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Beware Of Margin
argin investing is speculative and involves high risk. That is why most investors should not buy stocks on margin. But for those
who do, NASD Regulation, Inc., has issued important investor guidance about purchasing securities on margin, and the risks involved.
Investors should heed this guidance, which is set forth below.
Use of Margin Accounts
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. If the customer chooses to borrow funds from a firm, the customer will open a margin account with the firm. The
portion of the purchase price that the customer must deposit is called "margin" and is the customer's initial equity in the account.
The loan from the firm is secured by the securities that are purchased by the customer. A customer may also enter into a short sale
through a margin account, which involves the customer borrowing stock from a firm in order to sell it, hoping that the price will
decline. Customers generally use margin to leverage their investments and increase their purchasing power. At the same time,
customers who trade securities on margin incur the potential for higher losses.
Margin Requirements
The terms on which firms can extend credit for securities transactions are governed by federal regulation and by the rules of the
NASD and the securities exchanges. This investor guidance focuses on the requirements for marginable equity securities, which includes
most stocks. Some securities cannot be purchased on margin, which means they must be purchased in a cash account, and the customer must
deposit 100% of the purchase price. In general, under Federal Reserve Board Regulation T, firms can lend a customer up to 50% of the
total purchase price of a stock for new or initial purchases. Assuming the customer does not already have cash or other equity in the
account to cover his share of the purchase price, the customer will receive a margin call from the firm. As a result of the margin call,
the customer will be required to deposit the other 50% of the purchase price.
The rules of the NASD and the exchanges supplement the requirements of Regulation T by placing "maintenance" margin requirements on
customer accounts. Under the rules of the NASD and the exchanges, as a general matter, the customer's equity in the account must not
fall below 25% of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more
funds or securities in order to maintain the equity at the 25% level. The failure to do so may cause the firm to force the sale of-or
liquidate-the securities in the customer's account in order to bring the account's equity back up to the required level.
Margin Transaction Example
For example, if a customer buys $100,000 of securities on Day 1, Regulation T would require the customer to deposit margin of 50% or
$50,000 in payment for the securities. As a result, the customer's equity in the margin account is $50,000, and the customer has
received a margin loan of $50,000 from the firm. Assume that on Day 2 the market value of the securities falls to $60,000. Under this
scenario, the customer's margin loan from the firm would remain at $50,000, and the customer's account would fall to $10,000 ($60,000
market value less $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25%, meaning that the
customer's equity must not fall below $15,000 ($60,000 market multiplied by 25%). Since the required equity is $15,000, the customer
would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules
operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of
securities.
Firm Practices
Firms have the right to set their own margin requirements - often called "house" requirements - as long as they are higher than the
margin requirements under Regulation T or the rules of NASD and the exchanges. In today's market, some firms have raised their
maintenance margin requirements for certain volatile stocks (such as stocks of companies that sell products or services via the
Internet) to help ensure that there are sufficient funds in their customer accounts to cover the large swings in the price of these
stocks. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Again,
a customer's failure to satisfy the call may cause the firm to liquidate a portion of the customer's account.
Margin Agreements and Disclosures
If a customer trades stocks in a margin account, the customer needs to carefully review the margin agreement provided by his or
her firm. A firm charges interest for the money it lends its customers to purchase securities on margin, and a customer needs to
understand the additional charges that he or she may incur by opening a margin account. Under federal securities laws, a firm that
loans money to a customer to finance securities transactions is required to provide the customer with written disclosure of the
terms of the loan, such as the rate of interest and the method for computing interest. The firm must also provide the customer with
periodic disclosures informing the customer of transactions in the account and the interest charges to the customer.
Loan from Other Sources
In some cases, firms may arrange loans for customers from other sources, and there have been instances of customers making loans
to other customers to finance securities trades. A customer that lends money to another customer should be careful to understand
the significant additional risks that he or she faces as a result of the loan and needs to carefully read any loan authorization
forms. A lending customer should be aware that such a loan may be unsecured and may bot be eligible for protection by the Securities
Investor Production Corporation (SIPC). The firm may not, without direction from the borrowing customer, transfer money from the
borrowing customer's account to the lending customer's account to repay the loan.
Additional Risks Involved with Trading on Margin
There are a number of additional risks that all investors need to consider when deciding to trade securities on margin. These risks
include the following:
You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin
may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or
other securities in your account.
The firm can force the sale of securities in your account. If the equity in your account falls below the maintenance margin
requirements under the law-or the firm's higher "house" requirements-the firm can sell the securities in your account to cover the
margin deficiency. You will also be responsible for any shortfall in the account after such a sale.
The firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them for a
margin call to be valid, and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has
contacted them first. This is not the case. As a matter of good customer relations, most firms will attempt to notify their customers
of margin calls, but they are not required to do so.
You are not entitled to an extension of time on a margin call. While an extension of time to meet initial margin requirements may be
available to customers under certain conditions, a customer does not have a right to extension. In addition, a customer does not have
a right to an extension of time to meet a maintenance margin call.
It is important that investors take the time to learn about the risks involved in trading securities on margin, and investors should
consult their brokers regarding any concerns they may have with their margin accounts.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
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Telephone 312-332-0000 | Fax 312-332-0003
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