrease in the capital of the project company. Although this issue will be touched upon afterward, as it is essential, if the parties would choose a turnover subordination to set up, then the senior creditor will be receiving the double dividend. In this respect, it will have a better way compared to any investor in equity subscription. In effect, the double dividend is the security facet of the subordinated debt, which comes to the surface when a negative pledge clause prevents the debtor from granting further security[52]. Nevertheless, the term double dividend and the reasoning of this advantage will be thoroughly explained below. Keeping up with the advantages; subordinated debt does not bother any shareholder’s rights, meaning that no consent is required to be taken by any shareholder. More importantly, it accesses the debtor to a more significant amount of cash-flow given the creation of a bigger capital cushion. Additionally, given its high-risk profile, subordinated debt provides higher interest rates[53].

6. Disadvantages of Subordinated Debt

Albeit the advantages are clear enough to direct the investors towards the subordinated debt to recourse in project financing, there is not an ocean of, but still few remarks to be made regarding the disadvantages of the subordinated debt. The essential con is deriving from the lack of right to say. Precisely, both types of creditors do not have a right to vote in the internal affairs of the target company—i.e., the project company except for the realization of mechanisms such as step in or substitution. They could only rely on the covenants that have been incorporated in the concluded contracts. Another disadvantage relates to the fact that creditors are not entitled to obtain dividends in terms of profits[54]. Nevertheless, concerning two of the disadvantages described above, as long as a junior creditor would be the parent company of the project company, the issues, on the way or the other will be solved to some extent.

As to the matter of sharing profits, there is an alternative way that helps to overcome the problem. According to Section 3 of the English Partnership Act 1980, in insolvency, the debt can be deemed as equity and could be shared by the creditors. Moreover, no benefit reflects in debt from the increasing value of the debtor’s business[55]. Further, except senior creditors who are benefitting from subordination, no other trade creditors would be willing to grant credit to the debtor. Last but not least, there are certain jurisdictions such as Turkish; they doubt the efficiency of turnover subordination. Besides, high revenue obtained over high-interest rates can receive a blow due to the usury laws[56].

7. Conclusion

After the examination of the application of subordinated loan/debts in the international arena—i.e., mainly English and American law, and in Turkish law, it is utile to touch upon few other legal systems in which the lawmakers provide different methods to invoke. Genuinely speaking, Pan-European countries developed various types of transaction to carry out a similar operation to the subordinated loans. For instance, under Greek law, the conclusion of an agreement on the exchange of rank is allowed to the parties. The first mortgagee is enabled to subordinate its priority to the second creditor; however, only the successive mortgages can benefit from such freedom[57]. Whereas contractual subordination has not been barred, there are cases where the creditor, in our case, the junior one (sponsor), might be compulsorily subjected to such subordination. That is the case where the dispute is based on insolvency of the limited liability companies, as per Art. 32 of L3190/1955[58].

Furthermore, Italian law grants both contractual and turnover subordination to the parties. Nevertheless, a full waiver must be executed by the junior debtor in a contractual subordination[59]. Moving through the North compared to the legal systems that we briefly analyzed geographically speaking, the law of Luxembourg is worth touching. Although there is strict compliance to the principle of equal treatment of all the creditors[60], which has been recognized as a public order in the case law[61], the impact of the Belgium commentators and given the fact that Belgium case law oftentimes heads the case law of Luxembourg, the application of subordination as a security device is possible. Besides, both types of subordination do not favor only one creditor (the senior creditor), but all the other creditors, as we explained previously on the protection of pro-rata-based distribution. Thus, there is no need to be scared of a possible violation of public order. Notwithstanding such allowance, three methods can be implemented to establish a subordination. Delegation, pledge, or assignment; the latter one is deemed more secure than the others under the legal system of Luxembourg[62].

Although the concept of subordinated loan is not recognized under the Turkish jurisdiction, it is one of the most commonly used tools that banks resort to in relation to securing the repayment of the financing provided to the project. Interpretations and implementations of this concepts vary in each jurisdiction as some consider the nature of subordination as a third-party beneficiary contract; under Turkish law, subordination takes effect upon the transfer of subordinated loans which would as an assignment of proceeds transaction. Depending on the agreement and preference of the parties, such transfer of subordinated loans can either be subject to a contingency or can be made by assignment of the dividends to the senior creditor. However, if such transfer is subject to a contractual contingency then transaction will be deemed as an act of disposal only after the realization of the respective contingency and the senior creditor must prove the occurrence of such realization.


  • Wood P R, The Law of Subordinated Debt (Sweet & Maxwell, London, 1990)
  • MacDougall B, Canadian Personal Property Security Law (LexisNexis Canada Inc., Ontario, 2014)
  • McKnight A, The Law of International Finance (Oxford University Press, Oxford, 2008)
  • Dewar J Ed, International Project Finance, Law and Practice (2nd Edition) (Oxford University Press, Oxford, 2015)
  • Wood P R, Project Finance, Securitisations, Subordinated Debt (2nd Edition) The Law and Practice of International Finance Series Volume 5 (Thomson Sweet & Maxwell, London, 2007)
  • Nassiri A (ed), The Lending and Secured Finance Review, (Fourth Edition) (Law Business Research, London, 2018)
  • Delmon J, Delmon V R (eds), International Project Finance and PPPs A Legal Guide to Key Growth Markets (Wolters Kluwer Law & Business, Kluwer Law International, The Netherlands)      

[1] MacDOUGALL, Bruce, Canadian Personal Property Security Law (LexisNexis Canada Inc, Ontario, 2014) pp 307-308.

[2] WOOD, Philip R., “Project Finance, Securitisation, Subordinated Debt” The Law and Practice of International Finance Series (2nd Edition) Vol 5 (Thompson Sweet Maxwell, London, 2007) p 36.

[3] McKNIGHT, Andrew, The Law of International Finance (Oxford University Press, Oxford, 2008) p 883.

[4] Ibid p 884.

[5] WOOD p 36; DEWAR, John, International Project Finance (Law and Practice) 2nd Edition (Oxford University Press, Oxford, 2015) p 63.

[6] McKNIGHT p 882.

[7] Ibid p 884.

[8] WOOD p 3

[9] Ibid pp 3-4.

[10] Ibid pp 4-5.

[11] McKNIGHT p 882.

[12] McKNIGHT pp 886-887.

[13] British Eagle International Airlines Ltd v Cie Nationale Air France [1975] 1 WLR 758.

[14] McKNIGHT p 887.

[15] Re SSSL Realisation Ltd [2004] EWHC 1760 (Ch), 2005 1 BCLC 1 (Lloyd), upheld 2006 EWCA Civ 7, [2006] CH 610 retrieved from McKNIGHT p 887.

[16] MacDOUGALL p 305.

[17] McKNIGHT p 882.

[18] WOOD p 214, MacDOUGALL p 305.

[19] WOOD p 215.

[20] McKNIGHT p 882.

[21] WOOD pp 215-216.

[22] McKNIGHT p 884.

[23] Re Turcan (1888) 40 CH D 5; Glegg v Bromley [1912] 3 KB 474; Russel & Co Ltd v Austin Fryers (1909) 25 TLR 414; The Litison Pride [1985] 1 Lloyds Rep 437 retrieved from WOOD p 194.

[24] Searle v Mechanics Loan & Trust Co 249 Fed 942 (9th Cir 1918); Re George P Schinzel & Son 16 F 2d 289 (SDNY 1926); Bank of America v Engleman 101 Ca App 2d 390, 225 P2d 597 (1950) retrieved from WOOD p 194.

[25] Re-Handy-Andy Community Stores 2 F Supp 97 (WD La 1932), Re Itemlab, Inc 197 F Supp 194 (EDNY 1961) retrieved from WOOD p 194.

[26] McKNIGHT p 884.

[27] WOOD pp 185, 193.

[28] McKNIGHT pp 884-885.

[29] Re British and Commonwealth Holdings Plc. [1992] 1 WLR 672.

[30] WOOD p 185.

[31] Ibid p 186.

[32] Ibid p 200.

[33] McKNIGHT p 889.

[34] MacDOUGALL p 309.

[35] McKNIGHT p 885.

[36] Re Maxwell Communications Corp Plc [1993] 1 WLR 1402.

[37] McKNIGHT p 885.

[38] Ibid p 886.

[39] WOOD p 187.

[40] Ibid p 883.

[41] WOOD p 37.

[42] McKNIGHT p 883.

[43] Ibid pp 885-886; DEWOR p 63.

[44] WOOD p 37.

[45] Retrieved from https://www.bstdb.org/our-projects/country-profile/turkey

[46] Jeffrey Delmon and Victoria Rigby Delmon (eds), International Project Finance and PPPs A Legal Guide to Key Growth Markets (Wolters Kluwer Law & Business, Kluwer Law International, The Netherlands) 

[47] Turkish Code of Obligations Law No 6098; dated 11 November 2011.

[48] Sera Somay, ‘Turkey’ in Azadeh Nassiri (ed), Lending and Secured Finance Review (Fourth Edition, Law Business Research, London, 2018) p 282.

[49] Ibid 74 p 280.

[50] DEWOR p 63.

[51] Ibid; WOOD p 183.

[52] WOOD p 184.

[53] Ibid; McKNIGHT p 883.

[54] WOOD p 184.

[55] Ibid.

[56] WOOD p 185.

[57] WOOD, Philip R, The Law of Subordinated Debt (Sweet & Maxwell, London, 1990) pp 143-147 contributed by Theodoros B. Karatzas p 143.

[58] KARATZAS pp 146-147.

[59] WOOD, Philip R, The Law of Subordinated Debt (Sweet & Maxwell, London, 1990) pp 147-151 contributed by Disiano Preite p 147.

[60] WOOD, Philip R, The Law of Subordinated Debt (Sweet & Maxwell, London, 1990) pp 156-161 contributed by Janine Biver p 157.

[61] Superior Court of Justice 18 June 1909 Lux. 22 January 1909 PAS 8, 22 retrieved from BIVER in Wood p 157.

[62] BIVER pp 157-158.

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