What You Need to Know About Bank Subordination Agreements
When a lender has a first lien interest in all of your business assets that means no other lenders can loan your company money on a secured basis. Most often, the first secured lender to your business will file a blanket UCC-1financing statement. That means that all your assets including contract rights and cash are collateral to the loan.
The one major exception to this practice is if a leasing company or other lender is lending money so you can buy a single piece of equipment, software, or other single item. Such items are usually serial numbered (such as a tractor). In those cases the financing source for the piece of equipment only files a lien against the specific piece of equipment you are buying.
Let’s suppose that you have a 5 year term loan with a bank that is secured by all your company’s assets. No new lender can make a secured loan until the first lender either subordinates their interest in a particular class of collateral, or enters into an intercreditor agreement with the second lender.
A subordination is a process where the second lender asks the first lender if they will “let go” of a particular class of collateral. The most common subordination agreements take place with accounts receivable and inventory. These are current assets that can be used to secure a working capital line of credit. Should the first lender agree to the subordination, they either assign their interest in the subordinated collateral to the second lender, or terminate their interest on the specific assets that are subordinated.
Subordination is the most common way lenders work with each other to allow multiple types of loans. One loan is usually a long-term loan and the second, a short-term line of credit facility. Once the first bank has subordinated their interest in the requested collateral, the second bank then files a UCC-1 financing statement showing they are in the first lien position on that class of collateral.
An intercreditor agreement is a bit different than a subordination agreement. They both serve to do the same thing, allow two different lenders to “split up” the collateral of a business so both can be secured in the first lien on their respective collateral.
Where an intercreditor agreement differs from a subordination is in the way it is structured. When lenders use intercreditor agreements they both file UCC-1 financing statements. The Uniform Commercial Code dictates that the one that is filed first is a superior lien to the second one. An intercreditor agreement is an agreement between the two lenders that essentially says, “regardless of the UCC’s filed at the state and local agency, the lenders agree to “split up the collateral” in a way specified by the intercreditor agreement.
The normal way this is worded is the first lender has first lien rights on those assets it has agreed to keep and second lien rights on the assets it has “given” to the second lender. The second lender has first lien rights on the assets that have been “given up” by the first lender. The second lender often has second lien rights on the remainder of the collateral.
One reason lenders use intercreditor agreements is because if one lender is paid off, the collateral that has been “given” to the other lender reverts back to the opposite lender.
In general second lenders prefer subordination over intercreditor agreements because intercreditor agreements don’t follow the normal UCC tried and true processes.
In either case, the borrower is benefited by getting access to additional credit with the two lenders working together to assist the borrower.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
You may contact Sam directly at: sam@lesliethacker.com
or follow him on Twitter: SMBfinance
EXTRA: If you have questions for Sam regarding business financing, the credit market, and similar issues, please send an e-mail. Your questions will be recorded and Sam will answer the best ones in his podcast show.
