A Rights Issue on a Concentrated Margin Account
A client's margin account at a broker-dealer carries a debit balance of J$3.6m secured by 800,000 shares of a listed distribution company valued at J$6.50 - collateral of J$5.2m and equity of J$1.6m. The firm's maintenance requirement is 25% of the value of pledged securities. The company announces a one-for-four rights issue at a subscription price of J$4.00, with the shares going ex-rights in three weeks. The client has no cash and asks the firm to lend him the subscription money 'just for a month', promising to repay after the rights shares are sold. He also asks whether he can simply let the rights lapse and keep the shares. The margin clerk has calculated the theoretical ex-rights price as (4 × J$6.50 + J$4.00) ÷ 5 = J$6.00. The account is concentrated: this is the only holding, and the client's only income is a salary already fully committed to the existing facility.
1. Calculate the account position before and after the shares go ex-rights, and assess the margin outcome under each of the three paths: subscribe with borrowed money, sell the rights, or let them lapse.
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Work the ratios, not the balances.
Before ex-date: collateral J$5.2m, debit J$3.6m, equity J$1.6m = 30.8% - compliant, with about 5.8 percentage points of buffer.
Ex-rights, no action taken: 800,000 × J$6.00 = J$4.8m; equity J$1.2m = exactly 25.0%. The account sits on the maintenance line with no headroom. A fall to roughly J$5.87 puts it in breach.
Path 1 - subscribe with J$800,000 borrowed (200,000 rights × J$4.00): 1,000,000 shares × J$6.00 = J$6.0m collateral; debit J$4.4m; equity J$1.6m = 26.7%. Within the requirement, but the maximum permissible debit is 75% of J$6.0m = J$4.5m, so there is only J$100,000 of headroom - a 2.2% price fall triggers a call, on a larger loan.
Path 2 - sell the rights: theoretical nil-paid value = J$6.00 − J$4.00 = J$2.00, so 200,000 rights ≈ J$400,000. Debit falls to J$3.2m, collateral J$4.8m, equity J$1.6m = 33.3%. The strongest ratio of the three.
Path 3 - lapse: the rights expire worthless, so the client forgoes about J$400,000 of value and ends at 25.0% with no buffer. The 'do nothing' option is an active decision to destroy value.
2. Should the firm lend the client the subscription money? What alternatives should be presented?
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Not on the terms described. 'Just for a month' is a repayment wish, not a repayment source - the client has no cash, and salary is already committed to an existing facility that will itself become more expensive on the larger debit.
If the firm considers an advance at all, it must be a properly approved margin advance: within the J$4.5m ceiling, priced at the disclosed margin rate, approved by credit, with a suitability assessment given the single-stock concentration and the fact that the extra collateral is the same stock. The 26.7% ratio and J$100,000 of headroom should be put to the client in writing.
Alternatives, in order of preference:
- Sell the rights. Raises roughly J$400,000, cuts the debit to J$3.2m and lifts the ratio to 33.3%. The catch: nil-paid rights on an illiquid name may not fetch theoretical value, so set a realistic floor and instruct the firm to sell above it.
- Subscribe from the client's own resources. Better than borrowing, but the ratio still ends at 26.7%.
- Sell part of the holding. If the client wants neither new debt nor dilution, reducing the position restores buffer and cuts concentration.
Whichever path is chosen, the conversation must happen before the ex-date, not after. Silence defaults the client into the worst outcome.
3. What should the firm do operationally before the ex-date, and how should the conflict in lending to the client be handled?
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Process, with a hard deadline:
- Issue a written notice to the client at least ten business days before the ex-date, setting out the three paths with the numbers, and stating the default (lapse) and the instruction deadline.
- Diary the deadline and follow up by telephone, recording the call. If no instruction is received, the firm should not silently allow a value-destroying lapse on a margined account - escalate to a supervisor for a documented decision.
- If the account is at or near the line, prepare a pre-emptive reduction plan with the client's written agreement.
- Confirm the firm's entitlement processing (rights credited, subscription monies deadline) with the registrar or depository, and confirm the client understands that the rights are not yet listed.
The conflict: the firm is the lender, the margin provider, the executing broker on any rights sale and the party that benefits from interest on a larger debit. That combination means the advice cannot be delivered by the account executive alone. A supervisor independent of the revenue line should review the recommendation, the client's acknowledgement should record that the firm explained the alternative of selling the rights, and the credit decision should be documented separately from the sales conversation.