Subordination in

banking A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...

and

finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...

refers to the order of priorities in claims for

ownership Ownership is the state or fact of legal possession and control over property, which may be any asset, tangible or intangible. Ownership can involve multiple rights, collectively referred to as '' title'', which may be separated and held by dif ...

or interest in various

assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

United States law

Subordination of debt

Subordination is the process by which a creditor is placed in a lower priority for the collection of its debt from its debtor's assets than the priority the creditor previously had, In common parlance, the debt is said to be subordinated but in reality, it is the right of the creditor to collect the debt that has been reduced in priority. The priority of right to collect the debt is important when a debtor owes more than one creditor but has assets of insufficient value to pay them all in full at the time of a default. Except in

bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...

proceedings, the creditor with the first priority for collection will generally have the first claim on the debtor's assets for its debt and the creditors whose rights are subordinate will thus have fewer assets to satisfy their claims. Subordination can take place by operation of law or by agreement among the creditors.

Subordination of security priority

Subordination is also an issue in the priority of

security interest In finance, a security interest is a legal right granted by a debtor to a creditor over the debtor's property (usually referred to as the '' collateral'') which enables the creditor to have recourse to the property if the debtor defaults in m ...

s in the ownership of property. For example, in real estate,

mortgages A mortgage loan or simply mortgage (), in civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pur ...

and other

liens A lien ( or ) is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation. The owner of the property, who grants the lien, is referred to as the ''lienee'' and the pers ...

on the title to secure the payment or repayment of money usually take their priority from the time they attach to the title. The purpose of this ordering of priority is to determine, in a

foreclosure Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has Default (finance), stopped making payments to the lender by forcing the sale of the asset used as the Collateral (finance), coll ...

resulting from a default, who gets paid first with the sale proceeds from the foreclosure proceeding. Earlier mortgages or other liens are often subordinated by their holders to later ones in order to accomplish agreed-upon ends. An example is for the holder of a mortgage on undeveloped land to subordinate that mortgage to a later construction loan mortgage. The motivation is either the belief that improvement of the land will benefit the first lender or that the first mortgage requires that it be subordinated to a future construction loan. The ''subordination percentage'' of a security is the percentage of the total capital which is subordinate to the security in question. Thus, the security will not suffer any losses until after that percentage of capital has been lost.

Dealer subordinable debt

In the automotive financing industry, many dealerships are allowed to designate personal loans which are payable to the ownership as subordinable debt. The finance institution and dealership may come to an agreement which allows this debt to stay within the confines of the financial statement and concurrently improve the dealership financial position from a liquidity perspective.

Equitable subordination

Bankruptcy courts in the United States have the power and authority to subordinate prior claims on the assets of a bankrupt debtor to the claims of junior claimants based on principles of equity. This is a remedy called "equitable subordination." The basis for subordination is usually the inequitable conduct of the prior claimant with respect to junior claimants. See, e.g., ''Murphy v. Meritor Savings Bank'', 126 B.R. 370, 393, 413 ( Bankr. D. Mass. 1991), in which an LBO left the corporation with insufficient cash to operate for longer than 10 days. In that case, the court not only avoided the mortgage securing the LBO debt, but it also subordinated the resulting lender's unsecured claim to the claims of all other creditors of the bankrupt debtor. Equitable subordination can be used to subordinate both secured and unsecured claims.

References