Put simply, a subordination agreement is a legal agreement which establishes one debt as ranking behind another debt in the priority for collecting repayment from a debtor. It is an arrangement that alters the lien position. Without a subordination clause, loans take chronological priority which means that a deed of trust recorded first will be considered senior to all deeds of trusts recorded after. As such, the oldest loan becomes the primary loan, with first call on any proceeds from a sale of a property. However, a subordination agreement acknowledges that one party’s claim or interest is inferior to that of another party in the event that the borrowing entity liquidates its assets. Further, shareholders are subordinate to all creditors.
The junior debt is referred to as a “subordinated debt”, and the debt which has a higher claim to any assets is the senior debt. Often, the borrower does not have enough funds to pay all debts, and lower priority debts may receive little or no repayment. For example, if a business has $400,000 in senior debt, $100,000 in subordinated debt, and a total asset value of $420,000, upon liquidation of the company, only the senior debtholder will be paid in full. The remaining $20,000 will be distributed among the subordinated debtholders. Subordinated debts are, therefore, riskier and lenders will require a higher interest rate as compensation.
Debt subordination is not uncommon when borrowers are working to obtain financing and are entering into loan agreements. Subordination agreements are often executed when a homeowner refinances the first mortgage. Refinancing cancels the loan and writes a new one. These events happen simultaneously. As soon as the bank cancels the primary mortgage, the second mortgage rises to senior position and as a result, the refinanced primary loan ranks behind the second mortgage. Primary mortgage lenders want to retain their first position rights in a foreclosure sale and will not approve a refinance unless the second mortgagee signs a subordination agreement. However, the second lender does not have to subordinate its loan. If the property’s value drops or the refinanced loan is greater than the previous loan, the second lender may refuse to subordinate. As such, homeowners may face difficulty in refinancing the mortgage. Additionally, due to the risk involved, second mortgages usually carry a higher interest rate.
Pursuant to California Civil Code section 2953.3, every subordination agreement shall contain the following:
- At the top of the agreement, the words “SUBORDINATION AGREEMENT” must appear;
- A Notice should be included after the title as follows:
- “NOTICE: This subordination agreement (“may result” or “results” as appropriate) in your security interest in the property becoming subject to and of lower priority than the lien of some other or later security instrument.”
- If the terms of the subordination agreement provide that a loan may be obtained for any purpose or purposes other than defraying the actual contract costs for improvement of the land, a notice must be included reading as follows:
- “NOTICE: This subordination agreement contains a provision which (“allows” or “may allow” as appropriate) the person obligated on your real property security to obtain a loan a portion of which may be expended for other purposes than improvement of the land.”
Further, these agreements are common in other real estate business practices. We briefly discuss three types of agreements below.
- An executory subordination agreement is an agreement under which the subordinating party, like the seller of land, agrees to execute a subsequent instrument subordinating his or her security interest to another security interest, like the lien of a construction loan. However, such an agreement is merely a promise to agree in the future which may be deemed an illusory promise and be difficult to enforce. As such, the party could refuse to sign the second agreement subordinating his or her interest, which can give rise to a breach of contract claim. Again, these agreements can be difficult to enforce and there are rigid criteria that need to be met.
- Automatic subordination agreement is when the principal agreement and subordination agreement are executed and recorded at the same time. For instance, usually a trust deed incorporating a subordination agreement will state that the lien of the trust deed will, on recordation, automatically be junior to the lien of another trust deed, or it will state that the new loan and deed of trust will, without any other or further instrument of subordination, become prior and superior to the lien of another trust deed.
- Another type of subordination agreement provides that the subordinating party agree that the instrument securing his or her interest in the property will be recorded after another security instrument and, by operation of the recording statutes, ranked as junior to it.
The law surrounding subordination agreements is complicated and there are many intricacies that only an experienced attorney will be able to analyze. If you need assistance with preparing an agreement or need analysis regarding the terms of an agreement, please contact the experienced attorneys at Bremer, Whyte, Brown & O’Meara LLP for a consult.