Second Circuit Interprets SEC Rule 10b-16 Requirements as to Disclosure of Margin Policies by Broker-Dealers (with Lofchie Comment)

The Second Circuit issued a significant decision as to a broker-dealer's disclosure obligations to its customers under Rule 10b-16 in connection with the broker-dealer's handling of a customer's margin account. As further discussed, the decision should (i) cause broker-dealers to review their Rule 10b-16 disclosures and (ii) remind customers that have margin accounts that, in the absence of a "lock-up" agreement, a margin loan is a demand loan that is subject to a demand for repayment at any time.

The case was brought by two hedge funds and their adviser (collectively, the "Funds") against UBS Securities, LLC, an SEC-registered broker-dealer ("UBS"). The Funds had maintained margin accounts with UBS for a number of years. In 2008, UBS sent a notice to the Funds informing the Funds that it would raise the collateral levels to which the Funds would be subject, and also send the Funds "detailed information" as to the manner in which UBS calculated the Funds' margin requirements. Two months later, UBS made another demand for margin and, in connection therewith, sent the Funds revised information as to how the Funds' margin would be calculated. The Funds apparently met the margin call, but moved their accounts.

In 2010, the Funds sued UBS, asserting that meeting the margin call had required the Funds to close out positions at an eventual cost to the Funds of $25 million. The Funds alleged a number of violations by UBS, such as a breach of an implied covenant of good faith, and, most interestingly (at least for purposes of this news item), that UBS had failed to make adequate disclosure of its margin terms as required by Rule 10b-16. In pertinent part, Rule 10b-6 requires that a broker-dealer disclose "the conditions under which additional collateral can be required."

UBS's Rule 10b-16 disclosure had cautioned that it could raise margin requirements based on factors such as "marketability" and "concentration" of the securities in the customer's account, as well as "market conditions generally." However, the Rule 10b-16 disclosure had not provided the customer with all of the information that UBS had provided at the time that UBS had made its margin calls. Two issues were thus raised by the law suit: (i) was UBS's Rule 10b-16 disclosure adequate and (ii) does a violation of Rule 10b-16 give rise to a private right of action? The SEC submitted an amicus brief on these these two issues which (i) generally supported the conclusion that UBS's disclosure was adequate and (ii) asserted that violations of Rule 10b-16 do create a private right of action.

The court agreed with UBS that the disclosure which UBS had provided was adequate. That is, UBS was not required to disclose the precise methods that it might use to determine a customer's margin requirements, particularly as such methods were subject to change at any time. The court did not issue a holding on the private right of action, as that issue was mooted by the court's holding that the Funds had no claim under Rule 10b-16.The really interesting aspect of the court's decision was that it distinguished this case from Liang v. Dean Witter Co., 540 F.2d 1107. In that 1976 case, a court had held that a broker's Rule 10b-16 disclosure was inadequate where the disclosure stated that the broker might raise its collateral requirements at any time in the broker's sole discretion, when, in fact. the broker had formalized procedures by which it calculated margin for customers generally. In short, the holding of this case is that it is not sufficient for Rule 10b-16 disclosure to simply provide that a broker has unlimited discretion to change its collateral requirements.

Lofchie Comment: Broker-dealers, on the one hand, and hedge funds and other borrowers, on the other, should draw somewhat opposite lessons from this decision.For broker-dealers, the lesson is that they should review their Rule 10b-16 disclosure carefully with a view to disclosing, in a general way, all of the factors that they may take into consideration in determining a customer's margin requirements. Such factors would probably include, by way of example, (i) issues as to the customer's securities, (ii) the general condition of the market, (iii) considerations as to the customer's status, (iv) considerations as to the broker's own ability to obtain financing, and (v) regulatory pronouncements. Further, although the court does not rule on the issue, broker-dealers should take the decision very seriously in light of the SEC's amicus brief asserting that a private right of action exists for violations of Rule 10b-16. For funds and other borrowers, the lesson is that, unless you negotiate a lock-up agreement, a margin loan is a demand loan agreement. In the absence of such an agreement, and assuming that the broker makes an adequate Rule 10b-16 disclosure, your margin requirements may be raised at any time.

View case in full here (Cabinet link).Additional Materials: Brief of SEC as Amicus Curiae; Liang v. Dean Witter Co., 540 F.2d 1107; SEC Rule 10b-16.