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Securities-backed lending is the term used to describe a lending arrangement in which an investor pledges securities as collateral for the loan. The loan is typically made by an affiliate bank or lender of the investor’s brokerage firm. These lending arrangements have attracted the attention of regulators and industry commentators in recent years because of the risks that they pose to investors. The focus of this attention has been on the rights of lenders to make collateral calls in the event that a market decline causes the lenders to become under-collateralized.

A less talked about issue, involving “cross-collateralization” clauses, was at the heart of a recent bankruptcy case which wound up in the U.S. Court of Appeals for the Sixth Circuit. In re Daley, 717 F.3d 506 (2013). The debtor in that case had rolled his IRA over to Merrill Lynch after signing a Client Relationship Agreement which contained the following “liens” provision:

All of your securities and other property in any account—margin or cash—in which you have an interest, or which at any time are in your possession or under your control, shall be subject to a lien for the discharge of any and all indebtedness or any other obligations you may have to Merrill Lynch.

As a result of this cross-collateralization clause, the debtor had pledged his IRA as security for any future debts to Merrill Lynch. The problem with this, or so the bankruptcy Trustee alleged, was that by pledging the IRA, the debtor had engaged in a prohibited transaction under the Internal Revenue Code, which destroyed the tax exempt status of the account, and in turn, caused the account to lose its status as an exempt asset under the Bankruptcy Code. As a non-exempt asset, the debtor’s IRA would have been part of the general bankruptcy estate and subject to the claims of creditors.

Ultimately, the Sixth Circuit sided with the debtor on the basis that, although there was a signed security agreement, the debtor had never actually been indebted to Merrill Lynch, and did not even have a credit account with the firm. The court stated as follows:

The mere existence of a “cross-collateralization agreement,” as the IRS calls it, does not by itself disqualify an IRA from exempt status. At most, it is the actual use of such an agreement—and the prohibited extension of credit through it in a later transaction—that might disqualify a retirement account.

If the debtor had taken a securities-backed loan, or actively traded on margin, it is likely that the court would have reached a different conclusion. Accordingly, investors with IRAs need to be careful not to sign broad cross collateralization clauses that might place their retirement assets in jeopardy.

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