Contractual Subordination And Guarantee Outline

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

• Security

• Time

  • 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

• [Covenant]

  • Restrictions on company – if violated, main remedy as bondholder can accelerate (later in time changed to earlier in time)

Subordination

• 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 – senior)

  • 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)

  • 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 creditors

• Structural Subordination

  • creditors of subsidiary get paid ahead of the creditors of the parent company

E.g. XYZ (owe some debts, only own stocks of ABC)

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ABC (wholly owned subsidiary of XYZ, own all assets, owe some debts

• Due 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

  • 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
Question 1

1. 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 payable

• Kahan: Accounts payable - $66.7 m; Seniors - $50 m; Senior Subs - $83.3 m

• Senior 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”

  • (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

  • Recovery: $66.67M

• 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

2. 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

Structural Subordination

• Now assets are held and accounts payable are owed by ABC, operating subsidiary of XYZ

• First figure out liquidation of ABC

  • Only debt, accounts payable, paid in full

  • Remaining $100M given to XYZ as equity holder

• Now figure out liquidation of XYZ

  • $50M to seniors (100%)

  • $50M to senior subs (50%)

  • Nothing to junior subs

• Accounts payable effectively have first crack on ABC assets XYZ Creditors get paid only from remaining assets

• If 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 subsidiaries

• To 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

3. 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 m

• Guarantees 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...

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