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Board Interpretations of Regulation U

5-793

ARRANGING

See last paragraph of 12 CFR 221.118 at 5-802.
5-795

BANK AS TRUSTEE

The question has arisen as to whether Regulation U applies to the activities of a bank when it is acting in its capacity as a trustee.
It is the opinion of the Board that Regulation U is applicable in such circumstances. In addition to the fact that this conclusion is indicated by the general purposes of the regulation, it is significant that the definition of “bank” in the regulation makes special reference to institutions “exercising fiduciary powers.” 1946 Fed. Res. Bull. 874.
5-796

BANK AS TRUSTEE—Employees’ Savings Plan

The Board’s advice has been requested on whether a bank’s activities in connection with the administration of an employees’ savings plan are subject to Regulation U.
Under the plan, any regular, full-time employee may participate by authorizing the sponsoring company to deduct a percentage of his salary and wages and transmit the same to the bank as trustee. Voluntary contributions by the company are allocated among the participants. A participant may direct that funds held for him be invested by the trustee in insurance, annuity contracts, Series E Bonds, or in one or more of three specified securities which are listed on a stock exchange. Loans to purchase the stocks may be made to participants from funds of the trust, subject to approval of the administrative committee, which is composed of five participants, and of the trustee. The bank’s right to approve is said to be restricted to the mechanics of making the loan, the purpose being to avoid cumbersome procedures.
Loans are secured by the credit balance of the borrowing participants in the savings fund, including stock, but excluding (in practice) insurance and annuity contracts and government securities. Additional stocks may be, but, in practice, have not been pledged as collateral for loans. Loans are not made, under the plan, from bank funds, and participants do not borrow from the bank upon assignment of the participants’ accounts in the trust.
It is urged that loans under the plan are not subject to Regulation U because a loan should not be considered as having been made by a bank where the bank acts solely in its capacity of trustee, without exercise of any discretion.
The Board reviewed this question upon at least one other occasion, and full consideration has again been given to the matter. After considering the arguments on both sides, the Board has reaffirmed its earlier view that, in conformity with an interpretation not published in the Code of Federal Regulations which was published at page 874 of the 1946 Federal Reserve Bulletin (at 5-795), Regulation U applies to the activities of a bank when it is acting in its capacity as trustee. Although the bank in that case had at best a limited discretion with respect to loans made by it in its capacity as trustee, the Board concluded that this fact did not affect the application of the regulation to such loans. 1960 Fed. Res. Bull. 631; 12 CFR 221.112.
5-797

CARRYING LOAN—Retirement of Debentures

The Board has considered a question as to whether Regulation U applies to a loan to a corporate investment trust on stocks to enable the investment trust to retire certain debenture bonds issued by it prior to the enactment of the Securities Exchange Act of 1934. It was understood that the debentures were originally issued to obtain funds for the usual operations of the investment trust which consist very largely of purchasing and carrying listed stocks.
Since the loan was to retire the debentures of the investment trust, it appeared not to be for the purpose of purchasing stocks registered on a national securities exchange and, therefore, the question was whether the loan was for the purpose of carrying such stocks.
It appeared from the nature of the loan that it was one for the purpose of carrying registered stocks unless some provision of the regulation removed it from that category. In this connection section 3(b) of the regulation provides:
 No loan, however it may be secured, need be treated as a loan for the purpose of “carrying” a stock registered on a national securities exchange unless the purpose of the loan is to enable the borrower to reduce or retire indebtedness which was originally incurred to purchase such a stock, or, if he be a broker or dealer, to carry such stocks for customers.
It will be seen that section 3(b) was intended to exempt from the regulation loans which might otherwise be considered to be for the purpose of “carrying” registered stocks merely because they happen to be secured by such stocks. This was to afford banks more certainty in their operations under the regulation.
It was the view of the Board that the debentures in question constituted indebtedness within the meaning of section 3(b) and that the purpose of the loan must be considered to be the retirement of these debentures rather than merely their purchase. It also was felt that in connection with matters of this kind the present status of the stocks should be considered and that, therefore, since the stocks in question had become registered after the passage of the act, the debentures should be considered to be indebtedness originally incurred for the purchase of registered stocks within the meaning of section 3(b). Furthermore, the reference in the section to brokers and dealers indicates that the section was not intended to exempt loans which are closely connected with trading in registered stocks and emphasizes the fact that loans of the type under consideration do not come within the general purposes of the exemption contained in the section.
In view of these facts, the Board expressed the opinion that the loan in question was subject to the provisions of Regulation U. 1937 Fed. Res. Bull. 717.
Now covered by section 221.2 of Regulation U (as revised 1998).
5-797.5

CREDIT TO BROKER-DEALER—Repeal of Certain Restrictions

See 5-473.
5-798.2

DATE OF COMMITMENT—Funds Dispersed After Commitment

The Board has concluded that the date a commitment to extend credit becomes binding should be regarded as the date when the credit is extended, since—
  • on that date the parties should be aware of law and facts surrounding the transaction; and
  • generally, the date of contract is controlling for purposes of margin regulations and federal securities law, regardless of the delivery of cash or securities.
12 CFR 221.102.
5-798.5

EMPLOYEE STOCK OPTION/OWNERSHIP PLANS—Financing of Stock Options and Stock-Purchase Rights Qualified or Restricted Under Internal Revenue Code

The Board has been asked whether the plan-lender provisions of section 221.4(a) and (b) were intended to apply to the financing of stock options restricted or qualified under the Internal Revenue Code where such options or the option plan do not provide for such financing.
It is the Board’s experience that in some nonqualified plans, particularly stock purchase plans, the credit arrangement is distinct from the plan. So long as the credit extended, and, particularly, the character of the plan lender, conforms with the requirements of the regulation, the fact that option and credit are provided for in separate documents is immaterial. It should be emphasized that the Board does not express any view on the preferability of qualified as opposed to nonqualified options; its role is merely to prevent excessive credit in this area.
Section 221.4(a) provides that a plan lender may include a wholly owned subsidiary of the issuer of the collateral (taking as a whole, corporate groups including subsidiaries and affiliates). This clarifies the Board’s intent that, to qualify for special treatment under that section, the lender must stand in a special employer-employee relationship with the borrower, and a special relationship of issuer with regard to the collateral. The fact that the Board, for convenience and practical reasons, permitted the employing corporation to act through a subsidiary or other entity should not be interpreted to mean the Board intended the lender to be other than an entity whose overriding interests were coextensive with the issuer. An independent corporation with independent interests was never intended, regardless of form, to be at the base of exempt stock-plan lending. 1969 Fed. Res. Bull. 891; 12 CFR 221.119.
5-798.51

EMPLOYEE STOCK OPTION/OWNERSHIP PLANS—Extension of Credit In

Questions have been raised as to whether certain stock option and stock purchase plans involve extensions of credit subject to this part when the participant is free to cancel his participation at any time prior to full payment, but in the event of cancellation the participant remains liable for damages. It thus appears that the participant has the opportunity to gain and bears the risk of loss from the time the transaction is executed and payment is deferred. In some cases brought to the Board’s attention damages are related to the market price of the stock, but in others, there may be no such relationship. In either of these circumstances, it is the Board’s view that such plans involve extensions of credit. Accordingly, where the security being purchased is a margin security and the credit is secured, directly or indirectly, by any margin security, the creditor must register and the credit must conform with either the regular margin requirements of section 221.3(a) or the special “plan-lender” provisions set forth in section 221.4, whichever is applicable. This assumes, of course, that the amount of credit extended is such that the creditor is subject to the registration requirements of section 221.3(b). 1975 Fed. Res. Bull. 33; 12 CFR 221.121.
5-798.52

EMPLOYEE STOCK OPTION/OWNERSHIP PLANS—Combined Credit for Exercising Options and Paying Resulting Income Taxes

Section 221.4(a) and (b), which provides special treatment for credit extended under employee stock option plans, was designed to encourage their use in recognition of their value in giving an employee a proprietary interest in the business. Taking a position that might discourage the exercise of options because of tax complications would conflict with the purpose of section 22l.4(a) and (b).
Accordingly, the Board has concluded that the combined loans for the exercise of the option and the payment of the taxes in connection therewith under plans complying with section 221.4(a)(2) may be regarded as purpose credit within the meaning of section 221.2. 12 CFR 221.123; 1980 Fed. Res. Bull. 573.
5-799

EXEMPT LOANS—Distribution of Securities

Neither of the following loans is a loan to aid in the financing of the distribution of securities within the meaning of the term “distribution” as used in the exception contained in section 2(c) of the regulation: (1) A loan to a dealer who, for the purpose of “making a market” in a stock registered on a national securities exchange, purchases such stock for his own account on the exchange or “over the counter” from or through members of a national securities exchange or brokers or dealers who transact a business through the medium of such members and who also sells the stock for his own account on the exchange but more often “over the counter” to his customers or other persons, where such loan to the dealer is secured by such stock and is for the purpose of enabling him to purchase the stock and carry it pending its sale; or (2) a loan to a dealer who is a member of a national securities exchange and whose business consists in part of purchasing on the exchange stocks registered thereon and of selling them on a cash basis to his customers or other persons “over the counter” where the purpose of the loan is to enable the dealer to purchase such stocks and to carry them pending their sale. Digest of 1936 Fed. Res. Bull. 549.
The National Securities Markets Improvement Act of 1996 changed the statutory exemption for loans “to aid in the financing of the distribution of securities” to an exemption for loans to finance a broker-dealer’s “activities as . . . an underwriter.” Section 221.5(c)(7) of Regulation U was revised in 1998 to reflect the statutory language.
5-800

EXEMPT LOANS—Temporary Advance

A dealer agrees with a customer to purchase a registered stock and deliver it promptly to the customer, and the customer agrees to pay therefor promptly upon delivery. The dealer purchases the security, instructing the seller to deliver it to a designated bank against payment. The bank, knowing the facts and understanding that it will be repaid by the dealer as soon as he can arrange for his customer to take delivery of and pay for the stock, makes a loan to the dealer for the purpose of paying the seller of the stock. Such a loan is excepted from Regulation U under the provisions of section 2(f) thereof, which excepts any temporary advance to finance the purchase or sale of securities for prompt delivery which is to be repaid in the ordinary course of business upon completion of the transaction. Digest of 1936 Fed. Res. Bull. 549.
Now covered by section 221.5(c)(2) of Regulation U (as revised 1998).
5-801

EXEMPT LOANS—Temporary Advance

In a case recently considered by the Board under Regulation U, a bank made a temporary advance to finance a broker’s or dealer’s purchase of certain shares of a preferred stock which was registered on a national securities exchange and had been called for retirement. The bank, acting for the broker or dealer, took up the stocks, paid for them, and delivered them to the issuer for retirement.
The question presented was whether an advance made for the broker or dealer by the bank in taking up the securities was covered by section 2(f) of the regulation, which exempts “[a]ny temporary advance to finance the purchase or sale of securities for prompt delivery which is to be repaid in the ordinary course of business upon completion of the transaction.”
The Board expressed the view that if the call for retirement had already been issued when the securities were purchased, and in addition the securities were promptly delivered to the issuer for such retirement, a temporary advance of the type described would come within the exemption. On the other hand, if the stocks had not been called for retirement when they were purchased, or if they were not promptly delivered to the issuer for retirement, the exemption would not apply, unless, of course, the transaction qualified as an ordinary cash purchase under the conditions described in section 2(f).
It is to be noted that in connection with the exemption mentioned, just as at other points in the regulation, it is necessary to distinguish between the purpose of a loan and the collateral for a loan. The exception in section 2(f) relates to purpose. Thus it exempts loans of the type described, but does not increase the loan value to which securities of the type described are entitled when they are collateral for a loan that is subject to the regulation. 1938 Fed. Res. Bull. 834.
Now covered by section 221.5(c)(2) of Regulation U (as revised 1998).
5-802

GUARANTY—Bank Arranging for Extension of Credit by Corporation

The Board considered the questions whether—
  • 1.
    the guaranty by a corporation of an “unsecured” bank loan to exercise an option to purchase stock of the corporation is an “extension of credit” for the purpose of Regulation U;
  • 2.
    such a guaranty is given “in the ordinary course of business” of the corporation, as defined in section 221.2; and
  • 3.
    the bank involved took part in arranging for such credit on better terms than it could extend under the provisions of Regulation U.
The Board understood that any officer or employee included under the corporation’s stock option plan who wished to exercise his option could obtain a loan for the purchase price of the stock by executing an unsecured note to the bank. The corporation would issue to the bank a guaranty of the loan and hold the purchased shares as collateral to secure it against loss on the guaranty. Stock of the corporation is registered on a national securities exchange and therefore qualifies as “margin stock” under Regulation U.
A nonbank lender is subject to the registration and other requirements of the regulation if, in the ordinary course of his business, he extends credit on collateral that includes any margin stock in the amount of $200,000 or more in any calendar quarter, or has such credit outstanding in any calendar quarter in the amount of $500,000 or more. The Board understood that the corporation in question had sufficient guaranties outstanding during the applicable calendar quarter to meet the dollar thresholds for registration.
In the Board’s judgment a person who guarantees a loan, and thereby becomes liable for the amount of the loan in the event the borrower should default, is lending his credit to the borrower. In the circumstances described, such a lending of credit must be considered an “extension of credit” under the regulation in order to prevent circumvention of the regulation’s limitation on the amount of credit that can be extended on the security of margin stock.
Under section 221.2, the term “in the ordinary course of business” means “occurring or reasonably expected to occur in carrying out or furthering any business purpose.” In general, stock option plans are designed to provide a company’s employees with a proprietary interest in the company in the form of ownership of the company’s stock. Such plans increase the company’s ability to attract and retain able personnel and, accordingly, promote the interest of the company and its stockholders, while at the same time providing the company’s employees with additional incentive to work toward the company’s future success. An arrangement whereby participating employees may finance the exercise of their options through an unsecured bank loan guaranteed by the company, thereby facilitiating the employees’ acquisition of company stock, is likewise designed to promote the company’s interest and is, therefore, in furtherance of a business purpose.
For the reasons indicated, the Board concluded that under the circumstances described a guaranty by the corporation constitutes credit extended in the ordinary course of business under the regulation, that the corporation is required to register pursuant to section 221.3(b), and that such guaranties may not be given in excess of the maximum loan value of the collateral pledged to secure the guaranty.
Section 221.3(a)(3) provides that “no lender may arrange for the extension or maintenance of any purpose credit, except upon the same terms and conditions on which the lender itself may extend or maintain purpose credit under this part.” Since the Board concluded that the giving of a guaranty by the corporation to secure the loan described above constitutes an extension of credit, and since the use of a guaranty in the manner described could not be effectuated without the concurrence of the bank involved, the Board further concluded that the bank took part in “arranging” for the extension of credit in excess of the maximum loan value of the margin stock pledged to secure the guaranties. 1969 Fed. Res. Bull. 441; 12 CFR 221.118.
5-803

INDIRECTLY SECURED

Regulation U governs “any purpose credit” extended by a lender “secured directly or indirectly by margin stock” and defines “purpose credit” as “any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock,” with certain exceptions, and provides that the maximum loan value of such margin stock shall be a fixed percentage “of its current market value.”
The Board of Governors has had occasion to consider the application of this language to the two following questions:
Loans Secured by Stock
First, is a loan to purchase or carry margin stock subject to Regulation U where made in unsecured form, if stock is subsequently deposited as security with the lender, and surrounding circumstances indicate that the parties originally contemplated that the loan should be so secured? The Board answered that in a case of this kind, the loan would be subject to the regulation, for the following reasons.
The Board has long held, in the closely related “purpose” area, that the original purpose of a loan should not be determined upon a narrow analysis of the technical circumstances under which a loan is made. Instead, the fundamental purpose of the loan is considered to be controlling. Indeed, “the fact that a loan made on the borrower’s signature only, for example, becomes secured by registered stock shortly after the disbursement of the loan” affords reasonable grounds for questioning whether the bank was entitled to rely upon the borrower’s statement as to the purpose of the loan (1953 Fed. Res. Bull. 951 at 5-823).
Where security is involved, standards of interpretation should be equally searching. If, for example, the original agreement between borrower and lender contemplated that the loan should be secured by margin stock, and such stock is in fact delivered to the bank when available, the transaction must be regarded as fundamentally a secured loan. This view is strengthened by the fact that the regulation applies to a loan “secured directly or indirectly by any stock.” * * * 1959 Fed. Res. Bull. 256; 12 CFR 221.110.
For discussion of second question see 5-815.
5-804

INDIRECTLY SECURED

A question has been presented to the Board as to whether a loan by a bank to a mutual investment fund is “secured . . . indirectly by margin stock” within the meaning of section 221.3(a), of Regulation U, so that the loan should be treated as subject to the regulation.
Briefly, the facts are as follows. Fund X, an open-end investment company, entered into a loan agreement with Bank Y, which was (and still is) custodian of the securities which constitute the portfolio of Fund X. The agreement includes the following terms, which are material to the question before the Board:
  • 1.
    Fund X agrees to have an “asset coverage” (as defined in the agreements) of 400 percent of all its borrowings, including the proposed borrowing, at the time when it takes down any part of the loan.
  • 2.
    Fund X agrees to maintain an “asset coverage” of at least 300 percent of its borrowings at all times.
  • 3.
    Fund X agrees not to amend its custody agreement with Bank Y, or to substitute another custodian without Bank Y’s consent.
  • 4.
    Fund X agrees not to mortgage, pledge, or otherwise encumber any of its assets elsewhere than with Bank Y.
In section 221.109 (at 5-814), the Board stated that because of “the general nature and operations of such a company,” any “loan by a bank to an open-end investment company that customarily purchases margin stock . . . should be presumed to be subject to Regulation U as a loan for the purpose of purchasing or carrying margin stock” (purpose credit). The Board’s interpretation went on to say that “this would not be altered by the fact that the open-end company had used, or proposed to use, its own funds or proceeds of the loan to redeem some of its own shares. . . .”
Accordingly, the loan by Bank Y to Fund X was and is a “purpose credit.” However, a loan by a bank is not subject to Regulation U unless (1) it is a purpose credit and (2) it is “secured directly or indirectly by margin stock.” In the present case, the loan is not “secured directly” by stock in the ordinary sense, since the portfolio of Fund X is not pledged to secure the credit from Bank Y. But the word “indirectly” must signify some form of security arrangement other than the “direct” security which arises from the ordinary “transaction that gives recourse against a particular chattel or land or against a third party on an obligation” described in the American Law Institute’s Restatement of the Law of Security, page 1. Otherwise the word “indirectly” would be superfluous, and a regulation, like a statute, must be construed if possible to give meaning to every word.
The Board has indicated its view that any arrangement under which margin stock is more readily available as security to the lending bank than to other creditors of the borrower may amount to indirect security within the meaning of Regulation U. In an interpretation published at section 221.110 (at 5-803) it stated:
 The Board has long held, in the . . . ‘purpose’ area, that the original purpose of a loan should not be determined upon a narrow analysis of the technical circumstances under which a loan is made. . . .  Where security is involved, standards of interpretation should be equally searching.
In its pamphlet issued for the benefit and guidance of banks and bank examiners, entitled “Questions and Answers Illustrating Application of Regulation U,” the Board said:
 In determining whether a loan is “indirectly” secured, it should be borne in mind that the reason the Board has thus far refrained . . . from regulating loans not secured by stock has been to simplify operations under the regulation. This objective of simplifying operations does not apply to loans in which arrangements are made to retain the substance of stock collateral while sacrificing only the form.
A wide variety of arrangements as to collateral can be made between bank and borrower which will serve, to some extent, to protect the interest of the bank in seeing that the loan is repaid, without giving the bank a conventional direct “security” interest in the collateral. Among such arrangements which have come to the Board’s attention are the following:
  • 1.
    The borrower may deposit stock in the custody of the bank. An arrangement of this kind may not, it is true, place the bank in the position of a secured creditor in case of bankruptcy, or even of conflicting claims, but it is likely effectively to strengthen the bank’s position. The definition of “indirectly secured” in section 221.2, which provides that a loan is not indirectly secured if 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,” does not exempt a deposit of this kind from the impact of the regulation unless it is clear that the bank “has not relied” upon the margin stock deposited with it.
  • 2.
    A borrower may not deposit his margin stock with the bank, but agree not to pledge or encumber his assets elsewhere while the loan is outstanding. Such an agreement may be difficult to police, yet it serves to some extent to protect the interest of the bank if only because the future credit standing and business reputation of the borrower will depend upon his keeping his word. If the assets covered by such an agreement include margin stock, then the credit is “indirect security” by the margin stock within the meaning of Regulation U.
  • 3.
    The borrower may deposit stock with a third party who agrees to hold the stock until the loan has been paid off. Here, even though the parties may purport to provide that the stock is not “security” for the loan (for example, by agreeing that the stock may not be sold and the proceeds applied to the debt if the borrower fails to pay), the mere fact that the stock is out of the borrower’s control for the duration of the loan serves to some extent to protect the bank.
The three instances described above are merely illustrative. Other methods, or combinations of methods, may serve a similar purpose. The conclusion that any given arrangement makes a credit “indirectly secured” by margin stock may, but need not, be reinforced by facts such as that the stock in question was purchased with proceeds of the loan, that the lender suggests or insists upon the arrangement, or that the loan would probably be subject to criticism by supervisory authorities were it not for the protective arrangement.
Accordingly, the Board concludes that the loan by Bank Y to Fund X is indirectly secured by the portfolio of the fund and must be treated by the bank as a regulated loan. 1961 Fed. Res. Bull. 657; 12 CFR 221.113.
The questions and answers referred to in this interpretation were removed when the regulation was revised in 1983.
5-805

INDIRECTLY SECURED—Good Faith Nonreliance

The Board has received questions regarding the circumstances in which an extension or maintenance of credit will not be deemed to be “indirectly secured” by stock as indicated by the phrase, “if the bank in good faith has not relied upon such stock as collateral,” contained in paragraph (2)(iv) of the definition of “indirectly secured” in section 221.2.
In response, the Board noted that in amending this portion of the regulation in 1968 it was indicated that one of the purposes of the change was to make clear that the definition of “indirectly secured” does not apply to certain routine negative covenants in loan agreements. Also, while the question of whether or not a bank has relied upon particular stock as collateral is necessarily a question of fact to be determined in each case in the light of all relevant circumstances, some indication that the bank had not relied upon stock as collateral would seem to be afforded by such circumstances as the fact that (1) the bank had obtained a reasonably current financial statement of the borrower and this statement could reasonably support the loan and (2) the loan was not payable on demand or because of fluctuations in market value of the stock, but instead was payable on one or more fixed maturities which were typical of maturities applied by the bank to loans otherwise similar except for not involving any possible question of stock collateral. 1968 Fed. Res. Bull. 439; 12 CFR 221.117.
5-805.1

INDIRECTLY SECURED—Debt Securities Issued to Finance Corporate Takeovers

Petitions have been filed with the Board raising questions as to whether the margin requirements in Regulation U apply to two types of corporate acquisitions in which debt securities are issued to finance the acquisition of margin stock of a target company.
In the first situation, the acquiring company, Company A, controls a shell corporation that would make a tender offer for the stock of Company B, which is margin stock (as defined in section 221.2). The shell corporation has virtually no operations, has no significant business function other than to acquire and hold the stock of Company B, and has substantially no assets other than the margin stock to be acquired. To finance the tender offer, the shell corporation would issue debt securities which, by their terms, would be unsecured. If the tender offer is successful, the shell corporation would seek to merge with Company B. However, the tender offer seeks to acquire fewer shares of Company B than is necessary under state law to effect a short-form merger with Company B, which could be consummated without the approval of shareholders or the board of directors of Company B.
The purchase of the debt securities issued by the shell corporation to finance the acquisition clearly involves “purpose credit” (as defined in section 221.2). In addition, such debt securities would be purchased only by sophisticated investors in very large minimum denominations, so that the purchasers may be lenders for purposes of Regulation U (see section 221.3(b)). Since the debt securities contain no direct security agreement involving the margin stock, applicability of the lending restrictions of the regulation turns on whether the arrangement constitutes an extension of credit that is secured indirectly by margin stock.
As the Board has recognized, indirect security can encompass a wide variety of arrangements between lenders and borrowers with respect to margin-stock collateral that serve to protect the lenders’ interest in assuring that a credit is repaid where the lenders do not have a conventional direct security interest in the collateral (see section 221.113, at 5-804). However, credit is not indirectly secured by margin stock if the lender in good faith has not relied on the margin stock as collateral in extending or maintaining credit (see section 221.2).
The Board is of the view that, in the situation described in the second paragraph above, the debt securities would be presumed to be indirectly secured by the margin stock to be acquired by the shell acquisition vehicle. The staff has previously expressed the view that nominally unsecured credit extended to an investment company, a substantial portion of whose assets consist of margin stock, is indirectly secured by the margin stock (see 5-917.12). This opinion notes that the investment company has substantially no assets other than margin stock to support indebtedness and thus credit could not be extended to such a company in good faith without reliance on the margin stock as collateral.
The Board believes that this rationale applies to the debt securities issued by the shell corporation described above. At the time the debt securities are issued, the shell corporation has substantially no assets to support the credit other than the margin stock that it has acquired or intends to acquire and has no significant business function other than to hold the stock of the target company in order to facilitate the acquisition. Moreover, it is possible that the shell may hold the margin stock for a significant and indefinite period of time, if defensive measures by the target prevent consummation of the acquisition. Because of the difficulty in predicting the outcome of a contested takeover at the time that credit is committed to the shell corporation, the Board believes that the purchasers of the debt securities could not, in good faith, lend without reliance on the margin stock as collateral. The presumption that the debt securities are indirectly secured by margin stock would not apply if there is specific evidence that lenders could in good faith rely on assets other than margin stock as collateral, such as a guaranty of the debt securities by the shell corporation’s parent company or another company that has substantial non-margin-stock assets or cash flow. This presumption would also not apply if there is a merger agreement between the acquiring and target companies entered into at the time the commitment is made to purchase the debt securities or in any event before loan funds are advanced. In addition, the presumption would not apply if the obligation of the purchasers of the debt securities to advance funds to the shell corporation is contingent on the shell’s acquisition of the minimum number of shares necessary under applicable state law to effect a merger between the acquiring and target companies without the approval of either the shareholders or directors of the target company. In these two situations where the merger will take place promptly, the Board believes the lenders could reasonably be presumed to be relying on the assets of the target for repayment.
In addition, the Board is of the view that the debt securities described in the second paragraph above are indirectly secured by margin stock because there is a practical restriction on the ability of the shell corporation to dispose of the margin stock of the target company. “Indirectly secured” is defined in section 221.2 to include any arrangement 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. The purchasers of the debt securities issued by a shell corporation to finance a takeover attempt clearly understand that the shell corporation intends to acquire the margin stock of the target company in order to effect the acquisition of that company. This understanding represents a practical restriction on the ability of the shell corporation to dispose of the target’s margin stock and to acquire other assets with the proceeds of the credit.
In the second situation, Company C, an operating company with substantial assets or cash flow, seeks to acquire Company D, which is significantly larger than Company C. Company C establishes a shell corporation that together with Company C makes a tender offer for the shares of Company D, which is margin stock. To finance the tender offer, the shell corporation would obtain a bank loan that complies with the margin lending restrictions of Regulation U and Company C would issue debt securities that would not be directly secured by any margin stock. The Board is of the opinion that these debt securities should not be presumed to be indirectly secured by the margin stock of Company D, since, as an operating business, Company C has substantial assets or cash flow without regard to the margin stock of Company D. Any presumption would not be appropriate because the purchasers of the debt securities may be relying on assets other than margin stock of Company D for repayment of the credit. 1986 Fed. Res. Bull. 195; 12 CFR 221.124.
5-805.5

INSURANCE PREMIUM FUNDING—Credit in Connection With

The Board has been asked numerous questions regarding purpose credit in connection with insurance premium funding programs. The inquiries are included in a set of guidelines in the format of questions and answers. (The guidelines are available pursuant to the Board’s Rules Regarding Availability of Information, 12 CFR 261.) A glossary of terms customarily used in connection with insurance premium funding credit activities is included in the guidelines. Under a typical insurance premium funding program, a borrower acquires mutual fund shares for cash, or takes fund shares which he already owns, and then uses the loan value (currently 50 percent as set by the Board) to buy insurance. Usually, a funding company (the issuer) will sell both the fund shares and the insurance through either independent broker/dealers or subsidiaries or affiliates of the issuer. A typical plan may run for 10 or 15 years with annual insurance premiums due. To illustrate, assuming an annual insurance premium of $300, the participant is required to put up mutual fund shares equivalent to 250 percent of the premium or $600 ($600 × 50 percent loan value equals $300 the amount of the insurance premium which is also the amount of the credit extended).
The guidelines referenced above also—
  • clarify an earlier 1969 Board interpretation to show that the public offering price of mutual fund shares (which includes the front load, or sales commission) may be used as a measure of their current market value when the shares serve as collateral on a purpose credit throughout the day of the purchase of the fund shares; and
  • relax a 1965 Board position in connection with accepting purpose statements by mail.
It is the Board’s view that when it is clearly established that a purpose statement supports a purpose credit then such statement executed by the borrower may be accepted by mail, provided it is received and also executed by the lender before the credit is extended. 1974 Fed. Res. Bull. 224; 12 CFR 221.122.
The questions and answers referred to in this interpretation were removed when the regulation was revised in 1983.
5-806

LOAN VALUE—Maximum

Section 1 of Regulation U provides in part that for the purposes of that regulation the maximum loan value of stocks shall be as specified in the supplement to the regulation and the maximum loan value of any collateral other than stocks shall be “as determined by the bank in good faith.”
This means, in effect, that for such purposes the maximum loan value of collateral other than stocks should be the amount which the bank would customarily lend on such collateral if that were the only collateral for the loan. Consequently, a bank may not determine that such other collateral, as for example a bond, has a maximum loan value equal to its current market value unless the bank would customarily lend such amount on the collateral without any additional collateral.
It is believed that the regulation is clear on this point, but since it has developed that there may have been some confusion regarding the matter, it has seemed desirable to publish the foregoing to remove any misunderstanding that may have existed in this connection. 1938 Fed. Res. Bull. 1042.
5-807

PURPOSE AND NONPURPOSE CREDIT TO SAME CUSTOMER

A bank proposes to extend two credits (Credits A and B) to its customer. Although the two credits are proposed to be extended at the same time, each would be evidenced by a separate agreement. Credit A would be extended for the purpose of providing the customer with working capital (nonpurpose credit), collateralized by margin stock. Credit B would be extended for the purpose of purchasing or carrying margin stock (purpose credit), without collateral or on collateral other than stock.
Regulation U allows a bank to extend purpose and nonpurpose credits simultaneously or successively to the same customer. This rule is expressed in section 221.3(d)(4), which provides in substance that for any nonpurpose credit to the same customer, the lender shall in good faith require as much collateral not already identified to the customer’s purpose credit as the bank would require if it held neither the purpose loan nor the identified collateral. This rule in section 221.3(d)(4) also takes into account that the lender would not necessarily be required to hold collateral for the nonpurpose credit if, consistent with good faith banking practices, it would normally make this kind of nonpurpose loan without collateral.
The Board views section 221.3(d)(4), when read in conjunction with section 221.3(c) and (f), as requiring that whenever a bank extends two credits to the same customer, one a purpose credit and the other nonpurpose, any margin stock collateral must first be identified with and attributed to the purpose loan by taking into account the maximum loan value of such collateral as prescribed in section 221.7 (the supplement).
The Board is further of the opinion that under the foregoing circumstances Credit B would be indirectly secured by stock, despite the fact that there would be separate loan agreements for both credits. This conclusion flows from the circumstance that the lender would hold in its possession stock collateral to which it would have access with respect to Credit B, despite any ostensible allocation of such collateral to Credit A. 1972 Fed. Res. Bull. 47; 12 CFR 221.120.
5-808

PURPOSE CREDIT—To Purchase Registered and Unregistered Stock

A loan, secured by stock, is made to a securities dealer and the proceeds of the loan, while not to be immediately employed, are kept available for use in acquiring registered or unregistered securities. The securities purchased are often unregistered securities, but some registered stocks are purchased by the dealer. In view of the business of the borrower as a dealer, it appears that one purpose of the loan is to purchase or carry registered stocks and accordingly, while the loan might also have certain other purposes, it should be considered to be a loan for the purpose of purchasing or carrying registered stock within the meaning of Regulation U. Digest of 1937 Fed. Res. Bull. 392.
5-810

PURPOSE CREDIT—Present Status of Stock Controls

The regulation is applicable, with certain exceptions, to any loan initially made for the purpose of purchasing or carrying a stock “registered on a national securities exchange” and the phrase quoted has reference to the present status of the stock. Accordingly, a loan for the purpose of purchasing or carrying a particular stock is for the purpose of purchasing or carrying a registered stock if that particular stock is now registered; and this is true even if the stock were not registered at the time the loan was originally made, as would be the case, for example, if the loan had been made prior to the enactment of the Securities Exchange Act of 1934. 1937 Fed. Res. Bull. 995.
5-811

PURPOSE CREDIT—Present Status of Stock Controls

The Board recently considered the question whether a loan is subject to Regulation U if made to purchase a stock and the stock was registered on a national securities exchange at the time the loan was made but has since become unregistered.
The ruling published at page 995 of the October 1937 Federal Reserve Bulletin (at 5-810) dealt with the converse situation in which a stock had become registered after the loan was made. That ruling stated that the question whether the loan there involved was a loan for the purpose of purchasing or carrying a stock “registered on a national securities exchange” should be determined on the basis of the present status of the stock.
The Board expressed the view that, at least under the existing regulation, the instant question should also be determined on the basis of the present status of the stock. Accordingly, in the circumstances described, the loan would not be subject to the regulation, although it was subject to the regulation at the time it was made and withdrawals and substitutions of collateral were also subject to the regulation until the stock became unregistered. 1938 Fed. Res. Bull. 90.
5-813

PURPOSE CREDIT—Registration of Stock After Making of Loan

The Board recently was asked whether a loan by a bank to enable the borrower to purchase a newly issued nonmargin stock during the initial over-the-counter trading period prior to the stock becoming registered (listed) on a national securities exchange would be subject to Regulation U. The Board replied that, until such stock qualifies as margin stock, the regulation would not be applicable to such a loan.
The Board now has been asked what the position of the lending bank would be under the regulation if, after the date on which the stock should become registered, such bank continued to hold a loan of the kind just described. It is assumed that the loan was in an amount greater than the maximum loan value for the collateral specified in the regulation.
If the stock should become registered, the loan would then be for the purpose of purchasing or carrying a margin stock, and, if secured directly or indirectly by any margin stock, would be subject to the regulation as from the date the stock was registered. Under the regulation, this does not mean that the bank would have to obtain reduction of the loan in order to reduce it to an amount no more than the specified maximum loan value. It does mean, however, that so long as the loan balance exceeded the specified maximum loan value, the bank could not permit any withdrawals or substitutions of collateral that would increase such excess; nor could the bank increase the amount of the loan balance unless there was provided additional collateral having a maximum loan value at least equal to the amount of the increase. In other words, as from the date the stock should become a margin stock, the loan would be subject to the regulation in exactly the same way, for example, as a loan subject to the regulation that became undermargined because of a decline in the current market value of the loan collateral or because of a decrease by the Board in the maximum loan value of the loan collateral. 1956 Fed. Res. Bull. 117; 12 CFR 221.108.
5-814

PURPOSE CREDIT—To Open-End Investment Company

In response to a question regarding a possible loan by a bank to an open-end investment company that customarily purchases stocks registered on a national securities exchange, the Board stated that in view of the general nature and operations of such a company, any loan by a bank to such a company should be presumed to be subject to Regulation U as a loan for the purpose of purchasing or carrying margin stock. This would not be altered by the fact that the open-end company had used, or proposed to use, its own funds or proceeds of the loan to redeem some of its own shares, since mere application of the proceeds of a loan to some other use cannot prevent the ultimate purpose of a loan from being to purchase or carry registered stocks. 1958 Fed. Res. Bull. 1279; 12 CFR 221.109.
5-815

PURPOSE CREDIT—Acquisition Financing

Regulation U governs “any purpose credit” extended by a lender “secured directly or indirectly by margin stock” and defines “purpose credit” as “any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock,” with certain exceptions, and provides that the maximum loan value of such margin stock shall be a fixed percentage “of its current market value.”
The Board of Governors has had occasion to consider the application of this language to the following two questions:
*     *     *     *     *
Loan to Acquire Controlling Shares
The second question is whether the regulation governs a margin stock-secured loan made for the business purpose of purchasing a controlling interest in a corporation, or whether such a loan would be exempt on the ground that the regulation is directed solely toward purchases of stock for speculative or investment purposes. The Board answered that a margin stock-secured loan for the purpose of purchasing or carrying margin stock is subject to the regulation, regardless of the reason for which the purchase is made.
The answer is required, in the Board’s view, since the language of the regulation is explicitly inclusive, covering “any purpose credit, secured directly or indirectly by margin stock.” Moreover, the withdrawal in 1945 of the original section 2(e) of the regulation, which exempted “any loan for the purpose of purchasing a stock from or through a person who is not a member of a national securities exchange” plainly implies that transactions of the sort described are now subject to the general prohibition of section 221.3(a).
*     *     *     *     *
1959 Fed. Res. Bull. 256; 12 CFR 221.110.
For discussion of first question see 5-803.
5-817

PURPOSE CREDIT—To Purchase Stock Under Employees’ Stock Plan

The Board of Governors interpreted Regulation U in connection with proposed loans by a bank to persons who are purchasing shares of stock of American Telephone and Telegraph Company pursuant to its employees’ stock plan.
According to the current offering under the plan, an employee of the AT &T system may purchase shares through regular deductions from his pay over a period of 24 months. At the end of that period, a certificate for the appropriate number of shares will be issued to the participating employee by AT&T. Each employee is entitled to purchase, as a maximum, shares that will cost him approximately three-fourths of his annual base pay. Since the program extends over two years, it follows that the payroll deductions for this purpose may be in the neighborhood of 38 percent of base pay and a larger percentage of “take-home pay.” Deductions of this magnitude are in excess of the saving rate of many employees.
Certain AT&T employees, who wish to take advantage of the current offering under the plan, are the owners of shares of AT&T stock that they purchased under previous offerings. A bank proposed to receive such stock as collateral for a “living-expenses” loan that will be advanced to the employee in monthly instalments over the 24-month period, each instalment being in the amount of the employee’s monthly payroll deduction under the plan. The aggregate amount of the advances over the 24-month period would be substantially greater than the maximum loan value of the collateral as prescribed in section 221.7 (the supplement).
In the opinion of the Board of Governors, a loan of the kind described would violate Regulation U if it exceeded the maximum loan value of the collateral. The regulation applies to any margin stock-secured loan for the purpose of purchasing or carrying margin (section 221.3(a)). Although the proposed loan would purport to be for living expenses, it seems quite clear, in view of the relationship of the loan to the employees’ stock plan, that its actual purpose would be to enable the borrower to purchase AT&T stock, which is margin stock. At the end of the 24-month period the borrower would acquire a certain number of shares of that stock and would be indebted to the lending bank in an amount approximately equal to the amount he would pay for such shares. In these circumstances, the loan by the bank must be regarded as a loan “for the purpose of purchasing” the stock, and therefore it is subject to the limitations prescribed by Regulation U. This conclusion follows from the provisions of the regulation, and it may also be observed that a contrary conclusion could largely defeat the basic purpose of the margin regulations.
Accordingly, the Board concluded that a loan of the kind described may not be made in an amount exceeding the maximum loan value of the collateral, as prescribed by the current section 221.7 (supplement). 1962 Fed. Res. Bull. 690; 12 CFR 221.114.
5-818

PURPOSE CREDIT—To Replenish Working Capital Used to Purchase Mutual Fund Shares

In a situation considered by the Board of Governors, a business concern (X) proposed to purchase mutual fund shares, from time to time, with proceeds from its accounts receivable, then pledge the shares with a bank in order to secure working capital. The bank was prepared to lend amounts equal to 70 percent of the current value of the shares as they were purchased by X. If the loans were subject to Regulation U, only 50 percent of the current market value of the shares could be lent.
The immediate purpose of the loans would be to replenish X’s working capital. However, as time went on, X would be acquiring mutual fund shares at a cost that would exceed the net earnings it would normally have accumulated, and would become indebted to the lending bank in an amount approximating 70 percent of the price of said shares.
The Board held that the loans were for the purpose of purchasing the shares, and therefore subject to the limitations prescribed by Regulation U. As pointed out in section 221.114 (at 5-817) with respect to a similar program for putting a high proportion of cash income into stock, then borrowing against the stock to meet needs for which the cash would otherwise have been required, a contrary conclusion could largely defeat the basic purpose of the margin regulations.
Also considered was an alternative proposal under which X would deposit proceeds from accounts receivable in a time account for one year, before using those funds to purchase mutual fund shares. The Board held that this procedure would not change the situation in any significant way. Once the arrangement was established, the proceeds would be flowing into the time account at the same time that similar amounts were released to purchase the shares, and over any extended period of time the result would be the same. Accordingly, the Board concluded that bank loans made under the alternative proposal would similarly be subject to Regulation U. 1967 Fed. Res. Bull. 964; 12 CFR 221.116.
5-819

PURPOSE CREDIT—Disproportionate Capital Contribution to Joint Venture

The Board recently considered the question whether a joint venture, structured so that the amount of capital contribution to the venture would be disproportionate to the right of participation in profits or losses, constitutes an “extension of credit” for the purpose of Regulation U.
An individual and a corporation plan to establish a joint venture to engage in the business of buying and selling securities, including margin stock. The individual would contribute 20 percent of the capital and receive 80 percent of the profits or losses; the corporate share would be the reverse. In computing profits or losses, each participant would first receive interest at the rate of 8 percent on his respective capital contribution. Although purchases and sales would be mutually agreed upon, the corporation could liquidate the joint portfolio if the individual’s share of the losses equaled or exceeded his 20 percent contribution to the venture. The corporation would hold the securities, and upon termination of the venture, the assets would first be applied to repayment of capital contributions.
In general, the relationship of joint venture is created when two or more persons combine their money, property, or time in the conduct of some particular line of trade or some particular business and agree to share jointly, or in proportion to capital contributed, the profits and losses of the undertaking.
The incidents of the joint venture described above, however, closely parallel those of an extension of margin credit, with the corporation as lender and the individual as borrower. The corporation supplies 80 percent of the purchase price of securities in exchange for a net return of 8 percent of the amount advanced plus 20 percent of any gain. Like a lender of securities credit, the corporation is insulated against loss by retaining the right to liquidate the collateral before the securities decline in price below the amount of its contribution. Conversely, the individual—like a customer who borrows to purchase securities—puts up only 20 percent of their cost, is entitled to the principal portion of any appreciation in their value, bears the principal risk of loss should that value decline, and does not stand to gain or lose except through a change in value of the securities purchased.
The Board is of the opinion that where the right of an individual to share in profits and losses of such a joint venture is disproportionate to his contribution to the venture—
  • the joint venture involves an extension of credit by the corporation to the individual;
  • the extension of credit is to purchase or carry margin stock, and is collateralized by such margin stock; and
  • if the corporation is not a broker or dealer subject to Regulation T, the credit is of the kind described by section 221.3(a).
1969 Fed. Res. Bull. 548; 12 CFR 221.111.
5-819.1

PURPOSE CREDIT—Applicability to Lenders in Public Offerings of Debt Securities

The following text is from the January 15, 1986 Federal Register notice of the adoption of the Board interpretation at 5-805.1 (51 Fed. Reg. 1,771).
The proposed interpretation stated that for purposes of this interpretation, there is no distinction between privately placed and publicly distributed debt securities. Thus, under the proposed interpretation, a person who purchases a sufficient amount of debt securities of the kind described in the interpretation to qualify as a lender under Regulation G would be regarded as subject to the margin lending restrictions, regardless of whether the debt securities were purchased in a public offering or in a private placement.
Several commentators state that if debt securities that are issued in public offerings are viewed as purpose credit that is subject to the margin lending restrictions, then serious operational problems would result in assuring compliance with those rules. For example, purchasers of publicly issued debt securities in the secondary market may not have access to the disclosure statements required by the securities laws and thus may not be aware that the proceeds of the debt securities were used to purchase margin stock and that the securities would be subject to the margin rules. Questions have also been raised about the consistency of the proposal in this area with past Board practice.
This provision in the proposed interpretation was intended at least in part to address the kind of normal public offering of debt securities involved in the Pantry Pride/Revlon transaction [described earlier in this Federal Register notice], in which acquiring firms registered the debt securities with the SEC as a public offering, but sold the securities in minimum amounts of $2.5 million, so that the sale in actual practice resembled a private placement. Although the staff has stated that publicly offered debt securities are not subject to the margin regulations, the staff opinions assumed bona fide public offerings for the purposes of applying the margin requirements.
The Board believes that in this case questions of whether purchasers of publicly issued debt securities should be treated as lenders for purposes of the margin rules are best dealt with in the context of a formal amendment to the provisions of Regulation G, since such an action would not involve an interpretation of words used in the existing provisions of Regulation G. Accordingly, the Board is not adopting [the final] paragraph of the proposed interpretation at this time and, with the caveat noted above, staff opinions may continue to be relied on.
51 Fed. Reg. 1,771 (1986), adopting 12 CFR 207.112 (revised 1998; now 12 CFR 221.124).
As of April 1, 1998, all lenders other than brokers and dealers are subject to Regulation U.
5-820

PURPOSE STATEMENT—Basis for

Under section 3(a) of the regulation, the statement signed by an officer upon which a bank may rely in determining whether or not a loan is for the purpose specified in section 1, or for any of the purposes specified in section 2, may be based not only on statements or representations made to such officer by the prospective borrower but also upon any other information which the officer has obtained from any source. Digest of 1936 Fed. Res. Bull. 421.
Now covered by section 221.3(c) of Regulation U (as revised 1998).
5-821

PURPOSE STATEMENT—Determination and Effect of Purpose

Under Regulation U the original purpose of a loan is controlling. In other words, if a loan originally is not for the purpose of purchasing or carrying margin stock, changes in the collateral for the loan do not change its exempted character.
However, a so-called increase in the loan is necessarily on an entirely different basis. So far as the purpose of the credit is concerned, it is a new loan, and the question of whether or not it is subject to the regulation must be determined accordingly.
Certain facts should also be mentioned regarding the determination of the purpose of a loan. Section 221.3(c) provides in that whenever a lender is required to have its customer execute a “Statement of Purpose for an Extension of Credit Secured by Margin Stock,” the statement must be accepted by the lender “acting in good faith.” The requirement of “good faith” is of vital importance here. Its application will necessarily vary with the facts of the particular case, but it is clear that the bank must be alert to the circumstances surrounding the loan. For example, if the loan is to be made to a customer who is not a broker or dealer in securities, but such a broker or dealer is to deliver margin stock to secure the loan or is to receive the proceeds of the loan, the bank would be put on notice that the loan would probably be subject to the regulation. It could not accept in good faith a statement to the contrary without obtaining a reliable and satisfactory explanation of the situation.
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. 1947 Fed. Res. Bull. 27; 12 CFR 221.101.
5-822

PURPOSE STATEMENT—Loans to Brokers or Dealers

Questions have arisen as to the adequacy of statements received by lending banks under section 221.3(c), “Purpose Credit,” in the case of loans to brokers or dealers secured by margin stock where the proceeds of the loans are to be used to finance customer transactions involving the purchasing or carrying of margin stock. While some such loans may qualify for exemption under sections 221.1(b)(2), 221.4, 221.5, or 221.6, unless they do qualify for such an exemption they are subject to the regulation. For example, if a loan so secured is made to a broker to furnish cash working capital for the conduct of his brokerage business (i.e., for purchasing and carrying securities for the account of customers), the maximum loan value prescribed in section 221.7 (the supplement) would be applicable unless the loan should be of a kind exempted under Regulation U. This result would not be affected by the fact that the stock given as security for the loan was or included stock owned by the brokerage firm.
In view of the foregoing, the statement referred to in section 221.3(c) which the lending bank must accept in good faith in determining the purpose of the loan would be inadequate if the form of statement accepted or used by the bank failed to call for answers which would indicate whether or not the loan was of the kind discussed elsewhere in this interpretation. 1952 Fed. Res. Bull. 30; 12 CFR 221.103.
5-823

PURPOSE STATEMENT—Good Faith Reliance on

Certain situations have arisen from time to time under Regulation U wherein it appeared doubtful that, in the circumstances, the lending banks may have been entitled to rely upon the statements accepted by them in determining whether the purposes of certain loans were such as to cause the loans to be not subject to the regulation.
The use by a lending bank of a statement in determining the purpose of a particular loan is, of course, provided for by section 221.3(c). However, under that paragraph a lending bank may accept such statement only if it is “acting in good faith.” As the Board stated in the interpretation contained in section 221.101 (at 5-821), the “requirement of ‘good faith’ is of vital importance;” and, to fulfill such requirement, “it is clear that the bank must be alert to the circumstances surrounding the loan.”
Obviously, such a statement would not be accepted by the bank in “good faith” if at the time the loan was made the bank had knowledge, from any source, of facts or circumstances which were contrary to the natural purport of the statement, or which were sufficient reasonably to put the bank on notice of the questionable reliability or completeness of the statement.
Furthermore, the same requirement of “good faith” is to be applied whether the statement accepted by the bank is signed by the borrower or by an officer of the bank. In either case, “good faith” requires the exercise of special diligence in any instance in which the borrower is not personally known to the bank or to the officer who processes the loan.
The interpretation set forth in section 221.101 contains an example of the application of the “good faith” test. There it was stated that “if the loan is to be made to a customer who is not a broker or dealer in securities, but such a broker or dealer is to deliver margin stock to secure the loan or is to receive the proceeds of the loan, the bank would be put on notice that the loan would probably be subject to the regulation. It could not accept in good faith a statement to the contrary without obtaining a reliable and satisfactory explanation of the situation.”
Moreover, and as also stated by the interpretation contained in section 221.101, the purpose of a loan, of course, “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 registered stocks, the loan is clearly for the purpose of purchasing or carrying margin stock.” The purpose of a loan, therefore, should not be determined upon a narrow analysis of the immediate use to which the proceeds of the loan are put. Accordingly, a bank acting in “good faith” should carefully scrutinize cases in which there is any indication that the borrower is concealing the true purpose of the loan, and there would be reason for special vigilance if margin stock is substituted for bonds or nonmargin stock soon after the loan is made, or on more than one occasion.
Similarly, the fact that a loan made on the borrower’s signature only, for example, becomes secured by margin stock shortly after the disbursement of the loan usually would afford reasonable grounds for questioning the bank’s apparent reliance upon merely a statement that the purpose of the loan was not to purchase or carry margin stock.
The examples in this section are, of course, by no means exhaustive. They simply illustrate the fundamental fact that no statement accepted by a lender is of any value for the purposes of the regulation unless the lender accepting the statement is “acting in good faith,” and that “good faith” requires, among other things, reasonable diligence to learn the truth. 1953 Fed. Res. Bull. 951; 12 CFR 221.106.
Now covered by sections 221.2 and 221.3(c) of Regulation U (as revised 1998).
5-824

PURPOSE STATEMENT—Acceptance of Without Face-to-Face Interview

The Board has been asked whether the acceptance of a purpose statement submitted through the mail by a lender subject to the provisions of Regulation U will meet the good faith requirement of section 221.3(c). Section 221.3(c) states that in connection with any credit secured by collateral which includes any margin stock, a nonbank lender must obtain a purpose statement executed by the borrower and accepted by the lender in good faith. Such acceptance requires that the lender be alert to the circumstances surrounding the credit and if further information suggests inquiry, he must investigate and be satisfied that the statement is truthful.
The lender is a subsidiary of a holding company which also has another subsidiary which serves as underwriter and investment advisor to various mutual funds. The sole business of the lender will be to make “nonpurpose” consumer loans to shareholders of the mutual funds, such loans to be collateralized by the fund shares. Most mutual fund shares are margin stock for purposes of Regulation U. Solicitation and acceptance of these consumer loans will be done principally through the mail, and the lender wishes to obtain the required purpose statement by mail rather than by a face-to-face interview. Personal interviews are not practicable for the lender because shareholders of the funds are scattered throughout the country. In order to provide the same safeguards inherent in face-to-face interviews, the lender has developed certain procedures designed to satisfy the good faith acceptance requirement of the regulation.
The purpose statement will be supplemented with several additional questions relevant to the prospective borrower’s investment activities such as purchases of any security within the last six months, dollar amount, and obligations to purchase or pay for previous purchases; present plans to purchase securities in the near future, participations in securities purchase plans, list of unpaid debts, and present income level. Some questions have been modified to facilitate understanding, but no questions have been deleted. If additional inquiry is indicated by the answers on the form, a loan officer of the lender will interview the borrower by telephone to make sure the loan is “nonpurpose”. Whenever the loan exceeds the “maximum loan value” of the collateral for a regulated loan, a telephone interview will be done as a matter of course.
One of the stated purposes of Regulation X was to prevent the infusion of unregulated credit into the securities markets by borrowers falsely certifying the purpose of a loan. The Board is of the view that the existence of Regulation X, which makes the borrower liable for willful violations of the margin regulations, will allow a lender subject to Regulation U to meet the good faith acceptance requirement of section 221.3(c) without a face-to-face interview if the lender adopts a program, such as the one described above, which requires additional detailed information from the borrower and proper procedures are instituted to verify the truth of the information received. Lenders intending to embark on a similar program should discuss proposed plans with their district Federal Reserve Bank. Lenders may have existing or future loans with the prospective customers which could complicate the efforts to determine the true purpose of the loan. 1978 Fed. Res. Bull. 567; 12 CFR 221.115.
5-825

SINGLE-CREDIT RULE

Inquiries have been received as to the effect of Regulation U in two situations: (1) an unsecured loan for the purpose of purchasing registered stock is outstanding and the customer wishes to obtain an additional loan for the same purpose which is to be secured by stocks; (2) a loan for the purpose of purchasing registered stocks and secured by stocks is outstanding and the customer wishes to obtain an additional loan for the same purpose which is not to be secured by stocks. None of the loans are exceptions as described in section 2.
In the first case, the bank must obtain, at the time the additional loan is made, collateral having loan value at least equal to the amount of the additional loan. No collateral is required to be provided at the time for the unsecured loan, but thereafter withdrawals and substitutions of collateral will be governed by the status of the entire indebtedness, both secured and unsecured, as related to the collateral for the secured loan.
In the second case, the bank may not make the unsecured loan, but, unless excess collateral is held for the outstanding loan, must obtain, at the time the additional loan is made, collateral having loan value at least equal to the amount of the additional loan. Thereafter, withdrawals and substitutions of collateral will be governed by the status of the entire indebtedness, including both the new and the old loan, as related to the collateral for both loans.
These results follow from the language of the second paragraph of section 1 which provides that the entire indebtedness for the purpose of purchasing or carrying registered stocks shall be considered a single loan and all collateral securing such indebtedness shall be considered together in determining compliance with the regulation. It is accordingly of no consequence that a portion of the indebtedness is technically unsecured if there is a portion which is secured by stocks. Furthermore, the results do not depend upon the existence of a “general pledge agreement” by which all collateral and property of the borrower in the possession of the bank is subject to the lien of every loan to the borrower. Consequently, the rules are applicable even where there is no such agreement. 1945 Fed. Res. Bull. 1198.
Now covered by section 221.3(d) of Regulation U (as revised 1998).
5-826

TRANSFER OF CREDIT

The provisions of section 3(e) of Regulation U permitting a bank to accept the transfer of a loan from another bank without compliance with the regulation, apply only to a loan which is transferred by the process of payment by the transferee bank to the transferor bank against the receipt of the proper collateral. Accordingly, a transaction by which a bank makes a loan to a customer to enable him to reduce or retire existing indebtedness at another bank or to replace funds which the borrower has used to reduce or retire indebtedness at another bank does not come within the provisions of this section of the regulation. Digest of 1937 Fed. Res. Bull. 715.
Now covered by section 221.3(i) of Regulation U (as revised 1998).
5-827

TRANSFER OF CREDIT—Aggregate Indebtedness and Collateral

Where indebtedness was incurred on or after May 1, 1936, for the purpose of purchasing or carrying stocks registered on a national securities exchange and where such indebtedness was not excepted from Regulation U, a bank may accept the transfer of the aggregate of the indebtedness accompanied by the aggregate collateral, although the transferor bank may have treated certain portions of the indebtedness as separate loans for certain purposes. Moreover, if a portion of the aggregate indebtedness is transferred to a bank and the transferred portion is accompanied by a corresponding portion of the collateral so that the ratio of the part of the indebtedness transferred to the part of the collateral transferred is the same as that of the aggregate indebtedness to the aggregate collateral, it may properly be considered that the “collateral for the loan is not changed” and the transferee bank may accept such a transfer in accordance with section 3(e) of the regulation. Digest of 1937 Fed. Res. Bull. 715.
Now covered by section 221.3(i) of Regulation U (as revised 1998).
5-828

TRANSFER OF CREDIT—Method of Determining Facts

No specific method of determining whether or not the conditions necessary for a transfer of a loan pursuant to section 3(e) are being followed is required. The requirement is that the bank act diligently and in entire good faith, and in doing this it may utilize various methods of ascertaining the facts in particular cases. As one method of determining the facts, the transferee bank acting in good faith would be justified in relying upon a signed statement of the borrower or the transferor bank. Digest of 1937 Fed. Res. Bull. 716.
Now covered by section 221.3(i) of Regulation U (as revised 1998).
5-829

TRANSFER OF CREDIT—Partial Transfer

The Board has been requested to rule whether a loan already outstanding under Regulation U may be divided up so that there will be two or more separate borrowers (and loans) instead of the original one. The sum total of indebtedness and collateral would not be changed, and the “subdivided” loans might all continue to be held by the original lending bank, or one or more of them might be transferred to other banks.
Amendment No. 5 to Regulation U, which became effective July 16, 1945, vitally affects this question, as that amendment changed section 1 of the regulation, particularly with regard to withdrawals. It limited many activities in a loan—including transactions which a bank would effect if permitted a borrower to transfer part of a loan to another borrower.
The effect of these restrictions is more readily apparent if we consider a simple case. The original borrower has a $30,000 loan secured by 1,000 shares with a total market value of $50,000. He wishes to sell 500 shares ($25,000 market value) and to transfer the shares, with $15,000 of indebtedness, to the purchaser. He would retain the rest of the loan and collateral for himself.
It is evident that there would be a withdrawal of collateral having a $25,000 market value and a reduction of only $15,000 in the loan. This would clearly violate the present requirement that in such a case the loan be “reduced by an amount equal to the current market value of the collateral withdrawn.” Section 3(e), dealing with the transfer of “a loan,” should not be construed to permit such a partial transfer that would vitiate one of the keystones of the regulation.
The result would be similar if the bank arranged a combination of transfers. These might be arranged so that all transfers would be made at once and the original borrower would step out of the picture at the same time. However, this would not change the fundamental fact that forbidden withdrawals would occur.
In other words, it is the view of the Board that the present withdrawal restrictions in effect prohibit the transfer of a part of a loan between borrowers, or any dividing up of a loan which has such an effect.
The ruling in the 1937 Federal Reserve Bulletin, page 715, was specifically limited to questions that “affect the transferee bank.” It did not consider the question of transfers between borrowers, and it would in any event be superseded, to the extent inconsistent, by later changes in the regulation. 1946 Fed. Res. Bull. 613.
Transfer of credit is now covered by section 221.3(i) of Regulation U (as revised 1998).
5-830

VALUATION—Current Market Value

Where a bank makes an agreement with an out-of-town customer to lend a certain amount of money on a registered stock, the amount being 45 percent of its then market value, and where the borrower delivers the stock and the note as promptly as possible on the next day, but the market value of the stock has become lower in the interval so that the amount the bank has agreed to lend is in excess of 45 percent, nevertheless, the market value of the stock for the purpose of completing the loan may properly be determined as of the time when the bank and the customer agreed upon the amount and terms of the loan. However, any clearly foreseeable change in the stock during the interval, such as a split-up of shares, or the stock selling “ex” a dividend of any kind, should be taken into account in such a determination. Digest of 1937 Fed. Res. Bull. 294.
The 45 percent loan value referred to in this interpretation has been changed several times since the date of the interpretation.
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