Investors have filed a class action at the New York Southern District County Court against Interactive Brokers over the management of portfolio margin accounts. The filing states that the company unlawfully provided portfolio margin treatment for exchange-traded notes (ETNs), leading to losses for its clients.

The peculiarities of portfolio margin accounts are at the heart of a lawsuit filed against Interactive Brokers.

The class action came from Timothy Moss and Heather Hauptman, clients of the broker, on Friday (December 1). The filing claims that the broker unlawfully managed portfolio margin accounts, and disregarded the rules in administering these accounts. Portfolio margin generally allows for the use of higher leverage than standard 'strategy-based' margin lending (commonly referred to as 'Regulation T' margin lending), according to the filing.

Finra Rule 4210 was amended in 2007 to allow, for certain types of securities, portfolio margin trading in retail customer accounts, allowing broker-dealers to use portfolio margin to calculate margin requirements using a 'risk-based' model. However, this is allowed only in relation to specific security types, such as equity-based securities, and derivatives on eligible equity securities - like options or warrants on equities. ETNs are not equities or (derivatives of equities), but unsecured debt instruments, according to the filing.

Interactive Brokers 'disregarded this rule in administering its customers' Portfolio Margin Accounts for ETNs, such as the Barclays Bank iPath S&P 500 Vix Short-Term Futures ETN (VXX), for which there is no equity position supporting the security.

The company was informed directly and on several occasions by both Finra and the Options Clearing Corp that unsecured debt instruments, such as the VXX, were ineligible for portfolio margin and risk-based margining treatment, according to the filing. However, the company 'knowingly violated Finra rules to its customers' detriment, and knowingly breached its contractual agreements with its customers which obligated IB to follow Finra rules and other industry regulations', stated the filing.

Additionally, the disclosure form required by the regulator and provided by the company to its customers specifically lists each category of investment product that may be included for calculating portfolio margin requirements. ETNs were absent from that disclosure form.

Although Finra informed the company that Rule 4210(g) excluded ETNs, because the inherent risks associated with ETNs make them inappropriate for risk-based margin treatment, the company exposed its customers to the same excessive investment risk that Finra rules, which the SEC formally approved, were designed to avoid by including 'these inappropriate financial products in risk-based margin calculations'.

According to the court documents, investors hired the services of Meridian Capital Advisors, which it provided discretionary authority over the investments. The Interactive Brokers account included VXX positions to which the company 'immediately began to improperly apply Portfolio Margin treatment' for approximately three months. The filing states that, on 21 August 2015, Meridian sold 125 call options on the VXX and purchased 125 put options on the same ETN on one of the accounts.

By selling calls and buying puts on the VXX, Meridian was taking a 'short' position in the VXX. If the price of the VXX dropped or stayed the same prior to expiration of the contracts, investors would benefit by keeping the premium collected from the sale of the call options that would expire worthless or from an increase in the value of the put options. If the price of the VXX rose, however, those investors would have been required to deliver VXX notes to the buyer of the call options and would lose 100% of the funds used to purchase the put options.

As a result of the company applying the risk-based (rather than strategy-based) margin model to calculate the margin requirements for the ETN positions, events in the Asian markets during August 2015 saw the value of the investors' portfolio margin accounts (and those of all similarly situated Interactive Brokers customers) dropping. 'Also, because the broker had increased the Portfolio Margin requirements, many customers were put into a margin deficiency situation,' stated the filing.

As a result, in August, the two defendants' accounts lost around US$175,000, and $150,000, respectively, primarily as a result of the VXX and VXX option trades that occurred using portfolio margin leverage.

The matter exceeds US$5m in aggregate, exclusive of interest and costs, and the defendants are seeking 'injunctive and declaratory relief on behalf of themselves and all class members, as well as damages in their individual capacity', according to the filing. The defendants accuse Interactive Brokers of breach of contract, unjust enrichment and breach of the implied covenant of good faith and fair dealing.

The case Hauptman et al v. Interactive Brokers, LLC (1:17-cv-09382), was filed by Heather Hauptman, and Timothy Moss, 'individually and on behalf of others similarly situated'.

There are over 800 structured products linked to the CBOE SPX Volatility Index across jurisdictions, of which 718 are still live products, according to SRP data. There are also three products marketed by Barclays in the US market linked to S&P Vix indices including two products linked to the S&P 500 Vix Mid-Term Futures Index ER and one linked to the S&P500 VIX Short-Term Futures Index ER.

Related stories:
US investment firm sues exchange in trade secrets structured notes case

US watchdog targets vol-linked products, fines Wells Fargo

US broker charged with leverage ETF/ETN fraud

US investors prefer bonds, ETFs and annuities over structured notes, Finra

Finra fines four banks for mis-selling leveraged ETFs