Mary Carollo: Lawyer for Excessive Use of Margin

Purchasing securities “on margin” equates to investing with borrowed funds. The risks of trading on margin are unsuitable for many investors. If a financial adviser encourages margin trading without regard for a client’s investment profile, or without a client’s full understanding of the risks involved, the client can potentially seek to recover any money lost as a result of the margin transaction.

WHAT IS BUYING ON MARGIN?

An investor can buy securities using money borrowed from a brokerage firm (rather than paying for the securities in full). This is known as “buying on margin.”

Buying on margin requires opening a margin account and depositing an initial amount of purchased securities. The initial account equity (margin) is used as collateral to borrow money and purchase additional securities. Like other types of loans, interest is charged on the amount borrowed until it is repaid.

MARGIN TRADING RISKS

The risks involved with trading on margin include:

Securities purchased on margin do not break even, or earn at least the amount of interest charged on the loan, resulting in the loss of funds.
Securities used as collateral drop in price and the firm issues a “margin call,” which requires the customer to repay all or part of the loan. The customer is not entitled to a time extension on a margin call.
The client has limited control over their margin account. For example, the firm can force the sales of margin account securities without notice, sell securities without contacting the client, and increase margin requirements at any time.

MARGIN ACCOUNT ABUSE

Margin investing isn’t an appropriate strategy for most investors. Margin loans, however, can be highly profitable for brokerage firms (because of the interest paid on borrowed money) and for brokers, who might be paid a fee based on the size of the client’s loan.

Investment professionals must understand a client’s investment profile, including their willingness and ability to incur risk. Before a client opens a margin account, they should fully understand how margin transactions could affect their portfolio.

If your broker misrepresented the risks of a margin account, opened an unauthorized account in your name, or made excessive trades in your account, any lost money may be recoverable through a legal claim.

HEDGE FUND INVESTMENTS

Once reserved strictly for wealthy, financially sophisticated investors, hedge funds have become increasingly popular investment vehicles for traditional investors. Often, this is achieved through investment in “funds of hedge funds.” Because I’m a securities lawyer, I’ve seen both good and bad from this.

Both hedge funds and funds of hedge funds have risks that are inappropriate for most investors. Financial advisers may make exaggerated and misleading claims about these funds in order to lure potential investors. Hedge fund managers have also been known to defraud investors.

HOW HEDGE FUNDS WORK

Hedge funds are a type of investment fund. Like mutual funds, hedge funds pool the money of many investors and follow a specific investment strategy. But that is about as far as the similarities go.

Unlike mutual funds, hedge funds are not regulated by the Securities and Exchange Commission (SEC), and therefore do not offer many of the investor protections that mutual funds and other registered investment products do.

FUNDS OF HEDGE FUNDS

Hedge fund investment is usually limited to wealthy individuals and institutional investors. But funds of hedge funds—an indirect way of investing in hedge funds—typically require lower minimum investments that make them accessible to a broader investor class.

While funds of hedge funds may be registered SEC products, the underlying hedge funds are not. Funds of hedge funds thus carry the same investment risks that hedge funds do.

HEDGE FUND RISKS

The risks of investing in hedge funds and funds of hedge funds include:

Not SEC Registered: Because hedge funds are not required to be SEC registered, they are not subject to mandatory reporting rules. As a result, it can be very difficult for investors to gauge a hedge fund’s performance. This can make it easier for a hedge fund manager to commit fraud.
Speculative Investing: Hedge fund managers are paid based on the fund’s performance, which gives them an incentive to maximize positive performance. This can lead to sophisticated (read: risky) investment strategies such as short selling, derivatives investment, leveraging, and hedging.
Illiquidity: Hedge fund investors may be unable to recoup their investment money if they want to opt out of the fund.
Expensive: Hedge funds usually have numerous fee layers and impose higher investor costs than mutual funds.
Tax Complexity: Hedge funds’ complex tax structure can present delays and difficulties during tax season.

WHEN YOU MAY HAVE A CLAIM FOR HEDGE FUND INVESTMENT LOSSES TALK TO A SECURITIES LAWYER

Hedge fund misconduct commonly occurs in the context of how the fund was sold.

Unless you are a wealthy, financially sophisticated investor, a hedge fund is mostly likely an unsuitable investment. And even if you are an accredited investor, an adviser must accurately present important information about the hedge fund. Any misrepresentations or omissions of material facts could constitute misconduct.

For non-accredited investors, funds of hedge funds may be suitable investments—however, their growth forecasts, risks, and drawbacks must be accurately presented.

Absent any misconduct in the sales stage, hedge fund managers and operators can commit investment fraud. Examples of fraudulent hedge fund conduct include providing phony account statements, not disclosing conflicts of interest, misappropriating investor funds, and operating Ponzi schemes.