Sellout
The involuntary sale of assets or securities due to unforeseen events or non-economic factors
What is a Sellout?
A sellout is a situation where investors are compelled to dispose of their assets due to non-economic factors, such as divorce, illness, or margin calls by a brokerage firm. In times of panic, investors are more interested in generating quick liquidity than optimizing the return on the security.
When an investor’s decision to sell their stocks does not relate to the underlying fundamentals, the price of stocks can be mispriced, often below the prevailing market price of the specific stock.
For example, when an investor sells his/her assets quickly due to a separate cash flow need, the assets will not receive the normal market exposure and, subsequently, the seller will not receive a fair market value for their asset. In times of panic, appraisers use a forced liquidation value to determine the worth of the asset.
Summary
- A sellout involves the involuntary sale of assets or securities due to unforeseen events or non-economic factors, such as divorce, legal order, or death of the debtor.
- A sellout may also occur when a brokerage firm sells an investor’s positions because the investor did not respond to a margin call or is unable to deposit additional funds.
- When a sellout occurs, the asset being disposed of is sold at the best available price, which may be below fair market value.
Understanding Sellouts
A sellout may occur in a customer’s margin account held in a brokerage firm when the customer fails to meet the broker’s rules on margin requirements. If the customer bought the security on margin, and its price drops, the customer’s account is said to be undermargined.
When such a scenario occurs, the brokerage firm issues a margin call to the customer, instructing them that their margin account in the firm is undermargined. They must top up the account or sell part of their securities to meet the margin requirement. If the customer does not deposit more cash or sell part of their securities to offset the balance, the brokerage firm is authorized to sell out part of the customer’s investment.
For example, assume that John maintains a margin account with ABC Limited. The firm’s minimum margin requirement is $1,000, and John’s margin account carries a net value of $1,300, which is above the brokerage’s minimum margin requirement.
Assuming that John’s securities perform poorly, and their net value drops to $900, ABC Limited would issue a margin call to John, requiring him to deposit additional funds into the account or sell part of his securities to increase the account value to the required minimum margin requirement.
If John fails to respond to the margin call or chooses not to deposit additional funds into the account, the broker can sell part of John’s current positions to reduce the leverage risk. In such a case, ABC Limited can sell $100 worth of John’s investment to meet the margin requirement.
A Sellout in a Margin Account
Sellouts are common in brokerage firms, where brokerages may be forced to sell part of an investor’s current position to meet the minimum margin requirement. When clients conduct transactions through a brokerage firm, the firm earns a commission for facilitating transactions between the seller and the buyer.
Usually, customers maintain margin accounts with the brokerage firm, which allows them to access loaned funds to use in purchasing stocks and other securities. Since the margin account operates on borrowed funds, the brokerage uses the securities purchased and any funds deposited into the account as collateral if the customer defaults. The brokerage charges a periodic interest rate on the margin account. The investor stands to earn a profit if the securities appreciate beyond the interest rate charged on using the margin funds.
If the margin account’s equity falls below the required maintenance level, the brokerage will issue a margin call to the customer, requiring them to deposit more cash or sell part of their investment to offset the difference between the maintenance margin and the security’s price.
If the customer does not respond, the broker may sue the investor or sell their securities to increase the margin account’s capital. The brokerage firm may also ask the customer to top up their margin account at any time, even if the account is still within the margin requirement.
A Sellout of Personal Assets
Sellouts may also involve selling personal assets due to a personal life change, such as bankruptcy, divorce proceedings, or even death. During divorce proceedings, the court may require all matrimonial properties to be disposed of and the proceeds shared between the two parties.
When a person dies, the court may require the deceased’s estate to be sold off to pay any debts that the deceased owed to creditors. In bankruptcy proceedings, a court may grant a writ of execution, authorizing the sale of a debtor’s assets and properties through an auction.
When a court issues a writ of execution, it requires a court official or sheriff to take possession of the debtor’s assets, such as money, real estate, and other assets. Proceeds from the assets are handed to the plaintiff to settle claims authorized by the court.
More Resources
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
