Buying Securities on Margin

Investors getting into trouble with margin calls

Using borrowed money to purchase securities is called "buying on margin." A "Margin Account" is a brokerage account in which the broker lends the customer cash to purchase securities. The loan is collateralized by the securities and cash.

You may also hear the term "leverage" to describe investing this way. When an investor buys on margin, any gains and any losses are inflated. It is consequently a more risky way to invest.

Most brokers will allow clients to buy on margin. Brokers have two motivations for enabling margin investing. First, some investors prefer to buy on margin and the brokers offer this opportunity as part of their customer service. Second, the brokers are the ones lending the money for the margin purchase, and they collect interest on the money loaned.

The minimum margin is the initial amount required to be deposited in a margin account before trading on margin. The NYSE and the NASD require investors to deposit a minimum of $2,000 before trading on margin. This amount is only a minimum, some brokerages may require you to deposit more than $2,000.

After you buy stock on margin, the NYSE and NASD require you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. You must keep at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the "maintenance requirement." In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent, and sometimes higher depending on the type of stock purchased.

Margin Calls

A margin call is a demand that an investor using margin deposit additional money or securities to bring a margin account up to the minimum maintenance margin. Margin calls happen much more frequently in bear markets than in bull markets, although they can happen to any individual investor any time that investor's account declines in value.

Other names for Margin Calls are Fed Calls or House Calls.

If you trade on margin, your broker can sell your securities without giving you a margin call.

As the use of margin has risen in recent years, so has the number of investor complaints to the regulatory agencies about margin calls. Many investors complain that they suffered serious financial losses - sometimes their entire life's savings - because their securities were sold to cover a margin call.

Margin Call Trouble

If the equity in your margin account falls below your brokerage firm's maintenance requirement, the broker will make a margin call to ask you to deposit more cash or securities into your account. Margin calls catch many investors by surprise. They can put a squeeze on an investor's personal finances.

If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.

The broker is not required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. The brokerage does not have to ask for more money to bring your account up to par. It can go ahead and sell your securities in the account without your permission. This can cause undesirable tax consequences.

Your broker may have the right to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

Is there anything wrong with Margin Calls?

Margin calls are perfectly legal and the rules are defined by the contract between the brokerage and the investor. The investor may have some cause for legal action if the margin account is a symptom of broker misconduct.

This misconduct includes:

Unsuitability of Investment

When making an investment recommendation to a client, a broker must make recommendations that are consistent with the customer's risk tolerance, needs and investment objectives. A broker has a duty to know his client and only recommend investments and trading strategies that are suitable for that client. Margin trading may be unsuitable if a customer does not have the financial ability to incur the risk associated with a particular investment, or if the investment was not in line with the investor's financial needs; or if the customer did not know or understand risks associated with certain investments.

A broker has a duty to understand the risk tolerance of an investor, the tax considerations for the client, the client's prior experiences and appetite for risk, and the level of return desired. It is the duty of a broker to make recommendations that are appropriate and suitable given his client's circumstances. If margin trading is unsuitable for a client, the broker may be liable to that client.

Misrepresentation

A broker is liable to a client if that broker misrepresents material facts or omits to disclose material facts to the investor regarding an investment, and that client loses money as a result. A broker has a duty to fairly disclose all of the risks associated with an investment.

If the broker failed to tell the investor that he or she was buying on margin can be a cause for legal action. Failing to tell the investor about the increased risk of margin trading can also be a cause for legal action.

Possible Legal Action

To determine if you might have a case, ask yourself:

• Do you know that margin accounts involve a great deal more risk than cash accounts where you fully pay for the securities you purchase? Are you aware you may lose more than the amount of money you initially invested when buying on margin? Can you afford to lose more money than the amount you have invested?
• Did your broker explain the terms and conditions of the margin agreement and tell you about how a margin account works and discuss whether it's appropriate for you to trade on margin?
• Were you aware of the costs you will be charged on money you borrow from your firm and how these costs affect your overall return?
• Were you aware that your brokerage firm can sell your securities without notice to you when you don't have sufficient equity in your margin account?

If the answer to these questions is "no", consult an attorney.