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What is a Subordination Agreement and How Does It Apply to Bankruptcy?

Like other specialized fields, bankruptcy contains many terms and financial concepts that can be confusing or unfamiliar.  Subordination agreement is often one of these terms.

To subordinate something means to place it lower in rank or importance.  In bankruptcy, creditors are subject to subordination, meaning some creditors take priority for payment over others. A subordination agreement establishes the ranking or priority of debt payment to creditors.  Understandably, creditors often try to maneuver debt agreements so their debts receive priority payment.  And in bankruptcy, creditors with low priority may receive very little payment or even none at all.  This occurs when the debtor does not have enough proceeds to pay off all debts.

Title 11 of the Bankruptcy Code outlines bankruptcy requirements, including debtors’ and creditors’ obligations, rights, and the procedures involved.  However, like many laws or legal documents, a lot of the language is not in plain English.  Title 11 of the U.S. Code, Section 510 addresses subordination, establishing the rules for subordination agreements, and how they work.

If you are an individual filing a personal bankruptcy, you usually encounter subordination agreements when dealing with home mortgages.  When you decide to refinance the mortgage on your house by taking out a second mortgage, the creditor for the second mortgage has lower priority than the first mortgage creditor.  However, the second mortgage creditors may decide when approving your refinancing that you should also sign a subordination agreement, which can establish a higher priority for their payment.  In essence, you have two creditors who are using the same collateral—in this case your home—to secure the loan.

How the bankruptcy courts rule on subordination is not always clear-cut or predictable.  An experienced bankruptcy lawyer can provide you with wise legal guidance and help you deal with subordination agreements during bankruptcy.

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