Margin loans were created to allow an investor to use securities already owned as collateral for a loan to purchase more securities. An investor can offer up to 50 percent of a securities portfolio as collateral on the margin loan, provided they are pre-approved stocks. The investor can then purchase more securities, without having to sell the originals, and potentially realize a gain on both sets of stock purchases. While the arrangement sounds lucrative, the loans are considered extremely high-risk and are liable to result in a loss as easily as turn a profit. For non-profit organizations, this volatility can create personal liability for directors choosing to use margin loans as an investment tool.
Margin loans were originally designed to be used in strong markets, rather than as emergency loans to cover short-term cash expenses. In the best-case scenario, both sets of stocks increase in value, and the investor realizes a gain on both, rather than just the initial holdings the investor offered as collateral. The investor can then sell some of the new stocks to pay back the interest and the loan and still retain the bulk of the securities. The scheme allows the investor to make significantly more profit than if a traditional loan were used.
When used as emergency short-term loans in an average or below-average market, however, margin loans end up doing more harm than good and often place the investor in a much deeper hole than the original situation. While they have the potential for greatly increased profits, they also have the potential to result in the investor losing all of his or her securities held as collateral and still owing interest.
Another issue for the investor is the lack of control over the timing of repayment. If the stocks held as collateral begin to lose value, the bank making the margin loan may make a ‘margin call’ demanding repayment or additional securities to make sure the value of the collateral that the bank holds still covers the amount of the loan that was borrowed. The investor is usually required to meet the bank’s minimum equity requirement without any option for an extension of time. If the investor does not or cannot meet the minimum requirement, the bank will immediately sell the investor’s securities it holds as collateral. The investor will then owe any amount necessary to make up the deficiency in the collateral value plus interest. In the end, the investor may end up owing more than the original securities were worth and have lost the securities themselves.
While margin loans are a risky undertaking for an individual investor, they are even more so for a manager or board member of a non-profit organization. The directors’ duties as fiduciaries of the organization’s funds are implicated due to the high-risk nature of the loans. Fiduciaries would have difficulty justifying why a conventional loan, which would not have jeopardized the securities of the endowment, was overlooked in favor of such an extreme risk which placed the ownership of the stocks outside of the non-profit’s hands. In a similar situation, a trustee in Pennsylvania was held to have violated his fiduciary duties by utilizing margin loans for a trust. The case, In re Dentler Family Trust, described a trustee who invested in a high-risk margin loan and caused the trust to incur a substantial liability. The Pennsylvania Superior Court found the investment to be contrary to the beneficiary’s best interests since it was an improper risk. Although the case did not deal with directors of a non-profit entity, it is likely that the reasoning would be equally applicable to them as well.
In the best-case scenario where non-profits realize gains utilizing a margin loan, the profits are subject to unrelated business income tax. If the nonprofit is a private foundation, the IRS has flagged margin loans as potential jeopardizing investments under § 4944 of the Internal Revenue Code (IRC) subject to a federal excise tax. The tax increases if the jeopardizing investment is not rescinded. Private foundations are thus strongly discouraged from investing their endowment funds in this manner
The IRS also classifies the new securities purchased for investment as “debt financed property,” and income derived from selling the securities is “an item of gross income derived from an unrelated trade or business” under IRC § 514. This subjects the non-profit’s gains to unrelated business income tax under IRC § 511.
In addition to the IRC, Pennsylvania law also applies. The Pennsylvania Solicitation of Funds for Charitable Purposes Act at 10 P.S. § 162.5(s) requires that a charitable organization “maintain and administer all contributions raised on its behalf through an account in the name of the charitable organization and under its sole control.” Thus, assets held within the control of a lender bank as collateral subject to immediate sale in the event of an unanswered margin call would be in violation of the Act. Many non-profits’ internal bylaws often include similar terms.
Non-profit entities are, therefore, cautioned that margin loans, while tempting on paper, are not the best option for investing funds, and they are downright dangerous to use for immediate short-term loans to cover operational expenses.
This article was written with contribution from Sarah Rothermel, 3rd year law student at Widener Law Commonwealth.