Series 14: 4.1.8. Subordination Agreements

4.1.8. Subordination Agreements

Investors who wish to invest in a broker-dealer may enter into a subordination agreement with the broker-dealer. A subordination agreement is an agreement to lend the broker-dealer cash or securities in the form of subordinated debt. This kind of debt is not backed by collateral and is the last kind of debt to be paid back if the firm is forced to liquidate. Because of the risks of subordinated debt, it may pay higher returns, but should not be offered to investors who cannot afford to lose their entire investment. Often, investors who take on subordinated debt will be parties with an already large stake in the firm who are willing to offer a riskier loan for the benefit of the firm (e.g., a partner in a partnership or a parent company).

These kinds of subordination agreements are often taken on by firms to increase their net capital. They increase net capital because a firm’s assets go up by cash from the loan, but the firm