Subordination Agreement

What Is a Subordination Agreement?

A subordination agreement is an agreement between two entities in which a more senior entity agrees to make all payments on behalf of a less old entity. 

It is enforceable if the agreement includes specific provisions, such as that the payments will be treated as a priority over other debts and are not made to avoid other creditors' rights, to state a few.

Subordination contracts are used in transactions such as syndication. In a typical syndication transaction, a senior lender will lend most of the funds to a borrower.

The senior lender then sells its subordinate debt to other investors. Those investors who purchase the subordinated debt (the junior debt) share the risk of default with the senior lender.

If there is no default and times go well for the borrower and his business, everyone makes money. The senior lenders get paid back first, followed by the junior lenders, who only receive their payments after the senior lenders have been paid back.

uses Of Subordination Agreement

Although these agreements can be included in merger and loan agreements, they are typically found in secured credit facilities for companies.

When a bank like Bank of America, for example, makes a secured credit facility to a company, it will secure its interests with collateral. However, if the company defaults on the loan, the bank prioritizes the collateral, whether real estate, equipment, or inventory.

If another lender agrees with the borrower, it can arrange to have payments treated as a priority over other debt if the borrower defaults. This protects both lenders' interests and the borrower's ability to obtain financing.

There are numerous uses, such as:

1. Increase in Credit Limit: It can include an increase in the credit limit on a pre-existing loan agreement and trust points.
2. Secured Credit Facilities: The contract can include changes in the collateral used to secure the loan, such as changing the type of collateral or increasing the amount from 60% to 100% of the loan.
3. Equity Financings: The terms of equity financing agreements usually include some agreement that affects how payments will be prioritized in future debt agreements.
4. Asset Financing: If it is used to limit the amount a lender can recover in the event of bad debts, it will also protect a borrower's ability to sell assets and repay the loan simultaneously. Additionally, they can protect all lenders should the company be sold or liquidated.
5. Amortization Agreements: The interest on most mortgages is paid semi-annually and is amortized over 30 years. To take advantage of this low interest rate, many borrowers use an amortization schedule that has payments accelerated (i.e., an accelerated payment schedule) or even eliminated (i.e., an eliminated payment schedule).

Advantages and Disadvantages Of Subordination Agreement

In subordinating the lender's senior credit obligations concerning other lenders' or investors' senior obligations, the lender may ask for an additional fee or cost from the borrower.

The advantages and disadvantages will be discussed below:

Advantages

• The borrower, other lenders, and the underwriter benefit from having a subordination contract in place.
• The lender may benefit by not having to make additional risk assessments and not waiting for periodic reviews to see if the borrower is making payments on time.
• Other lenders or investors may benefit as they can still participate in the project with senior commitment, as there is no difference between senior and subordinate obligations.
• It is also more cost-effective for lenders to have multiple subordination arrangements than just one, especially if many actors are involved in a project's financing process.

Disadvantages 

• The borrower and other lenders or investors may not be able to participate in the project if the lenders with critical investments are unable to provide their commitment.
• If the lender fails to make payments, other lenders or investors will benefit as they have priority over others' payments. However, the lender may also lose its rights to recover any collateral if another lender or investor makes the repayment of capital and interest.

various parts of the Subordination agreement

As the general form of Subordination Contracts is relatively straightforward, it may not require the help of a lawyer.

However, if you intend on entering into a loan that requires subordination, it is highly recommended to retain counsel to ensure that your agreement will be enforceable under the law. The following parts are generally found in any such agreement:

1. Definitions: Usually found in Paragraph 1 of the agreement, it defines any terms used in the document that may not be commonly known.
2. Parties: Usually found in Paragraph 1 of the agreement usually lays out the names of the parties entering the contract.
3. Purpose: Usually found in Paragraph 1 of the agreement describing the intent of agreeing.
4. Subordination: Usually found in Paragraph 1 of the agreement, it includes any payment schedules or additional provisions that will be used to determine priority if there is a default or missed payment on a loan.
5. Covenants: Usually found in Paragraph 2 of the agreement, covenants are affirmative obligations that may be required to be met by both parties before enforcing a contract, including what steps need to be taken if a party believes another party has breached such covenants.
6. Default: Usually found in Paragraph 3 of the agreement, a default is defined as a breach of one or more covenants.
7. Payments: Usually found in Paragraph 1 of the agreement, the section specifies and includes whom, how much, and when payments are to be made under a subordination.
8. Default and Remedies: Usually found in Paragraph 4 of the agreement provides remedies for both nonpayment and any other breach that may occur during the life of a loan or a subordination agreement.
9. Non-Default Remedies: Usually found in Paragraph 5 of the agreement describes remedies for breach of covenants that should occur if no default has occurred.
10. Survival, Renewal, and Amendment: Usually found, Paragraph 6 provides for how the subordination agreement will determine the impact of covenants surviving a specified event, such as a change in control or sale of a company.
11. Other Provisions: Usually found in Paragraph 7 of the agreement, it includes any other necessary provisions to complete the document.

types Of Subordination

Several types of subordinations are commonly used in most industries; it is crucial to understand what kind of contract fits your business, such as:

Variable subordination

Variable subordination occurs when an agreement has no fixed terms for a subordinate position. Still, it varies according to various factors, such as fluctuations in market rates and other economic indicators that affect loan performance. 

This type of contract may be terminated at any time by the lender.

Contingent

The contingent category specifies that the lender's payments will depend on the principal repayment schedule of a certain quantity of securities and interest. If the borrower fails to make payments, the position is not subordinate but "contingent."

A contingent contract may be terminated at any time by either party giving notice to the other party.

Reverse operation

A reverse operation subordination agreement may include payment schedules in which target dates for payments on subordinate responsibilities.

They are predicated on dates for payment on senior obligations such as interest (if interest is payable) or principal if there is no feature of fixed rate payback. 

Once these dates have passed, no further payments are made on the subordination contract until the principal and interest on the senior obligations are paid.

Self-liquidating

A self-liquidating subordination agreement specifies that in the event of default by the borrower, all or a certain percentage of any outstanding amounts owed to other lenders or investors will be paid from proceeds from a specific source or sources.

If the borrower cannot pay senior obligations, then prices are made to the subordinated entity. This subordination contract may be terminated at any time by either party giving notice to the other party.

Preferred

A preferred subordination agreement is also known as a "senior preferred." It specifies that specified payments will be made above all other creditors and investors in terms of timing and priority. 

This type of agreement may be terminated at any time by either party giving notice to the other party.

Event of Default

An Event of Default is the defaulting party's failure to meet any contractual obligations. To prevent an Event of Default, it may be necessary for parties to agree on a grace period for meeting contractual obligations.

However, suppose a specific time has passed, and the borrower still needs to make payments. In that case, the lender may initiate foreclosure proceedings on collateral such as real estate owned by the borrower.

When the agreement is executed in conjunction with other securities managed by a project company, it is referred to as an "add-on" or "ancillary" subordination.

Understanding Termination of a Subordination Agreement

In some cases, the contracts may be terminated due to several reasons.

These agreements may be subject to several different defenses that could cause your lender to lose its priority claim on assets such as:

1. Fraud: If a lender enters into a loan agreement based on fraud, the lender loses its priority claim to the assets used as collateral for the loan.
2. Unconscionability: This defense arises when a lender and borrower enter into a loan agreement or subordination agreement in which the terms and conditions are far from fair, honest, or reasonable under any circumstances.
3. Mistake: This defense arises when both parties have made an error that has cost one party more than they were legally obligated to pay.
4. Undisclosed Principal: A lender is never permitted to lend more money than the principal amount owed on a loan or subordination agreement. If the lender enters into any such arrangement, it leads to a default-causing event.
5. Unenforceable Subordination: If it is not correctly drafted or was signed by an unauthorized individual, it may not be enforceable in court. These agreements are used in many industries and have become an essential part of general corporate law.

Whether you need an agreement for your business or are planning on lending money, it is always recommended to consult with a licensed attorney before entering into any legally binding contract to fully understand where your rights and obligations lie under the law.

Researched and authored by Amir Jamal Kaddoura | Linkedin

Reviewed and Edited by Krupa JataniaI | LinkedIn

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