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Friday, Sep 22, 2023

Jane Bryant Quinn — Margin Calls Can Become a Nightmare for Naive Players

Investors who buy on margin have no clue about the risks they run.

You’ve probably heard about margin calls. What you don’t know is how bad they can get.

Buying stocks on margin means that you’re using money borrowed from your stockbroker. You can borrow up to half the purchase price. If the stock costs $5,000, the broker will lend you $2,500.

In the fabulous markets of 1999 and early 2000, stock-buying innocents borrowed in record amounts. Loans let you buy more shares, which magnifies your gains. When stocks decline, loans magnify your losses. You can lose more money than you put up.

But there’s a graver risk. An abusive broker can cause you to take a margin loan without knowing it, and you’ll still have to repay!

Maybe you didn’t want to buy that particular stock. Maybe you never intended to borrow. Maybe the loan was technically illegal. Tough luck. The loan is yours.

Anyway, that’s the current state of the law. “Consumer protection” for margin borrowers is a joke.

This brings me to Judy and Arnold Hyman of Boynton Beach, Fla., now retired. The Hymans used to own three dry-cleaning stores. For years, they’ve kept their money in mutual funds.

But then their sons, Mark and Bill, decided to try day trading for a living. They hitched up with a day-trading firm. Bill, 37, told his folks it would be a big help if they opened accounts to help him trade.

They did, in 1995. They didn’t invest a penny of their retirement savings, they just signed the papers.

Fast forward to 1997. The firm failed. The owner was barred from the securities business for making unauthorized trades in customers’ accounts. The clearing firm that handled the Hymans’ trades failed, too. Its owner settled with the Securities and Exchange Commission, on a charge of misappropriating clients’ money.

The Securities Investor Protection Corp. stepped in to clean up the mess. SIPC, an industry-funded insurance program, replaces lost or stolen cash and securities, up to $500,000. It also collects any money the failed firm is owed, including (without pity) customers’ unpaid margin loans.

So it came to pass that in January 1998, a trustee for SIPC sued the Hymans for more than $1 million in margin loans. “What loans?” the stunned Hymans cried. “Your loans,” SIPC said loans that turned up in their account.

It wasn’t son Bill’s day trading that did the Hymans in. They discovered, instead, that the owner of the firm had been buying a little-known stock for clients, all on borrowed money. When the stock price declined, the firm collapsed.

Here’s where the real lesson about margin borrowing starts.

At small brokerage firms, you don’t borrow from the firm itself. You borrow from the clearing house. SIPC told the Hymans that the clearing house wasn’t to blame for their problems. They had to pay off the loan, regardless of what the broker did.

When you’re on margin, you have a virtually ironclad contract to repay, says securities law professor Steve Thel of Fordham University in New York. You can’t default by saying you didn’t understand what was happening.

Nor does it matter if the broker borrowed more than the margin rules allow. You owe the money! Maybe you can accuse your broker of fraud. Still, you owe the clearing house!

There are only two possible ways out.

First, the margin loan might be erased, if the trade was fraudulent and the clearing house was directly involved. This line of attack was taken by the Hymans’ attorney. He lost the case and has appealed.

You might also escape if you watch every single transaction that your broker makes and protest immediately in writing if you object (telephoned objections don’t count).

Your letter might get the trade reversed. If the broker ignores you, however, you’ll still have to cover the loan. Hard to believe, but true.

Even writing a letter isn’t as straightforward as it sounds. It doesn’t count if you simply write the letter to the brokerage firm. You have to write directly to the clearing house. Who tells investors that?

Furthermore, the letter will work, as a legal defense, only if your margin contract allows it, says retired securities lawyer Charles Rechlin of Sullivan & Cromwell in Los Angeles.

The Hymans are frantic, needless to say. But SIPC has no sympathy.

“These people aren’t victims,” says SIPC general counsel Stephen Harbeck. “They made bad market decisions.”

Pure hardball. Now will you rethink your margin account?

Syndicated columnist Jane Bryant Quinn can be reached in care of the Washington Post Writers Group, 1150 15th St., Washington D.C. 20071-9200.

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