Margin contract disputes: Potential risks for securities companies in Vietnam

Margin trading is a popular financial service that allows investors to buy securities with loans from securities companies, with the purchased shares and assets on the account as collateral. This service helps to increase purchasing power and amplify profits for investors, but at the same time amplifies risks. When the market fluctuates adversely, the value of collateral declines rapidly can lead to disputes over escrow contracts between investors and securities companies over the performance of obligations, handling of collateral, interest rates and compensation for damages.

When the market fluctuates adversely, the value of collateral declines rapidly can lead to disputes over escrow contracts.

Through the appellate case No. 200/2022/DS-PT of the People's Court of Ho Chi Minh City dated 27/04/2022 on the dispute over the margin trading contract between Mr. Nhan Duc Lam (investor, defendant) and KIS Vietnam Securities Joint Stock Company (plaintiff),[1] the article clarifies legal issues,  at the same time, make a number of legal comments and recommendations to improve legal regulations and minimize the risk of disputes in practice.

Background of the incident

Mr. Nhan Duc Lam opened a margin trading account at KIS and signed a margin trading contract to buy securities, with a total disbursement of about VND 109.7 billion. The collateral for the loan is the shares Mr. Lam bought with the loan money and other securities on his escrow account. According to the agreement, Mr. Lam is obliged to maintain the minimum margin ratio (the ratio of real assets to total debt) at a certain level (usually 30%) according to the regulations of the State Securities Commission. In early 2020, the stock market fell sharply, and the margin ratio on Mr. Lam's account fell below the maintenance level of 30%. KIS has repeatedly sent notices of additional margin calls asking Mr. Lam to deposit more money or securities in order to bring the margin rate back to the prescribed level. However, Mr. Lam did not add assets. Therefore, KIS exercised the right to handle the collateral: selling the shares in Mr. Lam's escrow account according to the signed contract terms and the law to recover debts.

After selling all securities, KIS recovered about VND 108.14 billion in principal from the disposal of assets, compared to VND 109.7 billion in principal disbursed to Mr. Lam. Thus, there is about 1.55 billion VND of principal that Mr. Lam has not paid to KIS after selling all the pledged securities.

Because Mr. Lam did not pay the remaining debt, KIS filed a lawsuit in court, requesting the Court to force Mr. Lam to pay the remaining principal amount and interest incurred at the interest rate agreed in the escrow contract. In response, in the counterclaim, Mr. Lam said that the securities company was also responsible for causing his damage. From there, Mr. Lam can ask the Court to declare part of the contract invalid or force the securities company to compensate him for damages, or at least offset the damage from the amount he has to pay.

The case was resolved by the People's Court of first instance in 2021, accepting part of the defendant's request. Specifically, the court of first instance rejected part of KIS's lawsuit request and accepted Mr. Lam's counterclaim. Disagreeing with the first-instance verdict, both Mr. Lam and KIS appealed. On April 27, 2022, the People's Court of Ho Chi Minh City heard the appellate hearing of the case. The Court of Appeal accepted the appeal of KIS Company, forcing Mr. Nhan Duc Lam to fully pay his obligations under the escrow contract to KIS.

Legal aspects arising from escrow contract disputes

Obligations of the parties to the escrow contract

In a margin trading contract, the basic obligations of the parties are determined as follows:

The securities company (lender) is obliged to provide loans in accordance with the agreement for customers to buy securities, manage collateral (securities purchased with loans and additional deposits of customers) and exercise contractual rights in case of customer violations. At the same time,  securities companies must comply with legal restrictions, for example: the total outstanding margin loans do not exceed 200% of equity; The outstanding loan balance of a customer does not exceed 3% of the equity. These are limits to ensure system safety, and violations can lead to sanctions from regulators.

The customer (investor, borrower) is obliged to use the loan for the right purpose (buy securities that are allowed to be margined), ensure the initial margin ratio and maintain it according to the contract, pay interest periodically and repay the principal on time. The law clearly stipulates that investors "are obliged to ensure the initial margin rate, the maintenance margin rate according to the contract signed with the securities company". When the margin ratio falls below the maintenance level, the investor must replenish the asset (money or securities) within the specified period. Otherwise, they will be considered a breach of contractual obligations, allowing the securities company to exercise its right to dispose of the collateral.

In the case, the defendant did not fully fulfill the obligation to maintain the margin ratio and payment obligation. When the market plummeted, his margin ratio fell below 30%. As is customary, KIS sent a notice of margin call to Mr. Lam via registered means of communication (email, SMS, phone) asking him to pay additional money. This is the obligation of the securities company: to promptly warn customers about the status of the account and additional requests to avoid selling assets. Circular 120/2020/TT-BTC does not specify the additional time limit, usually stipulated by the contract. KIS affirmed that it had fully implemented the notification. Mr. Lam's side, for some reason, did not add assets. Thus, the defendant has breached its contractual obligations by failing to maintain the margin ratio.

Source: KIS

The right to dispose of collateral under the escrow contract

The collateral here is the stocks and securities on the customer's margin account, including securities purchased with loans and other securities that the investor additionally deposits (collateral). According to Circular 120/2020/TT-BTC, "securities obtained from margin trading and other securities traded on margin of investors are used as collateral for loans". In terms of civil law, this relationship is considered a contract to pledge property. Securities are assets with valuable papers, so they can be considered as objects of pledge.

Article 299 of the Civil Code 2015 stipulates the following cases: (1) the obligor fails to perform or improperly performs the obligor; (2) the obligor breaches the obligation to perform ahead of time as agreed upon or by law; (3) other cases prescribed by agreement or law. Mr. Lam's case falls into (1) and (2): he does not keep the correct ratio (violating the obligation according to the agreement, leading to having to perform the obligation ahead of schedule to supplement the margin), and when the debt is due, he does not pay in full. Therefore, the conditions for handling collateral have been pushed sufficiently according to the agreement between the parties as well as the provisions of the law. Thus, KIS has the right to sell Mr. Lam's shares by himself when he does not add margin. This is a legal right, agreed in advance by the customer through a contract.

In the case, the defendant argued that KIS sold the property unreasonably, such as massively selling to push the price down, causing the damage to increase. However, the appellate court did not accept this argument because it considered that this was a market risk that both parties had to accept.

It should also be noted that Article 11 of Circular 120/2020/TT-BTC prohibits securities companies from providing margin loans to buy high-risk stocks (such as shares of self-guaranteed securities companies, main shares of the parent company,... and cases prescribed by the SSC). If KIS lends to investors to buy shares that are prohibited from being margined, the pledge of those shares may be considered invalid, or at least not counted as collateral. When a dispute arises, the client may argue that the company violates the category regulations, resulting in losses for himself.

Interest rates in margin contracts and related legal issues

Margin loan interest rates are a matter of special concern, because this is a large cost for investors and an important source of income for securities companies. Legally, interest rates are also often a controversial point in loan contracts. The Civil Code 2015 sets a ceiling on lending interest rates in civil transactions: "the agreed interest rate must not exceed 20%/year of the loan amount, unless otherwise provided for by other laws".[2] If the interest rate agreement is higher than this, the excess is not valid. For escrow contracts between securities companies and individuals, this is considered a civil transaction. The Law on Securities 2019 and related documents do not stipulate a specific ceiling for margin interest rates, so the provisions of the Civil Code should be applied implicitly. Therefore, all margin contracts must follow the ceiling of 20%/year.

Another aspect of interest rates is late payment interest and overdue penalty interest. Many contracts stipulate that when customers are overdue, the overdue debt will bear an interest rate equal to 150% of the usual interest rate. For example, if the margin interest rate is 13%/year, the overdue interest rate is ~19.5%/year, still below the ceiling of 20%. In this dispute, the defendant objected to the interest rate charged by KIS, arguing that the calculation was too high or unreasonable. One argument may be: because the escrow contract is commercial in nature, there is an opinion that the application of the Commercial Law 2005, when compensating for damage due to late payment, only interest is calculated according to the basic interest rate of the SBV. However, the relationship between KIS (a company) and Mr. Lam (an individual) is considered a civil transaction in nature, not completely governed by the Commercial Law. Therefore, the court applied the Civil Code 2015 and the contract as a basis, not the ceiling of the commercial interest rate of 9%. Moreover, as argued, the ~13% margin interest and ~19.5% overdue interest are still within the 20% frame, so they are completely valid. The Court of Appeal accepted KIS to collect interest under the contract, which means that the interest rate and calculation method of KIS do not violate the law.

The Ho Chi Minh City Stock Exchange

Potential risks and remedies in margin operations

The dispute between KIS and Mr. Lam shows that although the law has a clear framework for margin trading, securities companies still face many potential and unpredictable risks when deploying this service.

Legal risks from violations of margin management regulations: The Securities Commission and the Ministry of Finance have strict regulations to ensure the safety of margin lending activities. As mentioned, the total margin limit is 200% of equity, and for a client up to 3% of the capital. In addition, the company must comply with the list of securities that are allowed to be margined. Violation of these limits will be subject to severe administrative sanctions. These violations not only lead to direct financial losses but also discredit the business. Therefore, compliance with the law is a vital principle. Securities companies need to build a control system to prevent exceeding the limit and automatically lock stock codes that are not allowed to be deposited.

Legal dispute risks and related costs: When a dispute occurs, even if the securities company ultimately wins the lawsuit, it still takes a lot of time and money. The company's reputation could also be affected if the lawsuit is made public in the media. Therefore, it is very important to prevent disputes from the beginning. Each escrow customer should be clearly consulted, sign a contract with full terms, focusing on the provision of dispute settlement by negotiation or arbitration. If it can go to arbitration, the company will avoid a public judgment and shorten the time to resolve the dispute compared to going to court. Currently, the basic legal corridor on escrow has been clearly shaped from law, to decrees and circulars. However, securities companies need to specify more clearly in the form of escrow contracts with customers as well as the process of processing additional margin and selling mortgages. For example, it is stipulated that the client must be notified at least through two specific means of contact such as email, phone, or text message and for a minimum period of time with a specific number of days to replenish the margin limit. When that time limit is exceeded, it is allowed to sell. At the same time, the securities company must store evidence that customers have received information, but do not respond or make requests. If every company applies relatively uniformly, it will be easier for the court or dispute body to consider the validity of the asset disposal.

The dispute between KIS Securities Company and investors over the margin contract is a wake-up call about the potential risks in this business. Although the final result is in favor of the securities company, the cost is not small: bad debts, prolonged litigation time, and reputation is affected. Securities companies need to uphold risk management in margin lending: always comply with the limits and regulations of the regulatory agency; establish a strict and transparent escrow process; proactively prevent and handle early to avoid the worst situation. Potential risks can come from market fluctuations that exceed forecasts, from customers themselves, or from the company's vulnerabilities. Securities companies must always prepare for bad scenarios, have a response plan, instead of being subjective in a favorable market period.

On the side of lawmakers and regulators, it is necessary to continue to improve the legal framework for escrow operations, creating a balance between promoting the market and protecting entities participating in the securities market. The issuance of guidelines for the implementation of margin operations, especially clearly stipulating the procedures for handling margin accounts in case of emergency to protect the assets of investors and securities companies, is very necessary in the current period. In addition, the State Securities Commission needs to strengthen supervision and sanctions, as well as guide investors to grasp their rights and obligations when participating in this transaction, which will contribute to reducing unnecessary conflicts. Investors also need to raise awareness: use margin prudently, understand their rights and obligations, and respect the committed contract.

In short, margin trading is a double-edged sword – it opens up opportunities for high profits but also poses significant risks for both investors and securities companies. The escrow dispute case analyzed in the article is a typical example. To limit similar disputes, it is necessary to join hands of all relevant parties from lawmakers, regulators, securities companies and investors. Thus, Vietnam's stock market will develop safely and sustainably, minimizing risks and unfortunate consequences in the coming time.