Subordination of common securities: Overview, definition, and example
What is subordination of common securities?
Subordination of common securities refers to a legal arrangement in which a particular class of securities, such as bonds or loans, is ranked below another class in terms of repayment priority. In the context of common securities, subordination means that the claims of the subordinated securities will only be paid after higher-ranked securities (senior debt) have been satisfied in the event of liquidation or bankruptcy.
This concept is most commonly used in the context of debt securities, where different classes of debt (e.g., senior debt and subordinated debt) have different levels of priority. Subordination of common securities typically occurs in financing arrangements, mergers, acquisitions, or restructurings where companies issue different tiers of debt, with subordinated debt taking on higher risk in exchange for potentially higher returns.
Why is subordination of common securities important?
Subordination of common securities is important because it clarifies the order of claims in the event that a company faces financial difficulty or bankruptcy. By establishing the priority of debt repayment, it helps investors understand the risks associated with each class of securities and ensures that creditors know where they stand in terms of the potential for repayment.
For issuers, using subordination allows for more flexible capital structures, enabling companies to raise different types of debt under different terms. It can also help in negotiating more favorable terms for senior debt holders, as the higher priority debt holders are given greater assurance of repayment.
For investors, understanding subordination is key to evaluating the risk and potential return on different securities. Subordinated securities may offer higher yields as compensation for the increased risk of repayment in a distressed scenario.
Understanding subordination of common securities through an example
Imagine a company that has issued both senior bonds and subordinated bonds to raise capital. The senior bonds have priority over the subordinated bonds in terms of repayment. If the company goes bankrupt, the holders of the senior bonds will be paid first, while the holders of the subordinated bonds will only receive payment if there are remaining assets after the senior debt has been fully satisfied. In this scenario, the subordinated bonds are considered "lower-ranked" or "junior" securities compared to the senior bonds.
In another example, a company might issue equity to investors but also offer debt instruments, such as subordinated debt securities. If the company experiences financial distress, the subordinated debt holders will be paid only after all senior debt (such as bank loans or senior notes) has been fully repaid. As a result, subordinated debt holders are taking on a higher risk, but they may be compensated with higher interest rates or other attractive terms.
An example of a subordination of common securities clause
Here’s how a subordination of common securities clause might appear in a financing or loan agreement:
“The Subordinated Debt shall be subordinated in right of payment to the Senior Debt. In the event of any liquidation or bankruptcy proceeding, the holders of the Senior Debt shall be entitled to receive full payment before any payments are made to the holders of the Subordinated Debt. The Subordinated Debt shall rank junior to the Senior Debt in all respects, and no payment on the Subordinated Debt shall be made until the Senior Debt has been paid in full.”
Conclusion
The subordination of common securities is a critical concept in finance, establishing the hierarchy of claims in the event of liquidation or bankruptcy. It determines the order in which creditors or investors are paid, with subordinated securities taking a lower priority. While subordinated securities carry higher risk, they often come with higher potential returns. Understanding subordination is important for both issuers and investors, as it helps manage risk and ensures transparency in financial structures, particularly in debt arrangements or complex capital raising scenarios.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.