What is contractual subordination?

Contractual subordination is an arrangement where senior and junior loans are made to the same borrower (common debtor) but the senior creditor and junior creditor agree by contract priority of payment.  The rights and remedies of senior lenders are free from any actions of junior lenders with respect to the common debtor (and often any guarantor) and the shared collateral. Contractual subordination is essentially the purpose of intercreditor and subordination agreements.

A subordination agreement is an arrangement under which a current lender contractually undertakes to subordinate some or all of its rights against a borrower to the rights and interests of one or more other lenders.  The subordination agreement contractually:

1. Establishes the relative priority of the claims of the lenders to security;
2. Prohibits or restricts payments to the junior lender; and
3. Prohibits or restricts the right of junior lenders to foreclose on the collateral or exercise any other default remedies until senior lenders have been paid in full.

The nature of the contractual subordination is of critical importance to investors (shareholders), senior lenders, junior lenders and the borrowers.  Where investors are normally not party to the finance documents, except as party to the intercreditor agreement.