Structural subordination versus contractual subordination has become a major issue when structuring the financing of leverage buy-outs in France.

Subordination is typically created in France through inter-creditors contracts or subordination agreements entered into between the borrower and the subordinated investors, and the junior and senior lenders. Structural subordination may however be elected depending on the circumstances.

In contractual subordination schemes, all the acquisition financing is incurred at the level of the entity acquiring the target and the subordination arrangements are usually based on a 'stipulation pour autrui', that is, a third party beneficiary mechanism. Such mechanism provides for the subordination of investors to the junior and the senior lenders and for the subordination of the junior debt to the senior debt. This stipulation pour autrui is accepted by the senior lenders in the senior credit documentation and by the junior lenders in the mezzanine credit documentation (either the mezzanine loan agreement or the terms of the notes when the junior debt is structured as a bond issue), thus rendering it irrevocable.

The main weakness of contractual subordination is that no French court has, so far, validated such type of subordination (even if most legal authors and practitioners consider it valid). The enforceability of subordination in a bankruptcy situation of the borrower may also be problematic. In this case, the priority rights of the senior lenders may be challenged by third party creditors based on the prohibition against 'preference payments' or violation of the principle of 'equality among creditors'. How then to ensure a priority order in the payments to be made to its creditors by the borrower? In most cases, subordination agreements include 'claw back' provisions whereby investors agree for the benefit of the junior and senior lenders and the junior lenders agree for the benefit of the senior lenders that any amount received from the receiver in violation of the priority rights set forth in the subordination agreement must be turned over in accordance with the priority order agreed under the subordination agreement. To our knowledge, the validity of 'claw back' provisions has not yet been challenged before French courts. Given the risks, on the one hand that the borrower becomes insolvent due to a default under the junior debt and, on the other hand, that the borrower may not have sufficient resources to repay the junior lenders after repayment of the senior lenders, and knowing that nobody can ensure the effectiveness of the subordination mechanism which may be agreed, it is not unusual to see negotiations on the subordination arrangements lasting longer than they should.

In structural subordination schemes, the junior debt is located at the level of an entity (Newco), parent company of the acquisition vehicle where the senior debt is located. If Newco is in default under the junior debt, this would normally not affect the solvency of the acquisition vehicle nor the value of the security interest from which the senior lenders benefit on the target assets. The senior lenders are then in a better position to negotiate with the investors the refinancing of the whole transaction or they may enforce their security interest in better conditions. For these reasons, conflicts of interest between junior and senior lenders on structural subordination arrangements may be set aside more easily.

However, structural subordination may not always be chosen in leverage buy-outs. The proceeds of the junior debt still have to flow from Newco to the acquisition vehicle in order to finance the purchase price and Newco needs to receive sufficient dividends from the acquisition entity for the repayment of its debt. In practice, this implies complex arrangements which in turn raise certain difficulties: in buy-outs where on-lending of the proceeds of the junior debt to the acquisition vehicle takes the form of intercompany loans, the loans may be subject to French usury law (ie a legal limitation on the level of interest paid by the acquisition vehicle on the loans). If the junior debt is not at a rate which is compatible with usury rates, it may however be possible to split the on-lending money into a share capital increase and intercompany loans. As the interest calculation basis would then be larger, a loan interest rate in compliance with usury law may be sufficient to provide Newco with the cash necessary to pay the interest on its debt.

The payment of dividends is also subject to several constraints : French joint stock companies may only pay dividends once a year on the basis of the audited and approved financial statements of the previous financial year and sufficient company's profits or distributable reserves, as decided by the majority shareholders. Thus, even if the target group has large distributable reserves, dividends have to flow up to the acquisition vehicle before they could be distributed to Newco. As the acquisition vehicle has structural and considerable indebtedness (ie the senior debt), its yearly net profit may not be sufficient to distribute the amounts of dividends necessary for Newco to service the junior debt.

None of the contractual or structural subordination is systematically preferable to another in all situations. Accordingly, achieving real and effective subordination requires complex debt structuring on a case by case basis.

For further information on this topic please contact Eric Cartier Millon at Gide Loyrette Nouel by telephone (+33 1 40 75 36 61) or by fax (+ 33 1 45 63 45 56) or by e-mail ([email protected]).

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