Understanding Regulation U

Purpose

Regulation U was adopted for the purpose of preventing an excessive amount of margin stock secured credit being obtained for the purpose of purchase or carrying of securities. By limiting this type of credit, the margin regulations are intended to, among other things, moderate the amount of

Credit going into the securities markets in order free up credit for other aspects of the economy and
Potential disruptions in the securities markets due to margin loans.

Regulation U

Governs credits extended by the HSC secured directly or indirectly by “margin stock”.
The advance limits apply when extending “purpose credit”.
These rules applies regardless of the jurisdiction of the borrower.

Note: “Margin Stock” is defined further in this publication

The general purpose of these rules is to manage extensions of credit (loans”) by HSC that are:

Made “for the purpose, whether immediate, incidental or ultimately, of buying or carrying margin stock” (“purpose loans” or a “purpose credit); and
Secured directly or indirectly by margin stock.

Credit Extension Limitations

To the extent a credit governed by Rules is both:

purpose credit; and
secured by margin stock.

Then the credit extended (i.e., the amount of the loan) may not exceed the “maximum loan value” of the margin stock and the non-margin stock assets securing the credit.

Maximum Loan Values

The “maximum loan value” of margin stock is currently set at 50% of the margin stock’s “current market value.”
The maximum loan value of all other collateral is its “good faith” loan value.

Note: puts, calls and options that are not margin stock do not have any good faith loan value.

Maintenance Test

The does not contain a maintenance test, so the Rules does not require HSC to make margin calls. Margin calls are set by a the HSC’s own credit requirements.

The rules does require re-testing in certain limited situations. For example, The rules requires HSC to re-test the value of the collateral when there is a withdrawal or substitution. (Single Credit Rules)

Scope

What customers are within the scope of HSC rules

Most borrowers (including individuals) will qualify as an investor under the rules. There are few exceptions to this general rule.

Primary exceptions are for

certain “Clearing Agencies” (see Regulation U Section 2201.1(b)(2) for exact criteria) and
Exempted Borrowers” which means a member of national security exchange or registered broker or dealer with a substantial amount of business with non-brokers or dealers (see Regulation U Section 221.2 for exact definition/criteria and Regulation U Section 221.3(e).)

Extending Credit:

HSC may extend credit as:
Traditional loan
Non-traditional credit
Guaranty
Reverse Repurchase Agreement
Case by case review for potential re-characterization

Maintaining Credit

Maintaining purpose credit previously extended by another lender or the same lender.

What is Margin Stock

Regulation U Section 221.2 (Definition of Margin Stock)

Equity security registered or having unlisted trading privileges on a national securities exchange; or
Any OTC security designated as qualified for trading in the National Market System under a designated plan approved by the SEC (NMS Security); or Debt security convertible into a margin stock or carrying a warrant or right to subscribe to or
purchase a margin stock; or
Warrant or right to subscribe to or purchase a margin stock; or
Security issued by an investment company registered under Section 8 of the Investment Company Act of 1940, other than (i) a company licensed under the Small Business Investment Act of 1958, as amended; (ii) a company which has at least 95% of its assets continuously invested in exempted securities; (iii) a company which issues face-amount certificates, but only with respect of such securities; or (iv) a company which is considered a money market fund under SEC Rule 2a-7.

Margin Stock” does not include:

Securities quoted in the “pink sheets” or the “over-the-counter bulletin board” (that do not otherwise qualify as margin stock); or
Foreign securities (that do not otherwise qualify as margin stock); or
Nonconvertible debt securities; or
OTC options (i.e., not listed options); or
OTC convertible equity.
Foreign securities (that do not otherwise qualify as margin stock);

Note: The FRB staff has stated that publicly traded American Depositary Receipts should be treated as “margin stock” for purposes of Regulation U as well as the underlying foreign securities of such ADRs

Purpose credit

Purpose credit under the Rules is “any credit extended for the purpose, whether immediate, incidental or ultimate, of buying or carrying margin stock.”

Carrying Margin Stock

Carrying credit under the Rules is “credit that enables a customer to maintain, reduce, or retire indebtedness originally incurred to purchase a security that is currently margin stock.”

Specific Issues on Analyzing Purpose Credit:

Customer’s Line of Business
Retirement of Shares
But For” Test
Short Sales
Status of Stock
Temporary Use of Proceeds

Secured by Margin Stock

What does it mean to be secured by margin stock?

Directly or Indirectly Secured

An extension of credit will be deemed to be secured by margin stock for purposes of the Rules if the credit is either directly or indirectly secured by margin stock.

Subject to certain exceptions, a loan may be deemed indirectly secured by margin stock if the loan documentation restricts the use of an obligor’s margin stock.
Regulation U treats indirectly secured credits the same as directly secured credits.

Examples of common provisions and situations that could cause a credit to be indirectly secured by margin stock:

Negative pledges
Cross-defaults/cross-collateralization
Scope of customer’s trading/investment activities
Certain liquidity maintenance requirements; and
Certain assets with a value derived from margin stock

Note: A case by case basis analysis is required due to the vast number of opinions on indirectly secured situations and the broad scope of certain opinions

Safe Harbors for Indirectly Secured

üThe FRB has adopted safe harbors so that the definition of “indirectly secured” excludes certain arrangements in which the margin stock is not a substantial portion of the restricted assets.

üThe primary safe harbor is a percentage test that creates a materiality standard for indirect security by stating that if, after applying the proceeds of the credit, not more than 25% of the value of the restricted assets are margin stock, then such restrictions (e.g., negative covenants) should not make the loan indirectly secured.

Withdrawal and Substitution Rule

The withdrawal and substitution rule requires a lender to re-test the collateral when the collateral is either withdrawn or substituted.

Specific rules for two scenarios:

If the loan does not exceed the Maximum Loan Value of the collateral, then a withdrawal or substitution is only permitted if it would not cause such loan to exceed the Maximum Collateral Value of the remaining collateral.
If a loan exceeds the Maximum Loan Value of the collateral, then a withdrawal and substitution is only permitted if it would not increase the amount that such loan exceeds the Maximum Collateral Value of the remaining collateral

Single Credit Rule

When a HSC makes multiple loans to a customer and at least one of the loans is a purpose credit:

If a lender makes a purpose loan and then later makes an additional purpose loan to the same customer, all the purpose loans need to be aggregated into one purpose credit.

Exception: Syndicated loans do not need to be aggregated with unrelated purpose credit.

If HSC makes a margin stock secured purpose loan and later wants to make an unsecured purpose loan to the same customer, the second loan would be prohibited unless there is sufficient collateral to cover both advances.

If HSC makes an unsecured purpose loan and later makes a margin stock secured purpose loan to the same customer, then all the purpose loans (secured and unsecured) would need to be aggregated when evaluating a withdrawal or substitution.

If HSC makes a nonpurpose loan and then makes a purpose loan secured by margin stock to the same customer and wants to utilize the single credit rule, then:

The two loans should be treated as separate loans;
The collateral from the purpose credit may not be relied upon as collateral for the nonpurpose credit; and
The margin stock collateral generally should be allocated first to the purpose credit and then to the nonpurpose credit.

Alternative: HSC may elect to treat both loans as purpose credit and combine the collateral.

Exempted Transactions

“Special Purpose Credit’ (See Regulation U Section 221.5):

Regulation U contains exemptions for “special purpose credits” extended to broker-dealers. These credits can be extended on a good faith basis (i.e., margin stock is not required to be discounted to 50%) and the single credit rule does not apply.

HSC needs to obtain a good faith certifications from the broker-dealer that the credit is a special purpose loan.

If purpose of credit ceases to be a special purposes credit based on a notice from the borrower orHSC, then the credit will cease to be exempt.

“Special Purpose Credit” (See Regulation U Section 221.5). These exemptions for loans to broker-dealers apply to: Hypothecation Loans

Temporary Advances and DVP Transactions Securities in Transit Intraday Credit Arbitrage Credit
Market Maker and Underwriter Credit Clearing Broker-Dealers Emergency Loans
Capital Contribution/Subordinated Loans

Exempted Transactions for Banks

A bank lender can extend purpose credit without regard to Regulation U if the credit is extended in certain specific circumstances.

For a complete list of these exempted transaction see Regulation U Section 221.6.

Note: These exemptions only apply to banks.

Lender Protection Clause

Regulation U Section 221.3(j) states that “nothing in this part shall require a bank to waive or forego any lien or prevent a bank from taking any action it deems necessary in good faith for its protection Note: There are specific FRB opinions on the applicability of this clause

Bank Lenders:

Bank lenders must have a Form U-1 executed by the customer when the loan is greater than $100,000 is secured by margin stock.

Note: there are multiple FRB opinions on revolving loans and Form U-1s.

HSC as Lenders:

HSS extends or maintain credit secured by margin stock are required to register with the FRB on Form G-1 if they reach certain thresholds.
HSC use a Form G-3 instead of a Form U-1.

Lender’s Obligations

The FRB opinions impose a duty on the lender to be, among other things, aware of the circumstances surrounding a loan and to make inquiries before accepting a purpose statement.

Potential Consequence of Lender Violates Regulation U.

Commission Enforcement
Criminal Prosecution Against Lender and Officers of Lender
Avoidance under Exchange Act Section 29(b)
Civil Liability