What is an Intercreditor Agreement?
An Intercreditor Agreement is an agreement between common lenders regarding the terms and the allocation of collateral in case the borrower defaults. Such type of agreement is extremely beneficial to subordinate lenders as it protects their rights.
Example of Intercreditor Agreement
Company XYZ is planning to raise $100M, the bank has agreed to pay $20M, so $80M will have to be raised from outside. Two external creditors have agreed to pay $50M and $30M, respectively. Now if the borrower defaults, then who will have the first claim on the property of the borrower and how much can be recovered for each lender.
All this confusion is sorted by an agreement that is signed between the two lenders. The agreement is called the Intercreditor Agreement. This will help both the creditors to distribute the collateral from the borrower in case of default. So the agreement prevents lenders from engaging in uncalled disagreements over collateral distribution.
Issues with Intercreditor Agreement
- It is difficult to set an order regarding the claim on individual assets in case of default. So if the assets are limited to cover the entire liability, then which creditor will be placed first in the claim is a tough thing to decide.
- Assets are of different values and liquidity, so it isn’t easy to decide as to which asset will be used to cater to whose needs. The agreement is tough to draft, considering all the issues.
Need Of Intercreditor Agreement
This agreement is used to deal with discrepancies and confusion that may arise in case of default in payment by the borrower. If multiple parties are involved in giving a loan to a borrower, then the collateral is challenging to distribute as the assets are not of the same liquidity and value. So it is essential to draft an agreement regarding the proper allocation of assets and rights. This agreement helps to deal with the appropriate distribution of collateral in case of default. It prevents unnecessary harassment of collateral distribution.
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Intercreditor Agreement vs. Subordination Agreement
Intercreditor Agreement is the distribution of collateral once a borrower defaults in case the lenders are both superior. In the case of the subordination agreement, the loans are ranked in order of priority. It means a rank is given regarding which debt is to be paid first compared to other debts. So this ranking clear doubts in the minds of the lenders as they know who all will be paid as per ranking.
- It helps to avoid confusion after the default of payment by the borrower as the payoff after default is already decided. Hence, it helps to eradicate confusion and helps in the smooth running of settlement.
- Junior creditor gains confidence and agrees to give loan to borrowers as they are aware that their rights will not be ignored by superior lenders.
- If the junior creditor fails to draft favorable terms, then they will have to abide by the unfavorable terms throughout the agreement.
- As superior lenders are considered to be more powerful as compared to subordinate lenders, so they might bend the justice towards themselves in case of a dispute.
Intercreditor agreement is extremely beneficial for subordinate lenders in case of default by the borrower as the terms are already drafted beforehand, so it removes the confusion that may arise in case of default. A well drafted agreement will help in the proper distribution of collateral. It is always advisable to form an inter-creditor agreement.
This has been a guide to what is an Intercreditor Agreement. Here we discuss examples, issues, and needs of inter-creditor agreement along with benefits and disadvantages. You may learn more about financing from the following articles –