New York City lawyers Fighting to recover investor losses since 2004
Skyscrapers at midtown New York City with the East River on the background
New York City Lawyers Fighting to recover investor losses since 2004

Securities-Backed Lines of Credit

With increasing frequency, brokerage firms are marketing and offering securities-backed lines of credit (“SBLOCs”) to investors. SBLOCs present an attractive opportunity for brokerage firms to increase their revenues, particularly during a prolonged bull market, in which many retail investors have been enjoying years of solid returns and significant portfolio growth. Against this backdrop, some brokerage firms heavily market SBLOCs as a financing vehicle or liquidity strategy designed to unlock value in a given investment portfolio.

Unfortunately, in the midst of bull market optimism and any associated SBLOC marketing blitz, the significant risks associated with securities based lending are often muted. Specifically, both the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) have issued recent investor alerts concerning the significant risks associated with SBLOCs, as further described below.

What are SBLOCS and how do They Work?

Put simply, SBLOCs are loans marketed to investors as an efficient and inexpensive means to access cash through borrowing against the value of assets held in a given investment portfolio. SBLOCs are set up as revolving lines of credit (not unlike a credit card), allowing the investor to borrow against the value of securities as collateral, and requiring monthly interest-only payments. An investor with an SBLOC can continue to trade securities while the SBLOC is outstanding and may pay some or all of the outstanding principal at any time.

In general, the securities eligible as collateral for an SBLOC include stocks, bonds, and mutual funds. Unlike margin loans, SBLOCs are non-purpose in nature. This means that the investor who takes out an SBLOC may not use the proceeds of the loan to purchase or trade securities. Conversely, a purpose (or margin) loan is credit extended for the purpose of buying, carrying, or trading in securities.

Proponents of SBLOCs point to their ease of use, flexible terms, and their many end uses (including real estate purchase, home renovation, expenses such as taxes or tuition, as well as auto or boat financing). Additionally, a key marketing component of SBLOCs are their attractive low-interest rates, which are typically priced using the London Interbank Offered Rate (“LIBOR”).

Regulation of Broker-Dealer Lending

The Securities Exchange Act of 1934, Section 7, grants the Federal Reserve Board the overall authority to regulate the extension of credit by broker-dealers (as to both purpose and non-purpose lending). Accordingly, the Federal Reserve implements this authority pursuant to Regulation T, more commonly known as “Reg T.” Reg T enumerates the minimum amount of equity that must be on deposit at the time a security is purchased (the initial margin requirement). Under Reg T, an investor may borrow up to 50% of the purchase price of securities that can be purchased on margin. Additionally, Reg T sets forth acceptable collateral by defining “margin securities” and including certain exempted securities, such as government or municipal bonds.

In addition to regulation by the Federal Reserve, the Financial Industry Regulatory Authority (“FINRA”) also maintain its own policies regarding the extension of credit to customers. For example, FINRA has elected to set a margin maintenance requirement of 25% for equities, leaving broker-dealers free to set a higher maintenance requirement. In practical terms, a 25% maintenance margin requirement means that an investor must have, at all times, at least 25% of the total market value of the securities in a margin or SBLOC account at all times.

Considerable Risks Associated With SBLOC Financing

The main risk associated with SBLOCs involves the nature of the loan itself and its underlying collateral – put simply, borrowing against securities creates leverage using collateral that is subject to the vagaries and volatility of the securities markets. In a bull market, SBLOCs may seem like an attractive way to access cash without having to sell out of securities that may have further upside potential (not to mention the tax consequences incurred when selling out of an investment). However, when the value of an investment portfolio significantly decreases, an uninformed investor will soon come to learn that the SBLOC’s leverage will magnify the impact of the losses.

When an investment portfolio leveraged with an SBLOC loses significant value, the brokerage firm issuing the loan will notify the investor that the underlying collateral is no longer sufficient to support the SBLOC loan. The investor will either need to pay down some (or all) of the loan, or add additional securities as collateral to support the SBLOC. And if an investor cannot pay down the loan or transfer additional securities into the pledged collateral account (pursuant to the loan agreement), the brokerage firm may liquidate some (or all) of the securities (depending on the situation). Furthermore, because SBLOCs are structured as demand loans, this means that a brokerage firm issuing the loan may call the loan at any time.

Because the value of a securities portfolio is subject to significant volatility due to numerous risks, including market risk, as well as security-specific risks (for example, loss in value of a single stock in which an account is concentrated, such as employer stock), investors would be wise to tread very cautiously when it comes to seeking financing through a SBLOC.

Suitability of a SBLOC

When recommending a SBLOC to a customer, a stockbroker and by extension, his or her brokerage firm, must adhere to the FINRA Rule 2111. In relevant part, FINRA’s Rule on suitability “… prohibits a member or associated person from recommending a transaction or… use of an investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment.

Therefore, before a broker recommends an SBLOC as part of an investment strategy, that financial advisor and his or her brokerage firm must first endeavor to exercise “reasonable diligence” to determine the appropriateness of the recommendation to borrow against the customer’s securities portfolio as collateral. Specifically, the following inquiries should be raised to help determine if the loan meets the suitability rule and is appropriate for the customer:

  • How much debt (from all sources) does the client currently carry?
  • Will this loan create more debt than is justified by the client’s financial circumstances?
  • What are the client’s liquid assets, apart from collateral securities? Does the client have sufficient liquidity to meet margin calls?
  • Is the additional risk created by the financial leverage suitable for the client?
  • Does the client understand all the risks associated with borrowing against his or her securities as collateral?
  • To what purpose is the loan being applies? Will the client have the means to repay the loan?
  • Are asset sales a better alternative?

The attorneys at Law Office of Christopher J. Gray, P.C. have considerable experience in representing investors who have incurred losses due to broker mismanagement and misconduct, including the recommendation of unsuitable investment strategies. Investors may be able to recover their losses through FINRA arbitration. Investors may contact our office at (866) 966-9598 or for a no-cost, confidential consultation.

Client Reviews
Chris did a great job with my case. He managed my expectations in the beginning of the process, consulted me along the way and always made sure I knew the advantages and disadvantages of decisions we collectively needed to make. He is very knowledgable about the finanical industry and how they work legally, which very much helped me and my legal initiative successful. Chris is straight-forward and doesn't mess around. I was very please with his professionalism and the outcome of my case, and would recommend him to anyone that is pursuing action against any company in the financial services industry. Greg
Chris displayed extreme professionalism. His dedication, research, and concern for his clients pocket book was displayed to the fullest when Chris tried my case. His diligence and perserverance were rewarded when we won our case. I have reccommended Chris to numerous friends who have concurred with my positive assessment. Jay
Chris became my lawyer for a FINRA Arbitration case in 2008. He listened to my complaint, filed notice soon after and engaged an expert witness. We discussed mediation, found it to be agreeable and approached the defendant who at first agreed and at the last minute reneged. At all times Chris kept me informed of the process, costs and developments. Andrew