Margin Call, Part Three: Advanced Regulation U Issues

by Latham & Watkins LLP
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In the last installment on the US margin regulations, we touched on the building blocks of Regulation U, which prohibits a bank or a non-bank lender (who is not a broker-dealer) from extending “purpose credit” that is “secured directly or indirectly” by “margin stock,” in an amount that exceeds the “maximum loan value” of the collateral securing the credit. In this installment, we will examine some other key concepts and highlight where Regulation U issues can arise in practice.

In order for Regulation U to apply, your client must be the lender in the margin transaction who is extending purpose credit to a customer that is secured directly or indirectly by any margin stock.

Who Is a Regulation U Lender?

A Regulation U lender can be a bank or a non-bank entity (other than a broker-dealer). A bank includes:

  • any banking institution or a federal savings association that is organized under US law;
  • any member bank of the Federal Reserve System; and
  • certain other types of banking institutions, including a US branch or agency of a foreign bank who is extending the credit in the United States.

A non-bank lender for purposes of Regulation U is any person who is not a bank or a broker-dealer. Any non-bank lender who, in the ordinary course of business, extends or maintains credit that is secured by margin stock (regardless of the purpose of the credit) in excess of certain thresholds is required to register with the Federal Reserve under Regulation U. A non-bank lender must register by filing a Form G-1 within 30 days after the end of any calendar quarter in which the lender has extended credit secured by margin stock that exceeds $200,000 or the amount of such credit outstanding at any time during such calendar quarter exceeds $500,000. In addition, a non-bank lender that is required to register under Regulation U must also submit an annual report to the Federal Reserve on Form FR G-4.

Who Is a Regulation U Customer?

A Regulation U customer is any person (or persons acting jointly) who borrows money for the purpose of purchasing or carrying margin stock. A Regulation U customer may include an affiliate of the lender. Questions often arise under Regulation U as to whether a lender must treat affiliated borrowers as one customer or as separate customers. Based on Federal Reserve Staff opinions, it is possible to consider a borrowing parent company and a borrowing subsidiary of the parent as separate Regulation U customers if they are legitimately established for valid business reasons and not as a means to circumvent the Regulation U requirements. This is particularly significant when applying Regulation U’s single credit rule, which we will discuss in a subsequent installment.

What Does Purpose Credit Look Like?

As you may recall, purpose credit is any credit that is extended for the purpose of buying or carrying of margin stock, either immediately, ultimately, or as an incidental component of a transaction. The borrower’s intent forms a crucial part of this determination, and it is the status of the stock at the time of the legally binding commitment that is relevant. Although there have not been many Federal Reserve interpretations of the concept of “extension of credit” for purposes of Regulation U, what constitutes an extension of credit for these purposes is quite comprehensive. In its most basic terms, extending purpose credit includes the making or renewing of a loan, granting a line of credit, or extending credit in any manner. Traditional bank loan agreements (whether term or revolving) and lines of credit clearly involve extensions of credit for purposes of Regulation U. Also, the issuance by a bank of a letter of credit is viewed as an extension of credit by the bank for purposes of Regulation U. Extensions of credit can occur in a number of other ways, including when a bank honors customer overdrafts used to pay the purchase price of securities purchased by the customer. To the extent that any such extension of credit is used for the purpose of buying or carrying margin stock, then the extension of credit will be considered purpose credit under Regulation U.

The following are some common examples of purpose credit:

  • credit extended to finance an acquisition through a cash merger of the borrower or a subsidiary of the borrower with another company, if at the time the lender commits to extend the credit, the stock of the other company is margin stock;
  • credit extended to finance of a public share buyback or public share redemption, where the corporation plans to hold the shares in treasury;
  • a third-party guarantee of purpose credit (the guarantor is deemed to be lending its credit to the borrower for the purpose of purchasing margin stock);
  • a sale of registered debt securities, via a private placement, the proceeds of which will be used to purchase margin stock; and
  • the sale of securities on an installment payment basis.

Certain extensions of credit can be deemed a purpose credit because of the nature of the business of the borrower. For example, a loan to an investment company that customarily purchases margin stock is presumed to be purpose credit, regardless of the immediate application of the proceeds. Also, the Federal Reserve has determined that credit extended to a borrower whose “business in important part is includes the extending of credit to other persons for the purpose of purchasing or carrying margin stock” can itself be purpose credit unless the proceeds are clearly separated from any purpose credit.

Bond Offerings

The Federal Reserve takes the position that the purchase of debt securities in a public offering is not an “extension of credit” for purposes of the margin regulations. The Federal Reserve regards a Rule 144A offering as being similar, in many ways, to a public offering. The Federal Reserve has therefore applied the same approach to debt securities purchased in a Rule 144A offering.

What Is Non-Purpose Credit?

The Federal Reserve staff has determined that certain types of credit that might otherwise be purpose credit are non-purpose credit, including the following:

  • credit used by an issuer to redeem or repurchase its stock for immediate retirement;
  • credit extended to finance the payment of income taxes related to the purchase of margin stock;
  • credit extended to finance liquidation payments to shareholders; and
  • credit used to finance customer short-sale positions at a broker-dealer.

What Does It Mean to Be Directly or Indirectly Secured?

Regulation U applies only to a purpose credit that is either directly or indirectly secured by margin stock. Direct security consists of the plain-vanilla pledge, lien or security interest that you are used to seeing, regardless of the lender’s priority. Generally, indirect security includes any arrangement that either (a) restricts the borrower’s ability to sell, pledge or dispose of margin stock (for example, a negative pledge, a restriction on asset sales, etc.) or (b) provides the margin lender with the right to accelerate the maturity of the credit.

There are exceptions to what may constitute an indirect security interest, including the following:

  • if, after applying the proceeds of the credit, margin stock represents 25% or less of the value as determined by any reasonable method, of the assets that are subject to the negative pledge or similar arrangement;
  • a lending arrangement that permits the lender to accelerate the maturity of the credit in the event of a default or renegotiation of another credit to the borrower by another lender who is not an affiliate of the lender;
  • the lender holds the margin stock only as a custodian, depositary or third-party trustee, and in good faith has not relied on the margin stock as collateral for extending or maintaining the relevant loan; and
  • the lender, in good faith, has not relied on the margin stock as collateral in extending or maintaining the loan or extension of credit.

What Are the Exemptions from Regulation U?

So far, we have focused on the requirements of Regulation U for situations in which Regulation U applies. However, it is equally important to note when Regulation U does not apply to credit extended by a bank. The requirements of Regulation U do not apply when a bank extends purpose credit:

  • to another bank or a foreign banking institution;
  • to an employee stock option program (ESOP);
  • to a plan lender who finances an ESOP, where the bank has no recourse to the relevant securities;
  • to temporarily finance Delivery Versus Payment (DVP) securities transactions;
  • to meet emergency customer expenses that were not reasonably foreseeable (for example, death of a customer or an extreme hardship); or
  • to a registered broker-dealer where a substantial portion of the broker-dealer’s business is conducted with non-brokers and non-dealers (for example, intra-day loans, loans to assist in the broker-dealer’s market-making and underwriting activities).

Regulation U also does not apply when a bank extends purpose credit outside the United States, that is, the loan is booked on the balance sheet of a foreign office of the bank. However, in order to take advantage of this exemption, all negotiations, execution and disbursement activities related to the relevant extension of credit must be conducted outside the United States.

It is important to note that these exemptions only apply to credit extended by a bank and are not available to nonbank lenders, such as hedge funds.

Do Not Get Regulation U Wrong!

Regulation U is implemented and interpreted by the Federal Reserve but enforced by the SEC. A violation of Regulation U is deemed a violation of the federal securities laws and may subject the lender to penalties, sanctions and enforcement action under the Exchange Act.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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