What is a Subordination Agreement?
A subordination agreement is a key document used in the arenas of banking and real estate. Most commonly, a subordination agreement is utilized to order the priority of a real estate lien – which means it outlines the priority status of each lender’s loan to the value in the subject property. But, a subordination agreement can be used in other situations as well. For example, it is also common to see a subordination agreement when a bank is lending money to a business that is being guaranteed by an individual or their assets.
Practically speaking, in the context of a mortgage loan, there are three parties to a subordination agreement . There is the existing debt lender, the new debt lender, and the borrower’s real estate. The lender who is in the most senior position has the most leverage and will usually get a subordination agreement from other lenders to confirm their debt is in a senior position. There are some instances in which multiple lenders could agree to share a senior position. The subordination agreement is set up to govern the relationship of the real estate lien holders; it is not just an agreement among lenders. It protects the most senior lender from losing its priority in the event the borrower defaults on a loan or goes into bankruptcy.
Essentials of a Subordination Agreement
A well-crafted subordination agreement must encompass specific terms that clarify the rights of each party involved in the deal. The key components of a subordination agreement include the following:
- Identification of parties. The agreement must specifically identify all parties involved. At its core, a subordination agreement will have three different types of parties: the subordinated debt holder (the subordinated lender), the senior debt holder (the bank or senior lender), and the borrower (which could be an individual or an entity such as a limited liability company).
- The debt. The agreement must describe the subordinated debt being offered, including details such as the principal sum, the interest rate, the maturity date, commencement date, and other key terms that are normally part of a promissory note. The agreement or a subsequent document such as the loan agreement should also contain information about the senior debt; the parties may need to restate certain terms of the senior debt for purposes of the agreement. Take care to identify any future loans that may also be subject to subordination—these could affect the priority of all debts applied to a property later.
- Relationship of parties. A subordination agreement must clearly outline the relationship between the parties involved and should also identify the subject assets, collateral or property that will be affected by this agreement. If the relationship is a lender-borrower relationship, the agreement must state that the subordinated lender is subordinated to the senior lender. If the relationship is a guarantor-guaranteed party, the agreement must state whether the guarantor sells and transfers its credit to the lender and to what extent—full and complete or partial. If the relationship is that of an equity partner, the agreement should state that the equity investor is subordinated and how much the investor is subordinated (i.e. pro rata or otherwise). This section should also set out in detail how the subordinated lender’s rights are affected, such as by limiting their right to sue or restricting their ability to sell the property; limiting the rights of the property manager; or prohibiting the lender from transferring their interest under the agreement without consent. The agreement should also identify possible future disputes, such as a dispute with the senior lender or borrower, and address how those disputes should be resolved. For example, the agreement may require the subordinated lender involved in a dispute to give the senior lender notice, or require the subordinated lender to first pursue settlement with the borrower before filing suit against the borrower.
When is a Subordination Agreement Required?
A subordination agreement contains an agreement between lienholders which defines their respective rights in the collateral. A subordination agreement may be necessary in the following instances: (i) a refinancing of a mortgage or other loan where the new loan being obtained is secured by a lien that needs to be ahead of a previously recorded lien, and/or (ii) the creation of any additional mortgage or lien on the property to be recorded on the public record of a particular county.
An example of a situation that may necessitate the use of a subordination agreement is when the owner of a condominium enters into a construction contract for repairs, upgrades and/or remodeling. If the owner has at least one outstanding mortgage on the condominium, the owner will likely need to obtain a construction loan to pay for the repairs, upgrades and/or remodeling. The problem is if the owner enters into a standard construction contract, most likely the contractor will place a lien on the unit. Because the construction lien has priority over the construction loan-to-be, the bank will likely refuse to advance money under the construction loan until the contractor removes its construction lien. In this case, the bank will require the owner to obtain a subordination agreement where the contractor agrees to subordinate its construction lien to the construction loan-to-be. The subordination agreement will probably allow the contractor’s construction lien priority over the construction loan-to-be once the construction loan-to-be is paid off.
Example of a Subordination Agreement in Real Estate
To give an example of a real estate subordination agreement, consider the agreement below between a first mortgagee and a second mortgagee on an office building. This hypothetical subordination agreement comes into play with a second mortgage, meaning the property has prior financing in addition to the second mortgage obligation.
SUBORDINATION
This Subordination ("Agreement") dated as of ________, 20__, is made by and among __________________, a __________________ ("Owner"), _______________________ ("First Mortgagee") and _______________________ ("Second Mortgagee").
RECITALS:
Owner is the owner of certain real property (the "Property") located at ______________________________ [address], in ______________________ County, State of _________________ which consists of ___________ acres, designated for tax purposes as Parcel(s) ________________________ (Parcel 1), ________________________ (Parcel 2), ________________________ (Parcel 3), ________________________ (Parcel 4), ________________________ (Parcel 5) and ________________________ (Parcel 6), commonly referred to as _________________ Office Park (the "Property").
First Mortgagee previously granted a lien, mortgage or other encumbrance (the "First Mortgage") upon the Property, as evidenced by that certain Mortgage Deed, dated ________________, 20__, which was recorded in the Clerk’s Office of the ___________________ County Registry of Deeds on ______________, 20__ in Book _______________ Page _______________ ("Record").
Second Mortgagee has entered into a mortgage, deed of trust, or other customary form of security instrument (the "Second Mortgage") dated _______________, 20__, and recorded on _______________, 20__ of the __________________ County Registry of Deeds in Book ________________ Page _______________ ("Second Mortgage Record").
NOW, THEREFORE, in consideration of the mutual covenants and agreements contained herein, Owner, First Mortgagee and Second Mortgagee agree as follows:
- Owner, First Mortgagee and Second Mortgagee each agree that the lien, mortgage, deed of trust or other encumbrance of Second Mortgagee upon the Property shall be, and is, and shall continue to be, subject and subordinate to the lien, mortgage, deed of trust or other encumbrance of First Mortgagee upon the Property and to its lien and rights under the First Mortgage.
- Upon any sale of the Property under the lien, mortgage, deed of trust or security interest of First Mortgagee, in the event of an exercise of rights under the First Mortgage (and any extensions, modifications, substitutions and restatements of the First Mortgage), Second Mortgagee agrees that the lien and rights of Second Mortgagee under the Second Mortgage shall be subject and subordinate to the lien, mortgage, deed of trust or other encumbrance of First Mortgagee and its rights under the First Mortgage.
- Second Mortgagee agrees that, in the event of a default under the terms of the Second Mortgage and upon request of First Mortgagee, Second Mortgagee shall execute and deliver such agreement or instrument in recordable form as First Mortgagee may reasonably require to evidence its subordination under this Agreement.
- This Agreement shall be governed by and construed under the laws of the Commonwealth of ____________.
How Subordination Affects Parties Involved
A subordination agreement can have a profound effect on the interests of various stakeholders. For example, the motivation of a court in ordering property to be held as security for an unsecured loan may be based on the potential benefits of avoiding unnecessary litigation, rather than competitive bidding, by subordination of a priority lien.
As for the creditor whose lien is subordinated, they will acquiesce because it is worthwhile to them. The same may be true of a certain group of creditors with other liens, and has been a negotiating point that has benefited many. In addition , the ability to agree to subordinate a lien may affect negatively a secured party’s fortune if they have subsequently lent on the basis of that security.
Potentially the greatest impact a subordination agreement has is on the commercial lifeblood of a corporate debtor. By allowing the debtor continued access to a pool of liquidity based on the cash flows from a key asset, if a lender agrees to a subordination of its lien to allow the debtor to take on an additional loan. A short, eloquent subordination arrangement clause will often prove invaluable.
Legal Aspects of Subordination Agreements
The subordination agreement and its documents must be signed by the holder of the subordinate lien, and by the owner of the property. The owner is typically the same person or entity as the borrower under the senior loan, but not always. If the owner is not the borrower, then the borrower must join in the subordination agreement (and execute any related documents) on an agreement to cause the owner to perform its obligations as owner of the property. This is oftentimes not a sticking point, since the subordinate lien has already been placed on the property and the borrower is already in possession of the senior lender’s proceeds, so it is more of a formality, but it can become a contentious issue if the borrower fails or refuses to cooperate with obtaining the required owner signature on the subordination agreement or any related documents. The California Civil Code does not explicitly require this; however, the borrower must be obligated to cause the owner to execute the subordination agreement as additional consideration for the loan.
A well drafted subordination agreement between a second lien holder and the holder of first lien should contain certain provisions and be filed properly to ensure its enforceability. The lender to which the second lien has been subordinated may want to consider the following in drafting or negotiating the terms of a subordination agreement:
In California, effective January 1, 2023, a new statute will add section 2915 to the Civil Code to require that, in order for a subordination agreement between a judgment creditor and a lender to subordinate a judgment lien on the property of a borrower, the subordination agreement must contain certain language, as discussed below. Note that this new requirement would not apply to a subordination agreement that subordinates a judgment lien to a deed of trust recorded prior to January 1, 2023, even if the deed of trust is refinanced. This statute does not address whether the new requirement would apply if the subordination agreement was entered into prior to January 1, 2023, but the deed of trust was entered into or refinanced after January 1, 2023.
The new law requires that any subordination agreement entered into after January 1, 2023, by a judgment creditor must contain the following language: "This agreement does not constitute due process of law. To the extent permitted by applicable law, the judgment creditor knowingly, voluntarily and intentionally grants to the judgment debtor, and the judgment debtor may accept from the judgment creditor, partial or complete satisfaction of the judgment in accordance with California Sections 697.590, 695.220, and 697.640." (Civ. Code, § 2915, subd. (a)) Section 2915(b) also requires that the subordination agreement contain an acknowledgment by the lender of the subordination agreement informing the customer of the nature of the agreement and that the lender may waive or not enforce the agreement. (Civ. Code, § 2915, subd. (b).) This information must be provided in writing in either size 16 point font or a print size that is at least twice as large as the largest type on the first page of the document that is not required by statute.
Subordination agreements are generally enforceable under California law, in the absence of fraud or other factors that would make the agreements unenforceable.
Best Practices for Drafting a Subordination Agreement
When drafted properly, a subordination agreement can effectively protect the interests of both the subordinating creditor and the more senior lender. The same basic principles that apply to notes, security interests and much other commercial documentation also apply here.
First, any subordination agreement should comply with the statute of frauds, i.e., it must be in writing, signed by each creditor and the debtor, and supported by consideration. Second, as with all agreements, subordination agreements must be clear and specific about what is and is not being subordinated. Ambiguities can lead to years of expensive litigation between creditors. Third, a subordination agreement should be signed by the knowledgeable agent for each of the participating creditors and a knowledgeable representative of the debtor or debtors, if not an individual.
It is almost always advisable to have legal counsel involved in negotiating, drafting and reviewing the subordination agreement, particularly if the creditor is a bank or other large financial institution . Because these financial activities often involve large sums of money, the cost of involving counsel pales in comparison to the financial risk of committing an error. Not infrequently, dirty tricks are involved, particularly among competing creditors. Even well-meaning parties can have a variety of misunderstandings and omissions in the document, particularly if one or more of the parties is not an experienced lender with in-house counsel.
It is also important to remember that the bankruptcy code and state law may have defenses to any attempted subordination other than those expressly provided in the agreement. Some of these include: (i) a right to equitable subordination, which any court can order based upon general equitable considerations; (ii) the fact that there has been no consideration received by the subordinating creditor in return for its subordination; (iii) a waiver of the subordination by the senior creditor; and (iv) failure of the subordination agreement to comply with the statute of frauds.
