Subordination Agreements with Between a Customer and a Brokerage Firm.  What are the Risks?

When a client thinks of investments and brokerage firms, he or she probably thinks of opening an account and buying stocks, bonds, or mutual funds. When a client enters into a subordination agreement, the client is making an investment, but the investment is in the brokerage firm itself. This investment can be very risky and is not suitable for everyone. Clients should never enter into a subordination agreement unless he or she can afford to lose their entire investment.

This post is designed to provide general information concerning various risks associated with entering into a subordination agreement with a brokerage firm.  This post is being provided for educational purposes and is not designed to be complete in all material respects.  Thus, if you have any questions relative to the below information, the reader should contact a qualified professional

This post explains what subordination agreements are, the risks involved with them, and how you can find out what you need to know to make a smarter investment decision.

What is a Subordination Agreement?

A subordination agreement is a contract between the client and a brokerage firm where you lend either money or securities or both to the firm. 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. The client also must provide cash or securities as collateral for the SDN. If the client uses securities as collateral, these securities must be deposited with the firm and registered in the firm’s name. The client cannot sell or otherwise use them unless he or she substitutes 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 the client provides as collateral. The discount can vary and can be as high as 30% if the client uses common stock as collateral.

What are the Risks?

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

  • No Securities Investor Protection Corporation (SIPC) protection. Subordination agreements are not subject to SIPC protection. Thus, if the broker defaults on a subordination agreement, the client can lose his or hers entire investment, including any cash, securities, or accounts that the client lends or pledges as collateral.
  • No private insurance protection. Subordination agreements are generally not covered by any private insurance policy held by the firm. Thus, if the brokerage firm fails to pay the loan, the client can lose all his or hers investment.
  • No priority in payment over other lenders. Subordination agreements cause the client to be subordinate to other parties if the firm goes out of business. In other words, the client would 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 the client lends under a subordination agreement almost entirely without restriction. The client should not 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 may not be enforceable.
  • The firm can force the 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, the client must deposit additional securities with the firm to keep the SDN at the proper collateral level. If the client does not give the firm additional collateral, the firm may sell some or all of the client’s securities. In addition, if the firm makes a demand for cash under an SDN, and the client does not provide the firm with cash, the firm may sell some or all of the the client’s securities.

Caution! While FINRA does review subordination agreements, this does not mean that FINRA has passed judgment on the soundness of these investments. Its review does not 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, make sure you get the information you need to make a wise investment choice.

  • Understand your investment. Before entering into a subordination agreement, you should carefully read the subordination agreement, the lender’s attestation, and the Subordination Agreement Investor Disclosure Document.
  • 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.
    • The 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. To obtain a copy of a firm’s X-17A-5, please contact the SEC’s Office of Public Reference.
    • The Better Business Bureau. Check with the Better Business Bureau to find any complaints against 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 that you know and trust. It is also important to make sure the investment fits with your financial goals, your tolerance for risk, and makes sense given your income and expenses.