Subordination Clause Guide: 5 Insights for Absolute Clarity

Hi! Looking to master the subordination clause in finance world?

I’m here to help you understand this important concept; consider this your exclusive backstage pass to the ‘Subordination Sonata‘.

So, here’s the deal:

If you’re dealing in the real estate world, this is something really important that you should be aware of.

Knowing how it works can give you an advantage in recovering strongly from the worst situations because this commercial clause can help you safeguard your hard-earned cash.

So, let’s get started with this Subordination Sonata.

Breaking Down the Subordination Clause

Define Subordination Clause

Example: One has two loans on one property: a primary mortgage and a secondary mortgage. If they can’t make payments and their home goes into foreclosure, the subordination clause makes sure that the primary mortgage gets paid off before the secondary mortgage.

Why this specific order?

The legal principle of “first in time, first in right” applies here. The first debt recorded has the first right to be repaid should the borrower default. It’s like calling ‘dibs’ on repayment.

Explain ‘Subordinate Lien’ and ‘Subordinate Mortgage’

These are just synonyms for a secondary mortgage or loan that comes after the primary one. These lenders know their spot in the repayment line, i.e., right behind the earlier ones.

What does “Priority” mean in the context of liens and mortgages?

It means the order in which debts get paid when a property is sold or foreclosed. It’s the VIP list that decides who gets repayment first.

It’s like a line at your go-to ice cream joint. The first person gets to choose from all the flavors. The second in line gotta chill and wait their turn. So, basically, if there’s a limited amount of ice cream (or money, in our real-life situation), the person at the front of the line gets served before anyone else. That’s the concept of lien priority.

Differentiation between primary and secondary mortgages

It’s actually quite easy to distinguish.

  • The primary mortgage is the big loan you get to buy your property, like the main meal.
  • A secondary mortgage is an extra loan tied to the same property, like a side dish or dessert. Most people get a home equity loan or a secondary mortgage to renovate their place or if they are facing financial hardships.

The importance of the subordination clause

It’s like an insurance policy for lenders. It’s a clear way to make sure they don’t get screwed if there’s a default. It’s like having a backstage pass to a concert – you always get the prime spot, even if the crowd gets a bit wild.

Who benefits from this?

Apart from the big lenders, small to medium commercial lenders also benefit from this clause to secure their subsequent loans and gain flexibility and financial strength.

What if the secondary mortgage holder doesn’t sign?

In such a case, you might need to offer some extra incentives as additional motivation, like potentially negotiating to offer the lender better terms.

Effect of subordination of guarantees or mortgages provided by third parties

If you’re a third party who has provided a guarantee or mortgage, this clause states that your rights will be secondary to the rights of the new lender.

Implications in the event of asset liquidation

A subordination clause determines the repayment priority. Seniors receive their share first, and juniors get any remaining, if there is any.

i1 – The Subordination Clause in Various Contexts

Subordination is one of the significant real estate provisions within the context of mortgage clauses.

Mortgage Note

When you get a mortgage, you sign a note to repay the loan. This note might have a subordination clause stating that if you take out another loan using the same property as collateral, your first lender has priority for repayment if things go wrong.

Commercial Real Estate Lease Agreements

A subordination clause in real estate gives the landlord’s mortgage lender priority over the tenant’s lease.

Imagine you’re renting space in a commercial building for your trendy new coffee shop. If the landlord defaults on their mortgage and the property is sold, your lease could be terminated unless there’s a subordination clause in your agreement.

In such a case, the Subordination clause in your Non-Disturbance and Attornment Agreement (SNDA) makes sure your lease stays valid even if the property gets sold – your coffee shop keeps on brewing.

Trust Deeds

These are similar to mortgages, but with a twist. A third party, called the trustee, is involved. If a trust deed has a subordination clause, it means it agrees to have a lower priority.

Intercreditor Agreements

These agreements determine which creditors have the main claim on the borrower’s assets. The subordination clause establishes the order of priority for creditors.

In a creditors’ tug-of-war, the rules determine who gets to pull the assets first.

A real-world example of a subordination clause in action

Remember financial crisis of 2008?

One important factor was subprime mortgage lending, where homeowners took additional loans on their properties. Some loans had subordination clauses, meaning the original lender would be repaid first if there was a default.

So, when the housing bubble burst and foreclosures started happening left and right, these clauses were tested, which resulted in primary lenders getting their money back first, leaving many secondary lenders with nothing.

i2 – Understanding Different Types of Subordination Agreement

Executory Subordination Clause

It’s a complex function, just like its fancy name. Debt subordination is not automatic in such agreements; it activates only when certain conditions are met, but meeting those predetermined conditions can be complex and challenging.

It’s like a thrilling scavenger hunt with a lot at stake. You’ll only be safe once you find and unlock the final clue, i.e., after all the specific conditions are met.

Here are a few examples of when an “Executory Subordination Clause” might come into effect:

  • Event of Default: It is a common condition that triggers this clause when the borrower fails to make payments on time (including the grace period), files for bankruptcy, or violates specific terms of the loan agreement.
  • Change in Creditworthiness: If the borrower’s creditworthiness declines significantly, this clause may come into effect to protect the main lender should the borrower’s financial situation become riskier.
  • Refinancing or Sale of the Property: If the borrower refinances or sells the property, it may trigger this clause.
  • Transfer of the Primary Loan: If the primary loan is sold or transferred to another lender, this clause may come into effect. It is included to make sure that the primary lender’s priority status remains intact, regardless of any changes in loan ownership.

Above were simple examples. The conditions for activation can vary and are specified in the agreement.

Automatic Subordination Clause

As the name implies, the subordination here happens automatically. It doesn’t wait for any specific conditions. Once you sign the agreement, it’s a done deal! The subordination clause takes effect immediately, without any questions or regardless of what happens in the future.

Subordination Clause Examples

Loan Agreement

Credit Agreement

Lease Agreement

i3 – Subordination Clauses in Commercial Real Estate Loan Agreements

Mezzanine loans

Mezzanine loans are a type of financing that sits between debt and equity. A mezzanine lender can share in the investment’s profit through an equity kicker.

  • These loans have two main advantages over pure equity investments. The lender is guaranteed a fixed return, and they have rights to the property as security for repayment, but they are second in line behind the primary mortgage lender.

Preferred equity

Preferred equity shares similarities with mezzanine lending, as both guarantee a specified rate of return for the investor. If the borrower doesn’t pay back the loan, the investor will be repaid before other equity investors, but after the first (and possibly the second) lender.

  • Preferred equity is different from mezzanine loans because it involves owning shares instead of borrowing money. These investors cannot use the property as collateral but are granted special rights, like priority access to a company’s assets and earnings, in specific default scenarios. It’s like getting the best slice of pie before anyone else.

i4 – Special Considerations in Subordinated Debt

Subordination clauses in wills and estates

It’s like when a grandparent leaves a treasure map, but instead of treasures, it’s debts. Subordination clauses in debt agreements determine the priority of loan repayment from someone’s estate if they have multiple loans.

Exception

A common exception is when a junior creditor uses a court order to stop the enforcement of a subordination clause.

i5 – Liens and Foreclosure

Understanding liens in real estate and how they come about?

It’s like a sticker that says, “I owe money!” A lien is a legal claim that a creditor has on your property due to an outstanding debt. They can occur due to unpaid taxes, obligations, or losing a court case.

Impact of lien priority on repayment order after a foreclosure sale

When a property is sold due to foreclosure, lienholders are paid based on their rank, with the first-priority lien getting paid first.

What happens if the value of a home isn’t enough to cover all of the liens?

If higher-ranked liens use up all the funds received, then lower-ranked lienholders do not receive any payment or may only receive a smaller portion, if anything at all.

How to remove a lien from a property title?

Removing a lien from a property title can be challenging. To remove a lien, you usually have two options: pay off the debt or prove that the lien is invalid. After paying off the lien, you usually need to file a lien release or similar legal document with the appropriate authority to officially remove it from the property title, and it’s important to be prepared to seek professional legal advice when needed.

Bankruptcy and Subordination

How a bankruptcy court determines the validity and enforceability of a subordination agreement?

When someone goes bankrupt, they’re usually in a pretty tough spot. They’re like the captain of a sinking ship, making sure everyone gets off okay. But when funds are limited, it’s not possible to help everyone by paying off all their debts, and that’s where the subordination agreement comes into play: the senior debts get paid off first, then the junior debts follow suit.

Subordination Agreements in Practice

Case Study 1: Argon Credit

In an Illinois court case involving a company called Argon Credit, the court had to decide on a money issue between two lenders. Argon Credit had borrowed money from a Senior Lender and a Junior Lender. The Junior Lender agreed to be paid back after the Senior lender.

However, when Argon Credit went bankrupt, the Junior Lender wanted to check the Senior Lender’s loan details. The court decided that the Junior Lender couldn’t do this because their agreement didn’t allow it. The agreement said that the Senior Lender had to be paid back first, no matter what.

This case shows that the bankruptcy court will uphold the agreement between the lenders unless there’s something unclear or problematic with the agreement.

Case Study 2: First Choice Bank

In a recent court case in Minnesota, a bank called First Choice sued a company named Riverview Muir Doran. The two had an agreement that said that if a borrower couldn’t pay back a loan, First Choice (the senior creditor) would be paid before Riverview Muir Doran (the junior creditor). However, the agreement was a bit unclear on who exactly could make these payments.

A problem arose when a third party (not the original borrower) made payments to Riverview Muir Doran. The court decided that these payments should have gone to First Choice first, according to their agreement. This decision surprised some people because, usually, such agreements are more explicit about third-party payments.

This case has caused some concern. It suggests that when setting up similar agreements in the future, it’s important to be very clear about who can make payments and who gets paid first, even when payments come from unexpected places.

Conclusion

Subordination clauses are important for determining debt priority in cases of default or bankruptcy. It can have various effects on borrowers and homeowners, such as higher interest rates and changes in subordination order during refinancing.

As this subordination sonata comes to an end, I hope it has given you a new perspective and made the idea of subordination less scary and more intriguing.

Over to you

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