Margin Stock and Purpose Credit Basics, Plus Two Tips

Purpose credit (sometimes referred to as margin credit or margin lending) refers to loans made to purchase or carry certain securities (margin stock) that is secured by such stock allowing the borrower to leverage their investments. This practice poses risks, as it can lead to substantial financial losses if the value of the securities declines. After the stock market crash in 1929, Congress in 1934 included as Section 7 of the Securities Exchange Act of 1934 (34 Act) restrictions related to such lending. The limits apply to banks, nonbank lenders, brokers and dealers, and other persons. Section 7 of the 34 Act granted the Board of Governors of the Federal Reserve (FRB) rulemaking authority, and the FRB subsequently issued regulations. Today, Regulation T (12 C.F.R. Part 221) establishes strict guidelines for bank and nonbank (persons other than brokers or dealers) lenders related to purpose credit.

Bankers are familiar with this topic, but from time to time it is good to go back to the basics to understand banks’ obligations related to purpose credit. Like all regulations, there are often interpretations issued that tease out additional considerations. This article provides a high-level summary of the basics plus two interpretations to keep in mind in your day-to-day lending to avoid violations of the regulation.

Important Definitions

Margin Stock

• The definition of “margin stock” is important to understand because if margin stock is not related to the loan, that ends any analysis. The FRB summarizes the definition of margin stock as “any equity security registered on a national securities exchange, such as the New York Stock Exchange or the American Stock Exchange; any over-the-counter (OTC) security trading in the Nasdaq Stock Market’s National Market; any debt security convertible into a margin stock; and most mutual funds.”

Indirectly secured

• The definition of “indirectly secured” is important to understand because the general prohibition under Regulation T is extending purpose credit “secured directly or indirectly” by margin stock in an amount that exceeds an established maximum loan-to-value ratio (currently 50%). Directly secured is more obvious. Indirectly secured is defined as:
  • Any arrangement with the customer under which:
    • The customer’s right or ability to sell, pledge, or otherwise dispose of margin stock owned by the customer is in any way restricted while the credit remains outstanding; or
    • The exercise of such right is or may be cause for accelerating the maturity of the credit.
  • But does not include such an arrangement if:
    • After applying the proceeds of the credit, not more than 25 percent of the value (as determined by any reasonable method) of the assets subject to the arrangement is represented by margin stock;
    • It is a lending arrangement that permits accelerating the maturity of the credit as a result of a default or renegotiation of another credit to the customer by another lender that is not an affiliate of the lender;
    • The lender holds the margin stock only in the capacity of custodian, depositary, or trustee, or under similar circumstances, and, in good faith, has not relied upon the margin stock as collateral; or
    • The lender, in good faith, has not relied upon the margin stock as collateral in extending or maintaining the particular credit.

Carrying

• The definition of “carrying” is important because the general prohibition relates to purpose credit which “is any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock.” You will most likely know if a borrower is using the loan to buy margin stock, but carrying may be less obvious. “Carrying credit” is credit that enables a customer to maintain, reduce, or retire indebtedness originally incurred to purchase a security that is currently a margin stock.

Tips

There are many nuances to learn related to purpose credit, and not understanding all of them can result in a violation of law or regulation, and potentially fines or penalties. A short summary cannot cover all of them but two of the most common follow.

First, a borrower’s purpose is its intention. Do not limit the intention to the first use of the proceeds. As indicated above, the purpose covers immediate, incidental, or the ultimate use of the proceeds. In one paragraph of one of its interpretations, the FRB provides this example:

• Furthermore, the purpose of a loan means just that. It cannot be altered by some temporary application of the proceeds. For example, if a borrower is to purchase Government securities with the proceeds of a loan, but is soon thereafter to sell such securities and replace them with margin stock, the loan is clearly for the purpose of purchasing or carrying margin stock.

The banker cannot stick its head in the sand on this either. In its definition of “good faith,” the FRB includes that accepting a borrower statement requires the lender to understand “the circumstances” related to the loan, and if the banker has possession of information that would prevent a “prudent person” from determining or accepting the borrower’s notice or certification without inquiry, the lender needs to make the inquiry to determine whether the notice or certification is accurate.

The second tip relates to nonmargin stock becoming margin stock subsequent to the loan being made. The FRB has indicated in that case that the loan subsequently should be considered purpose credit. The FRB recognized in coming to its conclusion that it would be difficult to reevaluate and change the loan amount, etc. at the subsequent date the stock became margin stock. The FRB does require the bank to be aware of the loan balance and the value of the stock as of the date it was registered along with the resulting maximum loan to value as of that date. The bank may find that it has to require more collateral or otherwise prohibit withdrawals of substitutions of collateral as a result. This is explained in one of the FRB’s interpretations found at 12 C.F.R. § 221.108.

In summary, Regulation T serves a vital function in regulating margin credit. Understanding the basic definitions and the main rule of the regulation provide a good base for the banker to identify whether potential purpose credit is involved. Once known, the lender can consult the regulations, interpretation, and other guidance issued by the FRB, or reach out to a trusted expert who can provide quick and clear guidance related to the transaction.