6.3 Loan-based Mezzanine Instruments 295term or long-term financing. Lenders usually require covenants (for covenants, see
Volume II).^43
The lender is remunerated in three ways: by means of fixed payments, variable
payments, and a kicker. Higher risk normally means an above-average interest
rate. There can be a combination of regular interest payments and interest payable
upon the maturity of the loan. A subordinated loan can have a variable or fixed in-
terest rate, and a combination of profit-related and profit-unrelated interest (equity
kicker).^44
In Germany, a subordinated loan is legally a normal loan under the German Civil Code
(BGB).^45 In principle, the above-average interest rate payable for subordinated loans could
be regarded as unethical (“sittenwidrig” under § 138 BGB). In practice, however, this is
unlikely because of the substantial risk to which the mezzanine lender is exposed.^46
Reasons to use contractual subordination. Subordination may be useful in a num-
ber of circumstances.
Subordination of debts enables a bank to increase its capital base for regulatory
purposes. Subordinated debts can be categorised as supplementary capital (Tier 2
or Tier 3) under the Basel II framework.^47.
According to Finch, the most important reasons to use subordinated loans in-
clude the following: “to allow shareholders or directors to inject funds into a com-
pany where existing creditors will not allow further unsubordinated borrowings; to
allow parent companies to enhance the credit of a subsidiary that is issuing securi-
ties (so that an appropriate rating for the securities will be obtained); to allow
companies to appeal to investors who seek high incomes in return for higher risk
bearing; and to allow a bank to issue funds for treatment as capital for capital ade-
quacy purposes”.^48
Bilateral contract. There is no one way to subordinate claims. Subordination
requires a contract. Where the debtor and a mezzanine lender agree on the subor-
dination of a debt, that agreement is binding between those two parties. However,
it would not necessarily confer any rights on other lenders (senior lenders), and
senior lenders prefer subordination agreements that they can enforce themselves.
Intercreditor agreement. To put senior lenders in such a position, it is necessary
for mezzanine lenders to give covenants directly in favour of the senior lenders.
This can be achieved either by the senior lenders themselves being a party to the
mezzanine debt documents, which is fairly rare, or by the senior lenders and the
mezzanine lenders being a party to an intercreditor agreement, regulating the en-
(^43) Wiehe H, Jordans R, Roser E, Mezzanine Finance Structures under German Law, JIBLR
22(4) (2007) p 219.
(^44) Ibid, p 219.
(^45) § 488 BGB.
(^46) Wiehe H, Jordans R, Roser E, op cit, pp 219.
(^47) Paragraph 49(iv) of the Basel II Accord.
(^48) Finch V, Corporate Insolvency Law. Cam U P, Cambridge (2002) p 444, citing Ferran
E, Recent Developments in Unsecured Debt Subordination. In: Rider (ed), The Realm of
Company Law. Kluwer, London (1998) pp 199–215 at p 201.