Most indentures permit an issuer to designate certain of its subsidiaries as "Unrestricted Subsidiaries" which, as a practical matter, leaves those entities outside of the credit to which bondholders look. With the customary high yield covenant package applicable solely to an issuer and its "Restricted Subsidiaries," this Unrestricted Subsidiary designation permits an issuer to operate that subsidiary free of the indenture limitations.
Why is this desirable? This designation typically allows an issuer to pursue - through its designated Unrestricted Subsidiary - joint ventures, project financings or other similar corporate transactions that an issuer may not otherwise be able to pursue by itself or through its Restricted Subsidiaries. The ability to designate certain subsidiaries as "Unrestricted" offers an issuer additional flexibility without, the theory goes, adversely affecting the bondholders' credit.
Unrestricted Subsidiaries Offer Flexibility
Since indenture covenants generally do not apply to an Unrestricted Subsidiary, the indenture treats amounts invested in an Unrestricted Subsidiary as a form of Restricted Payment. The designation of an Unrestricted Subsidiary is, therefore, deemed a Restricted Payment, just like a "dividend" or an investment in a third party. In other words, the indenture treats whatever value may be captured in that Unrestricted Subsidiary as having "escaped" from the system (and being beyond the "credit"). Once a subsidiary has been designated as Unrestricted, and free from the covenants, an issuer may use that subsidiary in ways that are not possible with a Restricted Subsidiary.
When evaluating the creditworthiness of an issuer, an Unrestricted Subsidiary would not typically be considered a part of the credit, since its ability to lever itself or leak cash is, unlike a Restricted Subsidiary, generally not limited. For instance, an Unrestricted Subsidiary does not generally have to satisfy the debt incurrence test in an indenture to incur debt, nor is indebtedness incurred by an Unrestricted Subsidiary included in calculating the issuer's leverage ratio or counted against an issuer's permitted indebtedness baskets.
An issuer may leverage an Unrestricted Subsidiary without limit, subject to complying with certain parameters intended to insulate that subsidiary - from a credit perspective - from the rest of an issuer's system. However, this purported "insulation" of the Unrestricted Subsidiary raises some interesting issues from a bankruptcy perspective. And it is precisely that ability to operate an Unrestricted Subsidiary outside the scope of the covenants that should concern bondholders. If the Unrestricted Subsidiary is highly levered and teeters on bankruptcy, what affect may that have on the issuer and its other subsidiaries?
Establishing Criteria to Reduce Risk
Most indentures contain provisions that seek to minimize the risk of creditors of an Unrestricted Subsidiary having access to the issuer's assets in the event of a bankruptcy or insolvency of the Unrestricted Subsidiary. One of the primary goals in establishing the criteria for an Unrestricted Subsidiary is to reduce the likelihood that creditors of that Unrestricted Subsidiary could argue that they were relying on the credit of the issuer or its other subsidiaries in making their credit decision.
How likely is it that the liabilities of an Unrestricted Subsidiary can be fully insulated and not endanger the overall credit? In general, bankruptcy courts respect the separateness of different corporate entities, even if the entities are related. They will, however, under certain circumstances ignore such separateness and make an affiliated entity responsible for its affiliates' obligations under a doctrine known as "substantive consolidation." A bankruptcy court may substantively consolidate the assets and liabilities of related entities if, among other factors, the companies were operated as "alter egos" or under the domination or control of a common ownership or management, corporate formalities were not observed and/or assets and business functions have been commingled. In addition, in determining whether to order substantive consolidation, bankruptcy courts may consider other factors, such as the existence of intercompany debt or guarantees, or the obligation to provide credit support to another corporation.
Mitigating the Risks of Substantive Consolidation
There are a litany of "bells and whistles" that typically are employed to mitigate the risks of substantive consolidation. Some of these include:
- Neither the issuer nor any Restricted Subsidiary may be liable for any indebtedness of an Unrestricted Subsidiary.
- The Unrestricted Subsidiary is not permitted to guarantee or otherwise provide credit support for the issuer or its Restricted Subsidiaries.
- Any debt incurred by an Unrestricted Subsidiary must be non-recourse to the issuer and its Restricted Subsidiaries.
- Neither the issuer nor any Restricted Subsidiary may have an obligation to subscribe for additional equity of the Unrestricted Subsidiary or to preserve the Unrestricted Subsidiary's financial condition (i.e., there can be no credit support).
- Contracts, and arrangements between the Unrestricted Subsidiary and the issuer or its Restricted Subsidiaries must be on arms'-length terms.
- The Unrestricted Subsidiary should have at least one director and/or executive officer who is not affiliated with the issuer or any Restricted Subsidiary. This is a typical construct for creating a special purpose, bankruptcy-remote vehicle, and furthers the argument that the Unrestricted Subsidiary is independent of the issuer.
While issuers may seek (and need) the financial flexibility offered by designating certain entities as Unrestricted Subsidiaries, it is essential to craft criteria for those designations that are likely to withstand the scrutiny of a bankruptcy proceeding. While allowing an Unrestricted Subsidiary to lever itself may affect the consolidated indebtedness of an entity, and its overall creditworthiness, properly limiting its creditors to the assets of that Unrestricted Subsidiary goes a long way toward mitigating the dangers that may come with this added flexibility.