• Regulation U: What Is It All About?
  • March 9, 2005 | Author: Richard P. Eckman
  • Law Firms: Pepper Hamilton LLP - Wilmington Office ; Pepper Hamilton LLP - Philadelphia Office
  • Clients seem to have many questions about Regulation U, which is issued by the Federal Reserve Board (FRB). Below is a summary of the basics of Regulation U. It is a complex regulation, so if you have questions about it, please call and we can discuss your specific issues.

    Q: What is the purpose of Regulation U?

    A: Regulation U is designed to limit the amount of credit that can be extended to a borrower that is secured by certain stock, generally any publicly traded securities, where the purpose of the loan is to purchase or carry the securities. These securities are referred to in the regulation as "margin stock." Under Regulation U, a loan to purchase or carry margin stock cannot exceed 50 percent of its market value at the time the loan is made. The regulation does not limit the loan amount if the margin stock is used only as collateral, and the proceeds of the loan were not used to purchase or carry the margin stock.

    Q: Who must comply with Regulation U?

    A: Regulation U applies to banks and any other lenders that are required to register under Regulation U. Non-bank lenders must register if they extend or maintain credit secured, directly or indirectly, by any margin stock. The non-bank lender has 30 days after the end of any calendar quarter during which (i) the amount of credit extended equals $200,000 or more; or (ii) the amount of credit outstanding at any time during that calendar quarter equals $500,000 or more; to register under Regulation U. A bank acting in its capacity as a trustee also must comply with Regulation U.

    Q: What must a lender do that makes a loan secured by margin stock?

    A: In general, customers are required to execute an FRB form, called a "purpose statement," whenever a bank extends credit exceeding $100,000 secured directly or indirectly by margin stock, whether or not the loan is for the purpose of purchasing or carrying margin stock.

    For revolving-credit or multiple-draw agreements, or financing of securities purchases on a payment-against-delivery basis, customers are required to execute a purpose statement when the credit arrangement is originally established, and then it must be amended for each disbursement if all of the collateral for the agreement is not pledged at the time the agreement is originally established.

    Q: What does "carrying" margin stock mean?

    A: Regulation U applies to loans used to purchase margin stock as well as loans used to "carry" margin stock. If the proceeds of a loan are used to pay off another lender and the proceeds of the loan being paid off were used to purchase margin stock, the new loan is being used to "carry" the margin stock and is subject to Regulation U. A lender needs to get information from the lender being paid off whether the loan being repaid was used to purchase margin stock.

    Q: What is a purpose statement and when must it be filled out?

    A. A purpose statement is a form that a customer must fill out before any loan secured by margin stock is made. Bank customers are required to execute Form FR U-1. Non-bank customers are required to execute Form FR G-3.

    Q: What is margin stock?

    A: margin stock is defined as:

    1. any equity security registered or having unlisted trading privileges on a national securities exchange
    2. any OTC security designated as qualified for trading in the National Market System under a designation plan approved by the SEC (NMS security)
    3. any debt security convertible into a margin stock or carrying a warrant or right to subscribe to or purchase a margin stock
    4. any warrant or right to subscribe to or purchase a margin stock; or
    5. any security issued by an investment company registered under section 8 of the Investment Company Act of 1940 (the 1940 Act) subject to certain exceptions.

    Q: What is the maximum loan value of margin stock and other collateral?

    A: The maximum loan value of margin stock and other collateral is 50 percent of its current market value.

    Q: What happens if the collateral value falls after the loan is made?

    A: The regulation makes it clear that the test for the value of the collateral is made at the time the original loan is made and that no additional collateral is required to be pledged if the collateral value falls after the loan has funded.

    Q: What is the single-credit rule?

    A: Under the single-credit rule, all "purpose credit" (which is the term used when a loan is made and proceeds are used to acquire or carry margin stock) extended to a customer is treated as single credit, and all collateral securing such credit is considered in determining whether or not the credit complies with Regulation U. However, Regulation U does not require that syndicated loans be aggregated with other unrelated purpose credit extended by the same lender. In addition, when a lender extends purpose credit secured by margin stock and non-purpose credit to the same customer, the lender must treat the credits as two separate loans.

    Once a lender extends secured purpose credit to a customer, the lender may not later extend unsecured purpose credit to such customer unless the total credit does not exceed the maximum loan value of the collateral.

    If the extension of credit is first for unsecured purpose credit and then followed by purpose credit secured by margin stock, the credit is only combined under the single-credit rule for purposes of the withdrawal and substitution provisions of Regulation U.

    Q: When may a lender permit a customer to withdrawal or substitute cash or collateral?

    A: So long as the withdrawal or substitution of the collateral does not (i) cause the credit to exceed the maximum loan value of the collateral; or (ii) increase the amount by which the credit exceeds the maximum loan value of the collateral, substitution is permitted.

    A lender may permit substitution of the securities received in order to enable a customer to participate in an exchange offer. The lender should treat the nonmargin, nonexempted security received in an exchange of the margin stock as if it is margin stock for 60 days following the exchange.

    Q: When is a renewal or extension of maturity of credit not considered a new extension of credit?

    A: The renewal or extension of maturity of credit is not considered a new extension if the amount of the credit is only increased by the addition of the applicable interest, service changes or taxes.

    The transfer of credit between customers or between lenders will not be considered a new extension of credit if (i) the original credit was extended by a lender in compliance with Regulation U; (ii) the transfer is not made to evade Regulation U; (iii) the amount of credit is not increased; and (iv) the collateral for the credit is not changed.

    Q: What procedure should a lender follow for transfers of credit?

    A: Different procedures apply, depending whether the transfer is between customers at the same lender or between lenders. When the transfer occurs between customers at the same lender, the customer transferring credit must sign a statement describing the surrounding circumstances and then that statement must be accepted and signed by a representative of the lender acting in good faith, and kept with the records of the transferee customer. For transfers between lenders, the transferee lender should get a copy of the original purpose statement filed with the transferor and keep that statement with the transferee's account. If no purpose statement had originally been filed, one is required at the time of the transfer.

    Q: When may a bank extend and maintain purpose credit without regard to these regulations?

    A: There are eight types of exempt transactions. Banks may extend and maintain purpose credit if such credit is extended to (i) any bank; (ii) any foreign banking institution; outside the United States; (iii) to an employee stock ownership plan qualified under Section 401 of the Internal Revenue Code; (iv) to any plan lender as defined in section 221.4(a) of Regulation U to finance an eligible plan as defined in section 221.4(b), provided the bank has no recourse to any securities purchased pursuant to the plan; (v) to any customer, other than a broker or dealer, to temporarily finance the purchase or sale of securities for prompt delivery, if the credit is to be repaid in the ordinary course of business upon completion of the credit and is not extended to enable the customer to pay for securities purchased in an account subject to part 220 of Regulation U; (vi) against securities in transit, if the credit is not extended to enable the customer to pay for securities purchased in an account subject to part 220 of Regulation U; (vii) to enable a customer to meet emergency expenses not reasonably foreseeable, and if the extension of credit is supported by a statement executed by the customer and accepted and signed by an officer of the bank acting in good faith.