The Inherent Risks of Non-Purpose Securities-Based Lending Transactions

No one knows how large the non-purpose SBL market is, and for now, nobody seems to care. Brokers are delighted to recommend SBLs as their brokerages incentivize loan sales with hefty bonuses. Brokerages are thrilled to sell SBLs as a means to diversify their revenue stream while also shackling their clients’ now-collateralized investment portfolio to their firm for the life of the loan. Finally, clients are happy as they secured a large personal loan to pay off a recent medical expenditure, buy a new condo, or take a world tour, by simply “unlocking the value of their portfolio.”

When the market is steadily producing returns—as in the present bull market—SBLs provide another option for borrowers to obtain additional capital. But what happens when the bull becomes a bear?

Initially, a market downturn will presumably cause a diversified collateralized portfolio to decrease in value and inch closer to the requisite margin amount. At this time, a brokerage will likely suggest that the client infuse more collateral, e.g., securities or cash, into the account to protect against the loan. A savvy client might instead opt to sell some of his collateralized securities to pay down the loan balance and decrease the margin. If the client is unable to do so and the portfolio continues to decrease in value below the contracted-for equity ratio, the brokerage will either (i) demand the client immediately infuse additional capital into the account or (ii) liquidate all or part of the investment portfolio—often, without notice to the client.

To illustrate, suppose a broker sells a $150,000 loan to a client that is secured by an investment portfolio of stocks and bonds worth $300,000. The loan states that the equity margin must be at least 30%. However, suppose an unrelated political event causes the market to tumble and the portfolio is now worth $250,000. The equity ratio would now be about 40%, sufficient, but inching closer to the equity margin. The ultimate tipping point, 30%, is when the portfolio is worth $178,573, and the loan value is $100,000. At this time, the portfolio would be subject to a margin call or forced liquidation.

There can be several potential methods of recovery for an investor harmed by a securities-based lending transaction, the most notable of which is holding a broker liable for an improper recommendation under FINRA.[11]  This section will discuss several FINRA-based arguments that could be raised against a broker or brokerage.

FINRA’s Suitability Requirement. The “suitability” requirement of the broker-client relationship is one potential means of recovery for a borrower harmed by a non-purpose SBL. Under FINRA’s suitability regulations, a broker must ensure that any investment-related recommendation is based on the best interests of the client and consistent with the interests of the client.[12]  Even if a client eagerly desires to take out a non-purpose SBL, the broker must refrain from making such a recommendation if doing so would not be suitable for the client.[13]  Similarly, SBLs should be considered part of a client’s investment strategy and are subject to FINRA Rule 2090, which requires brokers to undertake due diligence before making investment related recommendations.[14]

Notably, a broker should examine whether the client has the ability to meet margin calls as part of the suitability due diligence. An innate red flag arguably exists for non-purpose SBLs as they are generally used for unplanned expenditures, such as medical emergencies, or luxury items, such as travel, yachts, and houses. If the borrower must rely on a securities-based loan to afford such an expense, his assets may not be sufficiently liquid to meet a margin call. Thus, in the event of a margin call, the borrower’s only reprieve would be liquidating the collateralized securities, which likely would be done at bottom prices. In these circumstances, a broker would have a difficult time justifying as suitable a non-purpose SBL recommendation as the borrower likely did not have the “financial ability to meet such a commitment.”[15]  In short, a borrower with scarce or no means to meet a margin call—other than by forced liquidation—is likely not suitable for an SBL.

In fact, the broker must make “reasonable” efforts to ensure that a client fully and actually understands the main characteristics of a recommendation, particularly the risks.[18]  “NASD Rule 2860 requires that a registered representative make sure that the client has not only read the disclosure documents for an investment, but also that he understood them. It is a deviation from industry standard to do otherwise.”[19]

As examples, forced liquidation at unfavorable prices is a significant risk that should be disclosed in any non-purpose SBL recommendation. Moreover, margin agreements generally provide that the brokerage can carry out these sales without contacting the client.

On the other hand, the client gains only a marginal short-term reward in exchange for potential financially devastating long-term risks. Clients enticed to obtain a non-purpose SBL to fund a current expense may not have enough liquid assets to pay off a margin call in the first place. As a result, the client may be perennially subject to the risk of forced liquidation of all or part of his investment portfolio at fire-sale prices.

Between this tension stands FINRA, which unequivocally states that clients may “rely on firms’ and associated persons’ investment expertise and knowledge, and it is thus appropriate to hold firms and associated persons responsible for the recommendations that they make to customers ...”[20]

Due in no small part to the aggressive marketing by brokerages and recommendations from highly-incentivized brokers, borrowers are swarming to SBLs as a means of obtaining additional capital. Eventually, however, these loans will come due, and for some borrowers, this will be in the midst of a bear market, resulting in precarious financial consequences.