Instructions: Look at the explanations provided for each answer--whether correct or not--to make sure you understand all aspects of the question and its implication. You can learn a lot from the explanations of the wrong answers.
The Consolidated Howell Companies
Big Bank NA is contemplating a US $1 million unsecured loan to a single company in the Howell Group, a conglomerate that manufactures pleasure boats, manages a cruise line and sells widgets. Due diligence on the Howell Group to date reveals the following information. The parent company is Thurston Howell Company, a Delaware corporation ("THC"). It has issued and outstanding 100 shares of common stock, representing all the capital stock of THC. THC shares are owned by Gilligan, Skipper, Ginger, Mary Ann and Professor, 20 shares each. THC owns 100 shares of common stock of Mrs. Howell Inc, a Delaware corporation ("MHI"). The summary consolidated financial statements of the Howell Companies disclose assets with a book value of US $3 million, long-term debt of US $1 million and short-term liabilities of US $500,000.
Assume you are the chief credit officer for Big Bank. Would you prefer to lend money to Thurston Howell Company or Mrs. Howell Inc?
Thurston Howell Company because it owns the shares of Mrs. Howell Inc, a potentially valuable asset.
Mrs. Howell Inc because Mrs. Howell is the brains behind the Howell family fortune (and good management should be important to a creditor).
Loan half the money to Thurston Howell Company and half the money to Mrs. Howell Inc in order to balance out the risk.
Mrs. Howell Inc because a claim against assets of a subsidiary is a direct claim.
More due diligence must be conducted on the Howell family of companies to make an informed lending decision.
Assume that THC is a pure holding company (i.e. its only assets are shares of stock). You know that THC borrowed the outstanding long-term debt. A Big Bank NA loan to MHI will be supported by assets valued at what minimum dollar amount?
Assets with a market value of US$3 million.
Assets with a market value of US$2.5 million.
Assets with a book value of US$1.5 million.
Assets with a book value of US$3 million.
Assets with a book value of US$2.5 million.
Assume that: (i) the existing US$1 million long-term debt is the sole obligation of THC, (ii) the short-term debt is the sole obligation of MHI and (iii) THC is a pure holding company. Identify the priority of claims if the new loan from Big Bank is made to THC.
The debt of Big Bank is senior to the short-term debt.
The debt of Big Bank is senior to the existing long-term debt.
The short-term debt is senior to the existing long-term debt and pari passu with the debt of Big Bank.
All the debt is pari passu because on the facts as stated THC must have contributed the proceeds of the long-term debt to MHI (which contribution creates a basis for substantive consolidation).
The existing long term debt and the new debt from Big Bank are pari passu, with the short-term debt being senior to both.
Assume that: (i) the existing US$1 million long-term debt is the sole obligation of THC, (ii) the short-term debt is the sole obligation of MHI and (iii) THC is a pure holding company. Identify the priority of claims if the new loan from Big Bank is made to MHI.
The debt of Big Bank is senior to the short-term debt.
The debt of Big Bank is senior to the existing long-term debt.
The short-term debt is senior to the existing long-term debt and pari passu with the debt of Big Bank.
All the debt is pari passu because on the facts as stated THC must have contributed the proceeds of the long-term debt to MHI (which contribution creates a basis for substantive consolidation).
The existing long term debt and the new debt from Big Bank are pari passu, with the short-term debt being senior to both.
What would happen to the different priority structures you identified in questions 3 and 4 above if THC caused MHI to be merged with and into it, with THC as the surviving corporation? With MHI as the surviving corporation?
Regardless of whether THC or MHI were the surviving corporation, any priority structures which relied solely on corporate form would be destroyed--with all the debt ranking pari passu (except to the extent that one class had the benefit of a security interest).
If THC were the surviving corporation, debt incurred at THC would be senior to debt incurred at MHI.
If MHI were the surviving corporation, debt incurred at MHI would be senior to debt incurred at THC
Both anwers B and C are correct.
The merger would eliminate all the liabilities of the company that did not survive the merger.
What would happen to the different priority structures if THC formed two new subsidiaries, keeping MHI to run the cruise line but transferring its widget manufacturing assets to Professor Inc. and its boat manufacturing operations to Skipper Inc.? [How does a lender know the identity of THC's subsidiaries in the first place? How and why does a lender control and monitor the identity of those subsidiaries?]
Any lender who relied on the prior location of those assets in a particular corporate entity (say, in MHI) by advancing funds to that entity would lose priority in those assets. This is one of the reasons why many loan agreements contain covenants against asset transfers.
Any lender who relied on the prior location of those assets in a particular corporate entity (say, in MHI) by advancing funds to that entity would lose priority in those assets. This is one of the reasons why many loan agreements contain covenants against the formation of new subsidiaries without the permission of the lender.
So long as the lender advanced funds to the holding company (i.e. THC) it would not matter that new subsidiaries were created and assets transferred because every member of a consolidated group is liable for parent company debts.
Any subsidiary listed in the loan documentation for the debt is responsible for the debt, so it does not matter so long as subsidiaries were disclosed.
What would happen to the different priority structures if MHI (and, if applicable, the new subsidiaries of Professor Inc. and Skipper Inc.) guaranteed the debt owed to Big Bank (whether Big Bank loaned to THC or MHI)? The other creditors?
The guarantee would function like a security interest, giving Big Bank and any other lender who benefitted from a guarantee a priority claim.
The guarantees, to the extent enforceable, would break down the priorities otherwise created by the existence of separate legal entities.
Any guarantees of this sort would have no impact because they are unenforceable--an upstream guarantee by MHI of debt of THC, like a cross-stream guarantee by Professor Inc. of debt of MHI are clear fraudulent conveyances.
What would happen to the various priority structures if THC merged into another highly leveraged company, Risky Corporation, which had outstanding $10 million in secured debt owed to Vulture Ventures LLC (with Risky Corporation being the surviving entity)?
The debt of THC would become debt of Risky Corporation as the survivor in the merger.
If the security agreement for Vulture Ventures contained an after acquired property clause, the assets formerly owned by THC might become collateral for Vulture Ventures, with Vulture Ventures having priority over an unsecured Big Bank.
Any lender to MHI would be unaffected by the merger because Vulture Ventures would not have a direct claim against the assets of MHI.
What would happen to the various priority structures if THC decided to provide security interests to its other long term debt, with secured guarantees from any and all of its subsidiaries?
If Big Bank remained unsecured, it would become junior debt to the long term debt if Big Bank had loaned funds directly to THC but not if Big Bank had loaned funds directly to MHI.
Big Bank might protect itself by a covenant which provided that it should receive an equal and ratable security interest in any security interest granted in debtor property to another creditor.
Big Bank might protect itself by a covenant known as a "negative pledge".
In light of the foregoing answers to questions in 5, 6, 7, 8 and 9 what sorts of covenant restrictions might you impose on THC and its subsidiaries to protect Big Bank? In what ways would Big Bank feel more protected if its loan to THC/MHI were secured instead of unsecured?
Big Bank would feel more protected with a security interest because changes to corporate structure would be less able to adversely impact its priority. Big Bank would like covenants that enhanced its ability to maintain those security interests.
Big Bank might want a negative pledge clause which prohibited THC, MHI and other entities against which it has a direct claim from granting security interests to other lenders.
If Big Bank is lending to the holding company--THC--it might want to prohibit the incurrence of debt (or, at least, more debt) at the subsidiary level (i.e. at MHI) because the fewer debt claims there are at subsidiaries, the fewer claims that will have priority over Big Bank.
A negative pledge clause could protect Big Bank against its borrower creating a subsidiary, transferring assets to the subsidiary and then incurring debt at the subsidiary level which was senior to Big Bank.
Big Bank, if it wanted to remain initially unsecured, might demand a covenant which required that, if its borrower ever granted another security interest to a third party that it also receive an equal and ratable benefit from that security interest.