Several unusual high profile company fraction effect collapses on the Australian Stock Exchange highlight the inconvenience posed to ordinary shareholders from gargantuan scale margin trading of shares by directors of listed firms. So dramatic have been the consequences that no equities investor can afford to ignore the lessons.
vital shareholdings by directors in a listed company have traditionally been viewed favorably as an alignment of executives’ and other private shareholders’ interests, but this ideal can be dramatically compromised in cases where those enormous shareholdings have been aggregated through, and remain security for, margin loans. Directors leveraging into positions well beyond their capacity to meet margin calls may beget a known and acceptable risk for themselves but their actions inescapably also construct a considerable but hidden and usually unsuspected risk for other shareholders.
On exposure in a falling market, the consequences can be devastating to all concerned.
Basically margin trading involves borrowing through a brokerage to grasp shares on deposit with the shares purchased being held as collateral for the loan. As with all leveraged investments the potential for both amplified profits and losses exists, but particular additional risks save to margin trading of shares.
Depending on the particular part being purchased and subject to other margin narrative criteria such as maintenance of a minimum balance, a private investor may be able to borrow, say, 50 loan to collateral value must be maintained at all times – hence a 50, owing to the director’s perceived influence on the company and the scale of business such a win will bring to the margin broker. Thus the director’s margin is only 20 of the assume label of one million $10 shares through a margin broker. Borrowings amount to $8 million with $2 million “equity” being saved up by the director to complete the $10 million remove. Furthermore, the margin trading agreement states that a minimum 80 to a market value of $9 per piece will sever the director’s holding of 1 million shares to a value of $9 million, but calm carrying the $8 million debt and therefore breaching the 80 loss) will then be served with a “margin call” for a further $1 million to re-establish the novel loan/asset ratio. Failure to meet the call will invoke conditions allowing the margin broker to sell some of the holding to re-establish the required 80 in the $10 part designate to $8 would search for the director’s initial $2 million equity wiped out altogether and, in the absence of any margin call being met, the broker would very likely dump the entire holding at best tag to minimize losses. Apart from sheer pressure of volume, attendant negative publicity through stock exchange disclosure requirements would probably discover the company’s fraction stamp devastated even though the company may remain as a viable enterprise. Any shortfall in recovery by the broker through sale of shares held as collateral would remain a liability against the director.
In this residence private shareholders become unsuspecting victims of a risk they didn’t even know existed.
This scenario is far from academic. In a number of now salient Australian cases, dumping of directors’, executives’ and related party holdings have indeed seen part prices slashed, stock exchange listings suspended, directors and executives lose their jobs with their entire company shareholdings wiped out. Residual personal liabilities are suspected of being broad in some cases. Consequently, private investors have also suffered massive write downs in the value of their acquire holdings.
Needless to say, any company subject to such a fate will accumulate it nearly impossible to raise new equity capital and will pay heavily for debt – particularly in today’s credit crunched world. Assuming the enterprise can remain solvent, aggressive sale of assets becomes the most logical choice to fund a restructuring program.
Private investors engaged in margin trading the same company may well suffer a similar fate to the directors, albeit without a loss of employment.
A more detailed case inspect is available through the resource link.
As the case observes points out, effects of a major margin call default can be widespread and devastating, seriously affecting even secured investors in related companies.
So how should the private investor guard against such an unwelcome outcome to a seemingly quite reasonable investment?
As we have discussed, potentially damaging margin trading by directors and executives can be difficult to detect, but some clues may be available through stock exchange announcements. Better serene, fair ask the Company Chairman through private correspondence or at the Shareholder’s Annual General Meeting. Companies able to record a super slate in respect of such activities are likely to be gay to do so. Investigate the others.
In one current case it turns out that not only were directors purchasing shares on margin for their maintain accounts but were also margin trading other listed shares with shareholders’ funds in the Company’s name. Needless to say the Company and its shareholders soon lost many millions of dollars once markets suffered a modest reversal.
For the private investor, friendly advice is to avoid margin trading through a margin broker altogether. This, however, does not completely exclude the leveraged seize of shares which remains a capable investment strategy under distinct circumstances. It does, however, station important separation between financier, share broker and shareholder.
In one new Australian margin trading case, some private investors reportedly had their entire nominee-held fraction portfolios seized and sold to recompense the margin financier, a major bank. When the margin brokerage house collapsed, private investors were left as unsecured creditors of the failed broker. Prospects of recovery from this set would be murky indeed.
At a time when ever more complex means of trading frail section markets are being developed, such as options, short selling, stock borrowing and margin trading, investors need to recognize that novel opportunities for exceptional profit also bring exceptional unusual risks. Some may well be hidden tedious a conceal of “immateriality” even though potential consequences could be disastrous.
In summary, private investors can minimize exposure to margin trading risk by taking a few precautions:
“Treat very hastily growing companies with caution. These companies and their high profile directors seem most susceptible to the allure of sizable rewards offered by serious margin trading while overlooking the exceptional risks posed to both themselves and others.
“expect available stock exchange announcements and news to unearth margin trading practices relating to major shareholdings, including those of directors, executives and related parties. These may be difficult to score and define, but they do exist.
“Simply ask the Company Chairman if Directors and Executives or even the Company itself, is fervent in margin trading the company’s hold shares – if the reply is yes, pause away.
“Also ask if shareholders’ funds are being extinct to margin trade any other company’s shares – hidden peril lurks there too.
“Avoid personal utilize of margin allotment trading accounts altogether – borrow elsewhere if you intend to exhaust leverage for piece purchases.
“Ensure any shares you bewitch on leverage are registered in your occupy name to avoid the possibility of seizure by a higher ranking creditor should your share brokerÂs business collapse.
Eventually disclosure of margin trading by company directors, executives and related parties may become mandatory under stock exchange listing rules, but until that time equity investors will need to include “margin trading risk” as yet another factor for their possess determination.