What is subordination?
Subordination, in a legal sense, means ranking one claim behind another claim regarding priority. The subordinated claim is referred to as the “junior” claim, while the claim with the highest priority is referred to as “senior”.
Subordination agreements are used to rank claims against a debtor in regard to priority, if there are more than one. This means that a subordinated claim can only be collected after the ones ranked above it are collected, which becomes particularly important when a debtor owes debts to several creditors and is unable to repay on time.
If a debtor defaults on repaying their creditors, subordination agreements can be used to rank the debt. One example would be a business declaring bankruptcy:
- The business owes a total of EUR 900,000 in debt to 4 different creditors.
- Of this total, EUR 400,000 are senior debt, the remaining EUR 500,000 are subordinated - or junior - debt.
- The business’ asset value amounts to EUR 600,000. Since the asset value of the bankrupted business is not enough to repay the total amount, the division into senior and junior debt becomes important.
- First, the senior debt is paid off. After that, the remaining EUR 200,000 will be distributed among the remaining junior debt holders.
Subordination clauses can primarily be found in mortgage refinancing agreements. If you enter into an agreement with a lender and the agreement contains a subordination clause, it usually means that this debt will stay senior to any debt incurred afterward.
- If no subordination agreements are signed, the different claims are automatically ranked in chronological order.
- A subordination agreement has to be acknowledged by a notary and entered into public record in order to be enforceable.