FINRA, the securities industry watchdog, recently updated an Investor Alert for investors who purchase securities with “borrowed funds.” According to the alert, investments made with borrowed funds by investors grew substantially in 2013. Investors are warned that the risk of margin calls is significant and they should better educate themselves about these risks before investing with borrowed funds. Investors must understand investing with borrowed funds and the risks of a margin call, in the event, securities used as collateral decline in value. The risks investors should understand about margin calls include:
- the forced sale of securities;
- no prior notification required;
- inability to choose which securities are sold;
- no time extension to meet margin call; and
- account losses can be greater than initial deposit.
The FINRA investor alert reminds investors about financial incentives paid to financial advisors who recommend the use of margin in brokerage accounts because the lending activities represent a substantial source of revenues. 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. For these profits, substantial financial incentives are paid to financial advisors including, greater commissions because investing with borrowed funds increases the amount of assets brokerage firms and their financial advisors can manage.
For many of our Puerto Rico clients, this FINRA Investor Alert is a timely and foreboding message about recommendations made by UBS Financial Services of Puerto Rico concerning UBS Bank Loans. In these instances, UBS extended bank loans to many Puerto Rico residents who allege they were improperly advised to use the funds to invest in UBS Puerto Rico Bond Funds. UBS bank loans can wipe out an investor’s brokerage account equity in a short period of time. The use of UBS bank loans collateralized with brokerage account assets exposed them to greater risk and costs. When UBS loans were used, the required net rate of return needed to breakeven increased because of greater interest costs. The higher required rate of return that is necessary may require a change from a more conservative investment strategy to a riskier one. This fact must be weighed carefully and disclosed by all brokerage firms, including UBS.
For many investors, a financial advisor’s recommendation to invest with borrowed funds may be considered a breach of fiduciary duty. Additionally, the use of margin or bank loans can in many situations be considered unsuitable investment advice. These factors are both important reasons for the recent updated FINRA Investor Alert to remind investors about the risks of investing with borrowed funds.