Meaning
Contractual arrangement where an internal lender agrees that its debt will be repaid only after the claims of external creditors are satisfied. Implementing intercompany loan subordination provides comfort to banks and bondholders that their claims have priority over the parent company’s own investments. This ranking of debt is a standard requirement for securing external financing for large scale manufacturing projects.
Payment Priority
Ranking of claims during a liquidation determines who gets paid from the remaining assets. When intercompany loan subordination is in effect, the parent company stands at the back of the line. This arrangement ensures that the available cash is first used to pay suppliers and commercial lenders who have no other relationship with the debtor.
Risk Ranking
Assessment of the likelihood of recovery helps external financiers set their interest rates. By accepting intercompany loan subordination, the parent company takes on the first loss if the subsidiary fails. This shift in risk makes the subsidiary a more attractive borrower for banks, as they know their capital is protected by the internal debt buffer.
Lender Agreement
Formalization of the priority rules requires a signed contract between the internal and external creditors. Because intercompany loan subordination is a binding legal promise, it cannot be changed without the consent of the senior lenders. A breach of this agreement can lead to an immediate default and the acceleration of all external debt.
