What is a Subordination Agreement?
A subordination agreement refers to a legal agreement that prioritizes one debt over another for securing repayments from a borrower. The agreement changes the lien position.
A lien is a right allowing one party to possess a property of another party who owns a debt until the debt is dissolved. The debt that’s been given lower claim to assets is called the subordinated debt, and the debt that’s been granted a higher claim to assets is called the senior debt.
The debt repayment preference matters a lot when a borrower either defaults or declares bankruptcy. A subordination agreement recognizes that the entitlement of one party to the loan interest or claim is inferior to another party in case the borrowing party’s assets are liquidated.
Moreover, all creditors are superior to shareholders in the preference for claims in the event of liquidation of a company’s assets. However, loans follow a chronological order in the absence of a subordination clause. It implies that the first recorded deed of trust will be regarded as superior to every deed of trust recorded thereafter.
- A subordination agreement refers to a legal agreement that prioritizes one debt over another for securing repayments from a borrower.
- The subordinated debts sometimes get little or no repayments when the borrowers do not hold sufficient funds to repay the debts.
- Subordination agreements are usually carried out when property owners refinance their first mortgage.
How a Subordination Agreement Works
Subordination of debts is common when the borrowers are trying to acquire additional funds, and additional loan agreements are put in place. Subordination agreements are usually carried out when property owners take a second mortgage on their property. As a result, the second loan becomes the junior debt, and the primary loan becomes the senior debt. Senior debt has higher claim priority over junior debt.
Hence, the primary loan lenders will want to keep the first position in the entitlement to receive debt repayments and will not approve the second loan until a subordination agreement is signed. However, the second creditor may refuse to do so. As a consequence, it may become difficult for property owners to refinance their assets.
Various businesses or individuals approach lending institutions to borrow funds. The creditors receive principle and interest payments as compensation. A creditor may need a subordination agreement for securing his/her payments if the borrower decides to take out a second mortgage in the future.. This ensures the creditors payments have a higher priority and will be paid before the second mortgage.
For example, assume that a company holds a subordinated debt of $150,000, a senior debt of $500,000, and an aggregate asset value of $550,000. Assume the company goes bankrupt and is liquidated. The senior debt will receive full debt repayment $500,000 and the remaining $50,000 ($550,000 – $500,00 = $50,000) will be shared among the subordinated creditors. Thus, subordinated debts are riskier, so creditors will need a higher rate of interest as compensation.
Types of a Subordination Agreement
As per the California Civil Code section 2953.3, all subordination agreements must include the following:
- “SUBORDINATION AGREEMENT” must appear at the top of every agreement.
- The title should be followed by a notice stating that the security interest has become a lower priority than a later or some other security.
The following are the two common types of subordination agreements:
1. Executory Subordination Agreement
In executory subordination agreement, a subordinating party agrees to subordinate his/her interest to the security interest of another succeeding instrument. Such an agreement may become difficult to impose later on since it is only a promise of agreeing in the future.
A contract claim violation can occur if the party refuses to sign the subordination agreement to subordinate his/her security interest.
2. Automatic Subordination Agreement
In the automatic subordination agreement, the execution and recording of both the main and the subordination agreements take place simultaneously. For example, if a trust deed includes the subordination agreement, it will usually be stated in the agreement that the lien of the concerned trust deed, once recorded, will involuntarily be secondary to another trust deed.
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