Glossary
Subordination
Subordination is the undertaking by which a creditor agrees to be paid after another creditor, on ordinary payments and in insolvency proceedings.
Definition
Subordination sets the order in which the creditors of the same borrower are paid. It is contractual when a mezzanine lender, a bondholder or a shareholder holding a current account agrees, in an intercreditor agreement, to be paid after the senior debt. It is structural when the debt sits in a holding company whose resources come from subsidiaries that have their own creditors. Contractual subordination combines three mechanisms. The first is payment blockage: interest and fees owed to the junior creditor remain permitted as long as no senior event of default exists, then are suspended, automatically or on notice from the senior lender. A senior payment default triggers a permanent blockage. For another default, such as a financial covenant breach, the blockage lasts a negotiated period, from 90 to 180 days in US mezzanine practice. The second is the turnover obligation: the junior creditor pays over to the senior lender any amount it receives in breach of the agreement. The third is the standstill period, during which the junior creditor takes no action against the borrower. Under French law, article L. 626-30 of the French Commercial Code requires affected parties to disclose to the court-appointed administrator the subordination agreements entered into before the opening of safeguard proceedings, failing which they cannot be relied on in the proceedings. The allocation of creditors into classes respects these agreements.
Worked example
A services group raises €160m of senior debt and €50m of mezzanine debt. The intercreditor agreement permits quarterly payment of mezzanine interest as long as the leverage ratio stays below the agreed threshold. In the third quarter, leverage exceeds the threshold and the senior lenders give notice of a blockage of 150 days. The €1.2m mezzanine coupon accrues during this period and becomes payable again at its end if the senior debt has not been accelerated.
Points to check
- Check which junior payments remain permitted: interest, fees, repayments of shareholder current accounts.
- Negotiate the maximum length of a blockage and the number of blockages allowed over the life of the loan.
- Keep a dated and signed copy of each subordination agreement so that you can disclose it in safeguard proceedings.
- Assess structural subordination if a holding company without guarantees from its subsidiaries carries the debt.
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