Arrangements with third-party creditors: Subordination of security interests

Hi my name is Richard Dusome and I'm a Financial Services lawyer at Gowling WLG and you are watching video #4 of our Arrangements with Third Party Creditors video series.

In this video we're going to review one course of action to address third party creditors you encounter in structuring a new senior lender financing for a prospective borrower. Specifically we will look at the formal and informal subordination of the security interest held by another third party.

There will be instances where your search under the Ontario Personal Property Security Act (known as the PPSA) uncovers a prior third party creditor of your borrower with a security interest that cannot be effectively dealt with through a PPSA Estoppel Letter or a No Interest Letter. This will typically occur when the other third party's interest is not in fact limited to a specific asset or assets like the interest of an equipment lessor. Perhaps the creditor also seeks to have a general security interest over all of the personal property assets of your debtor. Or perhaps the creditors are intended to have different priority rankings to different classes of assets.

In many, but not all, cases PPSA priority is established by way of the order of registration. Thus, the only real way to adjust or re-establish the relative priorities of the parties and to put a new lender into first position is by way of a subordination.

The subordination can be implemented by way of a separate agreement, or by way of a clause within a larger and more complicated inter-creditor agreement or priorities agreement.

Generally speaking, a subordination is simply an agreement whereby one creditor (known as the subordinate creditor or junior creditor) agrees that its present and future security documents and PPSA registrations shall rank junior or subordinate in priority to the security documents and PPSA registrations of another creditor (known as the senior creditor). The subordination re-sets the priorities as between the junior creditor and senior creditor otherwise established by the initial order of registration.

A Subordination Agreement is key because it gives you, as the senior creditor, a direct covenant from the junior creditor that you can enforce independently. It is typically a document signed only by the junior creditor in favour of the senior creditor as the covenants are customarily all granted by the junior creditor in favour of the senior creditor. It may address the subordination of debt or security or both. The document is often combined in the form of an Assignment, Postponement and Subordination Agreement. It may include provisions subjecting the junior creditor to security enforcement standstills which we outline in a later video in this series.

So from whom should you seek Subordination Agreements ?

1.  VTB / Second Lien / Mezzanine Financing. Subordination Agreements are frequently obtained from lenders intending to have a second ranking security interest over all assets of a debtor behind the security of an operating lender. This may be in the context of a vendor takeback loan or a second lien or mezzanine financing made available to the debtor. It may also be sought from a lender acquiring a second ranking security interest over all assets of a debtor to support a first ranking loan made by that lender to a related party.

2.  Secured Shareholder Loans. Subordination Agreements may also be obtained from shareholders and related parties to the debtor who chose to secure the repayment of their shareholder loans or inter-company loans when the debtor was first incorporated. It may include provisions subjecting the junior creditor to security enforcement standstills so they cannot take action on the inter-company or shareholder related debt without the Senior Lender's consent. Otherwise the shareholder could force the Senior Lender's hand and make it step into enforcement early in order to be able to control the enforcement.

3. Unsecured Inter-company Loans. Finally, Subordination Agreements may be obtained from shareholders and affiliates who do not currently hold security but may take security in the future.

Subordination Agreements can be simple or complicated and One Size does definitely not fit all. The document to be used depends upon:

(i) which person is providing the subordination,

(ii) does that person have security, and

(iii) what is the level of complexity of the inter-creditor arrangements.

In other words, a 15 page formal agreement may be overkill for a related party whereas a three page document would not.

Remember that Subordination Agreements have their limitations. In some cases where there are multiple PPSA registrations involved or more complicated arrangements, you will need the benefit of a more fulsome inter-creditor agreement or priorities agreement. We invite you to our subsequent video on that topic.