What is a Subordination Agreement?

Last Updated: 8 Jul 2022

Investors utilise the capital they have saved over time to start their journey in the Indian financial market. Some start with equitycommodities while smart investors diversify their portfolios by allocating the capital to various asset classes such as debt.

The asset class of debt is considered to be the holy grail of a healthy portfolio as it provides regular income to the investors, allowing them to take more risk in other asset classes to realise higher profits. However, being a financial instrument, debt instruments also include a default risk where the issuer may fail to fulfil the payment promises. In such a case, it is vital that the investors know about the Subordination Agreement.

Subordination Agreement

A subordination agreement is a legal document that terms a debt as superior to another. This ensures the holder of the superior debt is repaid by the debtor before repaying the other holders. The subordination agreement provides ranking to a debt and represents priority over repayment, which becomes vital in the case the debtor defaults on payments or repayments due to declaring bankruptcy.

Under the subordination agreement, holders can claim the right to be paid earlier than other holders of the debt instrument even if the issuer does not have enough remaining assets at the time of liquidation to repay the rest of the holders. The debt that is given the lower-ranked claim is known as subordinated debt, and the holders who are given less priority over repayments are known as the subordinated party.

How does a Subordination Agreement work?

Businesses and Individuals take loans from various institutions to cater to their personal or professional financial needs. In return, the lender gets regular interest payments on the loaned amount until the tenure specified in the loan agreement is over. Almost all such loans demand collateral that is personally owned by the business or the individual taking the loan. However, there is a possibility that the borrower may place additional liens (the right to own the collateral until the debt is fully paid) on the collateral by taking a different loan by pledging the same collateral. If that happens, and the borrower defaults on interest payments to both the lenders, both the lenders can present their ownership over the collateral to sell it and realise the defaulted amount.

The initial borrower attaches a subordination agreement with the loan agreement to prevent such incidents and have a legal claim over the collateral before any other party. With the attached subordination agreement, any debt taken additionally is called the second or junior debt (subordinated debt) and has a lower claim over the debt repayments. The original or first debt is called senior debt and has a higher claim over the debt repayment than the junior debt.

Types of Subordination Agreement

There are two basic types of subordination agreements:

• Inchoate Subordination Agreement: It is a type of subordination agreement that does not become operative until the borrower’s assets go through a voluntary or involuntary distribution to the creditors. The event of insolvency and bankruptcy triggers this type of subordination agreement. The Inchoate subordination agreement is considered the most beneficial to the junior debtor and the least advantageous to the senior debtor. It is because the junior debt may have been redeemed by the time of insolvency.

• Complete Subordination Agreement: Under the complete subordination agreement, the borrower is legally restricted from offering principal repayment or interest payments on the subordinated debt as long as the borrower is obligated to the senior debtor. Hence, the complete subordination agreement is drawn so that it is beneficial to the senior debtor as it restricts the payments to the junior debtor until the senior debtor is fully paid.

Example of Subordination Agreement

Suppose a company has Rs 7,50,000 in senior debt and Rs 3,40,000 in subordinated debt, with the company’s total asset value at Rs 9,50,000. Now, the company is filing for bankruptcy and entering the asset liquidation phase at a market value of Rs 9,50,000. In this event, under the subordination agreement, the senior debtors will be paid in full, and Rs 7,50,000 will be taken out of the valuation of the company. The rest of the Rs 2,00,000 will be distributed among the subordinated debtors, with them losing Rs 1,40,000 as there will be no money left.

Final Word

A subordination agreement is one of the most crucial agreements that the original lender can attach to the loan agreement to ensure their lent amount is protected and will be repaid on a priority basis at the time of liquidation. A subordination agreement is common in the mortgage field and protects obligations if the borrowers take a second loan with the same collateral.

Frequently Asked Questions

What is a hypothecation agreement?

A hypothecation agreement is a legal document between the lender and borrower where the lender gives a loan in return for pledging collateral. The lender has the right to cease the asset in case the borrower defaults on the loan agreement terms.

Who is the grantor on a subordination agreement?

Under a subordination agreement, the borrower is the grantor who grants the property as collateral to the lender, called the grantee.