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The Securities-Based Loan Margin Call Is "Exactly The Risk We Are Focused On," Says FINRA

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In a thriving bull market, investors looking for a little extra cash while simultaneously hoping to maintain their investment assets as the stock market rises might find that, thanks to a practice called securities-based lending, it is possible to have your cake and eat it, too.

The too-good-to-be-true allure of securities-based lending caught FINRA's eye in 2015, when the regulator listed securities-based lending in its Regulatory and Examination Priorities Letter, writing that the practice's significant credit and call risk is "exactly the risk we are focused on." The SEC later joined in, issuing its own Investor Alert pertaining to the similar securities-backed lines of credit (SBLOC) business.

As a brief overview, securities-based lending occurs when an investor uses a portfolio's stocks or other investments as collateral in order to obtain a secured personal loan, sometimes called a non-purpose loan—essentially, borrowing against one's investments for any purpose other than to purchase or carry securities.

The cautionary tale preceding FINRA and SEC's alerts occurred in 2014 when UBS reached a $5.2 million settlement with Puerto Rican regulators over unscrupulous sales practices on the island involving securities-based loans that UBS eventually called when closed-end bond funds crashed, leaving investors with losses (which UBS was ordered to repay via restitution).

According to regulators, the loan recommendations were unsuitable for the UBS clients who were elderly and had conservative investment goals, not to mention that the securities-based loans were purportedly used to purchase other securities in direct violation of industry rules.

As the Puerto Rico example alludes to, a lender has the right to call the loan (sometimes called a maintenance call or margin call) if the value of securities used as collateral declines to an amount that is no longer sufficient to support one's line of credit. This call usually sets a tight deadline (a matter of days or sometimes hours) for the investor to post additional collateral to the account or repay the loan, and if the investor fails to do so, the lender then will liquidate some or all securities in the account in order to satisfy the call.

Even worse, some firms, such as Wells Fargo, write in their fine print, "Wells Fargo Advisors will attempt to notify clients of maintenance calls but is not required to do so." Imagine never being notified about potential forced liquidation until after your securities have already been sold off!

In times of growth, neither this call risk nor the loan's interest rate and associated fees/commissions that otherwise pose a conflict of interest as the broker/financial adviser seeks to gain from a potentially harmful loan are detractors from the magical concept of borrowing money against an existing portfolio asset without having to actively pay it back.

It's easy for a broker to downplay the risks and reassure customers: As long as the investments continue to perform well, an investor might be able to pay back the entire loan using only portfolio proceeds, put off paying out pocket, or use the profits to pay back the loan at a massive cash discount.

After all, as long as there isn't any accounting for risk, it sounds like a perfect strategy toward instantaneous free cash. As long as the markets (and stocks/investment assets being used as collateral) continue to thrive, it's as if money is growing on a portfolio tree: who wouldn't want to use a "free" loan to buy a car or go on vacation and potentially never have to think about actively returning the money?

The pitfall, as we previously discussed in Coronavirus Losses, Stock Market Decline Expose Fraudulent Schemes, is that the high tide of a healthy economic environment serves to mask risky strategies, and a securities-based loan is, according to FINRA, a risky strategy.

All that's needed to derail the securities-based loan train is for the market to stumble, and once the train goes off the tracks, it can easily cause a massive financial wreck, the realized risk of a maintenance call rearing its ugly head as it has during the COVID-19 pandemic.

By then, an investor's portfolio will not only have lost value based on market performance alone, but thanks to the margin call, the portfolio's true losses will continue to be felt due to additional selling-off of assets or other forced liquidations made in order to satisfy the call, which accelerates the risk of losing some or all of one's principal.

If you have suffered damages after investing with a broker or financial adviser who unsuitably recommended a securities-based loan without adequately disclosing the true extent of its risks, such as that of a margin call, please call an experienced FINRA arbitration attorney at The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.

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