Legal Definitions - subordination agreement

A subordination agreement is a legal contract that establishes a clear hierarchy between different debts or legal claims. Essentially, it means that one debt or claim is formally designated as "junior" or "subordinate" to another "senior" debt or claim. This ensures that if a borrower defaults or a company faces financial difficulty, the senior debt must be paid in full before the subordinated debt receives any payment. This agreement is often used to allow a borrower to obtain new financing by providing assurance to a new lender about their priority, or it can be used to specify that the terms of one legal document are subject to those of another higher-ranking document.

• Example 1: Home Mortgage Refinancing

  Imagine a homeowner, Sarah, has a first mortgage on her house. Years later, she decides to take out a home equity line of credit (HELOC) from a different bank to pay for renovations. The bank providing the HELOC will typically be in a "second lien" position, meaning their claim on the house would be paid after the original first mortgage in case of foreclosure. However, sometimes the original first mortgage lender might need to sign a subordination agreement to explicitly confirm that their existing mortgage retains its primary, "first lien" position, even though the HELOC is a newer loan. This reassures the HELOC lender that the payment hierarchy is clear, and it protects the original mortgage lender's priority.

  How it illustrates the term: The original mortgage lender agrees, via the subordination agreement, that their existing loan remains the primary debt, making the new HELOC loan explicitly secondary or "subordinate" to it in terms of repayment priority if the house were to be sold due to default.

• Example 2: Business Expansion Loan

  A manufacturing company, "InnovateTech," has an existing loan from Bank A, which is secured by all of InnovateTech's machinery and inventory. InnovateTech wants to expand and needs additional funding, so they approach Investor B for a new loan. Investor B is willing to provide the capital but wants assurance that their loan will be repaid before Bank A's existing loan if InnovateTech encounters financial trouble. Bank A, however, wants to maintain its primary position. To facilitate the new financing, Investor B might agree to sign a subordination agreement, stating that their new loan will be subordinate to Bank A's existing loan. This allows InnovateTech to get the new funding while reassuring Bank A that its original priority is maintained.

  How it illustrates the term: Investor B's new loan is made "subordinate" to Bank A's existing loan through the agreement, meaning Bank A's debt must be satisfied first from InnovateTech's assets before Investor B can claim any repayment.

• Example 3: Intercompany Loans in a Corporate Group

  A large parent company, "Global Holdings," often lends money to its various subsidiary companies to fund their operations. One of its subsidiaries, "Local Solutions," needs a significant loan from an external commercial bank to launch a new product. The commercial bank, before approving the loan, will likely require Global Holdings to sign a subordination agreement. This agreement would state that any existing or future loans from Global Holdings to Local Solutions will be subordinate to the commercial bank's new loan. This gives the external bank greater security, as it ensures its loan will be prioritized over the internal loans from the parent company if Local Solutions faces bankruptcy.

  How it illustrates the term: The parent company's loans to its subsidiary are explicitly made "subordinate" to the external bank's loan, establishing the bank's debt as the senior claim in the event of the subsidiary's financial distress.