subordinated debts is one of the ways that a company can reduce its senior liabilities and bolstar its capital base , thus giving senior creditors an additional cushion of protection in liquidation the following diagrams indicate the effect of subordinated debt on the balance sheet
the addition OF Subordinated debt improves true Working Capital and provides the firm a broadened Equity base with commensurate increased debt capacity .this could induce the bank to lend whrere otherwise it might not have ,or to lend unsecured where it might otherwise have required security .
DEFINITION
A subordination agreement is a leagel instruments by wich specific creditors or class of creditors agrees to ajunior or subordinated position with respect a particular lender ot to all other senior creditors for the purpose of ranking creditors cliams .the subordination agreement ensures that in liquidation senior debt will be paid in full before payments can be made on subordinated debt .the party whose claims are given priority over the claims of sbordinated creditors in the agreement is known as the beneficiary the party that agrees to take a subordinate position is known as the subordinator
TYPES OF SUBODINATIONS
there are two types of the subordination agreements
- complete
- inchoate
compelete subordination a complete subordination agreement is usually a two party agreement drawn up in favour of one creditor with respect to another creditor or class of creditors . atypical complete subordination agreement is one between the bank as the benificiary and other creditor (or class of creditors ) of the corporate borrower who agrees to a subordinate position with regard to the bank . creditors most likely to be subordinators in a completet subordination agreement are interested parties , such as stockholders .parent and subsidiary companies , and directors or owner managers who have loaned funds to the company .indeed ,subordination of intercompany debts or payables by subsidiary firms in order to attract or retain bank debts is quite common ,although the exact provisions of the arrangements may vary ,of course .the key features of a complete subordination are:
- ongoing concern basis ,the subordinator agrees to accept no payment of princible or interest on the subordinated debt while the corporate borrower has debt outstanding to the beneficiary .sometimes ,rather than prohibting payments entirely ,the subordination agreement will allow for the payment of interest to the suboredinated debt holder or payment of the subordinated debt up to a specified limited amount
- in bankrubtcy or liquidation ,the subordinator agrees that all payments or proceeds from liquidation that would otherwise have been paid to yhe subordinated debt holders must be paid over directely to the holder of the senior debt of the beneficiary in the subordination agreement .the beneficiary ,threrefore,will recieve thier own share of the proceeds ,plus the pro-rata share that would normaly go the subordinator .the beneficiary cannot ,however recieve more than his original claim .
NOTE that in a complete subordination
1-those creditors who are not signatories to the subordination agreement are not affected and will recieve the same pro rata share regardless of the subordination agreement in effect between the praticular subordinator creditor and the bank
2-the excess of the subordinator creditor's pro-rata share of the liquidation proceeds that remains after the bank loan has been fully satisfied is not distributed to other creditors that goes to the subordinated creditors
complete subordination of debt has two broad effects that can improve the safty of the loan
1-the cash flow improves since complete subordination reduces cash drain for interest and principal amortization on the subordinated debt ,thus improving probability of loan repayment on a going concern basis
2- asset protection improves since the beneficiary has the right to the share of subordinator .thereby improving the chance of payout in liquidation .
bank from legal 45 is the document used to effect complete subordination (please refer to the documents manual for a specimen copy ).legal 45 is atwo party agreement between (the beneficiary )and the subordinator >the corporate borrower also signs the agreement as acknowledgement .the major provisions of the agreement are :
- no payment of princibles or interest may be paid on the subordinated debt untill all of the borrowers indebtedenss to beneficiary has been satisfied
- the subordinating creditors will not assign or transfer claims to other parties
- the subordinating creditors pro rata share in liquidation goes to bank (up to the amount of the bank claim )
- breach of the subordination agreement will put bank's loan to the borrower in default
INCHOATE SUBORDINATION
in an inchoate subordination , one creditor or class of creditors assumes a subordinate position with regard to all other corporate borrower .inchoate subordination is afeature of various public bond or private placement issues (ie subordinated debentures )
an inchoate subordination is a contingint subordination ; that is the subordination does not become operative until a voluntary or involuntary distribiuton of assets of the debtors is made to its creditors .the specific event that triggers the subordination such as bankrubtcy or insolvency will be specified in the agreement .until such financial distress occurs,the subordinated debt may be amortized ,payments may be made to a sinking fund ,or the subordinated debt may be redeemed or refunded by the debtors through other means in accordance with the terms of the loan agreement .the benefit to the senior creditor is realized only upon liquidation .because junior debt may have amortized by the time insolvency strike the debtors .inchoate subordination is less desirable to the senior creditor than complete subordination
the key features of inchoate subordination are
1- interest and principal amortization payments continue to be made to the subordinated creditors
2- in bankrubtcy or liquidation (or whatever event specified in the agreement that triggers the subordination ),the senior creditors recieve thier own pro-rata share of the proceeds that would otherwise have gone to the subordinated creditors (i.e the pro rata share of the subordinated credsitors is distributed among all senior creditors
