What is a Subordination Agreement

Subordination agreement is a legal agreement which establishes one debt as ranking behind another debt in the priority for collecting repayment from a debtor. The priority of debts is extremely important if the debtor defaults on payments or declares bankruptcy.

BREAKING DOWN Subordination Agreement

When individuals and businesses need to borrow funds, they turn to lending institutions. If the loan is approved, the lender is compensated by receiving interest payments on the loaned amount. However, there are some instances in which the borrower defaults on his payments. To protect its interest, the lender may require a signed document called a subordination agreement.

A subordination agreement is a document that acknowledges that one party’s claim or interest is inferior to that of another party in the event that the borrowing entity goes bankrupt and liquidates its assets. The junior debt is referred to as a subordinated debt, and the debt which has a higher claim to any assets is the senior debt.  Lenders of senior debts which have a higher priority have a legal right to be repaid in full before lenders of subordinated debts receive any repayments. Often, the debtor does not have enough funds to pay all debts, and lower priority debts may receive little or no repayment. For example, consider a business that has $670,000 in senior debt, $460,000 in subordinated debt, and a total asset value of $900,000. The company files for bankruptcy and its assets are liquidated at market value. The senior debtholders will be paid in full, and the remaining $230,000 will be distributed among the subordinated debtholders for 50 cents to the dollar. Subordinated debts are, therefore, riskier than higher priority loans, and lenders will require a higher interest rate as compensation.

Note that if this company had shareholders, they would receive nothing in the liquidation process, given that shareholders are subordinate to all creditors.

Subordination agreements may be used in a variety of circumstances, including complex corporate debt structures. Unsecured bonds without collateral are deemed to be subordinate to secured bonds. Therefore, should the company default on its interest payments due to bankruptcy, secured bondholders will be repaid their loan amounts before unsecured bondholders. However, the interest rate on unsecured bonds is typically higher than that of secured bonds, earning higher returns for the investor should the issuer make good on its payments.

Subordination agreements are common in the mortgage field in which an individual attempts to refinance the first mortgage on a property which has a second mortgage. The second mortgage has a lower priority than the first mortgage, but these priorities may be upset by refinancing the loan. When a first mortgage is refinanced, the mortgagor is essentially paying it off and receiving a new loan. The new loan is now second in line, and the existing second loan moves up to become the first loan. Therefore, the lender of the first mortgage refinance requires that a subordination agreement be signed by the second mortgage lender to ensure that it remains in the top priority for debt repayment. The signed agreement must be acknowledged by a notary and recorded in the official records of the county.