What is Subordination?

Avoiding Potential Pitfalls When Entering into a Subordination Agreement

What is Subordination?

Subordination is “the process by which a creditor holding a priority debt agrees to accept a lower priority for the collection of its debt in a deference to a new debt.” according to Cornell University Law School’s Legal Information Institute. Or “A written contract in which a lender who has secured a loan by a mortgage or deed of trust agrees with the property owner to subordinate its loan (accept a lower priority for the collection of its debt), thus giving the new loan priority in any foreclosure or payoff.”

There are instances when a secured creditor decides to subordinate a senior-priority position to another creditor because it increases the prospects of the obligation being satisfied.

However, if a creditor is considering whether or not to provide financing, equipment or other assets based on obtaining a senior priority position, by swapping priority with an existing creditor, said creditor must be cautious of this approach.

The junior-priority creditor entering into the subordination agreement must carefully review the security agreement and perfection procedures undertaken by the pre-existing creditor to determine that the prior security interest was properly perfected.

Pitfalls of Subordination

The recent case of Caterpillar Financial Services v. Peoples National Bank, N.A. (March 4, 2013) from the Seventh Circuit of the U.S. Court of Appeals, reveals the potential pitfall of entering into a subordination agreement without an experienced professional lien processing service.

In Caterpillar, the debtor obtained loans to purchase mining equipment from three separate entities: (1) Peabody Energy Corporation (“Peabody”), (2) Caterpillar Financial Services Corporation (“Caterpillar”) and (3) Peoples National Bank (“Peoples”).

Each of the creditors extended their loans in the order indicated and filed their UCC Financing Statement at the time of obtaining the loan so they had the priority position indicated above. Debtor eventually defaulted on all three loans.

Partial Subordination or Total Subordination?

When Peoples obtained its loan, Peabody agreed to subordinate its first position, in terms of priority, to Peoples to increase the possibility that Debtor would have the ability to repay the Peabody loan.  The court addressed whether the subordination agreement permitted Peoples to move ahead of Caterpillar in terms of priority.  The court observed that there are two approaches to subordination – “partial subordination,” which constitutes the majority approach and “total subordination,” which is followed in a minority of jurisdictions.

“The “partial” in “partial subordination” denotes the fact that the parties to a subordination agreement swap places in the priority ladder only to the extent of the smaller of the swapping parties’ loans. If, for example, Peabody had been owed $1 million by S Coal, the subordination agreement would have given the bank [Peoples] first priority only with respect to the first $1 million of the bank’s $1.8 million loan. The order of priority would then be bank ($1 million), Caterpillar ($7 million), bank ($.8 million), Peabody ($1 million). The amount subordinated is limited to the amount that the creditor having priority over the nonparty was owed before he swapped places with a junior creditor. In the real as distinct from the hypothetical case, S Coal owed Peabody at least $4 million, which was much more than the bank’s loan, and so the bank was able to move into first place for its entire loan without hurting Caterpillar.”

The partial subordination approach allows the creditors to actually swap positions, so that the junior secured creditor Peoples would actually jump ahead of Caterpillar.  By contrast, the total subordination approach would have had Peabody simply take the position of Peoples without Peoples jumping ahead of Caterpillar.

While the Seventh Circuit observed that it followed the partial subordination approach, this was not the end of the analysis. Peabody was unable to produce a security agreement authenticated by the debtor that identified the collateral.

Because the first position priority interest of Peabody was not properly perfected, the subordination agreement did not permit Peoples to assert a security interest with a more senior-priority than Caterpillar.  Further, the court noted that even if Peabody’s security interest had been properly perfected, Peoples could only claim priority status in relation to Caterpillar up to the amount of the Peabody loan.

This would seem a fair resolution because it prevents Caterpillar from being prejudiced by the subordination agreement to which it was not a party.  The priority of Caterpillar would remain unchanged with the same amount of secured indebtedness needing to be paid prior to Caterpillar having its debt satisfied.

This case demonstrates that, under the majority approach, subordination agreements can be an effective tool for prospective creditors requiring additional collateral.  Since the senior creditor may be facing the prospect of not being paid if the debtor is financially struggling, the senior creditor may be agreeable to a lien subordination agreement.

However, prospective creditors considering such an approach need to carefully review the security agreements and UCC filings of the other party to the subordination agreement.

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