More On Legal & Compliancefrom The Advisor's Professional Library
- Conducting Due Diligence of Sub-Advisors and Third-Party Advisors Engaging in due-diligence of sub-advisors isnt just a recommended best practice it is part of the fiduciary obligation to a client. An RIA should be extremely reluctant to enter a relationship with a sub-advisor who claims the firms strategy is proprietary.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
The Financial Industry Regulatory Authority (FINRA) has issued a regulatory notice addressing price volatility concerns associated with low-priced equity securities in customer margin and firm proprietary accounts. The notice advises that close attention be paid to low-priced equity securities; price volatility is usually associated with low-priced equities because they are inherently volatile. But what does FINRA consider a “low-price equity,” and what does it mean for you and your customers?
FINRA advises firms to weigh the risks that come with low-priced equity securities before extending credit in strategy-based or portfolio margin accounts. FINRA cautions firms to consider “volatility and concentrated positions in a single customer account and across all customer accounts, as well as the daily volume and market capitalization of each security when imposing ‘house’ maintenance margin requirements.”
For instance, it is more likely for newer companies to have low-priced equities due to their undeterminable earnings (unlike older companies with higher-priced equities which have already established themselves in the market). Further, low-priced equity securities can be removed from an index, which also raises the equity’s volatility level and price risk.
A house maintenance margin requirement is the minimum equity level that the customer must maintain in his or her margin account. This requirement is unique to each brokerage firm. Generally, a firm’s house maintenance requirement will be higher than the federal maintenance margin so that firms do not subject themselves to high risk levels if customers are unable to maintain their minimum equity levels.
The federal requirement for long equity securities is approximately 25 % of the current market value; it is approximately 30 percent for short equity securities. For portfolio margin accounts, the minimum maintenance requirement –for long and
short equity securities – is determined by the Theoretical Intermarket Margin System’s (TIMS) stress range of plus-or-minus 15%.
The FINRA notice fails to define “low-priced equity security,” but the presumption is that the notice applies to stocks trading at below $5 per share. Because of the volatility often present at that price point, FINRA is recommending that firms consider whether to voluntarily increase their margin requirements for these equities.
Implementing increased margin requirements safeguards customers’ accounts by ensuring they can cover large price fluctuations – and reduce the risk of brokerage firms being left on the hook for uncovered margin account balances. By understanding and balancing the volatility risks associated with low-equity securities, firms can keep these equities in margin and firm proprietary accounts without unnecessary risk to the firm or its customers.
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See also The Law Professor's blog at AdvisorFYI.