What is the difference between senior and subordinated debt?

Senior debt is paid first from whatever a borrower has available. Subordinated debt has agreed, or is structured, to wait behind it. The distinction is about rank, so it says nothing by itself about security: an unsecured loan can be senior to another unsecured loan by agreement. A commercial lender in the subordinated position usually charges more for the risk. An owner in that position usually accepts it as the price of the bank's loan.

Can a subordinated loan be repaid early?

Only as the deed allows. Many deeds permit stated payments, such as interest while no default exists or repayment after a financial test is met, and prohibit everything else until the senior lender has been repaid. A payment made in breach is usually caught by a turnover clause, so the owner who received it can be made to pass it across.

Is a subordinated shareholder loan equity?

Not in law, and usually not in the accounts. The company still owes the money, and it normally appears as a liability unless its terms take it out of that classification. A lender may treat it like equity when assessing the business, and some covenant definitions count it toward net worth, but only because the deed stops it leaving. Without a deed, a lender generally reads an owner's loan as money that can leave first.

Is subordination enforceable if the company goes into liquidation?

Generally yes, and that is when it is meant to work. New Zealand's Companies Act allows creditors to agree a lower priority before liquidation. Australia's Corporations Act protects a debt subordination so far as it does not disadvantage creditors outside the arrangement. The English courts have held creditors to subordination agreements made while the company was solvent. The exact effect depends on the words used, which is why the form of the deed matters.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Subordination: a Worked Example

The owners' loan stays in until the bank is out.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

When a bank asks an owner to subordinate a loan, it is asking for two things: that the money stay in the company while the bank is owed, and that anything recovered on it in a failure reach the bank first. The document does both by contract between the creditors concerned, and it can be narrow or wide, ranking the owner behind the bank alone or behind every other creditor. The debt does not become equity, and the accounts will usually still show it as a liability, but a lender can read it as a cushion beneath its own loan.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 03 — Kauri Dairy Holdings. The patriarch is retiring. The bank hears about the succession plan from the accountant first. Your call first, then the senior banker's.

Read the file →

PART OF What Your Bank Holds as Security

// 01 — WHY A LENDER WANTS THE OWNERS BEHIND IT

Owners of private companies often fund them with loans rather than shares, because a loan is easier to take back. That ease is what troubles a lender. The owners see the figures first and control the bank account, so the months in which they are most tempted to repay themselves are the months in which the lender most needs the cash to stay. If the company then fails, an owner's unsecured loan generally claims alongside trade creditors and any unsecured balance of the bank's debt, and the money the owners described as their commitment competes with the lender for what is left.

Subordination removes both problems. It also changes how the balance sheet can be read. A loan that cannot leave until the bank has been repaid supports the bank in much the way equity does, which is why some covenants add subordinated loans back when they test tangible net worth.

// 02 — WHAT THE DEED DOES

Before a default no repayment, or only stated permitted payments

On a default payments to the owner stop

On insolvency owner claims after the senior debt, or hands over

what it receives

Turnover anything received out of turn is held for the bank

Undertakings no demand, no security, no transfer unless the

transferee signs

Two forms are common, and they treat other creditors differently. In one, the owner ranks behind the bank alone: the owner still claims in the liquidation and receives a dividend, but must pass it to the bank until the bank is repaid. In the other, the owner agrees to rank behind every creditor of the company, and the loan drops out of the queue altogether. Deeds are negotiated, and the wording decides which form a file has.

All three markets enforce the bargain, each in its own way. New Zealand's Companies Act allows a creditor to agree before liquidation to accept a lower priority. Australia's Corporations Act says its priority rules do not make a debt subordination unenforceable, except so far as it would disadvantage a creditor who was not a party to it or otherwise concerned in it. In England, the Court of Appeal said in 2006 ([2006] EWCA Civ 7) that creditors who strike such a bargain while the company is solvent should be held to it. If the owner also holds security, that needs its own treatment: the New Zealand and Australian personal property securities Acts each let a secured party subordinate its interest.

// 03 — THE EXAMPLE

A family-owned printer of food labels, constructed for this page like every figure in it, owes its bank US$4.0m, secured by a first mortgage over its factory and by nothing else. The owners have lent the company US$2.4m and, as a condition of the bank's loan, have signed a deed of subordination. The company fails. The factory sells for a net US$2.5m, which leaves the bank US$1.5m short. Everything else, after the liquidator's costs and the claims the law pays first, yields US$1.0m for unsecured creditors. Trade creditors are owed US$2.1m. Figures in US$m.

Bank Trade Owners Total

Unsecured claims 1.50 2.10 2.40 6.00

No deed: all claim equally, 1.00 ÷ 6.00 = 16.7 cents in the dollar

Dividend 0.25 0.35 0.40 1.00

Deed, behind the bank alone: owners turn over their dividend

Finally received 0.65 0.35 0.00 1.00

Deed, behind every creditor: 1.00 ÷ 3.60 = 27.8 cents in the dollar

Finally received 0.42 0.58 0.00 1.00

Under either form the owners end with nothing, but the wording decides who gains. Behind the bank alone, all US$0.40m goes to the bank, and the trade creditors are exactly where they would have been. Behind every creditor, the US$0.40m is shared and the bank gets US$0.17m of it. The first form suits the bank better and leaves no other creditor worse off, which is the test Australia's section applies.

The larger effect came earlier. In the nine months before the failure the owners asked to take US$0.6m back, and the deed stopped them. Suppose there had been no deed and the money had gone. The pool would have been US$0.4m, the owners' claim US$1.8m and the dividend 7.4 cents: the bank would have received US$0.11m instead of US$0.65m, and the owners US$0.73m in all. A liquidator may be able to attack such a repayment as a voidable preference, but that is a claim to pursue after the money has gone. The form of the deed and every figure are the example's.

// 04 — SUBORDINATION AND THE TERMS BESIDE IT

A deed of priority ranks security interests, usually up to a capped sum; subordination ranks the debt itself, secured or not. Structural subordination needs no agreement at all: a lender to a holding company stands behind the creditors of its operating subsidiaries because of where the money sits. An intercreditor agreement contains a subordination and adds rules about enforcement and control between lenders.

Converting the loan into shares goes further than any of these. Share capital ranks behind all creditors in a winding up, carries no debt claim, and can be returned only within each market's capital-maintenance or solvency rules. A lender may prefer that outcome and owners often resist it. Subordination gives the lender most of the protection and lets the owners be repaid once the bank has gone.

DEFINED IN ONE PARAGRAPH → · HOW TWO LENDERS RANK → · THE SHAREHOLDER'S CURRENT ACCOUNT →

// 05 — WHERE IT DECIDES A FILE

The first work is finding all the loans. The balance sheet may show advances from a shareholder, a director, a family trust and a related company on separate lines or as one, and the deed binds only those who sign it. A lender reading the notes asks who holds each balance, whether any is secured and whether any fell due inside the facility's term. The deed is then commonly listed as a condition precedent: no signature, no drawdown.

After that the argument is about what may still be paid. Owners often ask for interest while covenants are met, or for repayment once leverage has fallen to an agreed level. A lender weighs each request against the cushion it approved, and later checks the accounts for payments that went further than the deed allowed. The deed also outlasts changes in the family: a death, a sale of shares or a dispute does not release it unless the bank agrees, which is why it commonly binds transferees.

READING YOUR FACILITY LETTER → · TANGIBLE NET WORTH →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Court of Appeal of England and Wales, [2006] EWCA Civ 7, paragraphs 64 to 66 — Treats a subordination agreed while the company was solvent as a bargain that binds the creditor in a winding up and that the court would enforce by injunction — section 02.
Federal Register of Legislation (Australia), Personal Property Securities Act 2009, section 61 (compilation as at 14 October 2024) — A secured party may subordinate its security interest, effective according to its terms — section 02.

// QUESTIONS PEOPLE ASK

What is the difference between senior and subordinated debt?: Senior debt is paid first from whatever a borrower has available. Subordinated debt has agreed, or is structured, to wait behind it. The distinction is about rank, so it says nothing by itself about security: an unsecured loan can be senior to another unsecured loan by agreement. A commercial lender in the subordinated position usually charges more for the risk. An owner in that position usually accepts it as the price of the bank's loan.
Can a subordinated loan be repaid early?: Only as the deed allows. Many deeds permit stated payments, such as interest while no default exists or repayment after a financial test is met, and prohibit everything else until the senior lender has been repaid. A payment made in breach is usually caught by a turnover clause, so the owner who received it can be made to pass it across.
Is a subordinated shareholder loan equity?: Not in law, and usually not in the accounts. The company still owes the money, and it normally appears as a liability unless its terms take it out of that classification. A lender may treat it like equity when assessing the business, and some covenant definitions count it toward net worth, but only because the deed stops it leaving. Without a deed, a lender generally reads an owner's loan as money that can leave first.
Is subordination enforceable if the company goes into liquidation?: Generally yes, and that is when it is meant to work. New Zealand's Companies Act allows creditors to agree a lower priority before liquidation. Australia's Corporations Act protects a debt subordination so far as it does not disadvantage creditors outside the arrangement. The English courts have held creditors to subordination agreements made while the company was solvent. The exact effect depends on the words used, which is why the form of the deed matters.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Legal counselAdvises the bank on what it can do, drafts and negotiates what it signs, and manages what goes wrong.
Lending operations officerTurns an approval into a working facility — documentation, security, drawdown, and the register that says what the bank actually holds.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE FIRST QUESTION · THE LOAN · PROTECTION

A term sheet offers three protections: a negative pledge, a quarterly leverage covenant, and monthly management accounts.

Which is likely to show deterioration first?

7 MORE ON THE LOAN · PROTECTION →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHSubordination What does it mean to subordinate a shareholder loan to the bank?