§ 1–209. Subordinated Obligations.

    An obligation may be issued as subordinated to payment of another obligation of the person obligated, or a creditor may subordinate his right to payment of an obligation by agreement with either the person obligated or another creditor of the person obligated. Such a subordination does not create a security interest as against either the common debtor or a subordinated creditor. This section shall be construed as declaring the law as it existed prior to the enactment of this section and not as modifying it.

Source: New York.

Prior Uniform Statutory Provision: None.

Reason for Change: The drafting history of Article 9 makes it clear that there was no intention to cover agreements by which the rights of one unsecured creditor are subordinated to the rights of another unsecured creditor of a common debtor. Nevertheless, since in insolvency proceedings dividends otherwise payable to a subordinated creditor are turned over to the superior creditor, fears have been expressed that a subordination agreement might be treated as a "security agreement" creating a "security interest" in property of the subordinated creditor, and that inappropriate provisions of Article 9 might be applied. This optional section is intended to allay such fears by making an explicit declaration that a subordination agreement does not of itself create a security interest. Nothing in this section prevents the creation of a security interest in such a case when the parties to the agreement so intend.

Purposes:

    1. Billions of dollars of subordinated debt are held by the public and by institutional investors. Commonly, the subordinated debt is subordinated on issue or acquisition and is evidenced by an investment security or by a negotiable or non-negotiable note. Debt is also sometimes subordinated after it arises, either by agreement between the subordinating creditor and the debtor, by agreement between two creditors of the same debtor, or by agreement of all three parties. The subordinated creditor may be a stockholder or other "insider" interested in the common debtor; the subordinated debt may consist of accounts or other rights to payment not evidenced by any instrument. All such cases are included in the terms "subordinated obligation," "subordination," and "subordinated creditor."

    2. Subordination agreements are enforceable between the parties as contracts; and in the bankruptcy of the common debtor dividends otherwise payable to the subordinated creditor are turned over to the superior creditor. This "turn-over" practice has on occasion been explained in terms of "equitable lien," "equitable assignment," or "constructive trust," but whatever the label the practice is essentially an equitable remedy and does not mean that there is a transaction "intended to create a security interest," a "sale of accounts, contract rights or chattel paper," or a "security interest created by contract," within the meaning of Section 9–102. On the other hand, nothing in this section prevents one creditor from assigning his rights to another creditor of the same debtor in such a way as to create a security interest within Article 9, where the parties so intend.

    3. The last sentence of this section is intended to negate any implication that the section changes the law. It is intended to be declaratory of pre-existing law. Both the history and the text of Article 9 make it clear that it was not intended to cover subordination agreements. The provisions of Section 9–203 for signature by the "debtor" would be entirely unworkable if read to require signature by public holders of subordinated investment securities. The priorities, filing provisions and remedies on default provided by Article 9 would also be largely inappropriate in many situations. The precautionary language of Section 9–316 preserving subordination of priority by agreement between secured parties points to the conclusion that similar arrangements among unsecured lenders are not covered unless otherwise within the scope of the Article.

    4. The enforcement of subordination agreements is largely left to supplementary principles under Section 1–103. If the subordinated debt is evidenced by a certificated security, Section 8–202(a) authorizes enforcement against purchasers on terms stated or referred to on the security certificate. If the fact of subordination is noted on a negotiable instrument, a holder under Sections 3–302 and 3–306 is subject to the term because notice precludes him from taking free of the subordination. Sections 3–302(3)(a), 3–306 and 8–317 severely limit the rights of levying creditors of a subordinated creditor in such cases.

Definitional Cross References:

"Agreement". Section 1–201.

"Creditor". Section 1–201.

"Debtor". Section 9–105.

"Person". Section 1–201.

"Rights". Section 1–201.

"Security interest". Section 1–201.