Meaning
Legal contracts establishing the priority of one debt over another determine the order of repayment during a liquidation. A subordination agreement is typically used when a company seeks additional financing and the new lender requires a first position lien. This document ensures that the junior creditor is only paid after the senior creditor has been satisfied in full.
The ranking of debt is a critical factor in credit risk assessment.
Creditor Ranking
Organizing the hierarchy of claims protects the interests of senior lenders. In a subordination agreement the secondary lender agrees to wait for payment until the primary lender is made whole. This ranking is verified during the due diligence process for a new loan.
Default Order
Determining who gets paid first during a bankruptcy prevents legal disputes between creditors. The terms of the subordination agreement specify the exact sequence of fund distribution. This order is a major component of the recovery rate for different classes of debt.
Payment Preference
Managing the flow of cash during normal operations ensures that senior debt is serviced before junior debt. A subordination agreement may include blocks on interest payments to the junior lender if certain financial ratios are not met. This preference is essential for maintaining the credit rating of the senior tranches.
