Margin Call: Advanced Topics and Practice Points

by Latham & Watkins LLP

In previous installments, we covered the basics of the margin regulations. In our final two installments, we’ll cover a few practice points and explore some of the more complex margin issues (particularly under Regulation U), that frequently arise in the context of financing transactions.

A Few Regulation U Practice Points

Purpose Statements: Regulation U requires a bank that is extending credit (regardless of the purpose of the credit) to obtain a purpose statement from a customer on Federal Reserve Form FR U-1, if the credit is in excess of $100,000 and is secured directly or indirectly by margin stock. A nonbank lender that is subject to registration under Regulation U is required to obtain a purpose statement from the customer on Form FR G-3 when it extends credit in any amount that is secured directly or indirectly by margin stock. In both cases, the customer must describe the purpose of the credit on the relevant form of purpose statement. If the credit is purpose credit (i.e., to purchase or carry margin stock), the lender must list all collateral securing the credit on the form. It is important to remember that it is the presence of margin stock as collateral, not the use of proceeds, which triggers the requirement for a purpose statement.

Purpose statements must be signed by the borrower or its authorized representative and accepted by the lender or its duly authorized representative “in good faith.” Form FR U-1 and Form FR G-3 purpose statements are not filed with the Federal Reserve or any other agency. Lenders are required to retain the purpose statements for three years after the credit is extinguished.

Representations and Warranties: Credit agreements and other lending documents often contain representations and warranties from the borrower about US margin regulation issues. These provisions will often contain, at a minimum, a representation that the proceeds of the credit will not be used to purchase or carry margin stock. That representation does not obviate the need for the lender to obtain a purpose statement on Form FR U-1 or Form FR G-3. Often lenders will also require a borrower to represent that the borrower is not engaged principally, or as one of its important activities, in the business of extending credit for the purpose of purchasing or carrying margin stock. Based on Federal Reserve interpretations, credit extended to any borrower engaged in such business can itself be deemed purpose credit. Finally, in transactions where the borrower is providing a negative pledge over some or all of its assets or similar arrangement, lenders will typically seek a representation by the borrower that margin stock makes up 25% or less of the assets subject to the lenders’ negative pledge or similar arrangement. The purpose of this representation is to attempt to ensure that, if possible, the negative pledge or similar arrangement will fall under the exemption from the definition of indirectly secured.

Status of the Stock Matters: Whether a credit that is extended to purchase or carry an equity security constitutes purpose credit depends on the status of the stock at the time a commitment to extend the credit is entered into. If the proceeds of a loan are used to purchase nonmargin securities and those securities subsequently become margin securities (i.e., because of a listing of the stock), the loan is considered to be purpose credit after that point. In that case, the lender is not required to reduce the amount of the loan or require additional collateral if the loan exceeds Regulation U’s 50% maximum loan-to-value ratio except when the borrower seeks to withdraw or substitute collateral. Conversely, if the proceeds of a loan are used to purchase margin stock and the stock subsequently ceases to be a margin stock (i.e., through delisting of the stock), the credit ceases to be purpose credit and is no longer subject to the requirements of Regulation U.

Maintaining Credit: Regulation U provides that, if a lender extends a purpose credit that was initially extended in compliance with Regulation U’s 50% maximum loan-to-value ratio (as determined by the market price of the margin stock collateral on the date that the lender enters into a legally binding commitment to extend credit), the lender will not be required to request additional collateral or reduce the amount of credit if the value of the margin stock collateral subsequently declines as a result of a drop in the market price of the margin stock collateral.

Is This Thing Margin Stock or Not?

Questions commonly arise as to whether a particular kind of instrument is margin stock. We previously took a look at the definition of margin stock and found that it includes, among other things, publicly traded stock and certain OTC securities. The types of instruments that frequently raise questions include the following:

  • OTC “Pink Sheets”: Securities quoted in the OTC pink sheets are not margin stock.
  • OTC Bulletin Board: Securities quoted in the OTC bulletin board (OTCBB) are not margin stock.
  • Foreign Securities and ADRs: A listing on a non-US securities exchange does not cause a security to be margin stock, but a foreign-listed security will be margin stock if it is also listed on a US exchange. Exchange-listed ADRs are margin stock, and foreign securities underlying such ADRs are also margin stock because they are also technically listed on the exchange in connection with the registration of the ADRs under SEC requirements. ADRs quoted in OTC pink sheets or OTCBB are not margin stock.
  • Convertible Equity: While debt securities that are convertible into margin stock are included in the definition of margin stock, equity securities convertible into margin stock are not considered margin stock. However, the Federal Reserve has taken the position that credit extended to purchase such convertible equity securities is purpose credit even though the securities are not margin stock.

Common Issues in Acquisition Finance Transactions

The “Junk Bond” Interpretation: The Federal Reserve’s 1986 interpretation on shell corporations (commonly known as the “junk bond interpretation”) is generally considered to be one of the more controversial Regulation U interpretations. The Federal Reserve determined that, where a lender extends credit to a shell company for the purposes of a tender offer for margin stock of a target, by purchasing unsecured debt securities of the shell company in a private offering when the shell company has no other operating business or other assets to support the repayment of the debt securities, the debt securities issued by the shell company will be considered “purpose credit” and such credit will be presumed to be “indirectly secured” by the target’s margin stock acquired by the shell company. Accordingly, the debt securities would be subject to the requirements of Regulation U, including the prohibition on lending more than 50% of the value of the target’s margin stock. The Federal Reserve interpretation is based on the view that, practically speaking, a lender can only extend credit to the shell company by relying on the margin stock as collateral for the loan, since the shell company has no assets other than the margin stock to support its indebtedness to the lender.

There are three circumstances under which a shell corporation’s unsecured debt securities will not be presumed to be indirectly secured by margin stock under the 1986 junk bond interpretation:

  • the debt securities are guaranteed by the issuer’s parent or another company with substantial nonmargin stock assets or cash flow;
  • a merger agreement has been entered into between the shell corporation and the target at the time the commitment is made to purchase the debt securities or in any event before funds are advanced; or
  • the obligations of the purchasers of debt securities to advance funds are contingent on the shell corporation’s acquisition of the minimum number of shares necessary to effect a merger without the approval of either the shareholders or the directors of the target.

There are a couple of additional points to remember about the junk bond interpretation. First, the presumption of indirect security will not apply in the case of a bona fide public offering or Rule 144A offering of the shell company’s debt securities. The Federal Reserve takes the view that purchases of debt securities in a public offering or in a Rule 144A offering do not constitute extensions of credit for margin regulation purposes.

Also, the junk bond interpretation is not applicable if there are any covenants or other arrangements relating to the shell corporation’s debt securities that limit the shell corporation’s ability to sell, pledge or otherwise dispose of the target’s margin stock or that make such sale, pledge or other disposition a cause for acceleration of the debt securities. In that case, the credit would be indirectly secured for Regulation U purposes as a result of such covenants or arrangements, so the presumption of indirect security under the junk bond interpretation would not be relevant.

Other Acquisition-Related Issues: The margin regulations have historically been applied to mergers, acquisitions and other business combination transactions. For example, credit extended to finance the acquisition by a borrower of a controlling block of shares of an issuer that are margin stock is considered purpose credit for purposes of Regulation U. This is the case whether the shares are purchased through a privately negotiated purchase from a substantial holder, in the open market, by a tender offer to public investors, or through some combination of the above. Also, credit extended to finance an acquisition through a cash merger of the borrower or a subsidiary of the borrower with another company is considered purpose credit if, at the time the lender commits to make the loan, the stock of the other company is margin stock. If the stock is subsequently either delisted or extinguished through the merger, the loan will cease to be purpose credit.

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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