Subordination agreement: Overview, definition, and example
What is a subordination agreement?
A subordination agreement is a legal contract in which one party agrees to subordinate (or rank below) another party's rights or claims in terms of priority. In the context of finance, subordination typically refers to the ranking of debts or claims against an entity’s assets in the event of liquidation or bankruptcy. In a subordination agreement, a creditor agrees that their debt will be paid after the more senior debts are satisfied. This agreement is often used in situations involving multiple creditors, where some creditors are willing to accept lower priority to increase the chances of financing or to make a deal more attractive to other parties.
For example, a secondary lender might agree to a subordination agreement that places their loan behind a senior loan, meaning the senior loan will be repaid first in case of default.
Why is a subordination agreement important?
A subordination agreement is important because it helps clarify the order in which debts or claims will be settled, reducing the potential for disputes in the event of liquidation or bankruptcy. By clearly defining priority, the agreement helps protect the interests of senior creditors and ensures that they will be paid first. For junior creditors, agreeing to subordination may be a necessary condition for securing financing or entering into a business arrangement, as it can allow the more senior creditor to have the security and priority needed to proceed with the transaction.
For businesses, having a subordination agreement in place can facilitate access to additional capital, as lenders are more likely to participate if they know the hierarchy of debt repayment. For investors and creditors, subordination agreements clarify their positions and help manage risk, ensuring they understand their chances of being repaid in the event of financial distress.
Understanding subordination agreement through an example
Imagine a business seeking to borrow additional funds to finance a new project. The business already has an outstanding loan from a bank, which is classified as a senior debt, meaning it takes priority in repayment. To secure a second loan from another lender, the second lender agrees to a subordination agreement, which places their loan in a junior position. In the event of a liquidation or default, the second lender will be repaid only after the bank’s senior loan has been fully satisfied.
In another case, a real estate developer is seeking funding from multiple investors for a property development project. The developer agrees to a subordination agreement, whereby one investor’s loan is subordinated to the other investor’s loan. If the project faces financial difficulty or bankruptcy, the subordinated investor agrees to wait for the senior investor to be repaid before they receive any repayment on their loan.
An example of a subordination agreement clause
Here’s how a subordination agreement clause might appear in a loan agreement:
“The Borrower agrees that the Debt owed to [Senior Lender] shall take precedence over all other outstanding debts owed to [Secondary Lender], and that in the event of any liquidation, bankruptcy, or financial distress, the Debt owed to [Senior Lender] shall be paid in full before any payments are made to [Secondary Lender]. The [Secondary Lender] agrees to subordinate its claim to the [Senior Lender].”
Conclusion
A subordination agreement is a key tool in financial transactions, establishing the order of priority for debt repayment in case of liquidation or bankruptcy. It allows junior creditors to agree to a lower priority in exchange for other benefits, such as securing financing. By defining the priority of claims, subordination agreements help prevent disputes, facilitate financing arrangements, and provide clarity for businesses, creditors, and investors regarding the repayment hierarchy in challenging financial situations.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.