What is junior security?
A subordinate security is one that has lower priority than other securities in terms of the income or assets of its issuer.
For example, common stocks are a junior security compared to corporate bonds. Therefore, if the issuing company goes bankrupt, the bondholders will be paid before the shareholders.
Key points to remember
- The junior titles have a priority of claim on the assets or the incomes lower than that of the senior titles.
- For example, common stocks are a junior stock while bonds are a senior stock.
- In bankruptcy procedures, the absolute priority rule requires that holders of restricted securities be reimbursed only if all other providers of capital have been reimbursed.
Understanding junior titles
In the event of bankruptcy, all of the company’s stakeholders will try to be reimbursed as much as possible for their investment. However, clear rules are in place that determine the order in which the different types of stakeholders are reimbursed.
At the top of the list are the holders of senior titles. Depending on the capital structure of the company in question, the oldest securities may be bonds, debentures, bank loans, preferred shares or other types of securities. However, in a typical capital structure, bondholders and other lenders are the first to be repaid, while common shareholders are the lowest priority.
This method of ordering the repayment of assets in the event of bankruptcy is known as the principle of absolute priority. It is based on article 1129 (b) (2) of the United States Bankruptcy Code. It is sometimes also called the principle of “preference for liquidation”.
The reason why certain types of securities have priority over others is that not all securities have the same risk-reward profile. For example, corporate bond holders can expect to receive an interest rate of 3.5% in the current market, while shareholders can theoretically get unlimited upside potential and dividend payments. Given the modest returns associated with corporate bonds, bondholders need to be compensated in the form of lower risk. They receive this compensation while being privileged compared to the shareholders in the event of failure of the company.
Real example of junior security
You own a manufacturing company called XYZ Industries. To start your business, you raised $ 1 million from shareholders and took out a $ 500,000 mortgage to buy real estate for your factory. You then obtained a line of credit of $ 500,000 from the bank to finance your working capital needs.
Ten years later, your business has faltered and you are forced into bankruptcy. By examining your balance sheet, you will see that you have reached the maximum of your line of credit and that you have an unpaid balance of $ 350,000 on your mortgage. After liquidating all of your equipment and other assets, you are able to raise a total of $ 900,000.
In this scenario, you must first pay your main creditors, the bank that lent you the mortgage and the line of credit. Therefore, of the $ 900,000 you raised by selling your assets, $ 350,000 would be used to pay off the mortgage and $ 500,000 to pay off the line of credit. The remaining $ 50,000 would be distributed to your investors, who are the last online because they invested in common stocks, which are a junior security.
Although this represents a very bitter loss of 95% for your shareholders, remember that if your business had been successful, there was no upper limit on the return on investment they could have benefited from.