Securities-Based Loans

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

Brokerages seeking to capitalize on the liability side of their clients’ investment portfolios developed SBLs as a means to earn investment income from client-based loans that are collateralized by the portfolios.

Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
“Are you looking for a flexible, convenient way to manage cash flow?”[1]  Then look no further, you can “[u]nlock the value of your [investment] portfolio” by using “[a] holistic approach to borrowing.”[2]  “A securities-based line of credit helps you to meet your liquidity needs by unlocking the value of your investments.”[3]  In short, securities-based borrowing helps you “[f]inanc[e] for today’s needs, without sacrificing tomorrow’s goals.”[4]

These optimistically bold statements exemplify just a few ways in which brokerages aggressively market their securities-based lending services. After a quick scan, an otherwise sensible client would consider himself foolish for not “unlocking” the potential of his portfolio by borrowing against it — after all, doing so in a “holistic” manner will not “sacrifice” his long-term goals.

Securities-based loans (“SBLs”) are nothing new to brokerages and their clients. Brokerages seeking to capitalize on the liability side of their clients’ investment portfolios developed SBLs as a means to earn investment income from client-based loans that are collateralized by the portfolios. SBLs encapsulate two separate lending structures, purpose and non-purpose.
  • Purpose SBLs, i.e., “margin” loans, are loans backed by a borrower’s investment portfolio that are specifically used to acquire additional securities.
  • In contrast, a non-purpose SBL expressly prohibits the borrower from purchasing additional securities or bonds. Rather, non-purpose SBLs — also backed by all or part of the borrower’s investment portfolio — are used to pay for any non-securities related expense, such as travel, a luxury yacht, business financing, taxes, or a medical bill.
This article addresses the inherent risks to non-purpose securities-based lending transactions.

I. General Background

What is a Securities-Based Loan? In brief, a non-purpose SBL is a loan issued by a brokerage, including those owned by banks, that is collateralized by all or part of a client’s investment portfolio and used to purchase or fund anything but the acquisition or holding of additional securities. A borrower can usually obtain up to 50% to 60% of a diversified portfolio of stocks and bonds[5]  and in some circumstances, can borrow up to 95% of the portfolio’s value.[6]

Under the terms of a typical non-purpose SBL, the borrower is required to hold a certain level of “equity” (loan-to-value ratio) in the account during the life of the loan.[7]  “Equity” means, for purposes of SBLs, the value of the pledged investment portfolio minus the loan balance. Generally, this figure will be around 30%. Should the loan-to-value ratio ever drop below the contracted value, the loan is subject to margin calls, which obligate the client to immediately infuse additional capital (e.g., stocks or cash) into the account. If the client is unable to do so, the entire collateralized portfolio is subject to forced liquidation by the brokerage without notice to the client. This means that a client will not be able to choose which stocks or bonds the brokerage sells.

The predominant focus of securities-based lending is on the collateral. Unlike a typical loan, such as a mortgage, underwriting of an SBL takes little to no consideration of an individual borrower’s credit rating or income-to-debt ratio. Rather, the amount of credit extended to a client vis-à-vis an SBL is tied directly to the value, liquidity, and volatility of the collateralized securities.

The Rise of Non-Purpose Securities-Based Lending. Due in no small part to the uptick in aggressive marketing and broker incentives, sales of non-purpose SBLs have dramatically increased in volume. For example, between 2012 and 2014, Morgan Stanley’s sales of SBLs increased nearly 70% to a value of over $38 billion.[8]

Non-purpose SBLs are not limited to full service firms like Morgan Stanley, however. Brokerages who provide services to registered investment advisors (“RIA”) have increasingly targeted the assets controlled by the RIA. For example, Pershing Advisor Solutions made $1 billion in SBLs between 2014 and 2015,[9]  while Fidelity Investments increased the volume of SBLs sold by its RIAs by 63% between 2013 and 2015.[10]

II. Budding Ramifications

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.

III. Means of Recovery

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.

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.[16]  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.”[17]

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.

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 ...”[20]

Supervision of Securities-Based Lending. Finally, brokerages are required under FINRA rules to have policies in place to protect investors from unethical sales practices.[21]  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.

IV. Conclusion

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.


5 Michael Wursthorn & Annamarie Andriotis, "Understanding the Mechanics—and Risks—of Securities-Based Loans," The Wall Street Journal (Aug. 28, 2015).

7 Often, SBLs do not have a pay-off date. Instead, interest is charged monthly and added to the loan’s principal balance.

8 Paul Meyer, Securities-Based Lending, 22 No. 2 PIABA B.J. 121, 121–22 (2015).

9 Mason Braswell, RIAs Join Brokers in Promoting Securities-Backed Lending, Investment News (June 11, 2015).

10 Id. 

11 “FINRA” stands for Financial Industry Regulatory Authority and is a self-regulating organization for brokers and brokerages.

12 Namely, Rule 2111 requires that a broker “must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.” FINRA, Rule 2111 (2012); see also 17 C.F.R. § 240.15c2-5(a)(1).

13 See FINRA, Rule 2111 (2012).

14 See FINRA, Rule 2090 (2012) (“Every member shall use diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.”).

15 FINRA, Rule 2111.06 (2012).

16 See 17 C.F.R. § 240.10b-16; 17 C.F.R. § 240.15c2-5(a)(1); FINRA, Rule 2264 (2011). 

17 FINRA, Notice to Members 01-23 (2001).

18 In re James B. Chase, Exchange Act Release No. 47476 (Mar. 10, 2003) (noting that a registered representative must “be satisfied that the customer fully understands the risks involved and is . . . able . . . to take those risks” (citing Patrick G. Keel, 51 S.E.C. 282, 284 (1993))).

19 In re Dale E. Frey, et al., SEC Initial Decision Release No. 221 (Feb. 5, 2003).

20 FINRA, Regulatory Notice 11-02 (2011).

21 FINRA, Notice to Members 98-96 (1998).

If you would like to discuss bringing a securities-based lending cause of action, we would be happy to discuss your potential case with you. To arrange for a consultation concerning your legal matter, please contact Robert Mitchell at or at (602) 452-2730.
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