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Subordinated debt is any type of outstanding debt that is considered to be lower in priority than other debt obligations deemed to be primary in nature. A subordinate debt may be in the form of a loan, a bond issue, or some type of debenture. Generally, the debt is not honored until other debts that are considered to be primary have been discharged.
In essence, the concept of subordinated debt creates a hierarchy in how debt obligations are dispensed when resources are tight. For the most part, a subordinate debt is paid according to terms as long as cash flow remains stable and sufficient to honor all outstanding debts. However, should the debtor experience a shortfall, the process of debt subordination is put into action, effectively lining up the debts in a specific order of payment.
One example of how subordinated debt functions when implemented can be found in a bankruptcy. This type of action often involves the liquidation of assets in order to at last partially settle the debts of the individual or entity declaring the bankruptcy. Any obligations deemed to be subordinated debt are only addressed after the claims of the primary debts, any taxes owed to local and national governments, and the charges applied by the liquidator.
Even once the subordinated debt is addressed, there is still a hierarchy that will apply to this type of debt. Any obligations that have been classified as senior subordinated debt will be addressed first. All remaining items are classified as junior subordinated debt and will be the last to receive any type of payment.
Determining what is considered subordinate debt requires understanding the laws that apply to bankruptcy and company liquidations within the country where the action will take place. Different nations provide guidelines that must be observed in classifying the outstanding debt. The suggested plan of bankruptcy must first be reviewed by a judge or magistrate of some type, given initial approval, then presented to the creditors for their input. However, it is not unusual for the judge assigned to have the final say in how the debts are classified, since many creditors would obviously do all they could to be included as a primary or senior debt rather than a subordinate obligation.
Whether talking about subordinated bank debt, subordinated bonds or other investment instruments, the process of prioritizing debts does help to maximize the chances for each creditor to receive at least partial compensation for the amounts owed by the debtor. From this perspective, creating this hierarchy of debt not only provides the debtor with some degree of protection, but each creditor as well.