Subordination Agreement

Definition

A subordination agreement is a legal document that establishes the priority of competing claims on a debtor’s assets. It designates one debt as senior (higher priority) and another as junior or subordinated (lower priority). Priority matters most when a borrower defaults, goes into foreclosure, or declares bankruptcy—senior creditors are paid before subordinated creditors.

How it works

  • Creditors agree in writing that one claim will take precedence over another.
  • If the debtor’s assets are insufficient to repay all obligations, repayment follows the established priority: senior debt first, then subordinated debt if funds remain.
  • Lenders that accept subordination assume greater risk and typically receive compensation (higher interest rates, fees, or other concessions).
  • For enforceability, subordination agreements are usually notarized and recorded in the county records where required.

Common uses

  • Real estate financing (multiple mortgages and liens)
  • Corporate financing and bond structures
  • Situations where a new lender requires first-priority security over collateral already encumbered by earlier loans

Practical examples

Business liquidation
- A company has $670,000 in senior debt, $460,000 in subordinated debt, and assets worth $900,000.
- In liquidation, senior creditors are paid first ($670,000). The remaining $230,000 is distributed to subordinated creditors, who receive only a portion of what they’re owed.
- Secured creditors with specific collateral claims may be paid from that collateral before unsecured creditors.

Home mortgage and HELOC
- A homeowner has a first mortgage and a home equity line of credit (HELOC) as a second lien.
- If the homeowner refinances the first mortgage, the HELOC could move into the first-lien position unless the new lender requires the HELOC lender to sign a subordination agreement.
- The HELOC lender may accept subordination for a fee or refuse, potentially blocking the refinance.

Subordination and bankruptcy chapters

  • Chapter 7 (liquidation): Nonexempt assets are sold and proceeds distributed by priority—senior debts paid before subordinated debts.
  • Chapter 11 (reorganization): Typically used by businesses to restructure and develop a repayment plan; priority still governs creditor recovery.
  • Chapter 13 (individual reorganization): Individuals can keep more assets while following a court-approved repayment plan; creditor priority is applied within the plan.

Risks and compensation

  • Subordinated creditors face higher risk of partial or no repayment in insolvency events.
  • To compensate for this risk, subordinated debt often carries higher interest rates, additional fees, or other contractual protections.
  • Investors and lenders should evaluate the borrower’s overall capital structure and the presence of secured claims before accepting subordination.
  • Proper execution (signatures, notarization) and recording of the subordination agreement are critical for enforceability.
  • Lenders should confirm title and lien positions before and after executing subordination documents.
  • Terms of subordination (scope, duration, conditions) should be clearly defined in the agreement.

When to seek advice

Accepting or requesting subordination has significant legal and financial implications. Consult a qualified attorney or financial advisor to review the agreement, assess risks, and negotiate compensation or protective provisions.

Key takeaways

  • A subordination agreement sets which creditors are paid first when assets are insufficient.
  • It is common in real estate financing and corporate capital structures.
  • Subordinated creditors assume higher risk and typically require greater compensation.
  • Proper execution and recording are essential for enforceability.
  • Get professional legal or financial advice before entering into or accepting a subordination agreement.