What is a Forced Liquidation?

Published by Thomas Herold in Economics, Investments, Laws & Regulations, Trading

'Forced Liquidation' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Forced liquidation involves a business or other organization selling its securities or assets in order to produce liquidity because of a deteriorating financial position and scenario. It is also referred to as forced selling. This activity is commonly pursued involuntarily, as a response to a series of economic or financially devastating events, business regulations, or court imposed legal orders.

Where stock securities and investments are concerned, this type of forced liquidation can happen if an investor possesses a margin trading account. Should the investor be negative with the account balance and refuse or be unable to raise the account value back over the mandatory margin requirements once a margin call has been issued, then the broker has the rights to begin forced selling of the account securities and positions. Typically, the brokerage will provide one or more warnings that an under-minimum margin situation has occurred before pursuing this drastic option. If the holder of the account refuses to respond to the repeated calls for margin leveling, then the broker can simply force sell off all positions.

It is helpful to consider a few real world examples in order to better understand this forced selling in a brokerage margin trading account. This could be the case with stocks, bonds, commodities, or futures holdings. Assume that brokerage Jean Paul Brokers enforces a minimum margin level requirement of $1,000 for all of its account holders. Gwen’s personal margin trading account had a stock portfolio originally valued at $1,500. Meanwhile, Jean Paul Brokers adjusted their margin requirements up to $2,000. They begin to issue margin calls to Gwen. She is instructed to either sell some stocks or deposit additional funds to raise her account value up to the new margin amount of $2,000. If Gwen refuses or ignores the order for the margin call, Jean Paul Brokers has the legal authority to force sell off at least $500 of her account position stocks.

In another scenario with the same account, Gwen has her account net value at $1,500 while the margin requirement remains at the original $1,000. Her stocks begin to plunge in value and are now only worth $800 all together. Jean Paul Brokerage will now send her a margin call demanding that she raise the account value by depositing an additional $200 cash to reach $1,000 in the account. Should Gwen not react by raising the now- delinquent account to this amount so that it is in good standing, then Jean Paul Brokerage will force liquidate her stock positions and shares so that it is able to decrease the amount of leveraged risk to which is it ultimately exposed as the broker responsible for the positions.

There is also an opposite of forced liquidation in such margin accounts. This is called forced buy-in. It happens in the event that the short sold shares of a margin account of a short selling trader are recalled by the broker or holder from whose account they were originally borrowed. In the unusual event when this triggers, the brokerage will buy back the shares to return them to the original owner and thus force close out the short position in the account. In such a case, the brokerage is not required to notify the account holder before performing such an account action. They must alert the account holder once they have done this.

With hedge funds and mutual funds, portfolio managers sometimes run into unanticipated financial crises. In this case, they may be required to sell off some of their holdings in order to cut their losses and free up cash. A real world example of this is Valeant Pharmaceuticals International. In May of 2016, the drug maker experienced a 90 percent stock price crash from its prior 2015 high. A number of hedge funds had poured in literally hundreds of millions of dollars into the pharmaceutical firm stock. They force liquidated their long holdings of the stock in order to salvage what remained of the investment and to safeguard their funds and clients from any further deterioration in the underlying share price.

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The term 'Forced Liquidation' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.