Because the vast majority of “margin calls” you are likely to get will arise under Regulation U in the context of a financing transaction by a bank (or in some cases, a non-bank lender), the ability to identify margin regulation issues in financing transactions requires a familiarity with the fundamental building blocks of Regulation U.
As noted in our last installment, Regulation U prohibits a bank or a non-bank lender from extending “purpose credit” that is “directly or indirectly secured” by “margin stock” in an amount that exceeds the “maximum loan value” of the collateral securing the credit. These four key terms form the core of Regulation U, so let’s examine each of these concepts in a bit more detail:
The first level of analysis in determining whether a financing transaction might have Regulation U issues is to determine whether the transaction involves any “margin stock.” Under Regulation U, “margin stock” includes the following:
- any publicly traded equity security;1
- any OTC security that has been designated for trading in the NASDAQ national market system;
- any debt security convertible into margin stock or carrying a warrant or right to subscribe to or purchase a margin stock;
- any warrant or right to subscribe to or purchase a margin stock; or
- any security issued by an investment company registered under the Investment Company Act of 1940 (subject to certain exceptions).
“Purpose credit” is any credit extended for the purpose (whether immediate, incidental, or ultimate) of purchasing or carrying margin stock. Usually it is fairly easy to determine whether the direct use of proceeds of an extension of credit is to purchase margin stock. Even then, the existence of purpose credit is not affected by the temporary use of the proceeds if the proceeds are ultimately intended to be used to acquire margin stock. For example, if a customer invests the proceeds of a loan in government securities or some other form of non-margin stock with the intention of shortly thereafter selling those non-margin securities and acquiring margin stock, the credit is deemed to be purpose credit under Regulation U from the time the credit is initially extended. The intention of the borrower at the time the loan was extended plays a critical role in determining whether an extension of credit is in fact purpose credit. If the proceeds of an extension of credit are used by a borrower to retire, reduce or maintain a prior loan that was used to acquire margin stock, then that subsequent loan will be considered purpose credit, as it is being used by the borrower to “carry” margin stock. In later installments, we’ll explore some of the trickier issues in identifying purpose credit, including in the context of M&A transactions and other business combinations.
Directly or Indirectly Secured
Determining whether an extension of credit is directly secured by margin stock is pretty easy. For purposes of Regulation U, the concept of “direct” security encompasses any legally recognizable security interest enforceable between the lender and the borrower. However, the concept of “indirect” security under Regulation U is much more elusive. By definition, the term “indirectly secured” includes any arrangement with the borrower under which:
- the borrower’s right or ability to sell, pledge or otherwise dispose of margin stock owned by the borrower is in any way restricted while the loan or extension of credit remains outstanding; or
- the exercise of such right by the borrower is or may be cause for accelerating the maturity of the credit.
The most commonly encountered form of indirect security is a negative pledge provision in a credit facility. When a borrower provides a negative pledge over its assets and the borrower’s assets include margin stock, the negative pledge creates an indirect security over the margin stock that is subject to the pledge. There are a number of arrangements that are expressly excluded from the definition of “indirectly secured.” For example, if a borrower is subject to a negative pledge arrangement and, after applying the proceeds of the loan, margin stock represents 25% or less of the value of the borrower’s assets that are subject to the negative pledge, then the negative pledge will not constitute indirect security over the borrower’s margin stock. Determining whether indirect security exists has been perhaps the primary area of interpretation addressed by the Federal Reserve since the adoption of Regulation U. As we look at the nuances of the concept of “indirect security” (particularly in the acquisition finance context) in subsequent installments, you’ll see why.
Maximum Loan Value
“Maximum loan value” is the maximum allowable percentage of current market value of various forms of collateral assigned by the Federal Reserve. A margin loan may not exceed 50% of the value of the margin stock securing the loan. The maximum loan value of any margin stock is determined as of the time the lender enters into a legally binding commitment to extend credit (not at the time the credit is actually disbursed), and it is generally determined by the closing price of the security on the preceding business day. Except for options that qualify as margin stock, puts, calls and combinations thereof have no loan value.
The maximum loan value of non-margin stock and all other collateral (except puts, calls and combinations thereof) is their good faith loan value.