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Should You Sign That UCC Lien Subordination Agreement?

So your lender asked you to sign a UCC lien subordination agreement. What does that mean and should you do it? I know, legal stuff can be confusing. Let’s break it down into simple terms.

A UCC lien is a legal claim on assets a business owns. It allows the lender to seize those assets if the loan goes unpaid. Pretty standard collateral for a business loan.

Subordination means the lender’s claim gets pushed lower in priority. So if other lenders also have liens, they get paid first if the business defaults. Not so good for the subordinated lender.

Now why would a lender want you to subordinate their lien? Usually it’s because you need another loan and the new lender demanded it. They don’t want to stand in line behind your existing lender if things go south.

The Pros:

• You might not qualify for the additional financing without subordinating the existing lien.
• It shows good faith to the new lender and makes them more comfortable lending to you.
• Subordination agreements often have time limits, so the risk may be temporary.

The Cons:

• If your business fails, the subordinated lender gets paid last. They may not get paid at all.
• It’s added risk with no reward for the subordinated lender.
• You lose leverage in future lending if your assets are already encumbered.

Questions to Ask Your Lender

Before agreeing to subordinate an existing lien, have a frank talk with your lender:

• How long will the subordination last? Can we set a maturity date?
• Will I default on my existing loan if I subordinate your lien?
• What happens if I default on the new loan? Does your lien stay subordinated?

You’ll also want assurances from the new lender:

• What is the term of the new loan? When will it mature?
• What collateral is securing the new loan, besides my subordinated assets?
• What are the interest rates and payment schedules?

Alternatives to Subordination

Instead of subordinating a lender’s claim, see if one of these options works:

• Pledge additional assets as collateral on the new loan.
• Seek an unsecured loan or line of credit.
• Get loan guarantees from the SBA or other agencies.
• Use receivables, inventory or equipment as collateral instead.

The Legal Side

Subordination agreements must follow state laws like the Uniform Commercial Code (UCC). The UCC governs security interests in personal property and fixtures. All 50 states have adopted articles of the UCC but may have minor differences.

Key issues regulated by UCC Article 9:

• Attachment of security interests
• Perfection through filing financing statements
• Priority of secured creditors
• Enforcement of security interests

The UCC also outlines formal requirements for subordination agreements in Section 9-339. Like they must be authenticated and indicate the order of priority.

Subordination Agreement Terms

Before signing a subordination pact, review it carefully and make sure it addresses these areas:

• Parties – Names the lien holders and borrower.
• Effective date – When subordination takes effect.
• Priority – Specifies exact order of creditors getting paid.
• Limits – Caps amount and duration of subordination.
• New debt – Defines the incoming obligation.
• Existing debt – Describes the current loan and collateral.
• Defaults – Consequences if you default on any loans.
• Governing law – Dictates which state laws apply.

The agreement should also address what happens if you refinance any of the loans later down the road. Can those new lenders retain the same priority?

Subordination Disputes

Despite detailed contracts, disputes over subordinated liens still occur. Common reasons include:

• Failing to execute a written subordination pact.
• Ambiguous priority levels between lenders.
• Refinancing loans without notifying existing lenders.
• Modifying the new loan terms without approval.
• Breaching the subordination agreement.

Sometimes lenders intentionally exploit ambiguities in the agreement. Other times there are innocent misunderstandings about enforcement.

To resolve disputes, parties can:

• Send demand letters asserting their position.
• Renegotiate the muddled portions of the contract.
• Mediate through an neutral third-party.
• File litigation to let a judge decide.

Judges often rule based on the clear intent spelled out in the agreement. That’s why it’s critical to negotiate detailed terms upfront before signing.

The Bottom Line

While subordinating a lien has risks, it might be necessary to grow your business. Just educate yourself on the pros and cons, negotiate strong contract terms, explore alternatives, and consult attorneys when needed.

With reasonable precautions, UCC lien subordination can be an acceptable price for getting that extra capital injection.