What is a Subordination Agreement?
A subordination agreement is a contractual agreement in real estate that allows a property to take priority over an existing lien. This priority often pertains to an existing loan or mortgage loan. In the event of a foreclosure, the holder of the first position has superior rights to the collateral, thereby acquiring the collateral subject to the senior lien. A subordination agreement first establishes the priority of a future loan, then allows the subsequent development of property by demolishing existing buildings, taking out a loan against the newer property , and then paying off the pre-existing debt with the proceeds. Without a subordination agreement, owners would face more difficulty reapplying the same property as collateral for a loan to fund new projects.
Subordination agreements are often executed to benefit junior lien holders in the event of default. In many instances, junior lien holders will refuse subordination because they are removing their only guarantee of repayment. By signing a subordination agreement, junior lien holders are ranking below the senior lien holders in the case of foreclosure, which can be a chance recovery of investment.
Subordination and Why It Matters
Subordination agreements play a fundamental role in real estate transactions, as they largely determine the priority or preference of different claimants who have been granted interests in property. In this way, subordination agreements directly affect what has become a common expectation held by real estate lenders, that a debtor will not place existing liens ahead of their recently placed mortgages.
In executing their subordination agreements, lenders and their debtors commonly bargain for a hypothetical situation in which they themselves have greater seniority than previously placed mortgage debts. However, the hypothetical scenarios in real estate transactions may not stay hypothetical if proper subordination measures are not taken. Take for example a debtor that borrows $250,000 from Bank A to purchase a piece of land and then later borrows an additional $600,000 from Bank B with which to construct a new building on the land. If Bank B fails to acquire a subordination agreement from Bank A, a foreclosure on Bank A’s land lien will unseat Bank B’s new building lien and place it behind Bank A’s land lien.
How Subordinate: Typical Scenarios
Often you see subordination agreements in these instances:
Refinancing
A mortgage subordination agreement is most commonly encountered in financing transactions involving refinance of an existing mortgage. For example, property owners may want to refinance existing debt at a lower rate of interest which would improve their cash flow. Refinancing usually puts new debt in a higher priority position than the existing debt which can be damaging to the previous lender if not subordinated to the new loan. The subordination agreement provides the lender with an enforceable promise that the new loan will always get priority over the old lender’s loan.
Second Mortgage
Subordination occurs when a lender making a first mortgage loan requires the borrower to subordinate a second mortgage loan (a home equity or home equity line of credit loan) to its first mortgage loan. This is common in New Jersey because under the law if a senior lender loaned money, made a payment on behalf of the borrower, or purchased property tax and municipal claims, even if the new loan is subordinate in time, such lender would be subrogated (assumed) to the priority of the debt paid so as to vest in the lender the rights, liens, and priorities of the outstanding debt. If this was not prohibited, it would have the potential to turn the senior loan into more of a second loan resulting in more risk for the senior lender who would not receive first priority of its loan as originally contemplated.
Subordination Agreement 101
A subordination agreement generally identifies the parties entering into the agreement, the loans subject to the agreement and the subordination provisions themselves. The agreement may also be recorded so as to give notice of it to subsequent purchasers or encumbrancers. The agreement will usually include the following:
Parties. There may be a number of parties involved in a subordination agreement. First, of course, are the lenders – those who have a claim against the land, whether through a mortgage or some other lien. Those are the creditors whose claims will be satisfied first. Second are the property owners. Third, of course, are those who want to buy the land, or who may have loans secured by the land. For example, if there are multiple loans secured by the land, there can be a dispute between lenders as to which one has priority. Finally, there may be a landlord and a tenant as well. In general, a subordination agreement discloses the status of each party to the transaction vis-à-vis the land.
Description of Loans in Subordination Agreement. The subordination agreement will typically describe the loan that is being subordinated and the interest of the lender to which a credit is being extended. While one or more loans can be extinguished through foreclosure, liens for the payment of ad valorem taxes on the land remain even after foreclosure. Although the lender can bring coverage from title insurance, it can be cheaper to give notice to prospective buyers or lenders through a recorded subordination agreement.
The Subordination Provision. The subordination provision may provide that the title of an owner of a note or the holder of a mortgage or deed of trust to any property described in the mortgage or deed of trust is prior in right to all other liens, or that certain liens will be prior to the lenders’ liens. In a simple form, the subordination provision may negate the legal implications of a priority or junior position. An example of a simple provision in a subordination agreement is, "The undersigned owner of the indebtedness and the undersigned lienor hereby subordinates his interest to Landlord’s lease for the term therein set forth."
The Legal Effects of Subordination
The legal implications of agreeing to a subordination agreement are significant for the parties involved. Primarily, the legal rights of the first lender and potential loss of priority or a secured position in the event a second lender is involved in the credit transaction.
While the legal remedies available to a first lender who has been subordinated may be limited to those set forth in the specific terms of the subordination agreement entered into by the first lender with the second lender , the review of the circumstances behind the execution and delivery of the subordination agreement may give the first lender some legal recourse.
In addition to the possibility of tortious interference with contract claims, it may also be possible for the first lender to establish a cause of action for negligence or breach of contract in the event such first lender was not provided the opportunity to review or consent to the specific terms set forth in a subordination agreement.
Drafting a Subordination Agreement
If the protection provided to all lien holders is to be maintained, then it is essential for the subordination agreement to be drafted carefully so that it accomplishes its intended purpose.
The most important step in drafting a subordination agreement is consultation with appropriate legal experts. Subordination agreements in commercial real estate transactions implicate complex issues relating to the rights of lien holders and lien claimants. Further, intercreditor issues and appraisal issues must often be considered when drafting a subordination agreement. Consequently, it is the view of this author that prudent practitioners will consult with a land use counselor, a foreclosure and bankruptcy attorney, an appraiser, and a collateral review and UCC expert when drafting a subordination agreement in order to ensure that the subordination agreement meets its intended purpose of protecting the respective rights of all lien holders.
The second step in customizing the subordination agreement to a specific real estate transaction is to consider the credit quality of the parties and how that is likely to impact upon the terms of the transaction. The better the credit quality of the parties the more flexible they can afford to be in negotiating the terms of the subordination agreement. In contrast, when the credit quality of the parties is suspect, the terms of the subordination agreement must be more closely linked to the proceeds of any sale of the property.
The last step in drafting the subordination agreement is negotiation of the agreement into final form.
Subordination Risks
Subordinating a loan typically will serve the purpose of getting a loan to a senior creditor of a borrower secured, by another or "subordinated" loan. Subordinating an existing loan may reduce the risk for the existing lender if the borrower is successful and assets increase in value which increases the size of the loan to be subordinated. In either event the subordination agreement may give rise to legal risks, such as a preference action if the borrower files for bankruptcy, or damage to a secured lender’s claim if the borrower defaults on the loan.
By executing a subordination agreement that permits additional credit to be extended to a borrower, the existing creditor may be exposing itself to preference risk in the event of a subsequent bankruptcy. The creditor may have wished to terminate the credit relationship and recover on its security interests prior to filing, but such opportunity may be lost by subordination. A subordination agreement should include a carve out to avoid such preference risk.
From the borrower’s perspective the risk is that if a subordinated lender fails to enforce its rights under its loan, then a senior lender may be given room to enforce its rights without any possibility for parri passu treatment for the subordinated loan. The best way for this risk to be avoided is for a subordinated lender to become part of the monitoring system put in place by the senior lender and/or to insist on rights to participate in any enforcement of obligations under the loan documentation.
An additional risk to consider may arise if two or more creditors enter into a subordination agreement. Suppose one of the subordinating creditors has defaulted on payments to its lender and has released its security in favor of a new lender who is to become a senior lender to the borrower. In that case, the senior creditor to the borrower may be able to assert that the creation of further security by the borrower was prohibited by the subordination agreement. However there also would be a risk to the existing lender that intercreditor status may be successfully asserted against it by establishing that it cannot enforce its rights under its security documents without the consent of the subordinate lender.
Conclusion: Using Subordination to Your Advantage
In conclusion, subordination agreements are an important element of most real estate transactions. They allow the parties to agree as to the priority of the respective security interests. As the rights of lenders, to be repaid on time and in accordance with the loan documents, decrease under a subordination agreement and, conversely, the rights of the borrower increase, it is essential to assure that the subordination agreement is properly executed by the parties . Lenders should require any necessary documents from the borrower. Finally, although there are many forms of subordination agreements, the parties in a transaction should pay particular attention to their individual situations, and not rely solely on a form. Consulting a qualified attorney is always the best advice.