What is Subordination Agreement?
809 reads · Last updated: December 5, 2024
A subordination agreement is a legal document that establishes one debt as ranking behind another in priority for collecting repayment from a debtor. The priority of debts can become extremely important when a debtor defaults on their payments or declares bankruptcy. The higher a debt's priority, the more likely it is to be repaid, at least in part.
Definition
A subordination agreement is a legal document that establishes one debt as ranking behind another debt in terms of collecting repayment from a debtor. When a debtor defaults on debt payments or declares bankruptcy, the priority of debts becomes extremely important. The higher the priority of the debt, the more likely it is to be repaid, at least to some extent.
Origin
The concept of subordination agreements originated with the development of financial markets, particularly in corporate financing and bank lending. As corporate financing structures became more complex, subordination agreements became essential tools for ensuring the interests of different creditors. In the late 20th century, with the globalization and complexity of financial markets, the use of subordination agreements became more widespread.
Categories and Features
Subordination agreements are typically divided into two categories: unsecured subordinated debt and secured subordinated debt. Unsecured subordinated debt lacks collateral support, making it riskier, while secured subordinated debt is backed by specific assets, reducing risk. The main feature of subordinated debt is its low priority in repayment order, meaning that in bankruptcy liquidation, subordinated creditors are usually paid after senior creditors.
Case Studies
A typical case is the bankruptcy of Lehman Brothers during the 2008 financial crisis. Lehman Brothers' bankruptcy left its subordinated creditors with little repayment, as senior creditors received asset distributions first. Another case is General Motors' bankruptcy restructuring in 2009, where subordinated creditors accepted a combination of stock and new debt instead of cash repayment, illustrating the low priority of subordinated debt in bankruptcy proceedings.
Common Issues
Common issues investors face with subordination agreements include misunderstandings about their high risk and the potential for low repayment rates in bankruptcy situations. Investors should carefully assess the risks of subordinated debt and consider its appropriateness within their overall investment portfolio.
