Financial Innovation of the Day: E*Trade's Springing Lien Notes

Peter Eavis has dug up E*Trade's 8K relating to the Citadel investment, and has discovered something rather weird. Citadel's E*Trade bonds mature in 2017. And it seems that they are pari passu with all the rest of E*Trade's debt until 2011, at which point the 2017 notes become senior to all the other debt.

From the filing, it appears that Citadel's debt has been given seniority over two other debt issues, which are scheduled to mature in 2013 and 2015 -- before Citadel's notes, which mature in 2017.
But the filing indicates that Citadel doesn't get seniority on its debt until notes maturing in 2011 mature in that year or are paid off by the company earlier than 2011. What if E*Trade were to go bankrupt before 2011 -- would the deal allow Citadel's debt to gain seniority over the 2013 and 2105 debt?
No, says a person familiar with the deal. Citadel's debt is on equal standing with the 2011, 2013 and 2015 debt until 2011 or until those 2011 notes are paid back before 2011, this person says.

The name that the 8K gives this rather peculiar structure is a "Springing Lien Note". And of course the legalese is borderline incomprehensible:

The Springing Lien Notes rank equal in right of payment with all of the Company’s existing and future unsubordinated indebtedness, and rank senior in right of payment to all of the Company’s existing and future subordinated indebtedness. The Indenture will require the Company to secure the Springing Lien Notes in the future, up to the maximum amount of indebtedness as would not require any of the Company’s existing senior notes due 2011, 2013 or 2015 becoming secured equally and ratably with the Springing Lien Notes, on the property and assets of the Company and certain of its subsidiaries as set forth in the Indenture. The Company will also be required to cause its restricted subsidiaries to guarantee the notes on the date on which the Company is first required to secure the Springing Lien Notes or on the date on which such restricted subsidiaries guarantee other indebtedness of the Company.

I have a feeling that what's really going on here is that there's some kind of language in the 2011 notes which prevents them from being subordinated by the issuance of new, more-senior debt. Once that obstacle is out of the way, when the 2011 notes mature, the new 2017 notes automatically become secured and therefore senior to all the existing unsecured debt. Or, to put it another way, Citadel's E*Trade bonds are as senior as they could be, short of calling the 2011s immediately.

Why is all this legal arcana germane? Eavis explains:

If Citadel has taken steps to gain an advantage under a bankruptcy, its investment objectives are in no way aligned with investors holding E*Trade stock, who'd be wiped out in a bankruptcy.

Questions about the seniority of debt only become really important in the case of bankruptcy proceedings, when senior debt holders get first dibs on all the company's assets. In this case, it's doubly important because Citadel appears to have paid essentially nothing for its 20% equity stake in E*Trade.

So I'm inclined to disagree with Eavis when he says this:

E*Trade stock has fallen by 29% since the deal was announced, which is a rude awakening for Citadel, because it indicates that investors disagree with Citadel's apparent view that E*Trade can recover.

My feeling is that the fall in the share price merely reflects the degree to which existing shareholders are being diluted by the Citadel deal, as well as the fact that Citadel's bonds are likely to eat up a large amount of the cashflow which shareholders had previously hoped to keep for themselves. The 29% drop looks big, but in fact it represents a fall of only about $500 million in market capitalization – much less than the amount of money Citadel is injecting into E*Trade.

On the other hand, if investors really were confident that Citadel's cash injection was capable of turning E*Trade around, then I do agree with Eavis that one would expect the stock to be trading much higher than it is now. At $4 a share it's trading on a price-to-book ratio of about 0.4, which is indubitably a highly distressed level.