Client Accounts and Relationships

Maintaining Client Accounts and Relationships

• This chapter explains how to operate and maintain cash and margin accounts
• It also details how to communicate account information to clients and address client complaints
• Further information is included regarding handling account transfer requests

Accounting for Client Transactions

• It is important to understand the accounting practices for transactions in both cash and margin accounts
• Transactions that might appear in client accounts are:
  • Client deposits or withdrawals of funds or securities
  • Crediting of dividends and interest earned by securities held long in the account
  • Charging of dividends and interest earned by securities held short in the account
  • Charging of interest on funds the client has borrowed from the dealer member
  • The purchase or sale of securities in the account
  • Other miscellaneous transactions, such as the payment of account fees
• Cash part of a client account works like a bank statement
  • Client deposits or payments to the client are credited to the account
  • Client withdrawals are debited to the account
• Debits include dividends or interest clients pay related to short securities and interest paid for borrowed money
• A deposit or withdrawal of securities does not affect an account's cash balance
• Deposits and withdrawals do affect the market value and loan value of securities in the account
• Include these valuations when determining the accounts overall status

Margin Accounts

• Margin accounts allow clients to buy and sell securities on credit and initially pay only part of the transaction price
• The dealer member lends the remainder of the transaction price to the client, charging interest on the loan
• The dealer member holds the securities which have been purchased by the investor as collateral
• Interest on the loan is calculated on the debit balance
• Dealer members usually charge margin clients interest based on the rates charged on loans made to them by the chartered banks
• Margin indicates funds the investor must personally provide
• The dealer member grants credit or loans based on the market value and quality of the securities in the account
• Long margin accounts allow the client to partially finance the purchase of securities by borrowing money from the dealer member
• Short margin accounts allow the client to sell securities they do not own by arranging with the dealer member to borrow them, which is known as a short sale
• The Canadian Investment Regulatory Organization (CIRO) regulates the amount of credit that dealer members may extend to clients on the purchase of securities (both listed and unlisted)
• CIRO rules specify the requirement for margin agreements and the maximum amount that may be financed (or the maximum loan value of each type of security)
• Regulations are rigidly enforced
• Some dealer members do not accept margin accounts
• Some maintain margin requirements that are substantially higher than the rates prescribed by the regulations
• Though CIRO permits dealer members to extend a certain percentage of credit to clients, dealer members may choose to have more restrictive house margin rules
• Borrowing for Investment Purposes – Suitability and Supervision, reminds dealers that they must fully disclose the risks associated with using borrowed money to invest
• Disclosure requirements include credit in the form of margin, as well as other types of investment loans provided or recommended by the dealer
• As part of investment strategy, the firm may recommend a leveraged loan, where the client obtains additional credit from an external source
• Clients need to know of all aspects of borrowing money to invest:
  • Using borrowed money involves greater risk than using their own money
  • Principal and interest must be repaid even if the value of the investment decreases
  • Borrowing to invest could result in far greater losses than investing without borrowing
• Potential Rewards to clients for using margin or additional leverage when the price of the securities purchased does not decline are:
  • More securities can be bought than if they did not get the loan
  • Rates of return on invested assets increase
  • Loans can be repaid at any time without penalty
  • Loans can be used for purposes other than buying more securities
  • Margin accounts are available for other security transactions (e.g., short sales or options trading)
• Any time a borrow-to-invest strategy is recommended, strategy suitability to assessed
• The dealer member is responsible for making a suitability assessment any time it becomes aware that borrowed money is to be used or is being used by a client
• Dealer members must have sound policies and procedures detailing how the firm will evaluate risks related recommendations
• Supervision should capture margin account loans, as well as loans advanced by third parties (called off-book loans)
• Dealers are not expected to have an expansive framework in place to identify and monitor off-book loans, but they should not ignore high-risk situations
• Clients who wish to use margin must sign a margin agreement with the dealer member defining the rights and obligations of each party
• The agreement must state, among other things, that clients must maintain adequate margin in the account, repay the amount loaned upon demand, and pay interest on the debt
• Under a margin agreement, clients give the dealer member power to take action if the client cannot maintain proper margin in the account
• Firms have the right to use a client's securities as collateral against the amount loaned to the client.
• Possible actions include:
  • Pledge a client's securities to raise money to fund the amount loaned to the client
  • Realize a client's securities and other assets to cover the purchase of short securities
  • Use a security in the client's account to make a delivery on a short sale
  • Liquidate a client's securities and other assets to cover any amount they owe
• Clients normally have an opportunity to fully margin their accounts before any action is taken
• Where the price of a margined security falls to the point where the account becomes undermargined, the broker issues a margin call, requesting sufficient funds to bring the account up to full margin
• Margin calls may be sent to clients in writing, but clients may be contacted by telephone, courier, or fax where there are time constraints
• Prior to selling the securities in a long margin account to cover a margin deficit (called selling out), every effort is made to notify the client
• The same is true prior to buying the shorted securities in a short margin account (called buying in)
• A copy of the notice is kept on file
• The margin agreement specifies the right to sell out or buy in part or all of the client's margined securities, without notice, in the event of dramatic and adverse price fluctuations
• It is considered necessary to notify the client and retain the documentation
• Clients should be encouraged with margin accounts to avoid margining close to prevailing price limits by keeping the minimum amount of margin on deposit in the account
• Where additional funds or securities with excess loan value are on deposit, a cushion of protection is provided
• Otherwise, the client may have to respond to frequent and minor adverse price fluctuations
• The cushion also reduces the possibility that the account will need to be sold out or bought in
• CIRO prohibits dealer members from accepting transfers from other dealer members of any undermargined account unless that dealer member holds sufficient funds or collateral to the account's credit to margin it when it is taken over
• CIRO determines a customized margin rate, reflecting their market risk, for each listed security, and margin eligibility to a larger group of securities listed on foreign exchanges outside of Canada and the U.S.
• Restrictions exclude bonds and debentures while including rights and warrants, other than Canadian bank warrants
• Minimum margin is the complement of the maximum loan value:
  • That is, at the time of purchase, the minimum margin that must be deposited is equal to 100% of the purchase price minus the maximum loan value
• Loan values are subject to change. Exchanges can prescribe higher margin requirements for specific securities when warranted by prevailing market conditions
• The minimum dealer member inventory margin and client account margin rate for foreign-listed equity securities is 50%
• CIRO produces a list of securities eligible for reduced margin by securities that demonstrate both sufficiently high liquidity and sufficiently low price volatility based on specific price risk and liquidity risk measures
• The more the price of a stock or bond is likely to fluctuate, the greater the potential losses are on holdings of those securities
• Regulators study the historical price volatility of securities to set margin rates, as well as the security eligibility criteria that capture the likely changes in a security’s price
• Securities eligible for reduced margin qualify for up to 70% of their value in dealer loans(e.g., 30% margin requirement)
• CIRO may change regulatory margin rates as conditions warrant
• Dealer members may also choose to have more stringent margin rates than those prescribed by regulations but not have less stringent rates
• Most debt securities can be purchased on margin at margin rates that are usually significantly lower than those for listed equities
• CIRO groups bonds and debentures into categories for margining purposes
• Within most categories, minimum margin requirements vary according to the quality of the credit and length of time to maturity
• Detailed minimum margin requirements for all of the above categories and maturities of obligations are fully set out in CIRO’s rules and regulations
• Apart from margin eligibility, the following general factors affect the set regulatory margin rates or the rates that dealer members set for themselves:
  • Issuer: greater security issuer creditworthiness results in a larger loan available to the purchaser. Thus, the margin rate for GOC bonds is much lower than the margin rate for speculative mining and exploration stocks
  • Term to maturity: the lifespan increase of a security results in a higher price volatility. Therefore, a GOC Treasury Bill (T-bill) requires less margin than a GOC bond with 10 years to maturity
  • Default: security risk increases result in a higher margin client deposit rate. Therefore, corporate bonds for a company that is not meeting current interest payments require more margin than comparable corporate bonds of issuers who are not in default

Operating a Long Margin Account

• To evaluate the status of a margin account, it is essential to understand the following:
  • Loan value: the maximum amount of financing that the dealer member will supply
  • Margin position: The status of an account with respect to margin requirements and actual margin deposited
  • Equity position: Whether the dealer loan is fully secured by equity in the client's account

Loan Value

• The basis for the financing arrangement in margin accounts is the loan value, which is the amount the dealer is willing to lend the client to finance the purchase of securities
• For example, if the margin rate on a fixed income security is 2%, its loan value is then 98% of its market value
• In some cases, the dealer member establishes a more conservative loan value than regulations require
• Regulations may set a 30% margin rate that gives a 70% loan value, whereas the firm sets a margin rate of 40%, yielding a 60% loan value
• The regulatory maximum loan value is the maximum amount of financing a dealer member may give to a client based on the market value of a security held in the client’s account
• Margin positions can be fully margined, meaning accounts loan value is equal to or greater than the amount borrowed (the debit balance)
• The difference between loan value and debit balance is called excess margin
• An excess margin indicates the account is eligible for a specified loan value that is not currently required in the account
• When loan value is less than the amount borrowed, the account is undermargined
• This shortage is called margin deficiency
• For example, a margin deficiency means the client must deposit more money to the account to meet margin requirements

Equity Position

• To find an account's equity position, the cash balance must be combined with the total market value of all securities in the account
• Equity positions are classified in three ways:
  • Fully secured: a positive equity position. If the securities were liquidated, their market value would cover any debit balance owing
  • Partly secured: a negative equity position when securities are held in the account. If the account were liquidated, there would still be money owing
  • Unsecured: an account with a debit balance and no securities. Is like a partly secured account, but without fluctuations. Any debit interest accrues, increasing the debit balance, while market prices have opposite effect

Long Margin Account: Case Study

• Accounts can become concentrated, where risks in concentrated accounts is greater because the client is more vulnerable to market events that affect the position
• There is not a single definition of makes an account concentrated
• Investments within the same industry, geographic region, or security type tend to be highly correlated
• Accounts with all the securities are from the same issuer, or they are all from the same industry sector could be considered concentrated

Short Margin

• The dynamics of short margin are different from long margin because of differences in risk, credit balances, and required margin, due to securities sold short have unlimited risk, while long positions can only loss value to zero
• With short trading, a credit balance appears in the short margin account as part of the margin calculation, which is non accessible to the client
• The client has an obligation to buy back the securities at a future date, as the securities can be sold short must be borrowed to make delivery on the sale, which may require a client buy-in if a return is demanded
• Margin is always required for a short position because of the involved risk, but in the reverse trading style from a long position. Proceeds of the short sale are deposited in the client's account
• Short selling is the reverse of purchasing shares on margin
• The proceeds of the short sale are deposited in the client’s account
• The client must deposit enough margin, in addition to the sale proceeds, to bring the account up to the required minimum

Special Margin

• Special circumstances exist with different margin rules for convertible bonds, debentures, hedge positions, options accounts and more for specific types of accounts:
  • Accounts with concentration issues
  • Accounts where excess margin in one client’s account is used to guarantee the margin required in another's accounts
  • Accounts where unlisted securities are sold short
• Firms should consult with firm's credit or compliance department before putting on margin positions in any of these types of accounts

Free Credit Balances

• Free credit balances include monies from any of the following sources that are received from, or held for, client accounts:
  • A deposit to pay for securities that have not yet been purchased
  • Proceeds of securities that have been sold, if those securities were already held in the account or have been properly delivered by the client
  • Income from securities held in the account, such as dividends or interest paid, which has not been reinvested
• With the exception of registered accounts (e.g., RSPs or RIFs), clients' free credit balances may be used by the dealer member as a financing source for its business
• Clients must be advised on all statements of account that any free credit balance represents funds payable on demand
• Furthermore, clients must be told that the funds, although recorded, are not segregated and may be used in the conduct of business
• Legislation governing registered accounts does not automatically permit free credits to be left with dealer members
• Satisfactory arrangements, approved by the administrator, must be made concerning bonding or insurance
• Most dealer members have arrangements with the legal trustee to hold such funds

Cash Accounts

• Cash accounts are accounts in which clients do not use any form of financing from the dealer
• The purchases and sales of securities are settled by the delivery of funds or securities on or before settlement date
• Is governed by the Cash Account Rule, and designed with 2 intentions:
  • Eliminate poor credit practices without restricting normal business relations with clients
  • Ensure that all dealer members extend credit to clients on an equal basis
• Poor credit practices include:
  • Accepting purchase orders from clients who do not intend to make payment in full or who do not have the resources to do so
  • Accepting sell orders from clients who do not intend to deliver the security sold and who may in fact be making an undisclosed short sale
  • The carrying of undermargined accounts under the guise of cash accounts
• If clients do not make settlement on time, both you and the dealer member are at risk for financial loss
• Violations of the Cash Account Rule generally fall under one of two types: failure to adopt practices that ensure compliance with cash account standards, and trading done to avoid or artificially delay settlement

Activities that fail to adopt practices that ensure compliance with cash account standards:

• Cash accounts with the debit balance outstanding for over 20 business days are not restricted
• Accounts are not restricted that should be restricted for reasons other than an outstanding balance
• Accounts not complying with the cash account settlement requirements are not transferred to a margin account in a timely manner:
• Accounts that should be restricted are permitted to continue trading under RR protection and approval
• Purchases are made in accounts without adequate equity, with settlement arranged through a subsequent sale of securities in the accounts

Example activities of trading done to avoid or artificially delay settlement:

• The same or a similar share position is sold and then bought on the same day or shortly thereafter, in a total dollar amount approximates a standing balance
• Highly liquid securities are bought and then sold on the same day or shortly thereafter with an amount not typically used in trading
• Debit balances are transferred to another account, re-aging in the process
• Canceled and correct journal entries are entered into the client balance and re-aged

Security Purchases

• Clients need to pay for securities on or before the settlement date
• If the client does not pay, the broker may sell the securities purchased
• If the securities increase in value, the broker recovers the amount and incurs no loss
• If the securities decrease in value, the client is responsible for the loss and may face termination of their relationship

Security Sales

• Securities must be delivered for client securities by the settlement date, where the broker will buy the securities if the client does not have them
• Shorted the client value reduces any potential loss if client cannot deliver the security
• If client securities are sold, a sale without delivery could be a possible short sell

Settlement Rules

• Normal settlement for each transaction in regular cash accounts must be made by payment (for purchases) or delivery(for sales) on the prescribed settlement date
• Payment may proceed via depositing cash or applying other funds, of transfers a free credit balance in another cash account, proceeds from sold securities
• Adequate margins must be maintained right before and after the funds transfer
• Requirements made during chapter are minimum standards
• The purpose of setting a capital charge on dealer members is for the risks related to cash accounts that do not settle on the prescribed base
• Security accounts overdue for 6+ business days are to be treated as though they are margin accounts, which has a big impact to the amount of equity and loss

Communicating Trading Information to Customers

• CIRO requires confirmation be sent to the client promptly after trade execution
• Firms must make CUIRO statements based on performance
• The following information must be in a trade confirmation:
  • The quantity, description, and price of the security
  • If the dealer member was acting as principal or agent
  • If working with an agent, the originating dealer member from which security was traded
  • The transaction date, and where it was executed
  • Any commissions charged, and number identification for the registered representative
• Trading confirmation needs security compensation, for both debt and retail:
  • The total mark-up or mark-down amount.
  • The total amount a commission is charged.
• Delivery of trading is done electronically, provided recipients follow policies outlinded by the IIROC:
  • Notice is sent to the recipient.
  • Recipient gains easy access to the document.
  • Received document is the same.
  • Evidence of a complete delivery is provided.
• Restricted shares should be handled correctly in confirmations

Account Statements

• Dealer members must send account statements on a quarterly basis, and monthly if clients entries have been active
• IDPC rules monthly required if:
  • The client's account has an unexpired and unexercized commodity futures contract option, open commodity futures contract, or exchange contract at the month end
  • The client has effected a transaction, or the balance of securities or cash in the client's account has been modified
  • The client asked to receive a monthly statement
• Quarterly client accounts must be given with debit, credit, or held securities
• Statements at minimum must include trading activity, interest payments and security information for each segregated security
• Safekeeping requires certain arrangements

Client Complaints and Account Transfer Requests

• Clients should make every complaint known for review
• Clients should also have all aspects of account and borrowing risks explained, also, the RR must assess that borrow-to-invest strategy is suitable for the client
• In customer service complaints, supervisors determine the appropriate resolution for disputes involving trading or client information by properly referring to documentation