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Using Subordination to Define Intercreditor Priority

The November 2009 issue of The RMA Journal, The Journal of Enterprise Risk Management, includes an article entitled "Using Subordination to Define Intercreditor Priority" by Ron Carleton and Tim Delaney of Financial Training Partners. The RMA Journal is published by the Risk Management Association, a leading organization of professional credit, market, and operational risk managers.

Today, with credit portfolios under growing stress, minimizing losses is more important than ever. "Using Subordination to Define Intercreditor Priority" explains the different types of subordination and how lenders can structure debt to protect themselves in case of a default. For a free copy of the article and more information on

Financial Training Partners, visit www.fintrain.com/publications.

Bondholders Agree to Let Bio-Rad Repay Loans First

Bio-Rad Laboratories Inc. is a life sciences company with sales of over $1.7 billion. In May of 2009, it issued $300 million of 7-year notes in a 144A offering through Credit Suisse. The company refers to the new debt as Senior Subordinated Notes. Does this mean the debt is senior or subordinated? How do we know the intercreditor priority of the notes?

Contractual Subordination

The notes are governed by an indenture, a contract signed by the borrower and by a trustee (in this case, Wells Fargo) who represents the noteholders. In addition to describing the notes and listing various covenants and defaults, the indenture includes a section on subordination. In that section, the noteholders agree that in the event of the borrower's bankruptcy or a payment default on the borrower's senior debt (or certain other events), the borrower will not make any payments on the notes until the default is cured or the senior debt is repaid in full. This arrangement is referred to as contractual subordination (see also our entries on structural subordination and effective subordination).

The Details Matter

The document creating contractual subordination can be a subordination agreement or indenture (as with Bio-Rad, and commonly used for public bonds and 144A issues), or an intercreditor agreement, which is more common with mezzanine finance and other privately placed subordinated debt. The terms of subordination vary from agreement to agreement. For example, the ability of subordinated debtholders to receive payments after a covenant breach in the senior debt can vary, as can the amount and type of allowable senior debt. Finally, the term senior subordinated debt (which is common for high yield bonds) means that the bonds are subordinated to all senior debt (typically bank loans) but it is senior to any junior subordinated debt (typically, mezzanine finance).

Who Issues Subordinated Debt, and Why?

Subordinated debt is more expensive than senior debt, so why would a company issue it? The big issuers of subordinated debt are:

1. Non-investment grade companies, who often need more debt or longer-term debt than the senior market will provide, and
2. Regulated entities, such as banks, insurance companies and electric utilities, who issue subordinated debt instead of equity in order to satisfy their regulatory capital requirements.

Michael Foods Term Loans Avoid Effective Subordination

When Thomas H. Lee Partners purchased Michael Foods in 2003, it financed the deal with a combination of term loans and bonds.  All parties agreed that if there was ever a problem, the term loans would be repaid before the bonds.  In exchange for agreeing to take this higher risk, the bondholders receive a higher return than the term loans.

Contractual Subordination

To ensure the term loans are repaid first, the bond documents include a subordination agreement.  This contract between the bondholders and the borrower says that if the company ever defaults on its debt, it must repay the loans in full before it pays anything to the bondholders.  This arrangement is referred to as contractual subordination: the bonds are called subordinated and the loans are called senior (see also our discussion of structural subordination).  Contractual subordination can also be accomplished via a contract between lenders called an intercreditor agreement.

What's the Problem?

The loans had an original maturity of 6 and 7 years, so they are due in 2009 and 2010.  The company is now looking to refinance these loans with new loans with maturities in 2014 and beyond.  These new loans will still be contractually senior to the original bonds, which don't mature until 2013.  The problem is that the new (senior) loans mature after the (subordinated) bonds.  If all goes as planned, the bonds will now be paid before the loans, defeating the purpose of the subordination agreement.  This situation, where subordinated debt is repaid before senior debt because it matures first,  is referred to as effective subordination (a banker friend of ours calls this "first in time is first in line").

What's the Solution?

Michael Foods will need to refinance the original bonds before they mature in 2013.  The new term loans include an "acceleration feature" that will bring the maturity date of the loans forward if the company can't refinance the bonds.  Thus, the loans will always come due before the bonds, avoiding effective subordination.

I'm Thinking Structural Subordination

Wendy's/Arby's Group, Inc. (ticker WEN) was formed in September 2008 through the merger of the Wendy's and Arby's fast food chains. In March 2009, WEN announced it had redone its main loan agreement to reflect the merger. Nothing unusual there. The surprise is that Wendy's/Arby's Group, Inc. is not a party to the loan agreement. Here' why.

Holdco - Opco Structure

Wendy's/Arby's Group, Inc. is a holding company ("holdco") - it has over 60 direct and indirect subsidiaries that actually own, franchise, or operate the restaurants (the operating companies, or "opcos").

• The opcos have real assets (buildings, inventory, receivables, contracts, etc.) and hopefully generate cash flow from their operations.
• The holdco's assets are stock in the opcos, and the holdco's primary source of cash is dividends from the opcos.

A Quick Lesson on Bankruptcy

Under the absolute priority rule, a bankrupt company must repay its creditors (i.e. lenders, suppliers, employees, etc.) in full before it can distribute any cash to its owners. So, if WEN and its subsidiaries ever went bankrupt, who would be repaid first: lenders to the holdco (i.e. Wendy's/Arby's Group, Inc.) or lenders to the opcos (i.e. the 60 subsidiaries)? Answer: the opcos, since they have the assets and cash flow and must repay their creditors before paying dividends to the holdco.

Structural Subordination

The idea that opco creditors are paid before holdco creditors is referred to as structural subordination. Because of structural subordination:

• Lenders to high risk companies (such as WEN) often prefer to lend to operating subsidiaries rather than to a parent company.
• Loans to holdcos often include a subsidiary debt limitation and upstream guarantees in order to limit the impact of structural subordination.
• The rating agencies typically rate the debt of a holdco lower than the debt of its operating subsidiaries. For example, Standard and Poor's rates Wendy's/Arby's Group, Inc. "B-" but assigned the slightly higher "B" to the loans of its subsidiaries.

See also our entries on contractual subordination and effective subordination.