Subordination Agreement

Definition

A subordination agreement is a legal document that establishes the priority of competing claims on a debtor’s assets. It designates one debt as senior (higher priority) and another as junior or subordinated (lower priority). Priority matters most when a borrower defaults, goes into foreclosure, or declares bankruptcy—senior creditors are paid before subordinated creditors.

How it works

• Creditors agree in writing that one claim will take precedence over another.
• If the debtor’s assets are insufficient to repay all obligations, repayment follows the established priority: senior debt first, then subordinated debt if funds remain.
• Lenders that accept subordination assume greater risk and typically receive compensation (higher interest rates, fees, or other concessions).
• For enforceability, subordination agreements are usually notarized and recorded in the county records where required.

Common uses

• Real estate financing (multiple mortgages and liens)
• Corporate financing and bond structures
• Situations where a new lender requires first-priority security over collateral already encumbered by earlier loans

Practical examples

Business liquidation
– A company has $670,000 in senior debt, $460,000 in subordinated debt, and assets worth $900,000.
– In liquidation, senior creditors are paid first ($670,000). The remaining $230,000 is distributed to subordinated creditors, who receive only a portion of what they’re owed.
– Secured creditors with specific collateral claims may be paid from that collateral before unsecured creditors.

Home mortgage and HELOC
– A homeowner has a first mortgage and a home equity line of credit (HELOC) as a second lien.
– If the homeowner refinances the first mortgage, the HELOC could move into the first-lien position unless the new lender requires the HELOC lender to sign a subordination agreement.
– The HELOC lender may accept subordination for a fee or refuse, potentially blocking the refinance.

Subordination and bankruptcy chapters

• Chapter 7 (liquidation): Nonexempt assets are sold and proceeds distributed by priority—senior debts paid before subordinated debts.
• Chapter 11 (reorganization): Typically used by businesses to restructure and develop a repayment plan; priority still governs creditor recovery.
• Chapter 13 (individual reorganization): Individuals can keep more assets while following a court-approved repayment plan; creditor priority is applied within the plan.

Risks and compensation

• Subordinated creditors face higher risk of partial or no repayment in insolvency events.
• To compensate for this risk, subordinated debt often carries higher interest rates, additional fees, or other contractual protections.
• Investors and lenders should evaluate the borrower’s overall capital structure and the presence of secured claims before accepting subordination.

Legal considerations

• Proper execution (signatures, notarization) and recording of the subordination agreement are critical for enforceability.
• Lenders should confirm title and lien positions before and after executing subordination documents.
• Terms of subordination (scope, duration, conditions) should be clearly defined in the agreement.

When to seek advice

Accepting or requesting subordination has significant legal and financial implications. Consult a qualified attorney or financial advisor to review the agreement, assess risks, and negotiate compensation or protective provisions.

Key takeaways

• A subordination agreement sets which creditors are paid first when assets are insufficient.
• It is common in real estate financing and corporate capital structures.
• Subordinated creditors assume higher risk and typically require greater compensation.
• Proper execution and recording are essential for enforceability.
• Get professional legal or financial advice before entering into or accepting a subordination agreement.