Legal Definitions - subordination

Subordination refers to the legal act or process by which one claim, right, or interest is ranked below another in terms of priority. This means that if there is a limited pool of assets to satisfy multiple claims, the "subordinated" claim will only be paid after the higher-ranked claims have been fully satisfied. It most commonly occurs in financial contexts, particularly when dealing with debt, to establish a clear order for repayment among creditors. Subordination can happen through a voluntary agreement between parties (a contractual subordination agreement) or, in certain circumstances, be ordered by a court to ensure fairness, especially in bankruptcy proceedings.

• Example 1: Real Estate Mortgages

  Imagine a homeowner who has an initial mortgage (the first mortgage) on their property. Later, they decide to take out a second mortgage or a home equity line of credit (HELOC) from a different lender. The lender providing the second mortgage or HELOC will almost always require that their claim be subordinated to the first mortgage. This means that if the homeowner defaults on their loans and the house is sold, the first mortgage lender gets paid back in full from the sale proceeds before the second mortgage or HELOC lender receives any money. The second lender's claim is explicitly placed in a lower priority position.

• Example 2: Business Loans and New Financing

  Consider a growing company that has an existing loan from Bank A, secured by its assets. The company needs additional capital for a major expansion and approaches Bank B for a new, larger loan. Bank B might agree to provide the new financing, but only if Bank A agrees to subordinate its existing loan to Bank B's new loan. In this scenario, Bank A contractually agrees that if the business faces financial difficulties and cannot repay all its debts, Bank B's loan will be repaid before Bank A's loan. This arrangement gives Bank B greater security, making them more willing to lend the new funds, as their claim now holds a higher repayment priority.