Margin Account Abuse
A customer who purchases securities may pay for the securities in full or may borrow part of the purchase price from his or her securities firm. Purchasing securities using borrowed funds is known as “buying on margin.” If the customer chooses to borrow funds from a brokerage firm, the customer must open a margin account with the firm. At the time the customer opens a margin account, the broker or other investment professional must determine whether the customer can afford the financial risks of margin investing, explain the risks inherent in a margin transaction, and determine whether the investor understands the risks in a margin transaction before entering into the agreement.
It is important to note that margin loans are highly profitable for brokerage firms and their brokers who may receive a fee based on the amount of their customer’s margin loan. In fact, many brokerage firms have their customers credit or debit cards linked to their margin accounts so that they can easily tap into their margin account.
Customers generally use margin to leverage their investments and increase their purchasing power. When the customer borrows from the brokerage firm or investment professional to pay for his/her securities, the portion of the purchase price that the customer borrows is called margin and is secured by the securities that are purchased by the customer.
While investing on margin increases a customer’s purchasing power, such trading also increases the risk of loss to a customer. First, the customer is at risk to lose more than the amount invested if the value of the security depreciates sufficiently. The margined stock could decline to zero, which would require the customer to pay off the entire amount of the loan, plus interest, without having any value in the collateral. Second, the interest being charged to the account adds to the customer’s costs, thereby requiring the investments to appreciate even more to cover the cost of the interest before the customer realizes a net gain. There are additional risks involved with trading on margin, which include, among others:
- Requiring the customer to deposit more money into the account, causing the customer to lose more funds than he/she deposited in the margin account;
- The firm can force the sale of securities in the customer’s account, possibly at a substantial loss to the customer;
- The firm can sell the customer’s securities without notice;
- The customer could end up owing money to the firm; and
- The customer is not entitled to an extension of time on a margin call.
For many investors, trading on margin is far too risky and unsuitable. While the use of margin can be an effective use of leverage to an investor who is capable of affording and understanding the risks, it is not typically a prudent tool for the average investor. Unless the customer has the financial ability to pay the full amount of the debit on short notice, the use of margin should not be allowed.
A broker or investment professional who encourages the use of margin in situations where it is not appropriate or suitable for the customer may be in violation of industry rules and liable for any ensuing financial harm. Brokers or other investment professionals have a duty to investigate the ability of an investor to afford the financial risks inherent in a margin transaction, and to determine whether the investor understands the risks in a margin transaction before entering into such a transaction. If he/she fails to investigate a customer’s ability to incur the risk in a margin account, or if he/she fails to make certain that the investor understands the risk in a margin transaction, the broker or investment professional has violated certain duties owed to the customer, who should be able to recover any damages incurred as a result of the margin transaction.
If your investment professional did not explain the impact margin can have on your account, (i.e., the risks of investing on margin), or you did not understand margin investing and told your investment professional as much, contact Stephanie M. Beige at email@example.com to discuss your rights.