So far, our series on the Federal Reserve’s margin regulations has focused on Regulation U, which imposes margin lending requirements on lenders. Now let’s turn our attention to Regulation X, which governs the securities credit activities of borrowers.
Regulation X has two principal purposes: (1) it extends the margin requirements of Regulation U and Regulation T to US borrowers (including foreign persons that are controlled by, or are acting on behalf of or in conjunction with, a U. S. borrower) who obtain securities credit outside the United States and (2) it makes a violation of Regulation U or Regulation T by a US lender also a violation of the relevant margin regulation by a US borrower, if the borrower willfully causes the violation by the US lender. Regulation X issues often arise in cross-border deals where a US entity or a foreign subsidiary of a US entity is the borrower and non-US lenders are providing credit.
Which borrowers are covered by Regulation X?
- any United States person, which is defined as a person that is organized or exists under the laws of any State or, in the case of a natural person, a citizen or resident of the United States; a domestic estate; or a trust in which one or more of the foregoing persons has a cumulative direct or indirect beneficial interest in excess of 50% of the value of the trust;
- any foreign person controlled by a United States person, which is defined as any noncorporate entity in which United States persons directly or indirectly have more than a 50% beneficial interest, and any corporation in which one or more United States persons, directly or indirectly, own stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote, or more than 50% of the total value of shares of all classes of stock; and
- any foreign person acting on behalf of or in conjunction with a United States person, which is not defined under Regulation X, but is the subject of interpretive advice by the Federal Reserve. The Federal Reserve takes the position that a foreign person can be considered to be “acting on behalf of or in conjunction with” a United States person when the foreign person is involved in a transaction in which a United States person has a “substantial direct interest” or a “substantial beneficial interest.” On the other hand, the Federal Reserve has also determined that a foreign company that forms a US subsidiary for purposes of acquiring shares of a target company would not be considered to be “acting on behalf of or in conjunction with a United States person” for purposes of Regulation X where the US subsidiary is a “mere vehicle of convenience” for financing the foreign company’s purchase of the target’s stock.
Which borrowers are exempt?
- any borrower who obtains “purpose credit” within the United States, unless the borrower willfully causes the credit to be extended in contravention of Regulation T or Regulation U;
- any borrower whose permanent residence is outside the United States and who does not obtain or have outstanding, during any calendar year, a total of more than $100,000 in purpose credit obtained outside the United States; and
- any borrower exempt from Regulation X by an order of the Federal Reserve.
What is “purpose credit” for purposes of Regulation X?
What constitutes “purpose credit” under Regulation X is different than either Regulation U or Regulation T. However, the practical impact of Regulation X is effectively the same as Regulation U or Regulation T, depending on the type of lender. For purposes of Regulation X, “purpose credit,” includes two types of credit:
- credit obtained outside the United States to purchase or carry United States securities, which are defined as securities (other than exempted securities) issued by a person incorporated under the laws of any State, or whose principal place of business is within a State; or
- credit obtained inside the United States to purchase or carry any securities.
The definition of “United States security” under Regulation X is much broader than the definition of “margin stock” under Regulation U or “margin security” under Regulation T. However, because Regulation X incorporates by reference Regulations T and U (depending on the status and location of the lender), the broader definition of purpose credit in Regulation X does not automatically subject credit extended outside the US to a US borrower to either Regulation U or Regulation T if a “United States security” is involved. To determine whether a particular credit that constitutes “purpose credit” for purposes of Regulation X is subject to regulation, you need to look at the requirements of Regulation U or Regulation T, as outlined below. For example, if a US borrower obtains credit outside the United States from a bank to purchase or carry United States securities that are not margin stock for purposes of Regulation U, the borrower would not be required to conform the credit to the requirements of Regulation U.
Transactions outside the United States
Regulation X provides that no US borrower shall obtain purpose credit from outside the United States unless it conforms to the following margin regulations:
- Regulation T, as it applies to broker-dealers, if the credit is obtained from a foreign branch of a broker-dealer;
- Regulation U, as it applies to banks, if the credit is obtained from a foreign branch of a bank; and
- Regulation U, as it applies to nonbank lenders, if the credit is obtained from any other lender outside the United States.
Regulation X does not apply to credit obtained by wholly foreign borrowers to purchase or carry United States securities. In addition, Regulation X does not apply to credit obtained by any US borrower to purchase or carry a non-United States security (i.e., a security of an issuer organized outside the US whose principal place of business is outside the US).
Transactions within the United States
The other key component of Regulation U provides that any US borrower or non-US related person described above who willfully causes credit to be extended in contravention of Regulation T and Regulation U must conform the credit to the margin regulation that applies to the lender extending such credit. This provision in effect makes a violation of Regulation T or U by a US lender also a violation by the borrower.
Burden on borrower
While Regulations T and U impose requirements on lenders to comply with limitations on securities credit, under Regulation X the borrower has the burden of ensuring that the credit it obtains conforms to Regulation T or Regulation U, as applicable.
Issues for lenders
The requirements of Regulation X are imposed on the borrower instead of the lender. However, the Federal Reserve has cautioned that a foreign lender (including a non-US branch of a US bank) that extends purpose credit outside the United States to a borrower that is subject to Regulation X can in theory be liable for aiding and abetting a borrower’s violation of Regulation X if the credit does not conform to the applicable margin regulations. Federal Reserve guidance suggests that such liability would likely require willful conduct by lender in connection with a borrower’s violation of Regulation X.
Generally speaking, a foreign acquirer of a US target will be deemed to be acting on behalf of or in conjunction with a United States person, and thus, will be subject to Regulation X, if the acquirer plans to have the target company merged into a US subsidiary of the foreign acquirer. Remember, however, that a US company formed as a “mere vehicle of convenience” solely to hold margin stock acquired by the foreign parent with funds borrowed from a foreign lender and affect the financing of its purchase of the target’s stock would not trigger applicability of Regulation X to the foreign parent as a “foreign person acting on behalf of or in conjunction with United States person.”