Brokerage Firm – Investor Subordination Agreements

March, 2012:

In our continued effort to educate the investing public about various aspects of the securities markets and fraudulent activity associated therewith, we are providing the below information. Because this information is being provided for educational purposes only, it should not be relied upon as providing legal or investment advice. Moreover, it is not intended to be complete in all material respects. If you have any questions concerning the information set forth below, you should contact a qualified professional.

Subordination Agreements – Understand the Risks:

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

There are a number of reasons that a brokerage firm will seek to obtain funds through the use of a subordination agreement. Most of the reasons are not good. The main reason usually is that the firm is strapped for cash and needs the funds to supplement its net capital position so that it can stay in business.

This post explains what subordination agreements are and the risks involved with them.

What is a Subordination Agreement?

A subordination agreement is a contract between you 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. 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 cannot 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% 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 are not subject to SIPC protection. Thus, if the broker 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 are generally not covered by any private insurance policy held by the firm. Thus, if the brokerage firm fails to pay the loan, you can lose all 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 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 you lend under a subordination agreement almost entirely without restriction. You 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, you must deposit additional securities with the firm to keep the SDN at the proper collateral level. If you do not 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 do not provide the firm with cash, the firm may sell some or all of the your securities.

Caution! While the Financial Industry Regulatory Authority (FINRA) reviews 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.

One of the ways that a brokerage firm may attempt to circumvent FINRA review of the transaction is to seek to have the investor loan the funds to another company affiliated with the brokerage firm at above market interest rates, which is a huge “red” flag.

Because of the unique characteristics of these types of investments, it is strongly recommended that you consult a qualified professional if you are contemplating making such an investment other than your account executive who works for the brokerage firm in which he is soliciting you to invest.