Subordination

by:

Subordination is the placing of a thing, such as a claim, in a position lower to another. Commonly used in the financial world, subordination refers to placing a loan at a lower priority than another loan to the same person or entity. This legal definition is not to be confused with the grammatical “subordinate clause,” which refers to the process of linking two passages in a single sentence, making one dependent on, or subordinate to, the other. Rather, for legal purposes, a subordination agreement is used when a creditor agrees that another loan has priority for repayment over its own loan.  To explore this concept, consider the following subordination definition.

Definition of Subordination

Noun

  1. The act of placing something into an inferior class or order
  2. The act of making something or someone subject to, or subservient

Origin

1425-1450       Middle English subordinat

What is a Subordination Agreement

Any contract or agreement may employ language that specifies the order in which things are paid, or accomplished, by assigning priority. Referred to as a “subordination clause” when placed within a larger contract, such an agreement effectively makes one claim in the contract senior to any other claims that may be added later. Subordination clauses are commonly used in mortgage contracts, where the original mortgage takes priority over any new loans against the property. Should repayment become an issue, such as in bankruptcy, the subordinate loans would take a backseat to the original mortgage, and may not be paid at all.

A subordination agreement need not be written into the original contract, as the parties may construct a separate subordination agreement to amend the contract, in the event circumstances change, new parties are added, or in a number of other situations. The addition of a separate subordination agreement must be made in writing, and signed by all parties to the original contract.

Example of Subordination in a Separate Agreement

Ronin’s band draws a big crowd at the local night clubs, leading to a desire to record an album and try to launch the band into stardom. Ronin’s dad, Frank, agrees to loan the group $5,000 to use for this purpose, and the band members sign a loan agreement to repay the money within six months. During the recording process, the band realizes they need some additional equipment, and money for other things related to the process. The drummer’s mother, Margaret, agrees to loan the group an additional $5,000, and the loan is made without consulting Frank.

Frank becomes concerned, when he finds out about the additional loan, about what would happen to his loan if the group falls short of being able to repay the hefty sum of $10,000. Although neither loan document mentioned other loans, a separate subordination agreement may be created in which Margaret agrees that her loan is subordinate to Frank’s loan. In this example of subordination, should the band become unable repay all of the money, Frank’s loan would be paid first, from whatever monies the group has. If there is anything left, Margaret’s loan would be paid.

Loan Subordination Agreement

The world’s economy revolves around the concept of investing, lending, and borrowing money. It is not uncommon for there to be more than one loan on a single property or project, but there could be trouble should repayment become a problem, and all of the lenders had to fight it out amongst themselves for payment. If this was the case, no bank or other creditor would ever lend money on a property or project on which there was already a lender.

Loan subordination agreements make it possible for lenders to work together on potentially lucrative deals. For instance, a small creditor on a large project may want to convince a large creditor to loan the client money on the same project. If the small creditor agrees to subordinate his loan, the opportunity will look much more tempting to the large lender. Essentially, in such an example of subordination, the small lender is promising the large lender that its claim will get first dibs on whatever money is available to repay debts, should the project go bad.

Pros and Cons of Loan Subordination

Loan subordination can be a terrific tool to obtain funding for the purpose of improving the property, or somehow creating more profit potential for all involved. Used improperly, loan subordination can be a deadly financial device for the lender that agreed to subordinate. Think of loan subordination like a piece of rope. It can be used to help someone across a ravine, but it can also be used to hang someone.

Example of Subordination Gone Wrong

Nancy and Greg buy a one-acre piece of property from Tom for $55,000. Tom has required only $5,000 down, and is financing the remaining amount himself, on a first deed of trust. The couple tell Tom they want to build a nice home on the land, and that they can get a $50,000 mortgage on the property, if Tom subordinates his interest. Because having a brand new home on the land will greatly increase its value, Tom agrees to the loan subordination.

Now this lot valued at $50,000 has a $50,000 first construction loan (from the bank), and a $50,000 second land loan on it (from Tom). Because he didn’t ask for more cash, or for some valuable collateral, Tom is holding a very large mortgage that is secured by nothing more than rainbows puffy clouds. Two months into the construction process, Greg and Nancy decide to get a divorce. They split up what’s left of the money and leave town, heading their separate ways.

Tom had subordinated his security position to the mortgage lender. This means that, if the lender forecloses on the property, Tom has no standing to get his money back from the deal. Tom may have had the option of taking the land back, but that would prove to be a serious burden, as he would then have a lot worth only $50,000, with a $50,000 construction loan on it that is ahead of his own loan.

On the other hand, had Tom required a larger sum of cash, or the use of valuable real estate as collateral for financing the property, the entire deal would likely look quite different. For example, Nancy and Greg use their other home, with equity valued at $180,000 to secure Tom’s seller financing. When they ask Tom to subordinate his loan to the bank’s improvements loan, they are able to get the financing they need to build a home on the lot, and Tom’s interests are protected.

Should the couple default on the deal, the bank could foreclose on the property, but Tom could foreclose on the couple’s other home. The buyer would be happy with his purchase of the property with little or no cash down, perhaps even obtaining 100% financing, leaving him with sufficient funds to improve the property. In this example of subordination, as long as Tom holds something of equal value to the property as collateral, this could be a great move.

When to Use a Subordination Loan Agreement

There are many reasons a subordination loan agreement makes sense. A junior creditor, which is a creditor whose loan takes a subordinate position to another loan, may increase the chances of the project being successful, or increasing the property’s value, by its willingness to subordinate to another lender.

A Subordination Loan Agreement may be beneficial in such circumstances as:

  • A junior lender wishes to persuade a senior lender to loan money for a property or project on which it has already issued a loan, believing the additional funding will improve the probability of success and profit. The junior creditor would be required to confirm that it is willing to subordinate its loan to the senior creditor.
  • The borrower needs to borrow money from a lender who is requesting a signed agreement that its own loan will take priority over the existing loans.
  • The lender is willing to loan money to the borrower, but wants assurance that its loan will have priority over other existing loans.

Lease Subordination Agreement

Commercial leases generally work differently than residential leases. Tenants often lease a premises for an extended period of time, then put their own money into improving the property. This happens because the business needs specialized equipment, or to construct a certain layout of the building. Much of this equipment, owned or leased by the tenant, is permanently installed. This pricey equipment includes such things as walk-in refrigerators and freezers, cooking equipment, or built-in display cases, manufacturing machinery, steam presses, and other items.

The tenant and landlord enter into a long-term lease agreement which guarantees that the landlord will have a tenant for that period of time, and guarantees that the tenant will have use of the property for that period of time. By entering into a lease subordination agreement, the tenant is ensured he can remain on the property, regardless of who owns it. This frees up the landlord to make changes to his investment properties, including the sale of such properties. A lease subordination agreement, also referred to as a “non-disturbance agreement,” protects the interests of all parties involved.

Example of Lease Subordination

Easy-Clean LLC wishes to lease a space in a strip mall, in which to operate their dry-cleaning business. The company signs a 10-year lease agreement with the landlord, Sam Smith. The agreement includes a lease subordination, guaranteeing that Easy-Clean can stay on the property, assuming they do not somehow breach the lease, regardless of who owns the property. The company leases equipment, including an industrial washer/extractor, industrial dryers, dry cleaning boilers, dry clean presses, finishing equipment, and garment conveyors, which is installed on the premises.

Three years into the lease, Sam Smith decides to sell the strip mall to ABC Corporation, which wants to gut and remodel all of the structures on the property. The family that owns Easy-Clean fears they will be forced to leave. After consulting an attorney, they are reassured that the lease subordination clause of their lease guarantees they can stay until the end of their lease term.

Subordination Examples

Subordination in construction contracts becomes a tricky thing, as there are many layers of people and entities involved. In 2013, a real estate developer, DBN Parkside, LLC (“DBN”), purchased a piece of property in California, intending to build a medical office complex. DBN hired Moorefield Construction, a general contractor, to clear the property, and to build the complex. Once Moorfield had cleared the land, DBN obtained a construction loan from Intervest Mortgage Investment Company, which required the contractor to subordinate its lien rights. Intervest filed a deed of trust to secure its loan.

As the project kicked off, DBS paid Moorefield the $7.2 million in the first 16 payments, as agreed. Unfortunately, DBN defaulted on the construction loan before paying Moorfield the remaining $2.2 million owed to the contractor. Moorfield filed a mechanic’s lien for that $2.2 million, and filed a civil lawsuit against DBN for breach of contract, and to foreclose on its mechanic’s lien. Moorfield then added Intervest to the lawsuit, seeking payment on its mechanic’s lien.

The lender responded with a cross-complaint arguing that the general contractor had signed a subordination agreement, making its lien inferior to Intervest’s own claim against DBN. In California, the law specifically protects subcontractors and suppliers from having their interests pushed aside by the heavy hitters, such as lenders. In fact, California’s Civil Code section 3262, prevents a subcontractor or supplier from waiving its right to pursue a mechanic’s lien, as it states:

“Neither the owner nor original contractor by any term of a contract, or otherwise, shall waive, affect, or impair the claims and liens of other persons whether with or without notice except by their written consent, and any term of the contract to that effect shall be null and void. Any written consent given by any claimant pursuant to this subdivision shall be null, void, and unenforceable unless and until the claimant executes and delivers a waiver and release.”

Moorfield used this legislation in an attempt to get out of the subordination clause in DBN’s mortgage with Intervest. The trial court agreed with the general contractor’s argument, and ruled in its favor. When Intervest appealed the decision, the appellate court interpreted the law as prohibiting a property owner from impairing the mechanic’s lien rights of a general contractor, and prohibits a general contractor from impairing the mechanic’s lien rights of a sub-contractor.

The crucial language of the law, which protects “other persons,” was interpreted to mean those involved who are not in a position of power, such as owners and general contractors. The court pointed out that the statute offers no protection for general contractors, who are clearly not in a position of inferior bargaining power. The appellate court overturned the trial court’s decision, ruling that, because Moorfield did not fall into the category of “other persons,” the contractor was free to subordinate or waive its rights to the mechanic’s lien process.

Related Legal Terms and Issues

  • Appellate Court – A court having jurisdiction to review decisions of a trial-level or other lower court.
  • Collateral – Something of value pledged as security for repayment of a loan.
  • Contract – An agreement between two or more parties in which a promise is made to do or provide something in return for a valuable benefit.
  • Legislation – A law, or body of laws, enacted by a government.