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Risks of Brokerage Firm Subordination Agreements

FINRA recently issued an Alert because of its concern that an increasing number of investors may be entering into financing arrangements with brokerage firms without fully appreciating the risks or implications of such arrangements.

Here are some of the basics of subordination agreements, and the risks of such agreements.

What is a Subordination Agreement?

A subordination agreement is a contract between an investor and a brokerage firm where the investor lends either money or securities or both to the brokerage firm. There are two types of subordination agreements.

Subordinated Loan Agreement ( SLA ). An SLA is used when an investor lends 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 an investor agrees to give cash to the firm on demand (i.e., without prior notice) during the term of the note. The investor also must provide cash or securities as collateral for the SDN. If the investor uses securities as collateral, these securities must be deposited with the firm and registered in the firm’s name. The investor cannot sell or otherwise use them unless he/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 investor provides as collateral. The discount can vary and can be as high as 30% if the investor uses common stock as collateral.

What are the Risks?

Before entering into a subordination agreement, the investor 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 investor can lose his/her entire investment, including any cash, securities, or accounts that they 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, the investor can lose all of his/her investment.

· No priority in payment over other lenders. Subordination agreements cause the investor to be subordinate to other parties if the firm goes out of business. In other words, the investor 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 the funds or securities. The firm can use the funds or securities the investor lends under a subordination agreement almost entirely without restriction. The investor 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 the investor pledges 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 investor must deposit additional securities with the firm to keep the SDN at the proper collateral level. If the investor does not give the firm additional collateral, the firm may sell some or all of the investor’s securities. In addition, if the firm makes a demand for cash under an SDN, and the investor does not provide the firm with cash, the firm may sell some or all of the investor’s securities.

Also, 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 An Investor Do If He/She Wants to Invest?

Before entering into a subordination agreement, an investor should get the information he/she needs to make a wise investment choice.
· Understand the 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:
o 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.

o 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 as follows:
Office of Public Reference
100 F Street, NE
Washington, D.C. 20549
Phone (202) 551-8090
Email: publicinfo@sec.gov

· 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.

If have questions about subordination agreements and would like to discuss your litigation options, please call the securities attorneys of The White Law Group at 312-238-9650 for a free consultation.

The White Law Group is a national securities fraud, securities arbitration and investor protection law firm with offices in Chicago, Illinois and Boca Raton, Florida.

For more information on the firm visit https://whitesecuritieslaw.com.

Tags: , , , , , , , , , Last modified: July 17, 2015