Margin Exchange Regulations

Government, Brokerage and Margin Exchange Requirements

By William H. Mears, CPA, JD 

Under the securities laws (the Securities & Exchange Act of 1934), the Federal Reserve Board is authorized to allow brokerage firms to lend against securities positions and charge interest, up to a legal limit, as outlined in Regulation T of the 1934 Act.

Regulation “T”

Under Regulation T, physicians and clients can borrow from a brokerage firm up to 50% of the long position value of their brokerage account. Under Regulation T, only securities listed on a registered stock exchange, the NASDAQ system, or certain approved over-the-counter stocks may be used in a margin account.

A physician investor who transacts in a margin account will be responsible for maintaining the equity in the account at the legal limit, i.e., the 50% level against a stock portfolio.

For example, if a physician investor has a margin loan of $500,000 against a $1 million stock account, and the value of the stock portfolio decreases to $500,000, the doctor-client will need to immediately repay $250,000 of the loan value, because the account no longer can support a $500,000 margin loan.

If the doctor-client is holding bonds in a margin account, the client may borrow under Regulation T up to 80% of the current market value of the securities. U.S. government and municipal bonds have even higher borrowing power.

Example:

Jim Hojo MD, owns a private healthcare equipment company that his father built into a $10 million business, would like to sell some of the equity of the company to long-time employees.

Jim is advised to sell 30% of his privately held company to an Employee Stock Ownership Plan. Jim was told that under Internal Revenue Code §1042, he will be afforded a tax deferral opportunity on the sale of a portion of the stock of the company to the employees. The delay in the recognition of the capital gains on the sale of a portion of the company to the employees is contingent upon compliance with certain criteria outlined in Code §1042.

Jim takes advantage of this transaction and, as advised, purchases domestic-issue floating rate bonds. He then borrows against the floating rate bonds in a margin account.

Because the bonds have a higher Reg T lending capacity, Jim is allowed to borrow 80% of the market value of the bonds. He takes his loan proceeds and invests in a diversified portfolio of equities.

If he had invested initially in stocks, his borrowing capacity against the stock position would have been limited to 50% of the market value of the account.

Failure to Maintain Regulation T Equity

If a doctor-client fails to maintain the Regulation T-required equity in an account, the client will get a “Reg T call” or a “margin call” from the brokerage firm. The Reg T call will require the doctor to meet the margin requirement through a deposit of cash or securities.

However, if the amount of the margin call is immaterial ($500 or less), the brokerage firm is not required to collect the additional margin requirement. Each brokerage firm will have house rules that further restrict the use and/or the availability of margin accounts.

Since securities in a margin account are held in a street name, a brokerage firm has the right to sell the securities if a Reg T or margin call is not met. Securities held in a street name are simply held for a customer’s account in the name of the brokerage house. If a margin call is not met, a customer will lose the securities in the account that are on margin.

Brokerage Credit Agreements

When opening a margin account, the physician investor must sign a credit agreement, which is not very different from any loan documentation, and a hypothecation agreement, giving the stock-broker the right to pledge the securities to a bank in order to provide for lending capacity. The loan consent agreement allows a brokerage firm to lend securities in a stock loan transaction.

Borrowing Capacity

To determine how much a physician-client can borrow, a series of complicated calculations must be made, and a number of key terms must be identified.

First, the doctor client’s equity in the account must be determined. The equity in the account will be the market value of the account less the debit balance (any outstanding debt). The long market value is the current market price of the securities in the account. The amount available for borrow will be limited by the Reg T restrictions, for example, 50% for securities. Whenever the market value of the securities in a margin account increases, the client will have increased borrowing capacity.

Next and conversely, whenever the value of the securities in a margin account decreases, the client will have a margin call. Excess cash in an account (cash from dividends, interest, or proceeds of sale of securities) will be included in the calculation of the margin call. An account holding cash will have increased buying power that cannot be reduced because of decreases in the market value of the account.

Finally, accounts that fall below the Federal Reserve Board requirements will be restricted in the execution of transactions. Stock exchanges also promulgate rules and regulations that must be complied with. The New York Stock Exchange and the National Association of Securities Dealers require an initial minimum equity of $2,000, or 100% of long market value, and a minimum maintenance requirement of 25% of the long market value [minimums may change without notice].

Assessment

The rules outlined above are for a long [owned securities] margin account. The rules for a short account [borrowed securities] are similar in that an uncovered (or naked) short margin requirement is still 50%, but a covered short sale has a Regulation T limit of 95%.

Conclusion

Have you, or a physician-client, ever been caught in one of these regulatory traps or “margin-calls”, and what was the outcome?

***

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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