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Have you ever loaned money to a business or individual only to realise your repayment is at risk when they take on additional debt? This frightening scenario is all too common, leaving lenders wondering if they will ever see their hard-earned money again.
However, there is a solution – the subordination agreement. This powerful legal document can safeguard loan repayments, even if the borrower defaults or goes bankrupt. By clearly laying out which loans take priority, subordination agreements provide peace of mind to lenders and promote responsible borrowing.
Read on to discover subordination agreements, how they work, and how to leverage them to protect your investments. With this knowledge, you can lend with greater confidence, no longer vulnerable to being pushed down the repayment queue.
Do you understand subordination agreements, and why do you use one?
A subordination agreement is a binding legal contract between two or more lenders. It specifies which loan takes priority over the others when repayment is due. These agreements only come into play when a borrower defaults or declares bankruptcy. They outline the order in which lenders can claim the collateral securing the loans.
The senior lender with the highest priority loan defined in the subordination agreement is the senior lender. Lower-priority loans are referred to as junior or subordinated loans. The senior lender gets paid first if the borrower’s assets cannot cover all loan repayments.
The main benefit of subordination agreements is reducing conflicts between lenders over the same collateral. They provide clear procedures for the order of repayment. Borrowers also benefit by making future loans more accessible and affordable. With an established specific priority ranking, new lenders feel more secure in providing capital.
How do subordination agreements assign priority?
Subordination agreements outline a hierarchy for loan repayment if a borrower enters bankruptcy or defaults. They give legal weight to designating some loans as subordinated debt to senior loans. Here are some fundamental mechanisms these agreements utilise to assign priority status:
1. Blocking payments to subordinate lenders
The agreement between a borrower and lender may prevent the borrower from paying off loans with lower priority until they fully repay loans with higher priority. This means that the lower-priority lenders may only receive payments once the higher-priority lenders are paid off, which can limit their access to funds.
2. Delaying subordinate lender payment claims
When multiple lenders lend money to a borrower, the senior lender gets paid first from any collateral. Only after the senior lender is paid in full can the subordinated lenders try to collect their money. This can delay the time for lower-ranked lenders to get their money back.
3. Binding legal commitment
A subordination contract is a legal agreement that sets the order for loan repayment. Senior lenders get first access to the borrower’s assets before junior lenders if the borrower fails to repay. This avoids confusion and disputes among lenders.
Subordination agreements prioritise senior lenders in case of borrower default or financial troubles, reducing conflicts and uncertainties among creditors.
Types of subordination agreements
Subordination agreements are legal documents establishing the priority of different claims on a particular asset in case of default or bankruptcy. Though these agreements have a similar basic idea, there can be some differences in the timing and procedures followed.
Generally, there are two main types of subordination agreements, which determine the order in which different stakeholders would be paid in case of a default or bankruptcy:
1. Complete Subordination Agreements: When a company takes multiple loans from different lenders, there is a hierarchy in terms of repayment. The senior loan holders get priority and must be paid back first. Lower-ranking subordinate loans can only receive payments once the senior debt is fully repaid. This means that the lower-ranked loans receive interest payments once the higher-ranked loans are paid off.
2. Inchoate Subordination Agreements: When a company borrows money, the lender can take some of their assets if it can’t repay it. Sometimes, the lender has to wait until the company is in trouble before they can take those assets. This ensures the company can keep making payments until they can’t.
Therefore, inchoate structures give lenders more flexibility and lower priority in receiving payments when the borrower is doing well financially. On the other hand, complete subordination is a way of providing the highest level of protection for lenders who are considered senior in priority.
Example scenario
Consider a business that takes out a ₹750,000 bank loan secured using the company headquarters as collateral. Two years later, the founders also took out a ₹340,000 personal loan from a private lender, putting up 25% ownership of the business as security.
As the younger loan, the personal loan would typically be considered subordinate. However, the lenders use a subordination agreement specifying that the bank loan takes lower priority. This gives the private lender precedence in getting repaid from the company assets.
If the business later goes bankrupt with only ₹950,000 in total assets remaining, the private lender can claim the first ₹340,000 under the agreement’s defined order. The bank only receives the remaining ₹610,000 of proceeds from liquidating assets. Without the structured priority ranking, the bank loan would have had precedence in payments.
How to complete a subordination agreement
Finalising a subordination contract involves four significant steps:
1. Defining Priority Order of Loans: Designate the ranking status of each loan as senior or subordinate. Also, include essential loan details like original amounts and repayment schedules.
2. Specifying Conditions Triggering Priority: Outline precise financial events like bankruptcy, insolvency, or default that activate the subordinated loans’ lower priority level.
3. Blocking Actions by Subordinate Lenders: Prevent actions like payment demands that subordinate lenders could take against the borrower until senior loans get repaid as agreed.
4. Signing the Agreement: Have authorised representatives from senior and subordinate lenders formally sign the agreement to make it legally binding.
When you borrow money, planning is essential to avoid future problems. One way to do that is to create a subordination plan. This plan can help you protect your assets and clarify who gets paid back first if you can’t repay the money immediately. Creating a subordination plan can prevent future complications.
Key takeaways
- Subordination agreements establish priority for repayment of different loans/debts tied to the same collateral
- They protect senior lenders from getting repaid first
- Junior lenders agree to stand in line behind senior lenders
- Having clear repayment ranks prevents legal conflicts between creditors
- Various types of agreements allow flexibility to suit each situation
A well-structured subordination agreement gives senior and junior lenders confidence, leading to more durable lending arrangements for all parties involved.
Conclusion
Subordination agreements may sound complex, but they help manage repayment risk when multiple parties are involved. By establishing a clear order of priority upfront, all stakeholders can better understand the risks when funding businesses. Subordination can expand the funding options available for small businesses, which can help them grow and achieve their goals.
FAQs
A subordination agreement establishes priority for repayment of debts if a business defaults or declares bankruptcy. It legally defines which creditors get paid first from remaining assets. This provides clarity ahead of time rather than costly legal disputes later over who had higher priority interests when the money ran out.
It designates specific lenders as “senior” while subordinating others to lower priority status. Senior lenders must receive full repayment on debts before subordinated or “junior” lenders receive anything in distress scenarios. This repayment hierarchy reduces risks for senior lenders.
Any debt financing beyond what a bank or primary commercial lender provides can be structured as subordinated debt. This often includes private financing from individuals or entities willing to accept higher risk for higher rewards.
Yes, subordination extends beyond repayment priority to subordinate security interests in collateral. Primary lenders retain the first claim over secured assets until their debts are fully repaid.
The borrower, senior lender(s), and junior lender(s) are all typically signatories. This binds all involved parties legally to the defined repayment hierarchy throughout the lifecycle of the debts.