Subordination Agreement: Key Purposes and Different Types

A subordination agreement is a formal contract that establishes the legal precedence of one debt over another for the purpose of repayment. Such an agreement is usually employed when a property has multiple existing mortgages against it. Let us delve deeper and learn more about the subordination agreement below.

What is a Subordination Agreement?

A subordination agreement is a legal document that establishes one debt or claim as ranking behind another in priority for repayment. The priority of debt repayment can become very important if a company or individual defaults on their debt repayment obligations and declares bankruptcy.

Generally, a subordination agreement is used to rank debt priority by lenders to ensure repayment priority from the borrower.

Key Purposes of a Subordination Agreement

A subordination agreement is generally used when there are two mortgages and the mortgagor needs to refinance the first mortgage. It acknowledges that one party’s interest or claim is superior to another in case the borrower’s assets need to be liquidated to repay debts.

When multiple liens against a property exist, a subordinate agreement will set lien priority. Often lien priority will be decided based on the date of mortgage, the first mortgage receiving priority over others. Some other liens, such as property tax liens also receive automatic priority. Lien priority determines the order in which debt will be paid if that prosperity is sold in a foreclosure sale.

Lenders of superior debts will have the legal right to full repayment before lenders of subordinated debts receive their repayments. In a case where the debtor doesn’t have the funds to make all repayments, the subordinate lenders might receive less or no repayments at all . For instance, when limited or no funds are available after a foreclosure sale, liens with low priority may not receive all or any repayments.

Therefore, a subordination agreement will adjust new loans’ priority so that when there is a foreclosure, it gets paid off in order of priority.

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Types of Subordination Agreements

There are two main types of subordination agreements, which are:

• Executory Subordination Agreement: In an executory subordination agreement, the subordinate party agrees to have their interest ranked at a lower priority to the security interest of another party. This provides a promise of agreement for the future and thus can be difficult to impose. In cases where the party refuses to sign the executory subordination agreement, a contract claim violation can occur.
• Automatic Subordination Agreement: In the automatic subordination agreement, the subordination agreement is agreed upon and executed simultaneously. For example, if a deed includes an automatic subordination agreement, it will generally be stated that once the lien of the deed is recorded it will be automatically secondary to another deed.

Here is an article about the purpose of subordination agreements.

Who Benefits from a Subordination Agreement?

Individuals and businesses need to borrow funds. For this, they turn to lenders or lending institutions. The lenders earn interest on borrowed funds till all repayments have been made. In case the borrower places other liens against the asset, such as a second mortgage, the lender would require a subordination agreement to protect its interests.

One might think why would other lenders agree to subordinate? Since conventional first-mortgage lenders do not agree to refinance a loan unless they are ensured priority in case of repayment, the only way refinancing works is through a subordination agreement. It provides ensured priority repayment to the first lender.

Second or junior lienholders do not agree to subordinate automatically unless the home equity is sufficient to cover all loans. Given these complications of refinancing, subordination agreements are relatively common practice in the lending industry. It benefits the homeowner by providing a lower interest on their property and also provides assurance to the primary lender that all debts will be repaid.

When are Subordination Agreements Used?

Subordination agreements are used when borrowers are trying to acquire additional funds while already having other loan agreements . It is generally used by property owners to take out a second or junior mortgage on their property to refinance their property.

Refinancing is the process of paying off an old mortgage and replacing it with a better one. Once the first loan is paid off, the second ranks up in priority automatically. Subordination agreements make this possible.

Here is an example of refinancing. For example, if you want to refinance a primary loan of $300,000 with 6.5% interest for a loan with lower interest rate. Let’s say you have a Home Equity Line of Credit (HELOC) on the property for $50,000. This would make the house worth $400,000. When refinancing, you would be paying off your first mortgage with a new loan. The HELOC would then technically move up in priority as it was made earlier. The second lender, which is helping you repay your first debt, would want to gain priority over HELOC so it would request HELOC to subordinate. Since the property has good equity to cover both loans, the HELOC lender would generally agree to give up its lien priority.

Apart from homeowners, subordination agreements are also used by businesses and corporations. A corporation would normally issue multiple types of bonds that are subordinated or unsubordinated debt. In case the borrower declares bankruptcy or defaults, the subordination agreement becomes important. All senior lenders are superior to subordinated lenders and shareholders in case of liquidation of company’s assets.

For example, a business has borrowed $400,000 from a primary lender and has $200,000 in subordinated debt. In case it declares bankruptcy, the company’s assets will be liquidated. If the company’s liquidated assets are worth $500,000, the primary debt of $400,00 will be paid first in full and the remaining $100,000 will be distributed among the subordinate lenders. Shareholders will receive nothing in this process.

Still unsure about what a subordination agreement is? Here is more on subordination agreements.

What to Consider Before Approaching a Lawyer for Subordination Agreements?

All parties must be well-prepared when approaching a lawyer for a subordination agreement. They must consider a few things mentioned below when working with the legal professional for such an agreement.

• Purpose of the Agreement: Define and check if the specific agreement relates to a real estate transaction, a loan, or other financial arrangement. The process of understanding this agreement helps draft different appropriate terms.
• Legal Requirements: Familiarize with all the legal requirements and regulations that may apply to the specific type of subordination to be contemplated. Different industries, as well as transactions, may have distinct legal frameworks.
• Party Roles: Identify the parties involved in the agreement. It may be the debtor, the creditor, and any subordinate parties. Try to state the roles, responsibilities, as well as relationships of each party.
• Debt Amount and Terms: Specify the amount of subordinated debt, including the terms of the original debt agreement. It should include the principal amount, interest rate, repayment schedule, and maturity date.
• Priority of Liens and Rights: Understand the existing hierarchy of liens and rights if the subordination relates to a real estate or property transaction. Determine where the subordinate lien will rank among other liens or claims.
• Consent of Existing Creditors: Obtain their consent for the subordination if existing creditors have higher-priority claims. The subordination agreement may not be enforceable without either party’s consent.
• Interest of the Subordinate Party: Analyze all the benefits and risks for the subordinate party. Ensure they understand the implications of subordination. It also includes potential loss of priority in the event of default.
• Terms and Conditions: Draft the terms and conditions of subordination and negotiate them accordingly. It also includes specific requirements or obligations one must meet for the subordination to take effect.
• Default Scenarios: Outline the consequences of default by the debtor or any party involved. Describe the remedies for the specific creditor, subordinate party, and other parties in default.
• Release and Termination: Define the circumstances under which the subordination agreement may be released or terminated. The most common instance is a full repayment of the subordinate debt or other triggering events.
• Governing Law: Determine the governing law that will apply to the agreement and specify the jurisdiction for resolving disputes.
• Legal Counsel: Engage legal counsel experienced in drafting and reviewing subordination agreements. A lawyer can provide valuable insights, ensure legal compliance, and protect interests.
• Documentation: Ensure that all necessary documentation is in place. Also, check that the subordination agreement is executed by all parties involved efficiently.
• Financial Review: Conduct a financial analysis to assess the impact of subordination on the debtor's financial stability and ability to fulfill their obligations.
• Insurance and Risk Mitigation: Consider whether insurance or other risk mitigation measures are needed to protect the interests of all parties involved.
• Third-Party Obligations: Specify their roles and responsibilities within the agreement if any third party is involved.
• Communication: Maintain open and transparent communication among all parties to address concerns or questions throughout the negotiation and drafting process.
• Compliance: Ensure the subordination agreement complies with all relevant laws, regulations, and industry standards.

Final Thoughts on Subordination Agreements

A subordination agreement is important for several financial transaction types. It helps specify the priority of the claims of creditors associated with the borrower’s assets. So, a party willingly gives its priority position to another creditor by subordinating its specific lien or claim. The document also helps lenders safeguard their specific interests and clarifies complex financial arrangements. However, making the legal document may not seem easy for either party. That is why it is recommended to approach a lawyer who has already worked on such agreements earlier.

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