16.DEBT ISSUED WITH STOCK PURCHASE WARRANTS

On March 20, 2011, the Company entered into a Funding Agreement (the “Funding Agreement”) with Hilltop and Oak Hill. On July 29, 2011, after receipt of stockholder and regulatory approval, the Company completed the following transactions contemplated by the Funding Agreement:

entered into a $100,000,000, five year, unsecured credit agreement with Hilltop and Oak Hill that accrues interest at a rate of 8% per annum;

issued warrants to Hilltop and Oak Hill allowing each to purchase up to 8,695,652 shares of the Company’s common stock; and

granted Hilltop and Oak Hill certain rights, including certain registration rights, preemptive rights, and the right for each to appoint one person to the Company’s Board of Directors for so long as each owns 9.9% or more of all of the outstanding shares of the Company’s common stock or securities convertible into at least 9.9% of the Company’s outstanding common stock.

On July 29, 2011, in connection with the loans made by Hilltop and Oak Hill under the Credit Agreement, the Company issued a warrant to Hilltop to purchase up to 8,695,652 shares of common stock (and in certain cases described below, shares of Non-Voting Perpetual Participating Preferred Stock, Series A (the “Series A Preferred Stock”)), and warrants to Oak Hill to purchase up to 8,695,652 shares of common stock (and in certain cases described below, shares of Series A Preferred Stock). These warrants are exercisable for five years and have a fixed exercise price of $5.75 per share, subject to standard anti-dilution adjustments for extraordinary corporate transactions, such as stock splits, dividends and combinations, the issuance of stock purchase rights, debt or asset distributions (including cash), tender offers or exchange offers and entry into certain business combinations. In addition, the warrants have a weighted average anti-dilution adjustment in the event the Company issues shares of common stock at less than 90% of the market price of the common stock on the date prior to the pricing of such shares. For each of Hilltop and Oak Hill, the warrants represent approximately 17% of the Company’s common stock for each investor as of June 30, 2014 (assuming that the warrants are exercised in full).

The warrants provide that the Company would only issue shares of Series A Preferred Stock upon the exercise of warrants if it is necessary to prevent Hilltop or Oak Hill from owning or being deemed to own shares of the Company’s common stock in excess of the “Ownership Limit” provided in the warrants. The “Ownership Limit” is 24.9% of any class of the securities of the Company or such level that Hilltop or Oak Hill reasonably determines would prevent them from being deemed to control the Company for purposes of the federal banking laws and regulations specified in the warrants. No shares of Series A Preferred Stock are issued or outstanding at June 30, 2014 and June 30, 2013. For additional discussion concerning the Series A Preferred Stock see the discussion in Note 20, Preferred Stock.

The warrants are recorded as a liability in the Consolidated Statements of Financial Condition at fair value. Initial and subsequent valuations of the warrants use a binomial valuation model. At initial valuation, July 29, 2011, the closing stock price was $5.45 per share yielding a fair value of $24,136,000. At June 30, 2014 and June 30, 2013, the closing stock prices used in the binomial valuation model were $7.28 and $5.45, respectively, and the warrants were valued at $27,796,000 and $24,197,000, respectively. The change in fair value for fiscal years 2014, 2013 and 2012 of $(3,599,000), $3,613,000 and $(3,674,000), respectively, was reflected as an unrealized loss on warrants valuation for fiscal 2014 and 2012 and an unrealized gain on warrant valuation for fiscal 2013 on the Consolidated Statements of Comprehensive Loss. The warrants are classified as Level 3 in the fair value hierarchy as disclosed in Note 26, Fair Value of Financial Instruments.

The loan is recorded as a liability with an 8% interest rate, a five year term and an effective interest rate of 14.9%. At July 29, 2011, the discount on the loan was initially valued at $24,136,000 and is being accreted using the effective interest method. For fiscal years 2014, 2013 and 2012, the Company recorded $4,667,000, $4,026,000 and $3,212,000, respectively, in accretion expense on the discount. The resulting long-term debt balance at June 30, 2014 and 2013 was $87,769,000 and $83,102,000, respectively. For both fiscal years 2014, 2013 and 2012, the cash portion of the interest expense paid on the loan to Hilltop and Oak Hill was $8,000,000, $8,000,000 and $7,355,000, respectively.

At July 29, 2011, legal and accounting fees, printing costs and other expenses associated with the loan and warrants totaled $2,459,000 and are being amortized on a straight-line method, which approximates the effective interest method, over the term of the loan. For both fiscal years 2014, 2013 and 2012, interest expense charged to operations was $492,000, $492,000 and $451,000, respectively.

The Company recorded total interest expense for this obligation for the fiscal years 2014, 2013 and 2012 on the Consolidated Statements of Comprehensive Loss of $13,159,000, $12,518,000 and $11,018,000, respectively.

The Credit Agreement contains customary financial covenants which require the Company to, among other things:

maintain a tangible net worth at least equal to the sum of $275,000,000 and 20% of cumulative consolidated net income (as defined in the Credit Agreement) for each fiscal quarter for which consolidated net income is positive;

maintain a minimum unrestricted cash balance (as defined in the Credit Agreement) of at least $4,000,000;

maintain an excess net capital balance at Southwest Securities of at least $100,000,000 as of the end of each calendar month; and

maintain a total risk-based capital ratio, Tier 1 risk-based capital ratio and leverage ratio for the Bank that ensures the Bank is considered well capitalized or is required by federal law or regulation or action or directive by the Federal Reserve Board.

In addition, the covenants limit the Company’s and certain of the Company’s subsidiaries’ ability to, among other things:

incur additional indebtedness;

dispose of or acquire certain assets;

pay dividends on the Company’s capital stock;

make investments, including acquisitions; and

enter into transactions with affiliates.

The Company was in compliance with the financial covenants under the Credit Agreement as of June 30, 2014. Should the Company determine it needs additional debt at SWS Group, the Company would require regulatory approval and approval from Hilltop and Oak Hill.

If the proposed merger with Hilltop occurs, Hilltop’s warrant to acquire the Company’s common stock, if outstanding, will be cancelled.

Concurrently with the execution of the Merger Agreement, the Company entered into a Letter Agreement with Oak Hill dated March 31, 2014 (the “Oak Hill Letter Agreement”). Pursuant to the Oak Hill Letter Agreement and the Merger Agreement, at the closing of the proposed merger with Hilltop, Oak Hill will deliver to the Company the certificates evidencing its warrants and any loans of Oak Hill to the Company that are then outstanding under the Credit Agreement, and SWS will issue and deliver to Oak Hill, in exchange for its warrants and loans, the following consideration: (i) the merger consideration that Oak Hill would have been entitled to receive upon consummation of the merger if its warrants had been exercised immediately prior to the effective time of the merger and (ii) an amount equal to the Applicable Premium (as defined in the Credit Agreement, being a calculation of the present value of all required interest payments due on a loan through its maturity date on the date the loan is repaid) calculated as if the loans held by Oak Hill were prepaid in full as of the closing date of the merger.