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August 3, 2000

NASD Rule Would Require Warning on Account Risk
By Ruth Simon and Terzah Ewing, excerpted from The Wall Street Journal

Margin Debt Nears Record Levels ... Weiss comments

Investors who buy stocks with borrowed funds could soon start seeing Wall Street's equivalent of cigarette-pack health warnings.

Securities firms could soon be required to include dire disclaimers on account statements, cautioning investors of the extreme risks of buying on margin. Among the possibilities: "The [brokerage] firm can sell your securities without contacting you," and "You are not entitled to choose which security in your margin account is liquidated."

It is all part of a regulatory push to rein in problems with margin accounts. Last week, the National Association of Securities Dealers' board passed a rule that would require brokerage firms to give holders of the risky accounts a disclosure statement before they sign on the dotted line -- and then send it again every year. The new rule must be approved by the Securities and Exchange Commission, which declined to comment.

The move is in some ways symbolic. Many brokerage firms already make special disclosures to margin account holders. Nonetheless, the new effort underlines continuing concerns among securities regulators that investors don't fully understand the risks of buying stock with borrowed funds.

Buying stock on margin can magnify the rewards, and risks, of playing the market. If stocks take a hit -- as they did in a big way during the spring and to a smaller extent last week -- customers can face "margin calls"; that is, demands that they put up additional cash or stock. Though investors don't always realize it, brokerage firms have the right to sell stocks to meet a margin call without notifying their customers beforehand.

Regulators say they have received a flurry of complaints from disgruntled investors with margin accounts. In the first half of this year, the SEC received 459 investor complaints about margin sell-outs and margin disclosures. That compares with a total of 314 complaints in all of 1999.

It is clear is that many investors borrow heavily from their brokers without fully understanding the potential downside. Margin loans hit a record $278.5 billion in March at securities firms, nearly double the $140.3 billion in March 1998. The level of margin debt sank in April after the Nasdaq Composite Index began what would become a 35% plunge from its high, triggering a flurry of margin calls. Yet in June, such debt increased nearly 3% from May's level, to $247.2 billion.

More recently, margin debt has held fairly steady, brokerage firms say. At E*Trade Group Inc., "margin balances have stayed pretty stable since about June," says spokesman Patrick Di Chiro. At Datek Online Holdings Inc., investor borrowing has "crept up slightly since the beginning of June ... but is still below April levels," says Mike Dunn, a company spokesman.

The NASD says there should be a fairly uniform way of clarifying margin accounts' risk. A week ago, its board approved a rule that would require all member firms to give customers seeking to open a margin account a clear statement of the possible perils.

The rule filing even includes a sample form with risks underlined and boldfaced: "The firm can force the sale of securities in your account," "You are not entitled to an extension of time on a margin call," and "You can lose more funds than you deposit in the margin account." NASD officials say firms would be able to use the sample form or customized forms, provided they disclose all of the risks.

A couple of factors pushed the NASD to attempt to impose the requirement. Mary Schapiro, president of the organization's regulatory arm, says that while many firms already make risk disclosures to new customers, the NASD discovered that the disclosures aren't necessarily clear and methods for making them vary from firm to firm.

Moreover, after the sharp downturn in the Nasdaq index in the spring prompted an increase in margin calls and account liquidations, "we saw a ramping up of customer complaints. Customers were angry, but mostly they were just confused," Ms. Schapiro says.

Ms. Schapiro notes that NASD regulation has a special section on margin accounts on its Web site, , including a Q&A; section and a list of rule filings on the subject.

Who can argue with the NASD's effort to educate investors about the risks of buying on margin? Anytime investors are given more information about the risks involved in investing, it is a good thing. What's more significant in this article, though, are the numbers.

Clearly, investors have not learned their lesson from the April tech wreck. The level of margin debt is nearly back up to March's record levels, and as the Nasdaq continues to spiral downward, more and more investors will be subject to margin calls. This is the same environment that caused April's record decline - stock prices dropped quickly as institutional investors bailed out of tech stocks and individual investors with margin accounts lost their shirts when their brokerages sold off their portfolios at a huge loss. This time around, though, it could be much worse.

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