Margin Lending:
Stock Account Purchases With No Money Down

With a stock account transaction in the United States, the subject money or shares (depending on which side of the transaction you are on) must be deposited into the account by the third business day following the day on which your order filled.

Creditworthy investors who have set up a margin account don't need to deposit money before settlement day and can pay instead on margin. The margin stock account feature permits investors to purchase shares on credit with little or no money down, using their purchased shares as collateral.

Although margin leverage can greatly increase the returns on a stock portfolio (since stock market returns are higher historically than margin interest rates), margin lending is also very risky.

Your Loss of Economic Rights. When you opened your brokerage account, you probably signed an agreement that contained terms for what the broker's rights would be if and when you are ever approved to purchase securities on margin.

Good luck finding that piece of paper from five, ten, fifteen years ago! (You may have signed it electronically, so don't bother checking your files drawer.) Of course, you can always ask your broker's customer service department to send you a copy.

Depending on how the margin agreement reads, your broker usually has all of the following rights:

• They can require you to deposit additional money into your account if a drop in your account value (usually when stock prices are falling) triggers a "margin call".

• If you don't deposit this money, they can sell securities out of your stock account to meet your margin call, typically without warning.

• They can sell any fully paid-for securities out of your stock account, not just the ones you purchased on margin.

• They can lend out securities in your margin account, causing you to lose capital gains tax treatment on your stock dividends (it would become ordinary income).

• They can refuse to let you choose which of your securities get sold to meet the margin call.

Your Loss of Voting Rights. When brokers lend out securities in your margin account, not only do you lose capital gains tax treatment on dividends on that stock, you also lose the right to vote them. Even worse, any securities sitting in a margin account may lose voting rights as well, even if they are fully paid. Here's how that could happen:

The (voting) proxy services department of a brokerage firm has a hard time reconciling their records with the stock loan department. This hurts you when the stock issuer sets a date to determine how many shares you are entitled to vote, but the broker doesn't know whether the stock loan department has lent out any of your shares.

If a customer's shares are lent out, the brokers should be subtracting the loan amount from your ownership amount to come up with your voting right (this is, after all, the amount reflected on the issuer's records!) -- but instead the broker often submits the vote as if you had the right to vote all of the shares you own.

Sounds up to this point like you are getting a good deal, right? Well, not so fast...

This behavior might cause an overvote to occur. When brokers treat all of the customers in the same way (failing to subtract out the loaned shares from the vote), their total submission might exceed what the issuer sees that they are entitled to vote.

The issuing company will then reject the vote and return it to the broker, giving them an option to resubmit.

But since it is too time consuming and costly for the broker to recreate the state of affairs on the voting record date in the past, brokers sometimes just reduce everyone’s vote pro rata and resubmit the vote that way.

What that means for you is that your vote may be unfairly reduced through no conduct of your own, but because of other shareholders at your broker whose shares were lent out to the extent of their margin debt.

How would you know whether your vote was reduced? The short answer is that you won't. The only customer that the issuer knows is your broker because your stock account shares are in street name (that is, they are in the name of the broker or its nominee.)

You may receive proxy cards as if nothing were out of the ordinary. When you vote your shares everything will appear to be the same as if you were getting one vote per share. You will never be informed to the extent that your voting rights were diminished.

Typically, this wouldn’t matter to you unless a vote was very close or you were a large shareholder with a personal stake in the outcome of the vote. Also, overvoting is not the common scenario since only 30% of shareholders typically do vote.

But overvoting can and does happen when a proposal prompts more people to vote than usual (such as a merger), or prompts more customers of a single broker to vote than usual (a random event, but it happens).

And when it does happen, the conduct of reducing votes pro rata offends a core principle of corporate governance.

Is Reform on the Horizon? The former regulatory arm of the New York Stock Exchange was looking into ways to require brokers to clean up their stock account loan practices and deal with the problem of overvoting, but with the merger between NYSE and NASD still in its infancy, it is unclear what priority this reform will have going forward.

Next: The Stock Market Growth Phenomenon

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