Margin and Non-Purpose Loan Background
In general, purchasing securities on margin involves purchasing part of the securities with the client’s own money, and borrowing or financing the remainder using the purchased securities as collateral for the remaining portion of the investment. The purpose of purchasing securities on margin is to increase purchasing power with the goal of increasing the customer’s potential return on investment. As of May 2020, debit balances in customers’ securities margin accounts exceeded $552 billion, according to Financial Industry Regulatory Authority (FINRA) statistics.
Federal regulations and FINRA and securities-exchange rules govern the terms on which firms can extend credit for securities transactions. Generally speaking, under Federal Reserve Board Regulation T, securities firms can lend a customer up to 50 percent of the total purchase price of a margin security for new or initial purchases. The rules of FINRA and the securities exchanges supplement the requirements of Regulation T by placing “maintenance” margin requirements on customer accounts.
Under these rules, the customer’s equity generally must not fall below 25 percent of the current market value of the securities in the account; otherwise, the customer may be required to deposit more funds or securities to maintain equity at the 25 percent level (this is referred to as a margin call). However, FINRA expects members’ firms to have higher “house” margin requirements, with industry practice being in the 30–35 percent equity range. Failure to satisfy this net equity level may cause the firm to liquidate the securities in the customer’s account in order to bring the account’s equity back up to the required level.
Firms can also offer non-purpose loans using securities-backed lines of credit (SBLOCs) under Regulation U. This lending allows financial firms to lend funds against marginable and non-marginable investments, and is typically more discretionary than a traditional margin account. These loans typically do not affect a borrower’s credit score. They also have minimum equity requirements and can subject borrowers to a capital call requiring the deposit of additional cash or assets, or liquidation of the investments in the collateral account. Extension of an SBLOC has become increasingly popular. FINRA noted that between 2012 and 2014, one large brokerage firm reported a 70 percent increase in its securities-based lending business, while another firm reported an increase of over 50 percent.
Likely Types of Leverage Cases and Considerations
FINRA investor arbitrations related to leverage are filed for a number of different reasons, and they include specific claims that firms and their counsel should be acutely aware of. These reasons may involve claims stemming from an alleged overconcentration or overleverage in a particular stock or industry. The customer may also argue that rapid market fluctuations caused forced liquidations near the bottom of the securities’ price, which was followed by a quick stock price rebound, and the customer did not have sufficient time to meet the margin call. This allegation is often coupled with claims for damages relating to tax consequences such as capital gains taxes, lost opportunity (what the stock is worth today), margin interest (interest due on loans from the brokerage to purchase securities), and the well-managed account theory (what the investor arguably would have made had the investor been “appropriately” invested). Finally, the complaint may allege that the financial advisor encouraged the use of leverage instead of liquidating assets.
Defending Leverage Cases
Defense of leverage-related cases starts with how well the advisor knew the customer and how well the advisor documented conversations. In situations where a client failed to meet a collateral call, the client will typically assert that the loan was made because of a lack of funds to meet the margin call or a lack of understanding surrounding the strategy. In these instances, the written loan disclosures may not be sufficient to defend the case. The advisor will have to explain how the leverage strategy was explained to the customer and why the strategy was suitable. The financial advisor will need to articulate what was told to the customer about the obligations and risks of leverage—specifically, whether a market decline and the cost of borrowing funds was discussed and the existence of supporting demonstrative evidence—e.g., notes—of these conversations. In addition to documenting discussion of the risks, it is also important to demonstrate that the advisor believed that the customer understood those risks and the time period within which to meet a margin call. In addition, documentation of discussion of any issues concerning concentrated or large positions (such as presentations to the customer), proof of review of risk disclosure documents, and evidence that the financial advisor reviewed the customer’s complete financial picture and had knowledge of the customer’s finances will be important considerations in defending these cases.
In evaluating the risk of leverage matters, a defense attorney will want to consider certain facts about the customer. Was the customer an experienced investor? Had the customer used margin before? Did the customer state that he or she had the means of meeting a margin call? Why were the funds borrowed? If it was to trade stocks on margin, was there a history of success? If the funds were used to invest in property, were there discussions about other financing alternatives? Are there issues relating to the customer’s age or cognitive abilities? What was the source of the collateral used to fund the loan? Did the client receive stock as compensation from an employer? Finally, who made the decision to use leverage to meet the customer’s lifestyle needs? If it was the advisor, it will be important to show that the advisor believed the strategy was suitable and that the customer understood the consequences of a margin call.
Finally, it is important to present evidence about how the margin call occurred. Did the advisor call the customer and explain how much was owed on the call? Or was this task left to an assistant or an office manager? As the account’s net equity declined, did documented conversations take place about the additional risk the customer incurred? Did the advisor document conversations and recommendations? Were firm procedures regarding concentrated positions and margin calls followed? Were the procedures consistent with industry rules? Each of these factors must be evaluated in addressing the strengths and weaknesses when defending a leverage-related arbitration.
Accordingly, while every case has its own distinct set of facts and circumstances, these are the primary claims that counsel and their brokerage firm clients are likely to encounter, and should consider, when defending the margin-related cases that are likely to arise as a result of 2020’s market volatility.
