Subordination

Priority

Where a company has several major financiers, issues arise as to priority of entitlements to repayment.  The general position on a winding-up is that creditors who are unsecured are treated pari passu.  If there is a shortfall in assets, they are paid proportionate to the balance, if any remaining after payment of preferential creditors, secured creditors and the expenses of liquidation.  This sum would commonly be zero, due to expenses of liquidation, secured creditors attaching worthwhile assets and the prevalence of preferential creditors, typically the Revenue Commissioners.

Subordination and priority issues focus mainly on the obligation of parties rather than the underlying security.  Security deals with priority in entitlement to the proceeds in the event of enforcement.  Generally, it does not in itself restrict a lower-ranking security holder from being paid off in a priority to a prior security holder.  Accordingly, if a secured creditor wishes to secure that it is paid first, other than in the context of payment, it must enter a priority or subordination agreement.

Subordination Agreement

If lenders enter an agreement in respect of their respective priority of securities, they will need to provide a mechanism to determine the decisions as to sale.  There can be a serious conflict of interest where one party has priority so that it will be paid substantially or in full, but the subordinated security creditor would wish to postpone the sale to see if the market would arise.

The general principle is that the senior lender is not obliged to wait to see if the market will arise but is obliged to get the best price reasonably obtainable in the current market. The creditors may agree on a mechanism for the valuation of assets and determination of the appropriate point of sale.

Under a subordination agreement, the subordinated creditor may receive interest, but will not generally be entitled to the payments of capital while the senior debt is outstanding.  Where there is a default on the senior debt, there may be a block on repayments of the junior debt or a standstill period.  The mezzanine lender is generally restricted from taking action where there is a default.

The junior lender may be restricted from taking enforcement action for a period.  This may be lesser in terms of default on its own debt.  Equally, there may be restrictions on taking action where there is a breach of covenants for less than certain periods.

The junior lender will be restricted from amending the terms of the loan agreements.  Senior lenders may be restricted from increasing their margin. The same security may be given for both.  New lenders will typically have the prime position in terms of enforcement.

De Facto Subordination

Structural subordination seeks to avoid loans to subsidiaries which may have the effect of undermining loans to the holding company.  Covenants may be placed on subsidiaries.  Alternatively, guarantees may be taken from subsidiaries to try to limit the risk that monies will be lent from the holding company down to a subsidiary and then be captured by a third-party lender or other creditors.

Negative pledge covenant seeks to prevent the creation of later security with priority over the lender.  It may be employed in unsecured lending.  In secured lending, issues may arise in terms of later security, typically granted to finance a particular acquisition.  The lender will seek to have the right to consent to the creation of such security.

Difficult issues of priorities arise where assets are financed by a secured lender where there are earlier fixed and floating charges.