A Subordination Agreement is a narrow form of Intercreditor Agreement that focuses on the priority of two or more creditors’ debts and claims concerning a borrower with multiple loans and common security interest. It is also known as a Priority Agreement.
The contract governs the lien position among creditors with the borrower’s security, which is critical when assessing repayment and credit risk. The Agreement helps reduce costs, risks, and inefficiencies when financing is provided to a joint borrower.
In a typical scenario, there are two loans, an existing one and a new one. A new creditor may wish to be the senior lender, but the existing lender must consent to give up (or subordinate) their superior claim over a security interest.
The Agreement thus defines the new senior and subordinated creditors and the priority of the two claims against specific collateral. The agreement remains in force until the senior debt is repaid and settled.
A Subordination Agreement focuses on creditor priorities and security claims, providing legal certainty to creditors when assessing repayment risk.
If a credit event (or default) occurs, a subordination agreement provides a senior lender superior repayment rights than the subordinated lender.
Two types of subordination agreements are: Executory Subordination and Automatic Subordination. These differ in the timing of when priority rights are given and the contractual performance required by the subordinated party.
Purpose of a Subordination Agreement
No matter the purpose of the loans or the security interests involved, lenders must ensure their repayment expectations align with the terms of the loan agreement. Whenever multiple lenders are involved, a subordination agreement ensures the debt ranking and defines which creditor (and debt) has priority over another. This is vital if a credit event occurs, as creditors may experience an unexpected loss if repayment expectations do not align with their legal rights.
For example, the contracted ranking of debt and claims may supersede chronological registrations (i.e., first to file a mortgage interest ahead of another claim against a property). The senior lender is paid first, and their claim is settled before the junior lender is repaid.
An Agreement eliminates the added work to extinguish and replace the existing creditor’s claim and realign legal priority to the new financing structure. It also reduces the possibility of creditor disputes when there are competing claims for repayment, should the borrower’s financial condition deteriorate.
Finally, an agreement declares the company’s capital structure to other interested parties (investors, owners, etc.), such as when a shareholder or other company loans are subordinated to the senior lender.
Types of Subordination Agreements
There are two main types of subordination agreements and they differ by the timing when priority rights are given and the contractual performance required by the subordinated party.
Executory Subordination Agreement
The subordination is contingent on a triggering event or condition. The subordinated party maintains its existing claims but agrees to subordinate its security interest to another succeeding instrument (i.e., in the future). As the main agreement is a promise to subordinate its claim, a contract violation may occur if the party later reneges to execute the entire subordination agreement.
Creditors may use this to manage credit risk when lending against specific interests. It offers flexibility to conduct financing transactions in the future without generating legal work to align priority if a subordination agreement is not agreed to in advance, at least in principle.
Automatic Subordination Agreement
Although the subordination is contingent on a triggering event or condition, the subordinated party has no further control, and they subordinate existing claims immediately to the security interest of another instrument that exists now or in the future. As the main and subordination agreements are executed concurrently, creditors are assured of their instrument. The priority of claims requires no further action of the subordinated party or any other creditor.
An example of automatic subordination is in commercial leases, whereby the landlord’s mortgage liens will supersede the tenant’s claims.
Example of a Subordination Agreement
Subordination of debts is commonplace whenever the borrowers obtain additional financing, and multiple loan agreements are in force.
A standard subordination agreement covers property owners that take a second mortgage against a property. One loan becomes the subordinated debt, and the other becomes (or remains) the senior debt. Senior debt has higher claim priority than junior debt.
The senior lenders will want to be in the first position in the entitlement to receive payments and may only consent to the other loan if a subordination agreement is signed. However, the other creditor may refuse the subordination. Such an impasse may prove challenging for property owners looking for refinancing.
Suppose a company has subordinated debt of $150,000 and a senior debt of $500,000. The asset liquidation value is $550,000, as the company experienced a credit event and went bankrupt. The senior debt will receive full repayment of $500,000, and the remaining $50,000 ($550,000 – $500,000 = $50,000) will be shared among the subordinated creditors. Thus, subordinated debts are riskier, and subordinated lenders require higher interest to compensate for the risk.
Subordination in Practice
Legal counsel drafts subordination agreements to suit the needs of the parties. It is common practice for retail lending, particularly when a mortgage is refinanced and often multiple mortgages and lenders are involved. Thus, subordination agreements in retail lending have standard language most lenders use when jointly financing a borrower and pledged collateral.
Subordination is often customized in corporate finance, with detailed advice from legal counsel. Nevertheless, implications may take time to be apparent.
A particular case is the “priming lien” under debtor-in-possession (DIP) financing, which is a lien against the property that is the same (or perhaps senior) in priority to existing liens.
Example #1 – J Crew
In the case of the US company J Crew, Torys described how the company moved its security interest in trademarks and refinanced against it via another entity. The refinancing effectively subordinated existing lenders claims to the trademark before the move.
Lien subordination in a reorganization may disadvantage certain creditors to the advantage of others. An example involves majority versus minority lenders that are creditors during DIP financing.
As the minority lenders did not participate in the new senior debt, it effectively subordinated to more debt than its original terms with senior lenders. As deconstructed by Chapman, it left the minority lenders in a more precarious position.
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