"Investors who want to tap into the value of their portfolio through a stock program should realize that these programs involve significant risk and cost, and may result in unintended tax consequences," said John Gannon, FINRA's senior vice president for Investor Education, in a prepared statement.
"It's basically the same risk as borrowing the equity of your home," says Mickey Cargile, a certified financial planner with Cargile Investments. "We all see how well that concept worked over the past few years. Promoters can be unregulated and unregistered. It's a hotbed for crooks."
These programs, according to FINRA, are typically marketed by financial planners, investment advisers, and insurance agents.
What's the Deal?
Essentially, you, the investor "pledge" stock that you own as collateral to a lender, who will lend you cash, often as much as 90% of the value of the stock, for a set period of time, according to FINRA. You agree to pay interest, often above 10% annually, and are credited with any dividends paid on the stock you pledged. At the end of the loan period, options include extending the loan, getting the stock back by paying off the loan balance, cashing in any profits, or walking away from downside losses. That's right -- if the value of the pledged stock has fallen below the amount you owe, including interest, then you can say adios by simply turning over the stock to the lender and keeping the money that had been loaned.
Tax-wise, stock-based loans are tricky. Whether the lender sells the stock during the loan, the Internal Revenue Service might consider the transfer of stock to be taxable. That means you might face unexpected tax liabilities and have to pay capital gains taxes upon receipt of the proceeds of the loan, or upon the lender's sale of the stock, according to FINRA.
It's not just the tax issues, either. There's a chance that the lender won't return your stock when you repay the loan. There can also be sales loads and fees and surrender charges if you use the proceeds to purchase another financial product, such as a fixed or equity-indexed annuity.
Suddenly, your quick cash solution is more complicated than it appeared at first glance.
Beware of the Bait
FINRA says not only may you be told that you can tap your portfolio for any purpose without incurring the tax consequences of a sale, but you might be encouraged to "leverage" a stock position to purchase additional financial products. Expect to hear too, that you have a limited risk of loss.
"FINRA's concern is that the programs are marketed to entice investors to borrow against fully paid stock and then invest proceeds in another commission/fee based product to generate commission for the salesperson," explains Cargile.
The lender promises to return the stock or pay the profits, at the end of the loan period, but there's no guarantee that they will. If they fake you out, you lose that portion of the value of the stock, typically 10%, kept by the lender when the loan was initiated, as well as any profits that you were due, so says FINRA.
Once you transfer your stock, you lose control of it. Don't believe the claims that your stock is being "held." FINRA says some lenders sell the stock almost immediately, leaving you open to tax consequences and the potential loss of appreciation to the stock you thought you still owned.
And when the loan period is up, if you don't have the money to pay it off, you may have to liquidate your new investment, which could mean incurring significant charges and a potential tax liability, or otherwise go into to debt to pay it off.
A Disturbing Lack of Transparency
Absent adequate due diligence, neither you, your financial professional, nor anyone involved in promoting the program can know for certain what these lenders actually do with your pledged stock -- specifically, whether they hold it for your benefit or sell it. Nor can you be sure the lender will have adequate cash on hand to honor its obligation at the end of the loan term, points out FINRA.
Some stock-loan programs are simply scams. In September 2009, the Securities and Exchange Commission sued the promoter of a stock loan program, HedgeLender LLC, and two of its principals for promoting a fraudulent loan program. The lender allegedly sold the pledged stock, misappropriated the proceeds, and could neither return the stock nor pay profits to people in the program.
Know the rules. Loans secured by the pledge of certain securities, including most stocks, are generally considered margin loans. Federal Reserve Board regulations restrict the use of those loan proceeds, and one of those limits is on purchasing securities with the money. As a result, you may not be able to use the proceeds of the loans in the same way you could if you simply sold the stock, cautions FINRA.
Not Such a Cheap Option
In order to be "in the money" at the end of the loan period, the pledged stock would have to appreciate enough to exceed the interest charges that accrued during the loan period. Interest rates charged by stock-based loan lenders tend to be high -- higher than margin rates typically charged by brokerages for loans over $100,000 (the minimum portfolio value for at least some stock-based loan programs), reports FINRA.
So can such loans be a viable option? "Margin applied through a nationally recognized brokerage house can be a source of short term liquidity; and in experienced hands, can supplement investment returns," says Cargile. "Leverage always adds risk, so work with experienced, professional and registered advisers, and avoid salesmen when you are dealing with your hard-earned savings."
Proceed With Caution
If you're considering a stock-based loan program, don't do business until you are satisfied with the answers to these five questions listed on FINRA's website.
With so many caveats, you can probably find a better way to get your hands on the cash you need.1. Are the lenders and promoters registered with FINRA or with bank regulators? Don't take their word for it. Use FINRA BrokerCheck to verify the registration and licensing status of the lender and any other promoter or other intermediary in the transaction and check their backgrounds. You can also verify whether the entity extending the loan is a regulated bank or credit union by visiting the website of the Federal Financial Institutions Examination Council. Be extremely wary of borrowing from an entity that is neither a brokerage firm nor a bank.
2. Does the lender have audited financials? Check the Securities and Exchange Commission's website to see whether the lender files reports with audited financial statements. If the lender is publicly traded, you can review its financial statements to independently assess its financial strength, including whether it has sufficient cash reserves to return pledged collateral to borrowers who pay their loans.
3. What happens to my stock once I pledge it as collateral? Verify who owns the stock, who receives dividend payments (and whether and how dividend payments get credited to your loan balance) and what tax consequences, if any, the loan might entail. Separately check with an independent tax professional to ask about your particular tax situation.
4. What benefit does the promoter receive for recommending the program? This is especially important if the financial professional touting the program (or his or her firm) receives compensation on any financial product you purchase with the proceeds of the loan. You want to be sure the transaction is in your best interest, not merely the promoter's.
5. If you purchase a financial product with the proceeds: What are the costs and risks? Ascertain whether the product involves upfront sales charges, ongoing fees, potential surrender charges or back-end loads, some combination of these or other costs. Ask about any sort of holding period and whether you will have to pay to cash out of the investment when the loan comes due. How easy or difficult is it to sell the investment? What are the specific risks of that investment?