Paper Summary: High Yield Covenants, Subordination and Related Topics

This paper was prepared by Cahill, Gordon & Reindel LLP for Merrill Lynch.


Limitations on Additional Debt Beyond the typical ratio test, there are several baskets (all of which are given independent effect) and allow incurrence of debt over and above what is allowed by the Ratio Test (however, the debt incurred in this way will counted for future computation of the Ratio Test, which is, of course, an incurrence test rather than a maintenance test). The following baskets are the most common –

  • Bank Credit Facility
  • Refinancing Debt (subject to certain conditions): Care should be taken to ensure that this carevout does not allow the issuer to “double-dip”, which means that it allows the issuer to refinance a category of debt that is permitted by another carveout as well. For example, an issuer can theoretically use the bank carveout to issue high yield debt and still have access to the bank debt carveout.
  • Swap
  • Purchase Money Debt / Capital Leases
  • Misc. Debt

Limitations on Restricted Payment Designation of a subsidiary as an Unrestricted subsidiary is treated as a Restricted Payment in an amount considered equal to the value of the subsidiary.

Limitations on Liens In case of an Unsecured debt, this covenant limits the amount to which the Notes become effectively subordinated to other obligations of the issuer. The covenant will either (a) prohibit liens for benefit of other lenders (sometimes even related to trade payables to avoid possible future structural subordination to trade creditors), or (b) permit them only if the issuer “equally and ratably” secures the notes (called a “negative pledge”).

Transactions with Affiliates This covenant is especially important if the issuer is controlled by one principal stockholder or a related group (e.g. a buyout shop, founder, etc.). The transactions are expected to conducted at arms-length basis. One of the sensitive issues related to this covenant and something that is highly negotiated is the payment of management or financial advisory fees.

Mergers, Consolidations and Sales of Assets The covenant needs to be evaluated in relation to the change of control put, and debt incurrence and asset sale covenants, all of which may be triggered if the merger covenant is triggered.

Limitation on Payment Restrictions Affecting Subsidiaries If a subsidiary has a credit facility, the dividend blocker is carefully examined and is often highly negotiated. The covenants in the Holdco Notes need to be carefully examined to take into account the Restricted Payment tests at the OpCo level.

Change of Control: If there’s no CoC, and IF an issuer wants to repay the notes, it can do a tender combined with a consent solicitation to amend the indenture to eliminate the restrictive covenants. Non-tendered notes would either be defaced or would remain outstanding without the benefit of restrictive covenants.

Defeasance: There are two types of defeasance: (a) legal and (b) covenant. In a legal defeasance the issuer is released from substantially all of its obligations, whereas covenant defeasance is an expensive way to amend or strip certain covenants. Tax laws play a material role in the type of defeasance pursued.

Fall-way or Suspended Covenants: When notes become IG-rated, if the covenants are fall-away, they go away for forever, but if they’re only suspended, the covenants are only suspended, as the name implies. In either case, if and when the covenants spring back, it should not cause a default.


Consolidated Net Income: this is used in three key places–(a) FCC, (b) Leverage Ratio, and (c) RP.

  • this is a highly negotiated definition when one or more subsidiaries of the issuer has outstanding debt with a dividend blocker (e.g. a credit facility). Some indentures allow such subs’ income to be counted despite the dividend blocker.
  • In HoldCo / OpCo deals, the OpCo indenture RP covenants should be looked at carefully to see if it in effect disallows the OpCo net income to be counted against any calculated financial ratios at the HoldCo that may need the OpCo cash.
  • Restricted Income is usually excluded but not subs’ losses.
  • Extraordinary income (losses), which is a GAAP concept is excluded as well.
  • Any gains (but not losses) from asset sales are excluded as usually the indenture permits repayment of the senior debt with proceeds from the sales, hence these gains are not available to increase shareholder payment as that would allow two exits for cash in the system.
  • Discontinued operations are often excluded (to better capture issuer’s future debt service capability), but sometime this may not appear in the CNI and would rather show up as an add-back to the calculation of Consolidated Cash Flow/EBITDA.

Cost Savings: This PF adjustment should be limited to (a) are reasonably believed in good faith by the issuer to have been achievable, (b) were identified and quantified in an officer’s certificate delivered to the trustee at the time of the acquisition/investment, and (c) have been commenced if the acquisition/investment occurred more than 90 days prior to the computation of the Ratio. Under regulation S-X, SEC takes a harder stance against these PF adjustments. Reduced headcount, closure/consolidation of facilities and elimination of redundant costs are rejected as PF adjustments, unless written contracts are available or if the plans are already being implemented.


Equity Claw: Redemption is typically at par plus premium (equal to coupon on the notes, plus accrued and paid interest). Some deals have allowed net cash proceeds from (a) private equity contributions and/or (B) contributions by “Strategic Investors” to be used to fund the equity clawback (these provisions are generally not applicable for a company with public stockholders).


Default Period: Generally there’s a 30-day grace period, however it is not uncommon to have no grace period in case of a breach of a merger covenant, CoC  covenant, or an asset sale covenant.


  • Issuer and bank lenders are generally unwilling to permit the note holders the right to accelerate in the event the issuer fails to comply with the bank covenants, as this would (a) indirectly benefit the bondholders from the maintenance covenants at the bank facility, and (b) would force the issuer to negotiate with two separate sets of parties.
  • Public indentures require 25% of the holders to accelerate
  • Some indentures, esp. subordinated indentures, require that if the notes were accelerated under the cross-acceleration provision, this is automatically rescinded upon the recession of the indebtedness that caused the acceleration to begin with.


CoC and Asset Sale are sometimes considered “money terms” and require unanimous consent for an amendment/waiver vs. a supermajority/majority consent.


There are 4 types of subordination–(a)contractual, (b) structural, (c) effective subordination to secured debt (Limitations of Liens covenant addresses this), and (d) Equitable subordination, which comes in play in bankruptcy courts.

  • Contractual subordination
    • affects only the relative rights of the “junior” and the “senior” creditors
    • any creditor cannot be subordinated to any other obligation, unless expressly agreed to by such creditor.
    • “Senior Debt” typically means the principal, premium (if any), interest (includes post-petition interest), and all charges, fees and expenses in connection with the incurrence of the Senior Debt.
    • Senior Debt excludes trade payables, debt due to subs, tax obligations and other obligations. So, they may or may not be pari passu with the Senior Debt as they need not be subordinated to them.
  • Effect of subordination in a U.S. bankruptcy
    • senior creditors sometimes pay an amount to the junior creditors (likely only the fulcrum security) to avoid lengthy bankruptcy proceedings.
    • if senior bond-holders aren’t paid, the subordinated debt is not paid as well. If there is any other breach, then the senior bondholders need to take action with the so-called blockage period (usually, 180 days) whether to block payments to the junior creditors. Usually one blockage notice is allowed with respect to a particular breach, and one notice in a specified period (usually, one year). BUT, a blockage on the junior creditors allows them to accelerate the maturity of such obligations, which leads to cross-defaults, and which in turn leads to a bankruptcy threat (something that the senior creditors want to avoid, and this serves as an important check on the senior creditors).


Chapter 11 must be approved by 66.67% of the each of the “impaired” classes unless there is something called a “cram-down”. Usually, because the equity holders are given something in the plan (I am not sure why), the subordinated holders usually cannot be crammed down.

Treatment of Interest:

  • Post-petition Interest : creditors are usually not entitled to post petition interest except when (i) the lender is a secured creditor and value of its collateral exceeds the amount of its claim, and (ii) debtor’s estate is solvent and there is surplus left after all the creditors are paid in full (rare).
  • OID : claim can be limited to the accreted value and unmatured interest may not be allowed

Substantiative Consolidation: related corporations are made responsible for each others’ debt only when it is found that company operated as “alter egos”. Fraudulent conveyances between related companies may be an additional factor leading to substantiative consolidation.

Equitable Subordination: This has sometimes been used to prevent stockholders’ claims from competing with those of the general creditors. This also solve the problem of classifying what is made to look like a loan but in fact is a capital contribution (even though this is proper, the fiduciary duty of the lender subjects the transaction to additional scrutiny).


For a corporate issuer, it makes sense to satisfy financing with interest on debt because interest on debt is tax-deductible. But, in certain cases, such as when (a) issuers has significant NOLs, (b) AHYDO rules, or any other limitations, it may make sense for the corporate issuer to receive certain tax benefits associated with dividends, such as (a) dividend received deduction and (b) preferential rate on qualified dividend income.

I have not summarized them here as I don’t think I understand them very well, not having had any experience, but they’re available on page 38 and onward of the document.


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