Understanding Structural Subordination and Its Impact on Debt

Structural subordination can have a significant impact on debt, particularly in the context of corporate finance. It's a complex concept that affects how debt is treated in the event of a company's bankruptcy or reorganization.

In a structurally subordinated debt, the debt is given a lower priority in the event of bankruptcy, meaning it will be paid out after other debts have been settled. This can lead to significant losses for investors who hold this type of debt.

For example, in the case of a company with both senior and junior debt, the senior debt will typically be paid out in full before the junior debt is even considered. This can result in a significant loss for junior debt holders.

The impact of structural subordination on debt can be far-reaching, affecting not only investors but also the overall stability of the financial system.

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Subordination is a crucial concept in understanding structural subordination. It determines the order in which subsidiary-level claims are repaid relative to claims held at the parent (or holding) company level of the operating subsidiary.

Subordination essentially means that some claims have a lower priority than others when it comes to repayment. This is often the case in complex corporate structures.

Subordination can be classified based on the type of debt, such as secured or unsecured debt. However, this is not specified in the article.

In a typical corporate structure, claims at the parent company level are often given priority over subsidiary-level claims. This is because the parent company is typically responsible for the subsidiary's debts.

Subordination can lead to capital structure complexities, such as upstream guarantees. These are guarantees provided by the parent company to the subsidiary, which can affect the repayment order.

In a common HoldCo / OpCo structure, the parent company (HoldCo) may provide guarantees to the subsidiary (OpCo). This can lead to subordination issues, as the subsidiary's claims may be repaid after the parent company's claims.

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In corporate restructuring, a ranking system called the priority of claims waterfall is used to determine which creditors get paid first. This system is essential in ensuring that creditors receive their due amount.

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The ranking system can get complicated if a company has a parent or holding company with equity ownership. This is where the concept of structural subordination comes into play.

Structural subordination states that subsidiary-level creditors have the first claim to the assets belonging to the subsidiary. This means that creditors to the parent or holding company will not have access to the subsidiary's assets until the subsidiary's creditors have first received full recovery.

Capital Structure and Guarantees can be complex, but let's break it down. Generally, debt obligations at a holding company level are structurally subordinated to the debt claims at the subsidiary level. However, legal provisions in loan agreements can impact the priority of creditors.

A key factor in determining structural subordination is the seniority of an upstream guarantee by a subsidiary. This guarantee can provide structural subordination of senior debt at the holding company level, allowing claims to be treated with the same priority. In fact, an upstream guarantee from a subsidiary can be subordinated to the senior debt of the subsidiary, but still result in the senior debt at the holding company level being treated as "pari passu" with the subordinated debt to the subsidiary.

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To avoid structural subordination, banks can use subsidiary guarantees. These guarantees represent a direct debt claim against the subsidiary, ranking equally with other similar obligations. By limiting the amount of debt that subsidiaries can incur, banks can also limit the amount that could rank effectively ahead of the parent's claims.

Upstream Guarantees can provide a level of security for lenders by structurally subordinating senior debt at a holding company level.

An upstream guarantee from a subsidiary can make the senior debt of the holding company "pari passu" with the subordinated debt of the subsidiary.

This means that the senior debt at the holding company level is treated with the same priority as the subordinated debt at the subsidiary level.

In Scenario 2, the structural subordination can make the senior debt of the HoldCo "pari passu" with the subordinated debt of the subsidiary.

However, in Scenario 1, an upstream guarantee from a subsidiary is subordinated to the senior debt of the subsidiary and does not result in the subordination of the senior debt at the holding company level.

The seniority of an upstream guarantee is the determinant of the structural subordination of senior debt at the holding company level.

Here are some key points to consider when evaluating upstream guarantees:

In a HoldCo / OpCo structure, the operating subsidiary has assets worth $600,000 and debt in the form of unsecured subordinated notes of $400,000. This means the subsidiary's creditors have a claim against its assets, but the holding company's creditors have an equity claim as the owner of the subsidiary's common stock.

The holding company's creditors rank behind the subsidiary's creditors, so if the subsidiary has unsecured subordinated notes of $400,000, the holding company's creditors won't be repaid until those claims are addressed. The holding company's residual equity is $200,000, which it would have a claim on through its $400,000 in debt.

In this case, the holding company would only receive 50% recovery on its debt, since there is a shortage of $200,000. This highlights the importance of considering the corporate structure when evaluating capital structure and guarantees.

Here's a breakdown of the key numbers:

Collateral subordination can effectively rank debt ahead of bonds or unsecured senior debt. This is often achieved through the use of collateral, such as a company's assets, to secure payment on debt outstanding under credit facilities.

Revolving credit facilities are typically viewed as higher cost by banks, who must reserve capital in case they're drawn. As a result, these facilities have more lender-friendly terms, including collateral from the borrower to secure payment.

In some cases, a junior debt might have a lien on the corporate assets, effectively ranking it higher than senior debt in the liquidation process.

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Collateral subordination is a way for debt to be ranked ahead of bonds or unsecured senior debt. This is often done by using collateral to secure payment on debt outstanding under credit facilities.

Banks view revolving credit facilities as higher cost because they don't know when or whether these credit lines will be used. As a result, revolving facilities have lender-friendly terms, including the benefit of collateral from the borrower to secure payment.

Certain types of facilities, such as asset-based loans, are secured by specific short-term assets, like inventory and accounts receivable. This means that junior debt might have liens to corporate assets and effectively be higher in rank than senior debt in the liquidation process.

To prevent this, senior debt often contains restrictive covenants that limit the issuer's ability to secure debt or other obligations ahead of the bonds. These covenants, known as negative pledges, require the issuer to provide an equal lien to secure the bonds.

Typically, credit agreements prohibit all liens other than those that are specific to the credit line that financed the asset with the lien. For example, operating leases are usually allowed.

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Real estate investment finance commonly uses a senior/mezzanine structure, where each obligor is increasingly removed from the properties. This means that the senior loan is advanced to the property-owning companies, while the mezzanine loan is advanced to their holding company.

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In this structure, the mezzanine debt is both structurally and contractually subordinated to the senior debt. The holding company (HoldCo) of the property-owning SPV (the PropCo) is the borrower of the mezzanine debt.

The senior loan is advanced to the property-owning companies (PropCos) as "Borrowers" and the mezzanine loan is advanced to their holding company (HoldCo) as the "Company" pursuant to a separate loan facility agreement.

HoldCo has recourse only to the shares in its subsidiaries (PropCos) and a residual claim to their assets ("Properties") after all Company creditors. In the event additional finance is provided to HoldCo, it is subordinate to the claims of the senior lenders.

Lenders have the full recourse and cross-collateralized guarantee of the shareholder of HoldCo, HoldCo and each PropCo. Security over subordinated debt is taken to facilitate the sale of the shareholder’s shares on enforcement against an obligor.

In Scotland, a "Standard Security" and an "Assignation of Rent" (Scots-law security documents) may also be of relevance.

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TLAC-Eligible Debt Securities are a type of bank debt that's eligible to be counted towards a bank's Total Loss-Absorbing Capacity (TLAC). TLAC-eligible debt securities have a specific structure that makes them more resilient in times of financial distress.

AT1s and tier 2 debt incorporate strict loss absorption language, meaning they have to be written off or converted into common equity when a trigger event occurs. This trigger event can happen when a bank's common equity tier 1 ratio falls below a certain level.

Senior TLAC bonds, on the other hand, do not have this loss absorption language. They only become at risk in an extreme scenario where a bank faces huge losses and is unviable even after its equities and AT1 bonds have absorbed losses.

Banks can skip coupon payments on their AT1 bonds without any penalty, and these bonds are perpetual – they have no fixed maturity date. This means investors in AT1 bonds accept the risk of incurring losses if the issuer faces extreme financial distress.

Senior TLAC bonds, by contrast, cannot skip coupon payments and mature at a set date. They must also have at least a year of residual maturity to be considered TLAC-eligible.

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Structural subordination can be a major concern for lenders, especially when dealing with complex corporate structures. It's essential to understand how it works and how to avoid it.

A single-currency fixed-term senior loan facility agreement is commonly used in real estate investment finance, where each obligor is increasingly removed from the properties. This can lead to structural subordination, where the lender is subordinated to any future creditors of the subsidiary.

To avoid structural subordination, banks should ensure they lend to the corporate entity that generates the cash and holds the asset, rather than lending to a subsidiary. This is because cash flow can be diverted pre-bankruptcy to outside entities, making it difficult for the lender to recover their investment.

In a common practice, banks lend to a subsidiary (LLC B 1) with corporate guarantees from the parent company (Corp A, Corp B, and Corp C). However, this structure provides minimal support for the credit, as cash flow can be diverted, support can be judgment-proofed, and the net worth of the guarantors cannot be maintained without a negative pledge on assets.

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Here are some key factors to consider when avoiding structural subordination:

By following these guidelines, banks can reduce the risk of structural subordination and ensure a more secure investment.