Margin abuse can result in excessive use of margin loans or the failure to utilize risk management strategies to protect account collateral. Margin calls can wipe out an investor’s brokerage account equity in a short period of time. The use of margin exposes investors to greater risk and costs. Margin interest increases the breakeven rate of return required for a particular investment strategy. A brokerage account cost ratio measures breakeven rate of return for the account to cover all costs, including commissions and margin interest. When margin is used, the required net rate of return needed to breakeven increases to pay interest charges. The higher required rate of return may result in a change to a riskier investment strategy that is unsuitable for the investor. This greater return and its corresponding risk are many times not disclosed to investors. This fact must be weighed carefully and disclosed by a brokerage firm and its financial advisor. Some brokerage firms and financial advisors recommend the use of margin to diversify. The use of margin or other loans in many situations is considered unsuitable investment advice.
Financial Advisor Incentives
Many brokerage firms provide financial incentives to financial advisors who recommend the use of margin because the lending activities represent a substantial source of revenues for the firm. The margin loans are fully collateralized with no chance of default because of the protections provided to the brokerage firms in the margin agreements. Margin agreements and lending regulations create a risk free lending business model for brokerage firms which may create conflicts of interest and tendency for failures in supervision. For these profits, financial incentives are given to financial advisors whose clients’ accounts have margin loans. These incentives include greater commissions because it increases the amount of assets the financial advisor can manage.
Risk of Margin Calls
Margin accounts involve substantial risks and are suitable only for sophisticated investors who understand the risks of substantial loss in brokerage account equity. Brokerage firms and its financial advisors are required to disclose to investors the risks of the use of margin including that:
- they can lose more money than their initial investment;
- they may have to deposit additional cash or securities in their account to meet margin calls;
- they may be forced to sell some or all of the security positions in the brokerage account to meet margin calls; and
- brokerage firms may sell any security positions without consulting you to meet margin calls.
Brokerage firms and financial advisors can protect your brokerage account equity through risk management strategies in the event the price of the stock purchased on margin declines. Financial advisor can calculate, in advance, the decline in account value that will trigger a margin call. Brokerage firms and financial advisors should recommend the use of risk management strategies in brokerage accounts to manage the risk of a margin call.
Tax Treatment of Margin Interest
Many brokerage firms and financial advisors advise customers to use margin because of the tax deductibility. In some instances, they suggest that all the interest is tax deductible. However, multiple factors need to be taken into consideration including:
- Margin interest deduction for interest paid, not a just accrued;
- Margin interest as it relates to taxable investments such as stocks, bonds or certificates of deposit, subject to the investment interest limitations;
- Margin accounts with municipal bonds may reduce the amount of loan interest that is deductible;
- Margin interest is only deductible to the extent of investment income;
- There may be no margin interest deductions for margin balances attributed to personal expenditures.
Most financial brokerage firm compliance manuals prohibit financial advisors from providing tax advice. Nonetheless, many financial advisors do so when they recommend the use of margin and state that the margin interest is tax deductible.
The Klayman & Toskes, PA can help you determine whether an investment loss is the result of a financial brokerage firm and their financial advisor’s unsuitable use of margin in an investment account. If an investor suffers losses as a result of margin calls they may be able recover their losses in a FINRA arbitration claim.