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. 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. 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. 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.
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.” 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.
Disclosure, Misrepresentation, and Omission of Material Facts. As a second potential means of recovery, a borrower may be able to recover if the broker failed to provide adequate disclosure of all material facts concerning the loan. As a general matter, brokers must provide open and honest disclosure about all material facts—including all “risks and disadvantages” and “material adverse facts”—associated with an SBL recommendation. Similarly, FINRA “member[s] cannot avoid or discharge [their] suitability obligation through a disclaimer where the particular communication reasonably would be viewed as a ‘recommendation’ given its content, context, and presentation.”
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. “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.”
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.
Conflicts of Interest. Third, there are certain and apparent conflicts of interest between a brokerage and its clientele in securities-based lending. In these transactions, the brokerage receives all of the benefits from issuing the loan but carries minimal risk. For example, the brokerage (i) earns monthly interest on the loan balance for the life of the loan, (ii) compounds its interest earnings by adding the accumulated interest to the loan’s principal, (iii) can require the borrower to input more collateral when the margin level dips below a certain threshold or (iv) it will exercise its unrestricted right to sell the underlying securities, (v) handcuffs the client’s portfolio to the brokerage for the life of the loan, and (vi) increases rapport with its brokers via hefty sales-based bonuses.
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 ...”
Supervision of Securities-Based Lending. Finally, brokerages are required under FINRA rules to have policies in place to protect investors from unethical sales practices. Namely, brokerages should have policies and procedures in place to ensure that non-purpose SBLs are suitable for the clients to whom they are being recommended. Similarly, brokerages should have policies in place to ensure that the clients are not using the funds to purchase additional securities.