Subordination: Overview, definition and example
What is subordination?
Subordination refers to the contractual arrangement in which one party agrees that their rights or claims will rank below those of another party in priority. This is commonly seen in financial agreements, where a creditor agrees that their claim will be subordinate to the claims of another creditor, typically to facilitate new financing or restructuring.
For example, a lender providing a second loan to a borrower might agree to subordinate their rights to repayment behind the first lender’s rights.
Why is subordination important?
Subordination is important because it establishes a clear hierarchy of claims or rights, ensuring that priority obligations are fulfilled first in the event of default, liquidation, or insolvency. It helps protect senior creditors or claimants and makes it easier for borrowers or entities to secure additional funding by reassuring new lenders about their repayment priority.
Including a subordination clause in contracts prevents disputes over the order of payments and provides transparency about the risks and rights of the involved parties.
Understanding subordination through an example
A company secures a $1 million loan from a bank, and the bank requires that any future loans be subordinate to its loan. Later, the company obtains a $500,000 loan from another lender, with a subordination agreement stipulating that the bank’s loan will be repaid in full before any repayment is made to the second lender. This arrangement gives the bank priority in case of default.
An example of a subordination clause
Here’s how a subordination clause might appear in a contract:
“The Junior Lender agrees that its rights to repayment under this Agreement shall be subordinate in all respects to the rights of the Senior Lender under the Senior Loan Agreement. In the event of default or liquidation, the Senior Lender shall be entitled to receive payment in full before the Junior Lender receives any distributions.”
Conclusion
Subordination clauses play a critical role in financial and legal agreements by defining the priority of claims and ensuring clear rules for repayment. By establishing a hierarchy, these provisions facilitate new financing, reduce conflicts, and protect the interests of senior creditors. A well-drafted subordination clause supports transparency, fairness, and effective risk management in contractual relationships.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.