As of January 2019, the Financial Industry Regulatory Authority (FINRA) reported that FINRA member brokerage firms are currently carrying more than $558 billion in outstanding margin balances in customer accounts. This statistic reflects a reduction from the 2018 peak of $668 billion. The amount of margin currently being utilized by customers imputes a tremendous amount of market risk to both customers and brokerage firms.
What is Margin?
A margin loan refers to money that an investor borrows from a brokerage firm. The margin loan is collateralized by the assets held in the customer’s investment account (i.e., securities). Customers are generally free to use the margin loan to buy additional securities or to withdraw the funds from the account for personal expenses.
Margin loans are immensely profitable for brokerage firms. Brokerage firms charge a rate of interest for the use of borrowed funds. In addition, to the extent the client uses the margin loan to purchase additional securities, both the brokerage firm and Financial Advisor generate additional commissions.
Risks of Using Margin
While using margin carries the potential to enhance an investor’s return, it also magnifies the risk in the account. If the securities that collateralize the margin loan decline in value, the investor may experience a margin or maintenance call from the brokerage.
In the event of a margin or maintenance call, the investor must either deposit additional assets into the account or liquidate securities to reduce or altogether eliminate the margin balance. If remedial action is not taken by the client to meet the call, the brokerage will often involuntarily liquidate securities in the client’s account to meet the margin call.
An example of trading and investing using margin is the following: You want to purchase $100,000 worth of stock but you only have $50,000 in your brokerage account. The brokerage will loan you the extra $50,000 and charge you interest on the loan. The loan is secured by the stock that is in the account. If the price of the stock increases, the investor has the potential to make more money that they otherwise would have made if the investment was limited to $50,000. However, if the price of the stock decreases, the investor may lose their $50,000 and still owe the brokerage the borrowed funds, thus magnifying the losses.
Duty of Brokerage Firms and Financial Advisors
Financial advisors owe several duties to a client before they can recommend the use of margin. The failure of a Financial Advisor to fulfill these duties will subject the brokerage firm to liability. Among the duties include the following:
- To discuss with the client the risks associated with the use of margin, including the risk of principal loss beyond the value of the account.
- To discuss with the client whether they have the financial ability to absorb a complete loss of principal in the account.
- To discuss with the client the nature and type of collateral supporting the margin loan and how it may impact the risk characteristics of the margin loan.
- To discuss with the client the rate of interest charged by the brokerage firm for the borrowed funds.
- To discuss with the client the margin limits and maintenance requirements imposed by law and the brokerage firm.
- To discuss with the client their obligations in the event there is a margin call.
In addition, to the extent a margin loan is extended, the brokerage has further duties:
- To ensure that the margin maintenance requirements are met and that the client does not become over-extended.
- To ensure that clients are kept informed regarding margin calls and given an opportunity to deposit additional collateral to meet a call instead of the involuntary liquidation of securities by the brokerage.
- If liquidation becomes necessary, to do so in an orderly way that puts the client’s interest first.
How Can the Wolper Law Firm Help?
The Wolper Law Firm has extensive experience handling matters involving securities backed lending. If you have experienced margin calls or investment losses due, in whole or in part to the use of margin, or otherwise believe that the use of margin has been improperly recommended, please call the Wolper Law firm for a free consultation and case evaluation. Call 800.931.8452 to schedule a free, no-obligation consultation with one of our investment loss recovery attorneys.