Tranching of Debt as Legal Construction

This paper addresses a core feature of the debt capital markets in general and securitisation transactions in particular; the creation of debt claims with different ranking and priority (also referred to as “tranching”). The primary purpose of the study is to develop an understanding of the contractual ranking of debt as an enforceable legal construction. It is suggested that a more coherent understanding of tranching could foster (i) greater compatibility of insolvency law with financial regulation; (ii) a reduction in unnecessary transaction costs through further standardisation; and (iii) a more level playing field between jurisdictions and different forms of debt finance. I discuss tranching of debt in securitisations as one of many junctures between EU financial market regulation and the realm of local private law. At the same time, tranching highlights the elusive distinction between contracts that are valid and binding inter partes, and those that purport to affect third parties. These are vast topics, and even more daunting when taken together. The focus on securitisation and tranching therefore offers an opportunity to study fractions of these issues by virtue of the limited context. The paper is organised as follows. After an introduction of the subject matter and theoretical foundations, it investigates the element of tranching by first looking at the term as it emerges in the Securitisation Regulation ((EU) 2017/2402). It then looks at how the ranking of a tranche of debt securities plays into the rules on capital adequacy in a securitisation context. The notions of tranching found in financial regulation do not however include the substantive rules that apply to the creation of an enforceable priority ladder between investors. That task is still left to domestic insolvency, contract, and property law. Moving therefore beyond the definitions and usages of tranching in EU regulatory sources, the paper analyses how tranches of debt with different priority are created in actual transactions. Based on public transaction documents and domestic legal sources from three EU jurisdictions (France, Germany and the Netherlands) and the UK, it analyses the building blocks used to create enforceable contracts on the ranking of debt. This is followed by concluding remarks, including a suggested common approach for evaluating enforceability of an agreed payment waterfall across jurisdictions. By disentangling the elements of public STS transactions that are used to ensure enforceability of an agreed payment order, this study provides a starting point for finding paths in domestic law that allows legal certainty in relation to the ranking of notes.