How an investor ended up with a debt of $260,000 when the market fell

We all hope for a silver lining in our financial dealings but one investor here lost a fortune when his dabbling in that precious metal crashed like a lead balloon.

He also got an unwelcome lesson in the risks of investing with borrowed funds because you can be forced to sell at a loss when the market turns.

And it’s not as if he could blame anyone else for his misfortune: This was a seasoned investor well aware of the high risks that margin account trading – borrowing in the hope of making a profit – entails.

The precious metal investor had 88 silver futures contracts under a margin account with his broker in early 2020. Each contract dealt with 5,000 troy ounces of silver, which was worth around $135,000 then.

It is not known how much of his own money had been sunk into his account, but the deal enabled him to borrow more to facilitate his trades.

All was well until global markets started tumbling on March 13, 2020, following the Covid-19 outbreak, resulting in his portfolio value tumbling to below the critical 20 per cent cut-loss mark in just over four days.

The market crash initially left his account in deficit to the tune of about $80,000. A call from his broker led him to sell close to 20 per cent of his portfolio to cover the shortfall.

But this was not enough to stem the tide of red ink, and the following day, he had a “margin call” to top up a shortfall of about $500,000.

He had a breather when trading closed for the weekend, allowing him to transfer money to his account, but it was not done in time.

More bad news awaited when trading resumed on Monday. The market continued to tumble, resulting in him having to cash out his entire investment, yet he still ended up with a debt of $350,000.

He later transferred about $100,000 to his account but stopped short of settling the rest because he felt he had been wronged by his broker. He claimed the broker had led him to believe that he would incur a much lower loss if he liquidated his contracts.

The investor sued the company and the employees handling his account, claiming that they misrepresented the situation and applied undue pressure that led him to make the wrong decision to cash out his investments.

The broker responded by filing a suit to reclaim the outstanding debt of over $260,000.

The investor lost the case at the High Court and was ordered to pay the debt because he could not prove that there was anything wrong with all the transactions.

When the case came before the appeals court, Justice Philip Jeyaretnam gave an overview of the actions that parties in such investment disputes should take for themselves.

For instance, when markets fall, investors alone must decide for themselves whether to buy, hold or sell. If they have borrowed to fund such investments, they would have signed agreements, which usually give the lender the right to take unilateral action to limit its exposure by cashing out when losses hit a certain level.

Brokers for margin traders will often offer clients time to top up their accounts to meet the shortfall before taking the drastic step of cashing out the investment.

This was what happened here, and the judge found that the investor took the opportunity to meet the shortfall by giving instructions over the course of one day to sell off his holdings. Despite this, the investor believed he had been wrongly pressured, influenced or misled into doing so and claimed against the broker.

Justice Jeyaretnam also made two important points that all investors should know.

The importance of the investment contract

Before signing any investment contract, you must read it carefully and watch out for any terms and conditions that could affect your money because it is usually hard to complain about it later when things go wrong.

After all, the law respects the rights of both sides to agree on such terms, even if it gives broad powers for one party to take unilateral steps.

Unless the terms are grossly unfair, and it can be proven that a customer was uneducated and misled into signing something he or she had not intended to, properly signed contracts are usually upheld by the courts.

In this case, the agreement clearly gave the right to the broker to protect its interests, and that such a right was not conditional on the customer being given a certain amount of time to meet a margin call.

Justice Jeyaretnam noted that such contracts reflect the nature of the business, where trading conditions might be volatile and the lender could face mounting exposure very quickly.

“Market conditions could deteriorate after a margin call was issued and prior to the time allowed to meet the margin call. This could necessitate urgent protective action by the lender,” he added.

Such contracts expressly state that investors have to monitor their transactions and comply with all margin requirements. These obligations are so serious that an unanswered call to the investor’s telephone number would be deemed as a default.

Since the drop in portfolio value in this case hit a critical level, the broker would have been entitled to cash out the investment unilaterally, even if the investor did not make such a decision himself.

So if a broker can sell without the customer’s permission, the court would not need to consider whether the sale was done under pressure or was even a misrepresentation.

Investors liable for own action

If you engage in high-risk trades, you must be prepared to face losses in a downturn because no one else will help share the burden.

As the decision to put in the money is taken by an investor alone, it is hard to pin the blame on employees of financial institutions who were merely doing their jobs.

In this case, the investor was reminded of the stop-loss policy on the 20 per cent trigger on various calls on March 13 and 16, 2020, even though he had been given time to make good on the shortfall.

The policy allowed the broker to forcibly liquidate his positions if the investor had not taken the steps to sell his contracts himself.

“Thus, it did not matter whether or not he was pressured or influenced to do so,” Justice Jeyaretnam said.

He added that the call transcripts on the parties’ transactions showed that both sides were operating under pressure, but that pressure came from the fall in the market, and not from any improper conduct on the part of the broker’s employees.

As the investor lost his appeal, he had to pay the broker’s legal costs of $85,000 in addition to the more than $260,000 deficit in his margin account.

This case provides a compelling cautionary tale that there is no free lunch when it comes to investing: You cannot rely on other people’s money to strike it rich without taking on a higher risk that could see you end up losing more.

If you borrow to invest, you must understand that the rules of the game do not permit you to hold on to your investment until the market recovers.

After all, investment companies make their money from fees and interest, while investors bear the losses when things go wrong.

Source: Straits Times © SPH Media Limited. Permission required for reproduction.

Hard to reclaim losses if you sign investment contracts without reading ADV: SAcLJ: Call for Papers