Introduction

In the evolving fund finance market, understanding the nuances of debt priority is more critical than ever, particularly as we see continued innovation beyond the traditional single-tranche credit facility. The foundational concepts of lien subordination and payment subordination are often conflated despite their distinct legal effects. In this Legal Update, we explain their differences and implications when structuring complex fund financings.

What is Lien Subordination?

Lien subordination addresses the priority of multiple creditors’ respective security interests or liens in specific collateral. It is a contractual agreement in which the senior creditor and junior creditor agree that the junior creditor’s security interest in the shared collateral will have lower priority.

• Focus: The collateral. Lien subordination governs the right to collect and sell the assets upon a default under the loan documentation.
• Effect: Proceeds of the collateral. The senior creditor is entitled to receive the proceeds from the sale or realization of the collateral first, up to the full amount of the senior debt. The junior creditor only receives the remaining proceeds, if any, after the senior debt is satisfied.
• Example in Fund Finance: In a subscription credit facility, a lien subordination agreement governs the rights of a revolving credit facility lender vis-à-vis a subordinated term loan lender, both of whom have a security interest on the uncalled capital commitments. Lien subordination provisions contained in an intercreditor agreement or the credit agreement itself ensure the senior lender has first access to any investor capital commitments called to repay the loan.
• The Fine Print: The most common form is the first lien/second lien structure. Lien arrangements can be more complex, however, involving split-collateral where one creditor holds a first lien on specific assets (e.g., equipment) while the other holds a first lien on other assets (e.g., inventory). The...