The Wall Street Journal recently reported that the use of margin debt has increased substantially with the recent run-up of the equity markets following the Trump presidential election. Traditionally, margin refers to borrowing money from a broker to purchase stock or other securities. More broadly, it is a reference to any borrowing associated with securities investments. The use of margin debt allows investors to increase returns. But it also increases investors’ risk of investment losses.
In our 25 years of securities litigation experience, we have seen a number of market cycles and subsequent securities litigation cycles. Although the investment products giving rise to the litigation change from one down-cycle to the next, margin is almost always a contributor to the outbreak of litigation that inevitably follows significant market drops. Here are some reasons why:
When investors borrow against securities in their portfolio, they give their broker a stake in the portfolio. While the investor owns the performance of the portfolio, the lending broker owns the security for the loan. This means that the investor owns all of the portfolio’s gains, but if the value of the portfolio falls at or near the level of the loan, the lending broker takes control. Under the Securities and Exchange Commission’s Regulation T, lending brokers have the obligation to protect their loans by selling the securities that are the loan’s collateral. Ideally, lending brokers allow their borrowing customers to bring in additional capital in the event the securities in the account decline. But sometimes there isn’t time if the stock securing the loan drops precipitously. Typically, brokers have the right to sell the securities in a borrowing-customer’s account to satisfy the margin debt with or without notice to the investor. If the market drops suddenly, the broker will liquidate the securities that are the collateral, and the investor’s portfolio could be gone. Investors who see their portfolios wiped out often resort to litigation.
Markets often fall quickly, which means margin loans often get unwound quickly. This can result in investors losing all or part of a portfolio they and their advisors carefully constructed. And if the lending broker doesn’t act quickly, a margined portfolio can be liquidated and leave a debit in the account that the investor owes to the broker. In our experience, brokers tend to be aggressive in collecting on these margin debts, but they often trigger counter claims from investors who allege their accounts were wrongfully liquidated, were constructed of unsuitable securities, or that they were not properly warned of the risks of margin.
A number of investments contain margin or borrowing. Leveraged ETFs, some Market Linked Notes, and some hedge funds marketed to retail investors include margin in order to increase their returns. Although many of these types of investments are professionally managed, the effect of margin in a falling market is the same: at some point a liquidation that wipes out the entire investment may occur. Anytime an investment results in a total loss, there is an increased likelihood of litigation.
We encourage investors to ask their advisors whether there is leverage in their portfolio, and how market declines will affect their leveraged investments. We encourage advisors to have, and document, conversations with clients about the risk of leverage should the markets suddenly decline.