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April 1, 2000

Margin Crackdown Likely at Regionals?SEC Stepping Up Enforcement Actions as Mar

By William Hoffman

Regional stock exchanges are a likely choice for initial SEC action as the agency cracks down on margin lending abuses at day-trading firms, according to a high-powered attorney who represents dozens of brokerages and several regional exchanges.

George T. Simon, a managing partner and head of the broker dealer regulatory practice at Foley & Lardner, said margin lending subterfuges often occur because violators are regulated by regional exchanges.

Regional exchanges aren't equipped to deal with sophisticated abuses off the exchange floor, he explained, and the SEC is loath to intervene in local affairs.

The National Association of Securities Dealers and the New York Stock Exchange also are not equipped to deal with the problem, he said.

As a result, he contended, SEC regulators would start with the regionals as concerns about margin practice grows.

"There has been increasing concern, given the volatility of the markets due to day trading and speculative trading, online brokers and the like," Simon added.

Rich Pickings

While SEC actions could reap rich pickings for securities attorneys in private practice, some broker dealers remain anxious as regulators warn about the dangers of shoddy margin arrangements.

The SEC recently sued broker dealers, All-Tech Direct and Investment Street Co., as well as nine associated individuals, for providing loans to day trading customers in excess of federal margin lending limits.

SEC lawyers have been quoted in press reports saying these are the first such actions by the commission against margin abuses at day trading firms.

In a speech in Los Angeles, SEC Chairman Arthur Levitt said, "In the past two months the level of margin debt has surged even faster than the stock market. In too many cases, investors are focusing on the upside without carefully considering the downside."

Start of Crackdown

Lisa M. Mezzetti, a consumer litigation partner at Cohen, Milstein, Hausfeld & Toll in Washington, said there's no way to know if the SEC action represents the beginning of a crackdown. The SEC isn't saying.

"But certainly when they pick these day trading companies and do them two at a time, there is a message, that we're going to act when necessary," Mezzetti said.

Simon added, "What you've got is a background in which people have figured out ways to do things that the people who drafted the margin rules never thought they could do."

Free-wheeling brokers have been experimenting for years with ways to get around federal margin lending limits, Simon asseerted. They require investors to put up cash equal to 50 percent of the value of securities they want to buy.

One strategy, called "good safe margin," involves creating a "joint back office" through a limited liability corporation, Simon explained. Investors in the LLC can use their equity in the company to exempt themselves from margin requirements, up to whatever limit their trading firm will tolerate.

Trading firms also use cash accounts to sequence trades so that accounts settled within the legal margin limits (usually by the end of each trading day, or within three trading days), are never legally triggered, according to Simon.

Lending Limits

The Federal Reserve has issued instructions warning that this practice is inconsistent with federal margin lending limits, Simon said, though the rule isn't yet well publicized.

Mezzetti said margin lending abuses put broader markets at risk. Novice investors can be ruined by unexpected margin calls, she noted.

Over-extended investors might also sell into a market that's sliding downward, she added. Depending on their exposure, that could make a bad situation much worse. Mezzetti says the SEC action addresses bigger issues of market health. "I think that is appropriate," she said.