Regulators Are Investigating Effort
By Firms to Circumvent Margin Rules
By RUTH SIMON
Staff Reporter of THE WALL STREET JOURNAL
June 23, 1999
Mark Ford, an Indiana day trader, lost $39,500 on a single transaction last year. But it wasn't from trading stocks.
It was from a loan Mr. Ford says he made at the behest of day-trading firm All-Tech Investment Group Inc. to a fellow investor who used the money to buy shares but ended up losing so much that Mr. Ford didn't get repaid in full.
Mr. Ford is trying to recover his loss in a lawsuit filed against All-Tech in a state court in Fairfax County, Va. His predicament illustrates what regulators say is a growing, but little noticed, problem: the creative, and sometimes questionable, efforts by day-trading firms to take advantage of loopholes in the margin-lending rules that limit how much customers can borrow.
"It's definitely a hot issue," says an official of the Securities and Exchange Commission who asked not to be identified. "We're seeing far too many loans from customer to customer and from associated persons to customers to make us comfortable."
The practice is something "we're looking at and are concerned about," says Barry Goldsmith, an executive vice president of NASD Regulation, the regulatory arm of the National Association of Securities Dealers. "Firms are effecting loans from customer to customer without full disclosure and sometimes without authorization."
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How a Loan Might Work
Regulators say customer-to-customer lending often works like this:
A day-trading firm "introduces" a customer to the idea of making loans to other traders to cover margin calls.
The firms prepares documentation authorizing the transfer and moves funds to the borrower's accounts.
The lender receives an interest payment equal to one-tenth of one percent per day on the loan balance.
The money is transferred back to the lender the next day, or soon after, unless the borrower defaults.
If the borrower can't repay the loan, the lender takes the loss.
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The SEC is investigating these practices and considering whether to bring enforcement actions. NASD Regulation and state securities regulators also are investigating these activities.
Such loans, under most circumstances, can be proper. But state and federal officials say these lending practices raise many troubling questions. At issue: whether some investors are being allowed to continue to trade when they no longer have sufficient capital and whether individual borrowers and lenders understand the potential risks of these loans.
Regulators also fear that this added borrowing could push share prices lower if day traders are forced to sell stock in a falling market to meet "margin calls," or demands for more collateral. "The greater the leverage there is built into the system overall, the faster the downturn could be," says John Ramsay, deputy general counsel of NASD Regulation.
Circumventing Rules
No one keeps track of such lending. But regulators say these practices appear to be on the increase as a way to circumvent rules that limit how much investors can borrow. "We believe the lending schemes violate or potentially violate a half-dozen state and federal laws or regulations," says David Shellenberger, chairman of a task force of state securities regulators that is examining the activities of day-trading firms. "Among other things, they circumvent margin requirements and allow accounts to remain open that would otherwise be closed."
Regulators say these loans are generally made on an overnight basis to traders who would otherwise face a margin call. Lenders typically receive interest payments equal to one-tenth of 1% daily, which amounts to 36.5% on an annual basis.
Investors generally can borrow as much as 50% of the value of the stocks they own, under margin requirements set by the Federal Reserve Board. An investor who wants to buy $15,000 of stock, for instance, can put up $7,500 and borrow the other $7,500, leaving all the shares as collateral for the loan.
Once the purchase is completed, an investor's equity -- that is, the current value of the stock less the amount of the loan -- must be equal to at least 25% of the current market value of the shares. Thus, the investor who bought $15,000 of stock on margin must have equity in his account of at least $3,750. If the stock price falls, pushing equity below that amount, the investor would have to deposit additional cash or securities or the broker could sell securities in the account.
Brokerage firms are barred from lending money in excess of these margin rules. But three years ago the Federal Reserve Board amended the rules governing margin lending in a way that permits firms to arrange loans from one customer to another or to find third parties who would lend to their customers.
'Just Sour Grapes'
Day-trading firms say they are simply responding to customers' requests when they move funds from one account to another to cover a margin call. "We don't arrange any loans," says All-Tech Chief Executive Officer Harvey Houtkin. "If someone gives us instructions to do that, we simply act on their instructions." Mr. Ford's lawsuit, Mr. Houtkin adds, "is just sour grapes. If he was lending the money to someone, he knew it was a personal loan by him. We have absolutely nothing to do with it."
But securities regulators say day-trading firms are using the loophole to get around margin rules, which were designed to limit borrowing. Texas Securities Commissioner Denise Voigt Crawford says her office has frequently seen day-traders leveraged as high as 10-to-1, though margin rules permit only 4-to-1 leverage. Last year, before regulators began scrutinizing lending practices, she adds, some day-traders were leveraged as high as 300-to-1. Texas regulators expect to bring enforcement actions involving these lending practices this year.
In some cases, the loan is from one customer to another. Mr. Ford, for his part, says in his lawsuit that All-Tech "introduced" him to making loans to other traders and told him that these loans carried "minimal risk." He says All-Tech also prepared documentation for the loans and "actively" managed the lending. Borrowers paid Mr. Ford one-tenth of 1% of the loan amount, or at least $25 a day.
Second Loan
Mr. Ford says that All-Tech failed to tell him when Lions Group Inc., a corporation set up by a Virginia day-trader, defaulted on a $15,100 loan. As a result, Mr. Ford says in his suit, he made a second $70,000 loan to Lions Group and ultimately lost $39,500. Steven Cocoli, who traded as Lions Group, says he was "advised by my attorney not to make any comments."
In other cases, loans are made by relatives of firm executives or others. In a complaint filed against Block Trading Inc. last year, Massachusetts securities regulators alleged that the father of Block President Jeffrey S. Burke and others made loans to customers facing margin calls. Regulators alleged that 44 of the 68 accounts in the day-trading firm's Boston office used funds borrowed from Mr. Burke's father, customers or others.
Regulators say that Block, which filed for liquidation under Chapter 7 of the Bankruptcy Code last year, told traders who would lend them money and how much interest they would pay, and also checked whether funds were available. In May, Jeffrey Burke and four other individuals named in the complaint settled the case by agreeing not to apply for registration in Massachusetts for five years.
Traders sometimes don't even know who is lending them the money. In testimony before Massachusetts regulators in December, Fred A. Zayas, manager of the Watertown, Mass., office of All-Tech, said that roughly half the customers in his office had funds lent to them by other traders. In some cases, when a customer couldn't meet a margin call "All-Tech would meet the margin call for them," Mr. Zayas said, adding that the loans were arranged by All-Tech's New Jersey headquarters. Traders in Watertown would sign a funds-transfer form to arrange for the loan, leaving blank the space that indicates who was to be repaid, he said.
'Trading With No Money'
Mr. Zayas also testified that some customers were allowed to trade even though they didn't meet margin requirements. "They were trading with no money and negative money," he said. One trader, Isaac Belbel, was allowed to trade even when the value of his account had a deficit of $4,000, Mr. Zayas testified. He added that he "literally had to fight" with All-Tech to shut Mr. Belbel down 10 days later, after Mr. Belbel had bounced a $50,000 check and his losses had increased to $20,000.
Mr. Belbel says he "has no idea" whether or not he was trading with negative capital. The All-Tech software "would allow you to trade as much as you wanted," he says. "No one knew what the profit and loss was for the day. Two days later they'd tell you that you had a margin call." Mr. Belbel says he ultimately lost $180,000 that belonged to him and two other individuals.
Last month, All-Tech agreed -- without admitting or denying the allegations -- to settle charges brought by Massachusetts regulators regarding the unlawful movement of funds between customer accounts to cover margin calls and other violations at the Watertown office. The firm paid $228,000 in customer reimbursements plus $50,000 to the Massachusetts Securities Division.
Messrs. Zayas and Belbel, who cooperated with regulators, agreed to be barred from securities registration in Massachusetts for three years, Massachusetts securities officials say. Mr. Zayas had been charged with forging customer signatures, moving customer funds without authorization and other securities law violations. Mr. Belbel had been charged with acting as an unregistered investment adviser by investing other people's money.
All-Tech's Mr. Houtkin says Mr. Zayas "did things that appear to be improper." If Mr. Belbel "was allowed to trade with negative margin," he adds, "there was either a major foul-up or our clearinghouse didn't notify them. We would never allow anyone to trade if they didn't have enough equity to cover their accounts."
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