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02F. #7,8. Contractual Subordination and Guarantee
Contractual Subordination and Guarantee
Kaiser Indenture, Definitions, Section 3.03
Petrohawk Indenture, Section 10.1, 10.7, 10.9, 4.9
Dimensions of Priority (factors that determine how much each creditor get if co. goes bankrupted)
- Contractual seniority
- Structural seniority
If company goes bankrupt, and you get paid 3 months ago if bankruptcy happens afterwards would have gotten more than other creditors
Senior creditor would worry about outflow of $ prior to bankruptcy since they should be paid first
o Restrictions on company - if violated, main remedy as bondholder can accelerate
(later in time changed to earlier in time)
- If company doesn't have enough money to repay everyone, senior creditors would be entitled to subordinated creditor's share to be paid in full (but not more than what senior creditors is owed)
- Affects the relative rights of creditors
- Contractual Subordination
Agreement by one group of creditors (subordinated for benefit of other group -
o The subordinated promise the senior to handover any part of their "pro rata"
distribution if and to the extend necessary to make them repaid in full (but nothing more)
o Compare: guarantees
Note: not agreement between senior and junior creditors but junior creditors agree with the companies to benefit junior
Senior may have other dealings with the company, e.g. no other debt unless junior to them
Junior usually gets a higher interest rate
Economics of Contractual Subordination
From perspective of a subordinated creditor
Better to have fewer senior creditor
Better to have more subordinated creditors
From perspective of a senior creditor
Better to have fewer other senior creditor
Better to have more subordinated creditorsStructural Subordination
creditors of subsidiary get paid ahead of the creditors of the parent company
XYZ (owe some debts, only own stocks of ABC)
ABC (wholly owned subsidiary of XYZ, own all assets, owe some debts 1 02F. #7,8. Contractual Subordination and Guarantee
o oDue to separate legal entity assets of ABC goes to its creditors
XYZ creditors do not get paid out of ABC's assets, only XYZ's assets (stock in
ABC) get paid only after ABC's creditors are paid
Would need to look at financial statements filed with SEC
o But SEC only aims at protecting shareholders (less in bondholders) most financial regulations are designed to assist shareholders
Only consolidated financial statement are filed (integrated debt and assets of ABC
need non-consolidated financial statement, which are generally not filed
Problem Set #7
(a) The junior subordinated notes are subordinated in payment to the senior subordinated notes and the senior notes. The senior subordinated notes are subordinated in payment to the senior notes. In a liquidation of XYZ, how much is paid on account of each liability?
XYZ, Corp. ("XYZ") has $200 million in assets. XYZ has the following liabilities:
1) $50 million in senior notes 2) $100 million in senior subordinated notes 3) $50 million in junior subordinated notes 4) $100 million in accounts payableKahan: Accounts payable - $66.7 m; Seniors - $50 m; Senior Subs - $83.3 mSenior Senior subordinate Junior subordinate [usually only 3 layers]
General principle: all creditors are equal, all receive a pro rata share of the company
First figure out share of recovery for creditors not affected by subordination "accounts payable"
o (4) Accounts payable are not affected by the subordination regime would get pro rata as if there is no subordination 1/3 of the 100M = $66.67M
Pro rata share
$200M assets/ $300M liabilities = 2/3
Then distribute remaining assets in order of priority
Remaining asset: $200M - $66.67M = $133.33M left for the rest
(1) $50M to senior notes
(2) $83.33M goes to senior subordinate
(3) $0 left for junior subordinate-
(b) Same as (a) except that: XYZ's only asset is the stock of ABC Corp. ("ABC"); ABC owns
$200 million in assets; ABC (rather than XYZ) owes $100 million in accounts payable. In a liquidation of ABC and XYZ, how much is paid on account of each liability?Kahan: Accounts payable - $100 m; Seniors - $50 m; Senior Subs - $50 m
- Now assets are held and accounts payable are owed by ABC, operating subsidiary of XYZ
- First figure out liquidation of ABC
o Only debt, accounts payable, paid in full 2 02F. #7,8. Contractual Subordination and Guarantee-
o Remaining $100M given to XYZ as equity holder
Now figure out liquidation of XYZ
o $50M to seniors (100%)
o $50M to senior subs (50%)
o Nothing to junior subs
Accounts payable effectively have first crack on ABC assets XYZ Creditors get paid only from remaining assetsIf a creditor lent money to XZY before it formed a new subsidiary and transferred all assets to
ABC, what can the lender do?
1. Subsidiary guarantees: creditors of company who are in risk of being structurally subordinated
2. Debt must be incurred by XYZ, and ABC cannot incur any financial debt, to limit risk of being subordinated structurally
Note: Prohibit XYZ to put money into subsidiary: but company likes to be able to move money freely between subsidiariesTo ensure company have sufficient assets to pay off
all creditors; or
only myself against other creditors (easier)
creditor can make deal with shareholder to screw other creditors
shareholders wouldn't want to increase the interest rate, but would be willing to give structural seniority
but sometimes creditors have influence over the company
(c) Same as (b) except that (i) the junior subordinate notes are not subordinated to the senior subordinated notes and (ii) the senior notes and the senior subordinated notes are guaranteed by ABC.Kahan: Accounts payable - $80 m; Seniors - $50 m; Senior Subs - $70 mGuarantees can eliminate impact of structural subordination
Problem Set #8 Kaiser Indenture
[Prof: better drafting - use paragraphs, defined terms]
1) Which of the following constitutes Senior Indebtedness of the Company under the Kaiser
Indenture. Which constitute Senior Indebtedness of a Subsidiary?
(a) Company owes Supplier $20 million for raw materials?
(b) Company owes $150 million in notes issued under an indenture. The notes were issued in an exchange offer in exchange for common stock?
(c) ABC, a wholly owned subsidiary of Company, owes $100 million to Bank.
(d) What if the ABC's debt is guaranteed by Company?Definition of Senior Debt 3.03 [01:18:00]
o Important element of subordination
"Indebtedness" means the "obligation for… borrowed money,
evidenced by indentures and notes (including financial debt), all indebtedness of others secured by a Lien 3 02F. #7,8. Contractual Subordination and Guarantee
o(providing collateral for others' debt), preferred stock,
indebtness of others guaranteed…"
2) senior debt
"Senior Indebtedness" means "obligations under credit agreement, and if designated by company, (A) to (E)"
What is rationale
Cannot negotiate with government (tax owed by company), which is senior to all creditors
Banks would always be senior
Bondholders are sometimes senior, and sometime junior
3.03 is a Stop payment provision
When there is a problem with the company senior debtor restricts co. from paying to junior debtors (since senior would have prior claim any money stayed in the company)
Seniority is good only as long as assets are with the company
When company runs into trouble, senior holders want to stop company from making future payments to subordinated holders
Stop payment provisions provide mechanism s.3.03 Default on Senior Indebtedness.
o [Payment Default] "No direct or indirect payments or distribution by or on behalf of the Company on or with respect to the Notes… shall be made if, at the time of such payment or distribution, there exists a default in the payment of all or any portion of any Senior
Indebtedness of the Company… and such payment default… shall not have been cured or waived…"
Payment default for senior debt cannot make any payment until payment default is cured (paid)
"In addition, during the continuance of any other event of default with respect to Specified Senior Debt… no direct or indirect payments or distribution by or on behalf of the Company on or with respect to the Notice may be made… for a period (the Payment
Blockage Period) commencing an
(A) the date of receipts by the trustee of notice of such default or event of default under any Specified Senior Debt…
and ending on the earliest of
(a) 179 days thereafter,
(b) the date which on or as of which (1) such default or event of default has been cured or waived, and
(c) the date on or as of which the Bank Agent or the trustee or other similar representative for the holders of such clause (i) Specified Senior Debt shall have consented in writing to the termination of such
Payment Blockage Period 4
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