Vanderbilt Law Review

First Page



Creditors distrust debtors and other creditors. Some of this in-security is dispelled by the two basic priority rules--"first in time"for secured credit and pro rata sharing for general credit. These priorities, however, are merely suppletive rules that replicate what most creditors want.' Individual creditors can have different objectives that call for different priorities. For that reason, creditors vary their rights by contract.'

Two motives exist for subordination agreements. First, a creditor may wish to subordinate its priority to induce another creditor to advance new funds. Second, a junior creditor may wish to advance credit, but the resulting increased leverage of the debtor would violate a covenant in a loan agreement between the debtor and some other creditor. A subordinated debt may be the only kind of debt that does not violate the covenant of a senior creditor.

Governance of remote contingencies within the remote contingency of the debtor's liquidation is often too costly. Hence, subordination agreements are often vague and incomplete. When financial disaster strikes, courts are called upon to fill in the omissions left by the contract. The best way for courts to fill in these contractual gaps is by reference to the economics of the basic subordination relationship among creditors.

This subordination analysis currently does not exist. The seminal article in the field has stated that a theory of subordination does not matter, providing the agreement is enforced.' The disdain for exploring the structure of the subordination relationship in that article may have deterred the courts from making this inquiry. As a result courts have not been solving interpretation disputes consistently with the dynamics of subordination.

This Article examines the nature of voluntary subordination of lien and bankruptcy priorities. Part II briefly addresses the judicial role in determining the meaning of subordination agreements. Part III will demonstrate that all aspects of the agreement to subordinate debt (but not agreements to subordinate lien priority)derive from the junior creditor's simple core promise. The junior creditor promises that, after a point in time, he will receive no payment from the debtor on the junior claim until the senior creditors are paid. From this core promise, courts can build a jurisprudence that is consistent with the economics of consensual subordination.

Part IV will show that every promise not to receive payment on the junior debt is a transfer of ownership (an "assignment") of the junior claim from the subordinated lender to the senior creditors. Subordination of debt (but not of lien priority) bridges the gap between the junior creditor's personal obligation and the encumbrance of the junior creditor's property. The shift from the junior creditor's personal obligation to the transfer of the junior creditor's property protects senior creditors from the junior creditor's bankruptcy or other misbehavior. This is an important consideration because the junior creditor is frequently an insider of the common debtor. Recognition that subordination of the junior claim is an assignment by a nonrecourse guarantor in order to secure the senior claim will permit courts to expropriate many useful doctrines pertaining to assignment of claims in action.