Margin Account or Securities-Backed Lines of Credit (SBLOC) Abuse

A "margin" account is a brokerage account in which the brokerage firm loans money to the investor. For example, if $100,000 is deposited into a "cash" account, it can be used to buy $200,000 worth of stock.

Most margin claims involve stocks, but not always.

In one particular situation, a financial advisor recommended the purchase of $500,000 thousand in bonds though there was only about $250,000 in the account. The other $250,000 was "borrowed" from the brokerage firm, which charged interest. The advisor sold the idea as a win-win as the interest on the bonds exceeded the loan interest rate. What the advisor failed to explain was that, unlike a home loan, when the collateral falls in value, the firm demands payment in what is referred to as a "margin call." If payment is not met, the security is sold out at the firm's discretion. That's what happened in this instance to our client. The bond was severely downgraded, and the price was almost cut in half. The client, a conservative bond investor by nature, lost just about everything.

The team of skilled bond loss attorneys and stock loss lawyers at SSEK has handled many claims involving margin and stock purchases. The use of margin increases buying power, which in turn increases commissions/fees for the broker and firm. An unscrupulous financial advisor may recommend a margin to a client that is not sophisticated or understand the margin call aspect.

In one of the many situations we handled, the advisor wanted to increase the management fees he was earning. His unsuitable solution was to recommend margin to a large portion of his clients. In this particular case, the advisor was able to turn a $300,000 account into a $600,000 account, thereby doubling the fees. The charged interest rate stayed the same, but the margin increased the initial investment under management. The client never realized the peril in which his assets were placed. Then, a market correction occurred, and the client stock losses were magnified. His account was decimated.

In the same vein, firms can recommend a line of credit, also known as a securities-backed line of credit (SBLOC), instead of a margin, but the principle is the same. In a recent matter, the client had almost a million dollars in liquid mutual funds. His intent was to sell $400,000 to make a real estate purchase. The financial advisor did not want her to sell as it would disrupt a fee trail he was receiving. Instead, he recommended the line of credit collateralized against the mutual funds. When a market correction occurred, the mutual funds were liquidated by the firm. The client never had the opportunity to recover financially when the funds returned to value.

While margin investing can double the gains on an investment, it also doubles the risk. In fact, because interest immediately begins to be charged to the account and a temporary drop in the stock value can cause liquidation, the danger is even greater than many investors realize.

Margin brokerage accounts are very profitable for brokerage firms. Just as Sears and other retailers earn more on financing than on selling goods, many brokerage firms earn more on margin interest than on commissions. Brokers sometimes get a bonus on interest charged to their client's accounts, but their goal is usually to double commissions. When management fees are charged instead of commissions, these fees are charged on the portfolio size rather than the client's "equity" in the account. As a result, expenses can be greatly increased in leveraged accounts, which is bad for the consumer.

Brokers often dispel a client's fear of investing on margin by reminding them they borrow 90% or more on the house, so borrowing 50% on a stock is conservative. Yet, this is false logic because most public entities carry debt to a large degree on their books. Thus, purchasing equity, on margin, in a publicly-traded entity increases risks.

Using margin is a high-risk method of investing and is only appropriate for sophisticated investors who fully understand the risk. The most egregious cases securities law firms handle for investors who have been decimated through margin accounts.