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Arbitration Cases Target Use For Stocks and Home Mortgages

Investment News

A common Wall Street practice to encourage clients to take out margin loans has come under fire from plaintiff’s lawyers who claim brokers put their own financial interest ahead of their clients’.

To boost margin-loan business, the lawyers claim, some brokerage houses changed the wording on new client account forms while others boosted their broker payouts to include fees not only on assets but also on debt.

At the same time, firms also began encouraging clients to take out loans to buy homes, using their investment portfolios as collateral. In effect, that made them margin loans as well.

Lawyers say Merrill Lynch & Co. Inc. and Morgan Stanley are facing arbitration claims over mortgages. Both New York firms provided 100% financing for home purchases.

Brokers were fighting to hang on to client assets, says San Diego lawyer Erwin Shustak. They told clients not to sell their stock position but, instead, to use the stock as collateral, with the firm providing the loan, he says.

“Then the value of tech stocks dropped, and with the major stock decrease, it triggered many calls” on the mortgage loans, Mr. Shustak explains.
During the tech-stock boom, broker-dealers generated an important amount of their profits from interest on margin loans and were anxious to increase their take from the revenue stream as the market headed south.

As the bull market soared, the volume of lending on margin skyrocketed as well.

At the top of the market in March 2000, investors had $278.5 billion in margin debt, according to a New York Stock Exchange listing of its member firms.

The amount of margin debt has fallen almost by half since the top of the market but remains substantially larger than it was a decade ago. By the end of last year, margin debt stood at $134.4 billion, according to the exchange. That’s close to three times the margin debt that existed in January 1993, according to the Big Board.


Danny Sarch, a brokerage re-cruiter in White Plains, N.Y., says Merrill Lynch changed its payout grid for its brokers in 1998 to include a fee on both a broker’s assets as well as the debt in a customer’s account.

In one case, a company went so far as to change its account application form to make it easier to get a client’s permission to make margin loans, says one lawyer.

Clients of First Union Securities, which is now owned by Wachovia Corp. in Charlotte, N.C., used to have to initial a space provided on the account-opening form to give brokers permission to invest on margin. But the firm changed that two years ago to a box clients needed to check if they didn’t want to open a margin account, claims Cleveland lawyer Brian Biggins.

“The firm made it a lot easier to establish a margin account,” he says. “The client almost has to say, ‘No, I don’t want that, specifically.'”

A spokesman from Wachovia says that First Union’s standard for margin investing has been “negative consent.” In other words, the client has to say ‘no.’

But First Union has made a number of mergers and acquisitions over the past five years, and at least one acquired firm changed its new account form to mirror First Union’s.

When the market began to spiral downward, brokers were desperate to maintain pay levels, and either gave clients bad advice or simply misled investors about the risk of their exposure to margin debt, say plaintiff’s attorneys.

As their client’s stock portfolio began to collapse, they began to face margin calls to maintain minimum collateral in those accounts, lawyers say.

In many cases, they say, the clients were wiped out.

Others say that brokers, by opening margin accounts, simply gave clients what they wanted — access to capital to buy more stock in a bull market many believed was on a permanent stampede.

Regardless, some plaintiff’s lawyers are zeroing in on alleged broker abuses of margin accounts in a growing number of arbitration cases.

“Branch managers are aware of the margin interest that the branch generates,” says Mr. Sarch, the brokerage recruiter.

He maintains, however, that compliance at the wirehouses is tighter than ever, specifically to avoid the cost of potential abuses, such as putting clients in margin accounts without their full awareness of the risks.

“I give the major firms more credit than that,” he says. “To think a branch manager would ruin a career” and give ‘a nod and a wink’ ” to brokers investing in margin without the client’s understanding is simply not the norm, he adds.

Brokers, however, are well paid when a client invests on margin. The normal compensation on margin interest is 0.25%, says Phil Aidikoff, an attorney in Beverly Hills, Calif.

In arbitration cases where brokers allegedly have made “unsuitable investments” for clients, the margin call “triggers the loss,” says Mr. Aidikoff. “It’s the icing on the cake. It increases and enhances the risk.”
In an NASD arbitration case in Dallas, for example, margin debt was at the center of the dispute.

Merrill Lynch broker Weldon R. Putty III was accused of advising a client to hold on to stocks in the spring of 2000, despite the declining market and its effect on $450,000 of margin debt, according to an NASD complaint.

Mr. Putty, a third-generation Merrill broker who has seven customer complaints on his NASD record, made unannounced margin maintenance calls on Jerry Ransom’s portfolio when the market began falling.

Then, he refused to disclose the reasoning behind his unilateral selection of the stocks that were liquidated to meet the margin call, the complaint states.

Mr. Ransom’s account was wiped out, says his lawyer, Jeanne Crandall of Dallas.

The branch manager, Dick Valentine, acknowledged that Mr. Putty was at fault, and in April 2001, Merrill Lynch’s director of private client compliance, Charles Senatore, reprimanded the broker and fined him $10,000.