What exactly is a subordinated loan ?

The Securities and Exchange Act of 1934 dictates that broker dealers maintain certain minimum levels of net capital. In order to obtain the required funds firms will often borrow the money from outside sources. A subordinated loan is used by broker dealers to borrow the needed capital. Satisfactory subordination agreements are instruments that allow an individual to loan cash or securities to a broker dealer in return for interest paid to the lender (this is debt for the broker dealer).

Subordinated lenders are not considered to be customers of the broker dealer and are not provided SIPC coverage in the event of the broker dealer’s failure. Under SEC Rule 17a-11, a violation is deemed to occur if the principal amount of satisfactory subordination agreements exceeds 70% of the broker dealer’s debt plus equity total for a period in excess of 90 days. This means that subordinated debt can be considered part of the broker dealer’s net capital, but only if it is through a satisfactory subordination agreement. In order for the loan to be satisfactory, it must meet the following requirements:

• The agreement must be in writing.
• The agreement must be for a specific dollar amount, even if securities are pledged.
• The agreement must subordinate any right of the lender to receive payment to the claims of all present and future creditors of the broker dealer.
• Proceeds of the loan may be used by the broker dealer for any general business purpose.
• The agreement must have a maturity of at least 1 year.
• The agreement may not be subject to cancellation by either party.