The relationship between a lender and a borrower is pretty simple. The lender makes a loan with the understanding that the borrower will repay the amount loaned plus an agreed upon rate of interest. Lenders don’t lend funds out of the goodness of their heart; they expect to be repaid. To fortify the prospect of repayment, lenders employ a series of tools. These include guaranties of payment by other parties (often those having an ownership interest in a business borrower, or parties otherwise benefited in some manner by the loan), and/or mortgages, pledges and security agreements. Pursuant to those guaranties, the borrower agrees that the lender may take the borrower’s property if the borrower fails to pay the loan. Simple enough.
However, what can you do if your lender, to whom you’ve already pledged all of your assets, won’t lend you additional funds to purchase something critical for your business? All is not necessarily lost. You may find another lender willing to step in to provide additional financing, but that lender too is often going to want collateral to secure repayment. For example, let’s say your business has already obtained financing secured by all of its assets. You then wish to finance the purchase or capital lease of additional equipment through the equipment’s manufacturer, but the manufacturer won’t do so without a lien on assets in addition to the equipment being purchased or leased. This can happen, for example, when the equipment you are purchasing or leasing is intended to be so integrated into your facility that it will be difficult for the creditor to remove and resell it to satisfy the debt if you fail to pay. The manufacturer’s financing arm may ask, for example, that your business open a certificate of deposit account with that financing entity which will serve as additional security. What do you do though if the funds necessary to establish the certificate of deposit are already subject to your primary lender’s security interest and the terms of that security interest prohibit the second lender’s lien?
One solution to consider is the use of a subordination agreement. A subordination agreement is an agreement between a borrower, prior lienholder and the later lienholder pursuant to which the prior lienholder agrees that its senior lien on the borrower’s assets, or more likely some portion of them, will instead be subordinate (junior) to the later lienholder’s security interest in those assets. So with the certificate of deposit example, your initial lender with the prior-in-time lien will, in the subordination agreement, agree that its lien in the certificate of deposit funds will be junior to the equipment lender’s interest in those funds. Your primary lender is not giving up its rights to the certificate of deposit, it just agrees to stand behind the second lender with respect to that asset.
Why would a primary lender agree to such an arrangement? Remember, the primary lender’s goal, like that of any lender, is to be repaid in cash; it does not really want to collect your assets and sell them to pay off your debt. Your primary lender itself may not be able or willing to extend additional credit to you, but that does not mean it doesn’t recognize that your purchase of new equipment is critical to your business’ success, and more selfishly to your repayment of its loan. If a primary lender determines that standing behind another creditor on some portion of assets increases the likelihood of it being repaid, then doing so makes perfect business sense, and that is the borrower’s sales pitch.
There are numerous variations of subordination agreements. Such agreements are also possible outside of the business context, and may prove helpful in permitting a consumer borrower, for example, to refinance one mortgage while maintaining the borrower’s home equity loan with another lender.
If you are a business or consumer borrower who needs to manage borrowing from multiple lenders, experienced Kreis Enderle attorneys are available to provide guidance.