Excessive Use of Leverage and Margin
Brokers frequently encourage investors to borrow against their account assets to buy additional securities. Known as ‘buying on margin’, this tactic poses some inherent risks to the investor. Using a margin account to make purchases basically means that they are borrowing money from the brokerage firm to make the transaction. They are required to pay interest on any balance owed to the firm, generating substantial profits because firms usually receive fees based on the amount of a client’s margin loans. Brokers have a duty to make sure that the investor can both understand and tolerate the financial risks associated with margin transactions. If they encourage this activity without taking these precautionary steps, they are in violation of securities industry rules, including FINRA’s guidelines for communication with the public, and be held liable for any resulting losses.
When a broker or brokerage firm is notified that they are under investigation for excessive use of leverage and margin, they should retain skilled counsel to advise them during any FINRA Arbitration or related investigations.
If a FINRA Arbitration panel finds that a broker or brokerage firm contributed to a customer’s losses due to excessive use of leverage and margin, they may assign penalties including but not limited to fines, registration suspension, a ban on employment in the securities industry, and complete or partial restitution to the customer.
In December 2013 FINRA ordered broker-dealer J.P. Turner & Company, L.L.C., which is based in Atlanta, to pay $707,559 in restitution to 84 of its customers for selling unsuitable leveraged and inverse exchange-traded funds (ETFs) and for excessive mutual fund switches.
According to FINRA, J.P. Turner failed in its duty to establish and maintain a proper supervisory system for leveraged and inverse ETFs, instead supervising them as if they were traditional ETFs. The firm also failed to adequately train its staff regarding these ETFs and let brokers recommend them without performing reasonable diligence to understand their features and risks.
Leveraged and inverse exchange-traded funds are a particularly tricky area that can result in FINRA intervention.They “reset” daily, meaning that they are engineered to achieve their objectives on a daily basis. This can cause their performance to diverge from that of the underlying index or benchmark. Investors can suffer considerable losses even if the long-term performance of the index revealed a gain.
J.P. Turner also failed to determine whether the ETFs were suitable investments for at least 27 clients, who sustained collective net losses of more than $200,000.
Unauthorized trading, churning, excessive commissions and fees, unsuitability, failure to diversify, misrepresentations and omission, and breach of fiduciary duty are charges that may also be laid against individuals or entities accused of excessive leverage and margin.
Those accused of this type of investment fraud should work closely with their attorney to strengthen their case. If they can prove that the customer understood the risks inherent with buying on margin, they may have a valid defense.