By Lawrence C. Melton, Esq., firstname.lastname@example.org
THE HAYES LAW FIRM, P.C., www.dhayeslaw.com
On April 21, 2007, the New York Times ran an article entitled The Perils of Being Suddenly Rich. Written by Katie Hafner, the article focuses on the fall of David Hayden, a dot.com Multimillionaire who lost almost everything due to irresponsible use of margin, failure to hedge and failure to diversify.
In 1997 Mr. Hayden established Critical Path, an internet start-up company that handled e-mail for corporations and large Internet service provides. Robertson Stephens, then on of Silicon Valley's premier investment banking firms, stepped in to underwrite Critical Path's initial public offering. In 1990, prior to the public stock offering, Mr. Hayden opened up a margin account with Robertson Stevens.
Using margin allows an investor to borrow part of the money needed to buy stock from a broker. The portion of the purchase price that the customer must deposit in called margin and is the customer's initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer.
A large percentage decline in your equity triggers a margin call from your broker. This means that the broker is demanding more money (or securities) to bring your position back up to its minimum margin requirement. If you do not come up with the money in time, your position may be closed out. This means that the broker can sell your stock in order to recoup the money you owe.
This is difficult to explain. Here is an example:
If you buy $100,000 of stock with a 50% margin, you will pay $50,000 for the stock and borrow the remaining $50,000 from your broker. Your equity in the account is $50,000 and you receive a margin loan of $50,000 from the broker. You pay 50% and your Broker pays 50%
Assume that later, the value of the securities falls from $100,000 to $60,000. How does this change the situation? The loan remains the same amount, $50,000. However, your equity decreases to $10,000 ($60,000 market value minus $50,000, loan amount). The law requires a minimum maintenance margin of 25%. In this hypothetical, this means that your equity must not fall below $15,000 ($60,000 market value multiplied by 25%). Since the required equity is $15,000, you would have to pay a margin call of $5,000 ($15,000 minimum required equity minus existing equity of $10,000).
See NASD Investor Alert: Purchasing on Margin, Risks Involved With Trading in a Margin Account,available on NASD web page.
MARGIN: When the customer borrows funds from a broker, the customer will open a margin account. The customer will pay for part of the securities and borrow the rest from the broker. The portion of the purchase price that the customer must deposit is called margin and is the customer's initial equity in the account. The margin loan is secured by the securities that are purchased by the customer.
MINIMUM MARGIN REQUIREMENT: The law requires that the customer's equity in the account not fall below 25% of the current market value of the securities in the margin account. If it does, the customer will be subject to a margin call.
MARGIN CALL: Broker's demand for additional cash or securities to maintain a minimum margin of 25%. The failure of the customer to provide additional cash or securities will cause the broker to sell or liquidate the securities in the customer's account to bring the account's equity back up to 25%.
In the case of Mr. Hayden, in 1999 he borrowed $2 million from Robertson Stephens, pledging all his Critical Path stock as collateral, as well as any future stock he might receive. In 2000 Mr. Hayden sold $45 million worth of stock, and continued to borrow against the remainder of his stock held by Robertson Stephens. Eventually, the loan was increased, first to $5 million, then $20 million, then $30 million.
Meanwhile, Mr. Hayden became a multimillionaire. He purchased an $8 million mansion in San Fransisco, property worth $4 million in Sun Valley, Idaho, put a down payment on a jet, and purchased an original copy of the Declaration of Independence.
Eventually the use of margin caught up with him. By 2001, Critical Path was in financial trouble. Hayden had to put up his mansion and property as security against his outstanding margin loan. Robertson Stephens continued to seek repayment, which would force Hayden into bankruptcy.
Hayden filed an arbitration claim against Robertson Stephens, claiming mismanagement and breach of fiduciary duties. Hayden lost the arbitration and was required to pay $23,828,209.60 to Robertson Stephens. The arbitrator admitted that if Hayden would have employed a strategy of hedging and diversification he would still be a rich man.
HEDGING is the the purchase or sale of securities to offset an existing securities position. A fully hedged portfolio is protected against shifts in the market, interest rates, or other identified risks. This strategy is typically used to protect an existing position in the underlying asset against a decline in value while retaining all of the upside potential.
A common way to hedge is to use derivative instruments such as a put option. A put option gives the holder the right to sell an underlying asset at a specified price on specified dates. Investors who are nervous about a short term decline that can erode the value of an asset can use a put to provide protection.
Example: Investor owns 1,000 shares in X Corporation, which is trading at 144. Investor is nervous that the price is going to drop. Investor does not want to sell the stock outright--he just wants short-term protection. What can he do? He buys 10 "X Corp. puts." Each of these puts gives the investor the right to sell 100 shares of X Corp at $140 per share (up until expiration), protecting the investor against a sharp decline in the price of X Corp.
DIVERSIFICATION is the spreading of investments among different industries and market sectors in order to reduce risks. "It is important to have in one's portfolio stocks that do not all depend on the same economic variables, such as consumer spending, business investments, housing construction and so forth." Burton Malkiel & William Baumol, Redundant Regulation of Foreign Security Trading and U.S. Competitiveness, in Kenneth Lehn & Kamphuis (eds.) Modernizing U.S. Securities Regulation 45 (Irwin, 1992). Studies show that diversification is not possible with less than 25-30 positions.
Right now, Mr. Hayden is challenging the arbitration ruling in California Superior Court. If he loses he will have to declare bankruptcy.
If you believe your broker has defrauded you, please contact THE HAYES LAW FIRM at 1-866-332-3567 and visit our web site at www.dhayeslaw.com