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Margin Call Blues
he market’s recent volatility has caused an increased number of margin calls. Under these circumstances, what can brokers do to minimize their liability in the event of an unwanted liquidation, especially when that liquidation occurs without first giving the customer an opportunity (let alone a reasonable opportunity) to deposit additional cash or securities?
Unfortunately, there is no clear rule regarding margin liquidations. The NASD’s recent notice to members (NTM 99-11), which provides guidance regarding stock volatility, simply observes that some firms are increasing their initial margin and maintenance margin requirements. Otherwise, Rule 2110 of the NASD’s Conduct Rules requires all member firms to observe “high standards of commercial honor and just and equitable principles of trade” in conducting business. Finally, IM 2310-2 of the NASD’s Conduct Rules remarks that all firms and reps have a “fundamental responsibility for fair dealing”. As one can see, these rules provide no practical guidance.
Brokerage firms require customers to sign margin agreements. These typically allow the firm to exercise unlimited discretion to satisfy margin calls, including liquidation. In fact, many margin agreements do not even require advance notice to the customer before liquidation. In that event, of course, the broker is left with answering the “customer service” type inquiries from the irate customer.
By comparison, it is worth noting that in commodities transactions, there are rules relating to margin call notification and liquidation. Both the Chicago Board of Trade Rules as well as the Chicago Mercantile Exchange Rules require giving the customer a “reasonable time” to comply with margin demands. Nonetheless, the rules allow firms to adopt one hour from demand as a reasonable time.
So, where can brokers look for guidance? Although court decisions are not consistent, they provide some guidance. In essence, there are four lines of reasoning that courts have applied in determining liability when a firm liquidates without notice.
The first line of reasoning is that the margin agreement controls. Courts in this camp refuse to create duties that are not fairly inferable from the express terms of the margin agreement. The likely result is that the firm can liquidate without advance notice. For example, some lower courts in New York and Florida have applied this approach. One court held that the margin agreement permitted the firm to liquidate without advance notice even though the court found that the broker's relationship with the customer was fiduciary in nature.
The second line of reasoning is more moderate. Courts in this camp examine the relationship between the broker and the customer in order to determine whether the firm should have acted differently. A recent New York lower court decision identified the following “critical issues”:
- The personality, state of mind, degree of sophistication and awareness of plaintiff (the investor), including related investment practices;
- The extent to which he exercised discretion or maintained control over the investments;
- The level of plaintiff’s trust in and dependence upon the financial advice of defendants; and
- The extent to which defendants reasonably advised plaintiff, and kept him properly informed.
The third line of reasoning requires that the firm exercise good faith and reasonableness in its dealings with customers. Some courts, including appeals courts in the Third Circuit (Pennsylvania) and the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee), have gone beyond the express language of the margin agreement to imply a duty of good faith and fair dealing upon the parties.
Indeed, the Third Circuit court specifically was presented with a margin agreement that gave the brokerage firm absolute discretion to liquidate, even without advance notice. The court found that the implied covenant of good faith and fair dealing overrode that absolute discretion. The court recognized that the implied covenant could not negate or modify express terms, but decided that the covenant could be applied to regulate the brokerage firm's use of its discretion provided under the contract. Consequently, the firm had a duty to act reasonably, the court held, and it could not act arbitrarily, capriciously or in a manner inconsistent with the reasonable expectations of the parties.
The final line of reasoning also restricts the brokerage firm's ability to liquidate without advance notice. Courts in this camp, such as the New York based Second Circuit Court of Appeals, base their decisions upon principles of fiduciary law as well as agency law (where the broker is the customer's agent). For example, one court held that “absent a waiver of notice running its favor”, the firm had a duty to notify the customer prior to liquidation and to obtain his consent as to the stocks to be sold. That is because, the court reasoned, all sales, including sales resulting from margin liquidations, require advance approval in non-discretionary accounts.
Given these court authorities, what should brokers do to protect themselves? First, be aware that communication with customers is critical. Especially with volatile stocks, brokers should discuss, well in advance, whether the customer has sufficient funds or securities readily accessible to cover a margin call. Tailor the message in view of the customer's level of sophistication. Should the brokerage firm issue a margin call, do your part to alert the customer and to discuss the options available to him or her. Finally, if a broker attempts, but is unable, to contact a customer, record those attempts in writing.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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