What Is a Restricted Subsidiary?

By Courtney Spratley
Agreements between a bank and parent corporation includes rules for the new restricted subsidiary.

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In a capital market such as the United States, businesses often purchase other companies to amass a large portfolio. These acquisitions are often financed by loans and indentures between the parent company and a bank. When creating an agreement, these newly purchased companies, called subsidiaries, are subject to several regulations and terms from the bank. A restricted subsidiary must be governed by the parent company by these established rules.

Definition

Subsidiaries in general refer to a company that has more than 50 percent of its voting stock controlled by a parent company. In finance, a restricted subsidiary is a company that is purchased by a parent company through the use of a loan. The parent company is required to perform certain actions to maintain the subsidiary (called a covenant), as well as repay the loan. If not, the subsidiary is subject to be taken by the bank.

Agreements

The loan documents issued by the bank include the "loan agreement, guaranties, collateral documents (such as security agreements and mortgages)" and any other material required for financing the bank loan, according to Practical Law Company. The income generated by the restricted subsidiary counts towards the covenant agreed to by the parent company and the bank. There is typically no limit on the amount of assets and money that can be distributed to the restricted subsidiary by the parent corporation and its other subsidiaries.

Security and Capital Subsidiaries

Securities and capital markets use indentures as a contract between a parent company and the bank. The indenture identifies which restricted subsidiaries must comply with covenants and the terms by which the parent company will repay the debt. Restricted subsidiaries, according to Practical Law Company, are considered "necessary to support repayment of the debt securities." All of the income generated by the restricted subsidiary is counted towards the financial obligations set by covenants and guaranties in the indenture.

Unrestricted Subsidiary

Unrestricted subsidiaries are those that are not governed by a loan agreement or indenture. These types of subsidiaries are not subject to the terms issued by a bank or its parent company. However, the loan agreement or indenture should implicitly state the nature of the relationship between the parent company and unrestricted subsidiary. This includes setting a limit on the amount of funds that can be transferred from a restricted subsidiary into the unrestricted subsidiary, the amount guarantees set by both subsidiaries, and equity calls.

About the Author

Courtney Spratley is a professional writer of instructional articles specializing in social, accounting, technology and government-related topics. She holds a bachelor's degree in government from the University of Texas at Austin and is now pursuing a Master of Public Administration from the University of Houston.

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