How To Avoid Structural Subordination In Commercial Bank Lending

INADVERTENT CREDIT RISK
INADVERTENT CREDIT RISK

Too many banks in the last financial crises fundamentally misunderstood or did not pay attention to structural subordination risk.  We feel that this pattern is partially repeating at some banks today.  Further, most banks overestimate the amount of credit support that can be recognized across corporate entities and individual sponsors, and this leads to misguided lending practices.  We want to explain where banks can buttress their credit underwriting when dealing with more complex corporate structures. 

Beware of the Corporate Veil

 

Our legal framework provides companies with a legal veil, meaning that the acts, liabilities, and assets of a legal entity is separate from their shareholders, directors, and managers.  This framework creates an opportunity for banks to unwittingly lend where assets, cash flow or guarantees do not apply.

 

For our examples, we will use the corporate hierarchy graphic below.   The asset and cash flow are at LLC B 1.

A corporate structure diagram

 

Structural Subordination

Example 1:

The basic form of structural subordination is created if the borrower is Corp B, and the real estate asset is held, and cash flow generated, at LLC B 1.  Even with an upstream guarantee from LLC B 1 to Corp B, the lender will be subordinated to any future, and possibly previous, creditors to LLC B 1.  Some banks will make this loan with strict negative pledge provision on LLC B 1 and frequent monitoring.  We do not see many examples of this structural subordination in the industry, as this is basic credit 101.  Lenders generally want to stay with the corporate entity that generates the cash and holds the asset to secure the loan.  

Example 2:

We have seen a few instances where banks lend to LLC B 1 and where the borrower’s collateral and cash flow support is weak.  Banks mitigate this weakness by looking at global cash flow from Corp A and Corp C.  However, if there is no guarantee or co-borrower arrangement for the loan with Corp A or Corp C, then the bank is structurally subordinated to creditors that deal directly with Corp A and Corp C. 

Example 3:

In a much more common practice, a bank lends to LLC B 1, have corporate guarantees from Corp A, Corp B, and Corp C.  However, there is no negative pledge and no monitoring of financial activity for the three Corps.  This structure provides very minimal support for the credit for the following reasons: First, cash flow can be diverted pre-bankruptcy to outside entities.  Second, support can be judgment proofed.  Third, the net worth of the guarantors cannot be maintained without a negative pledge on assets.  In this case, particularly in times of financial stress, a bank may find themselves quickly structurally subordinated.

Example 4:

We also see examples where banks will lend to LLC B 1 and LLC B 2.  The credit strength of LLC B 2 is superior to the credit strength of LLC B 1.  Banks may cross-collateralize, cross-default and cross-accelerate, but do not include a cross due-on-sale clause in each note.  This mistake is more common than one would suspect where many properties and LLCs are involved, and the structure becomes difficult for portfolio management to track.

Example 5:

This is the most noteworthy example of a structural issue in middle-market lending.  Many bankers have written about this, and it continues to be a much-debated subject.  The lender makes the loan to LLC B 1 which barely meets underwriting standards, but the lender obtains a personal guarantee from Individual A.  Individual A has sufficient cash flow, liquidity, and assets.  We see three main issues in this example.  First, the bank needs to underwrite and assess cash flow, collateral sufficiency and stress test the entire corporate hierarchy.  The same bank needs to, at least annually, perform a review on the entire organizational hierarchy.  For sub-$5mm loans, most banks do not have the resources to perform this task.  The vast majority of credits at community banks fall into this bucket (large enough to be a credit problem but not quite large enough to allocate the resources needed to assess multiple Schedule Ks, financial returns, appraisals, and valuations). 

Second, while Individual A at the inception of the loan had substantial cash flow, liquidity, and assets, individuals typically pursue a living in a single industry with little diversification.  If Individual A is financing a warehouse through LLC B 1, chances are his other holdings in various corporate entities are also warehouses (or other highly correlated assets).  If that real estate category is challenged, that individual’s cash flow, liquidity, and assets are strained across the entire portfolio. The lender has a strong claim against the assets of LLC B 1, but not the other assets.  Third, and this is where the debate gets heated, unlike corporate guarantees, individual guarantees are a different animal.  Individual A has a family, a house, cars, and basic living expenses.  When the economy is strained, Individual A will attempt to preserve cash flow, liquidity, and assets.  A personal guarantor will protect the family first, and corporate assets with equity remaining second.  The keys to LLC B 1 will be the first ones delivered to the bank because that was the weak credit with minimal equity at inception.  Personal guarantees are essential, but they are not a substitute for 10% debt yield.      

Conclusion

There are many ways for banks to unwittingly step into structural subordination issues but these can all be avoided if the borrowing entity demonstrates sound cash flow and collateral coverage. Further, banks should be aware of this issue and create specific training for lenders and credit underwriters in order to both understand when structural subordination occurs and how to mitigate the risk. Finally, banks should obtain a counsel’s opinion more often if any question arises as to the clarity of guarantees or cash flow structure.   

As guarantees become broadly distributed and move up or down the corporate hierarchy, structural subordination, especially with personal guarantors, becomes a significant credit issue and could be terminal for some banks in the next downturn.