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Structural Subordination

Guide to Understanding Structural Subordination

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Structural Subordination

Structural Subordination – Classifications of Debt

In corporate restructuring, the distressed company is legally obligated to abide by the ranking system set by the priority of claims waterfall.

However, some complexities can emerge if the company is an operating subsidiary, where a parent company or holding company also has equity ownership.

The concept of structural subordination states that the subsidiary-level creditors have the first claim to the assets belonging to the subsidiary.

Therefore, the 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.

Upstream Guarantees

Capital Structure Complexities

Generally, debt obligations at a holding company level are structurally subordinated to the debt claims at the subsidiary level, irrespective of if the debt at the holding company level is senior debt.

However, there can be legal provisions in place within the contractual loan agreement that can impact the precise methodology by which creditors are paid, e.g. the HoldCo senior debt could be treated as “pari passu” with the subordinated debt to the subsidiary.

Specifically, an upstream senior guarantee by a subsidiary of the holding company can provide structural subordination of the senior debt at the holding company level, allowing the claims to be treated with the same priority.

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

  • 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
  • Scenario 2: The structural subordination can make the senior debt of the HoldCo “pari passu” with the subordinated debt of the subsidiary.

Structural Subordination Example

HoldCo / OpCo Structure

For example, suppose an operating subsidiary has assets worth $600,000 and debt in the form of unsecured subordinated notes of $400,000.

  • Subsidiary Assets = $600,000
  • Subsidiary Unsecured Subordinated Notes = $400,000

The holding company owns the equity of the subsidiary, but there are no assets to its name (and we’ll assume there is no language in their contract that could complicate the ranking of priorities).

  • Subsidiary Unsecured Subordinated Notes = $400,000

If there are unsecured subordinated notes of $400,000 at the parent company level, the subsidiary’s creditors have to be repaid in full (i.e. “made whole”) before those claims are addressed.

From there, the residual equity is $200,000 which the parent company would have a claim on through its $400,000 in debt. Since there is a shortage of $200,000, the parent company in this case does not receive full recovery (100%) and would only receive fifty cents on the dollar.

  • Residual Equity = $200,000
  • Proceeds to Parent = $200,000 (50% of $400,000)
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