What does the distinction between “Restricted” and “Unrestricted” mean?

The Restricted Group refers to entities which are restricted by the covenants of the relevant loan/bond, and typically includes the borrower/issuer and its subsidiaries (often referred to as the Restricted Subsidiaries and, collectively, the Restricted Group).

Conversely, Unrestricted Subsidiaries sit outside of the group for purposes of the financing instrument, akin to third parties in this regard. The bond or loan covenants do not bind Unrestricted Subsidiaries or their assets, and they are free to transact unencumbered. It follows, therefore, that loan/bond covenants limit the Restricted Group’s dealings with Unrestricted Subsidiaries, in much the same way they would limit dealings with any other unaffiliated third parties.

It’s also important to note that given Unrestricted Subsidiaries are treated similar to third parties, any positive (or negative) effects on the group are also excluded. For example, EBITDA, assets or any other value attributable to the Unrestricted Subsidiaries is excluded for purposes of the Restricted Groups financing documentation - specifically when calculating financial ratios, EBITDA/total assets-based baskets and incurrence covenants generally (though the Restricted Group will not have the burden of the debt/liabilities of the Unrestricted Subsidiaries in its ratio calculations either). These are key considerations for a company when determining whether any subsidiaries should be designated as unrestricted (remember, too, that all subsidiaries of an Unrestricted Subsidiary will also be Unrestricted Subsidiaries). Indeed, most HY and leveraged loan deals have no Unrestricted Subsidiaries at the outset (in the bond context, this is specifically disclosed in the offering documentation (see example language here)). To the extent entities are designated as Unrestricted Subsidiaries, any reporting in the future will need to provide relevant financial statements that show Restricted Subsidiaries and Unrestricted Subsidiaries separately.

Why designate subsidiaries as “Unrestricted”?

There are, of course, legitimate and uncontroversial reasons for wanting to designate subsidiaries as unrestricted. It may provide a group with necessary flexibility to operate a specific part of the business on a standalone basis, with the ability to incur and secure its own debt and establish its own dividend policy. For example, a project financing or whole-of-business securitisation structure will require debt and security arrangements, and dividend limitations, at the business unit level that might not otherwise be permitted by the Restricted Group’s financing. By way of another example, certain joint venture investments where the Restricted Group holds a majority stake (rather than a straight 50/50 split) may be easier to structure through an Unrestricted Subsidiary to avoid the JV partner being subject to the Restricted Group’s financing covenants and allow the JV to incur and secure its own debt and set its own dividend limitations.

Problems arise when the designation is used more creatively (i.e., unexpectedly). J.Crew is perhaps the name that immediately comes to mind when investors think of ways in which the Unrestricted Subsidiary designation may be used to transfer value out of the Restricted Group in an unexpected way, but there are plenty of examples beyond the scope of this piece (for a more detailed look at J.Crew and its ilk, see 9fin Educational “J-Screwed” - a quick look at unexpected value leakage).

How do you designate subsidiaries as “Unrestricted”?

Given legitimate reasons companies may have for designating certain subsidiaries as unrestricted, the ability to make the designation is a feature in most HY bonds and leveraged loans. Designating subsidiaries as unrestricted requires that certain conditions are met, most notably that the Unrestricted Subsidiary is appropriately insulated from the Restricted Group, and the Restricted Group has restricted payment and/or investment capacity to make the designation and related asset/value contribution.

There are likely to be various baskets and carve-outs that may be utilised for purposes of the latter condition, not all of which may be obvious. The following are some of the more common permissions that may be relied on:

• Restricted Payments: the RP builder basket (50% CNI builder, or other retained cash/proceeds builder) and any related ‘starter’ basket; General RP basket; and Leverage-based RP basket; and
  
• Permitted Investments: dedicated Unrestricted Subsidiary investment basket; General investment basket; Similar Business investment basket; JV investment basket, Ratio based investment basket.
  

Perhaps the least controversial permissions and baskets are those that may be used for Restricted Payments more generally; the value could in any event be sent out of the Restricted Group directly, by way of cash dividends or other distributions.

Permitted Investments may have greater potential for surprise use, not least because the term “investment” itself implies some retained benefit for the group. A dedicated basket for investments in Unrestricted Subsidiaries is clear enough; but it is worth bearing in mind other investment capacity that is available which, coupled with an inevitably broad definition of the term “Investments”, may be used for investments in Unrestricted Subsidiaries (and otherwise outside of the Restricted Group). Some of these investment permissions are notably more generous than Restricted Payment capacity: for example, a ratio based Permitted Investment basket may be set as much as a turn of leverage higher than the leverage-based RPs basket, or may be by reference to a looser FCCR test, or in either case have a ‘ratio no worse than before’ alternative (clients can see here for an example of a deal where the Permitted Investment leverage test is set a turn higher that than for RPs generally, and has the ‘no worse than’ alternative).

Of course, once assets and other value have been invested in Unrestricted Subsidiaries, they are outside the scope of the Restricted Group’s covenant regulation and may be used by Unrestricted Subsidiaries as they (or the ultimate shareholders) see fit. In addition, there are customary permissions that allow the equity of Unrestricted Subsidiaries to be contributed up to shareholders (e.g. an RP carve-out permitting the distribution, as a dividend or otherwise, of shares of capital stock of Unrestricted Subsidiaries). These provisions, taken together, may provide material capacity for value leakage through Unrestricted Subsidiaries at an earlier point than would otherwise be permitted through Restricted Payment capacity alone.

What about re-designating Unrestricted Subsidiaries as “Restricted”?

Most focus in the market is around the designation of subsidiaries as ‘Unrestricted’, as this is where the value leakage is. However, there may be circumstances where a group has Unrestricted Subsidiaries that it wishes to bring back into the Restricted Group fold. This too is regulated under the relevant loan/bond documentation, and typically requires that the Restricted Group have ratio debt capacity (e.g. 2x FCCR test) for, or the relevant ratio is not worsened as a result of, any debt that will come with the subsidiary being re-designated.

How is this different from the Guarantor and non-Guarantor distinction?

We sometimes encounter confusion around the distinction between non-Guarantors and Unrestricted Subsidiaries. In short, non-Guarantor Restricted Subsidiaries are still part of the Restricted Group and bound by its covenant package, even though they do not provide direct credit support for the bonds or loans (via a guarantee). It follows that regulation of leakage to non-Guarantors from Guarantors is less strictly regulated than leakage out of the Restricted Group entirely; indeed, in HY bonds and loans with HY-style covenant packages leakage within the Restricted Group (including from Guarantors to non-Guarantors) is generally not restricted. But, it is still important to craft covenants so as to mitigate the shifting of value away from the entities providing credit support for a financing. For a detailed discussion around the treatment of Guarantor and non-Guarantor Restricted Subsidiaries, see our 9fin Educational “Restricted Group - not all Subsidiaries are created equal”.

If you need to quickly review the Unrestricted Subsidiary provisions on a particular transaction, what should you look out for? The following is intended to be a short list to help you focus your review on key points.

1. Are there any Unrestricted Subsidiaries day one? If so, consider materiality and rationale and how much future investment should be permitted in them.
   
2. Does the ‘Designation of Unrestricted Subsidiaries’ clause contain typical conditions, including, among others, compliance with the Restricted Payments clause and the requirement that a subsidiary to be designated as an Unrestricted Subsidiary does not hold capital stock or debt or liens on property of any Restricted Group member.
   
3. In addition to RP capacity generally, which Permitted Investment baskets could be used for investments in Unrestricted Subsidiaries (or otherwise outside the Restricted Group)?
   
4. Consider whether certain general purpose PI baskets (e.g., the general basket, similar business basket or ratio-based basket) should expressly limit the amount of such baskets that may be used for investments in Unrestricted Subsidiaries.
   
5. Are there specific assets of particular importance to the Restricted Group that should be more tightly regulated (for example, material IP), especially if those assets fall outside the scope of the security package for the bonds/loans?
   
6. See “J-Screwed” - a quick look at unexpected value leakage for a more detailed list of what to look out for in the context of trapdoors and similar avenues of leakage.

This article was released alongside our 9fin Educational piece entitled "Restricted Group - not all Subsidiaries are created equal (9fin Educational)". IF you would like to read this article, please request a copy here.