Litigation Risks: Understanding The Potential Loss Of Investments In Court Battles

Whether you will lose your investment if it goes to court depends on several factors. Firstly, the type of investment and account you hold will determine the level of risk. For example, with a cash account, you are prohibited from borrowing money from a broker to purchase securities, so you cannot lose more than you invest. On the other hand, with a margin account, you can borrow funds to invest, which increases your purchasing power but also exposes you to greater potential losses.

Secondly, the type of bankruptcy filed by the company you have invested in will affect the outcome. Chapter 7 bankruptcy often results in shareholders losing their investment, as the company liquidates its assets to pay off debts, with secured creditors taking priority. In contrast, Chapter 11 bankruptcy allows for reorganisation and rehabilitation of the business, giving a small chance for shares to survive, although they usually lose value.

Additionally, the specific laws and regulations of your state or country may offer some protection for investors. For instance, in the United States, investors benefit from safeguards provided by organisations like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). These regulations ensure that customer assets are protected and separated from those of the brokerage firm.

Lastly, the financial situation of your spouse or ex-spouse can impact your investments in cases of divorce or separation. If one spouse has greater access to money, they may be less inclined to negotiate or cooperate, knowing that the other spouse cannot afford lengthy court proceedings. However, judges may intervene to level the playing field by ordering the spouse with more financial resources to provide monetary support to the other spouse.

Investment protection in the US

In the United States, investors enjoy a range of safeguards for their investment portfolios in the event of their brokerage firm going bankrupt. These protections are provided by regulators such as the US Securities and Exchange Commission (SEC) and the industry-funded regulator, the Financial Industry Regulatory Authority (FINRA).

Protections Offered by the SEC and FINRA

The SEC and FINRA enforce market regulations and ensure that customers' funds and securities are not at risk in the event of a brokerage firm's bankruptcy. This is achieved through a "net capital rule", which requires firms to keep a certain amount of cash on hand, depending on the size of the firm. Additionally, the SEC's customer protection rule prohibits brokerage firms from co-mingling firm-owned funds with customer-owned funds, thus compartmentizing funds and securities.

The Role of the Securities Investor Protection Corporation (SIPC)

The SIPC is a non-profit corporation created by Congress in 1970 to protect investors. It steps in when a SIPC-member brokerage firm fails financially and assets are missing from customer accounts. The SIPC has recovered billions of dollars for investors, safeguarding up to $500,000 on deposit in rare cases of fraudulent activity or theft.

Bilateral Investment Treaties (BITs)

The US also has bilateral investment treaties in place, which protect private investment, develop market-oriented policies in partner countries, and promote US exports. These treaties require that US investors and their "covered investments" be treated as favourably as the host country treats its own investors. BITs also establish clear limits on expropriation, provide for prompt compensation in such cases, and restrict the imposition of performance requirements.

The Investor Protection Act of 2009

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Investor Protection Act was established to expand the powers of the SEC and prevent future financial crises. It increased protections for whistleblowers, established an Investor Advisory Committee, and created the SEC's Investor Protection Fund.

While investors in the US benefit from robust regulatory frameworks, it is important to note that not all investment products are covered equally, and market volatility and global unrest can still impact investment portfolios.

Chapter 7 bankruptcy

Chapter 7 of the Bankruptcy Code provides for the liquidation and distribution of a debtor's assets to creditors. This type of bankruptcy is available to individuals or businesses that are unable to make regular monthly payments toward their debts.

In a Chapter 7 bankruptcy case, a trustee is appointed to gather and sell the debtor's nonexempt assets and use the proceeds to pay off creditors. The bankruptcy code allows debtors to keep certain "exempt" property, but the trustee will liquidate any remaining assets. Potential debtors should be aware that filing a petition under Chapter 7 may result in the loss of property.

To qualify for relief under Chapter 7, the debtor may be an individual, a partnership, or a corporation or other business entity. The debtor must also meet certain income requirements, which are determined by a "means test". If the debtor's income is higher than the state median, the means test will determine whether the Chapter 7 filing is presumptively abusive.

The Chapter 7 process begins with the debtor filing a petition with the bankruptcy court in the area where the individual lives or where the business is organized or has its principal place of business or assets. In addition to the petition, the debtor must file schedules of assets and liabilities, a schedule of current income and expenditures, a statement of financial affairs, and a schedule of executory contracts and unexpired leases.

During the Chapter 7 process, the trustee will hold a meeting of creditors, where the debtor will be put under oath and asked questions about their financial affairs and property. Within 10 days of this meeting, the trustee will report to the court whether the case should be presumed to be an abuse of the system.

At the conclusion of a Chapter 7 bankruptcy, the debtor will receive a discharge of debt, releasing them from personal liability for certain dischargeable debts. However, it is important to note that not all debts are discharged in Chapter 7, and debtors should consult with an attorney to understand the scope of the discharge.

Chapter 13 bankruptcy

To initiate the process, individuals must file a petition with the bankruptcy court in their area of residence. Along with the petition, they must submit various documents, including schedules of assets and liabilities, income and expenditures, executory contracts, and a statement of financial affairs. The filing of the petition automatically halts most collection actions against the debtor or their property.

Chapter 13 Eligibility Requirements

Any individual, regardless of self-employment or business ownership, is eligible for Chapter 13 relief as long as their combined secured and unsecured debts are less than $2,750,000 at the time of filing. To qualify, individuals must have regular income, have filed necessary tax returns, and meet other requirements outlined in the bankruptcy code.

The Chapter 13 Plan and Confirmation Hearing

The debtor must propose a repayment plan to make installments to creditors over the specified period. The plan must be submitted for court approval and must include fixed payment amounts to the trustee, who then distributes the funds to creditors according to the plan's terms.

Advantages of Chapter 13 Bankruptcy

Chapter 13 offers several benefits over liquidation under Chapter 7. It allows individuals to save their homes from foreclosure, reschedule secured debts (excluding primary residence mortgages), and extend them over the life of the repayment plan. It also includes a special provision protecting third parties who are co-signers on "consumer debts."

Making the Plan Work

Once the court confirms the plan, the debtor must make regular payments and adhere to a fixed budget. Incurred new debt without consulting the trustee is prohibited, as it may compromise the debtor's ability to complete the plan.

The Chapter 13 Discharge

Upon completion of all payments under the Chapter 13 plan and meeting certain conditions, the debtor is entitled to a discharge, releasing them from personal liability for certain dischargeable debts. However, some debts, such as long-term obligations, alimony, certain taxes, and government-funded educational loans, are not discharged in Chapter 13.

The Chapter 13 Hardship Discharge

In cases where circumstances prevent the debtor from completing the plan, they may request a "hardship discharge." This option is typically available if the debtor's failure to complete payments is beyond their control and if creditors have received at least as much as they would have in a Chapter 7 liquidation case.

Cash accounts

A cash account is a type of brokerage account in which the investor must pay the full amount for securities purchased. This means that investors using a cash account are not allowed to borrow funds from their broker-dealer to pay for transactions in the account (trading on margin).

The Federal Reserve's Regulation T governs cash accounts and the purchase of securities on margin. This regulation gives investors two business days to pay for security, known as T+2.

In accounting, a cash account, or cash book, may refer to a ledger in which all cash transactions are recorded. The cash account includes both the cash receipts journal and the cash payment journal.

Unlike margin accounts, cash accounts do not allow short selling or trading on margin. This means that investors must be careful to have sufficient cash in their account and not try to pay for the purchase of securities by selling other securities after the purchase date. For example, an investor who has no cash in an account cannot decide to make a stock purchase worth $10,000 and then sell other stock shares worth $10,000 the next day to pay for it. This would be a violation because the purchase will settle one day before the sale. There would be no cash available in the account to cover the trade, and this is known as a "cash liquidation violation."

Another example of a violation is if an investor with zero cash available buys a security and then quickly sells it before a previous sale has settled to provide the necessary cash. This is known as a "good faith violation."

Margin accounts

A margin account is a type of brokerage account that allows investors to borrow money from a broker to purchase securities. This strategy is also known as leveraged investing, where investors contribute a small amount of their own money and borrow a larger sum to make bigger investments.

When opening a margin account, a brokerage firm extends a line of credit to the investor, which can be used to buy securities. These securities act as collateral for the loan, and the brokerage firm charges an interest rate on the loan.

• Minimum margin: Before trading on margin, investors must meet the minimum margin requirement set by FINRA (Financial Industry Regulatory Authority). This is the lesser of $2,000 in cash or 100% of the purchase price of the stocks to be bought on margin.
• Initial margin: Investors are typically limited to borrowing 50% of the cost of the securities they intend to buy, effectively doubling their purchasing power.
• Maintenance margin: Investors must maintain a certain balance in their margin account, known as the maintenance margin or maintenance requirement. At least 25% of the assets in the margin account must be owned outright by the investor. If the account falls below this threshold, the investor may receive a margin call.
• Margin interest rates: The annual interest rate charged on a margin loan varies across brokerages.
• Margin call: A margin call is an alert from the brokerage firm that the value of the investor's securities has fallen below the threshold for the margin loan. In this case, the investor must deposit more money into their account or sell investments to maintain the account value that acts as collateral for the loan.

The benefits of a margin account include increased purchasing power, access to cash, and the ability to postpone capital gains taxes. However, using a margin account also comes with higher risks and costs. Investors may encounter margin calls, amplified losses, and higher interest costs. Margin accounts are generally recommended for sophisticated investors who understand the additional risks and requirements associated with this type of investing.

Frequently asked questions