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Subordination Agreements: Understand the Risks

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When you think of investments and brokerage firms, you probably think of opening an account and buying stocks, bonds or mutual funds. But when you enter into a subordination agreement, the investment you’re making is in the brokerage firm itself. This investment can be very risky and isn’t suitable for everyone. You should never enter into a subordination agreement unless you can afford to lose your entire investment.

What Is a Subordination Agreement?

A subordination agreement is a contract between you and a brokerage firm where you lend money, securities or both to a firm that’s seeking to generate additional capital. There are two types of subordination agreements:

  • Subordinated Loan Agreement (SLA) – An SLA is used when you lend cash to a firm. The SLA discloses the terms of the loan, including the amount of the loan, the interest rate and the date the loan will be repaid.
  • Secured Demand Note Agreement (SDN) – An SDN is a promissory note in which you agree to give cash to the firm on demand (i.e., without prior notice) during the term of the note. You also must provide cash or securities as collateral for the SDN. If you use securities as collateral, these securities must be deposited with the firm and registered in the firm's name. You can’t sell or otherwise use them unless you substitute securities of equal value for the deposited securities. Securities and Exchange Commission (SEC) rules require that the firm discount the market value of the securities that you provide as collateral. The discount can vary and can be as high as 30 percent if you use common stock as collateral.

What Are the Risks?

Before entering into a subordination agreement, you should understand the following risks:

  • No Securities Investor Protection Corporation (SIPC) protection – Subordination agreements aren’t subject to SIPC protection. Thus, if the firm defaults on a subordination agreement, you can lose your entire investment, including any cash, securities or accounts that you lend or pledge as collateral.
  • No private insurance protection – Subordination agreements generally aren’t covered by any private insurance policy held by the firm. Thus, if the firm fails to pay the loan, you can lose all of your investment.
  • No priority in payment over other lenders – Subordination agreements cause you to be subordinate to other parties if the firm goes out of business. In other words, you’d be paid after other parties are paid, assuming the firm has any assets remaining after it satisfies its debts to other parties.
  • No restrictions on the use of your funds or securities – The firm can use the funds or securities you lend under a subordination agreement almost entirely without restriction. You shouldn’t rely on side agreements with a firm that purport to limit the use of the loan proceeds. These agreements are inconsistent with the subordination agreement and might not be enforceable.
  • Potential forced sale of securities you pledge as collateral – If the securities pledged as collateral decline in value so that their discounted value is less than the face amount of the SDN, you must deposit additional securities with the firm to keep the SDN at the proper collateral level. If you don’t give the firm additional collateral, the firm may sell some or all of your securities. In addition, if the firm makes a demand for cash under an SDN and you don’t provide the firm with cash, the firm may sell some or all of your securities.

Note: While FINRA does review subordination agreements, this doesn't mean that FINRA has passed judgment on the soundness of these investments. Its review doesn't include an opinion regarding the viability or suitability of the investment for you or the credit worthiness of the brokerage firm.

What Should I Do If I Want to Invest?

Before entering into a subordination agreement, follow these tips to get the information you need to make a wise investment choice.

  • Understand your investment. Carefully read the subordination agreement, the lender's attestation, and the Subordination Agreement Investor Disclosure Document, which a firm is required to have you sign before entering into such an agreement with you.
  • Check out the brokerage firm before you invest. You can get information from the following sources:
    • FINRA – Check with FINRA BrokerCheck to learn whether the firm is licensed, the types of businesses it operates, and whether there are any disciplinary actions against the firm.
    • SEC – Obtain a copy of the firm's report on Form X-17A-5. Form X-17A-5 is the audited financial report that every registered broker or dealer must file annually with the SEC.
    • State Securities Regulator – Contact your state securities regulator to learn more about the firm’s license, operations and disciplinary history.
  • Consult the Better Business Bureau. Check with the Better Business Bureau to find out if there are complaints against the company. Recognize that BBB ratings might be based on a limited set of information and that a high rating does not necessarily correlate with the soundless of the investment in the company.

Finally, as with any investment, don't allow yourself to be pressured into a quick decision. Consider discussing the investment with an accountant, attorney or investment professional whom you know and trust and who isn’t associated with the brokerage firm that would receive the proposed subordinated loan or SDN. Also consider whether the investment fits with your financial goals and risk tolerance and if it makes sense given your income and expenses.