Asset-Level Eligibility Series: Margin Stock

This Legal Update explores why, in order for an underlying loan to be included in a warehouse facility’s borrowing base, the underlying loan cannot be margin stock.

Example of Eligibility Criteria:

• Such Loan does not constitute “Margin Stock” (as defined under Regulation U of the Securities Exchange Act).

What Is Margin Stock?

• The Federal Reserve Board defines “Margin Stock” generally as (i) equity securities registered on a national securities exchange; (ii) over-the-counter securities that trade in the Nasdaq Stock Market’s National Market; (iii) debt securities that can be converted into margin stock; (iv) warrants or rights to purchase margin stock; or (v) securities issued by an investment company registered under the Investment Company Act.
• With some limited exceptions, the definition is broad enough to capture most publicly traded securities, over-the-counter stocks and mutual funds.

What Are Regulations T, U and X?

• Regulations T, U and X of the Securities Exchange Act are often collectively referred to as the “margin regulations.”
• Regulation U is a Federal Reserve Board regulation that restricts the amount of loans lenders can provide to finance the purchase or carrying of margin stock.
• Regulation T is a similar regulation but applies to extensions of credit by broker-dealers rather than bank lenders.
• Regulation X regulates the ability of borrowers to borrow from non-US lenders or broker-dealers in a manner that would violate Regulations T and U.

Why Do Lenders Care if the Collateral Includes Margin Stock?

Lenders need to ensure that the SPV borrower to which they are providing advances is not using the proceeds of those advances to purchase or carry “Margin Stock.” Otherwise, the lenders could be in violation of Regulation U, resulting in fines, regulatory sanctions, reputational damage and liability for the lenders. For this reason, SPV warehouse facilities customarily include an eligibility criterion that the Eligible Loan not be “Margin Stock.” In addition, warehouse facilities will typically include a representation from the borrower that its performance under the credit facility will not violate Regulations T, U or X and a requirement in the “use of proceeds” negative covenant that no proceeds of the advances from the lenders be used to purchase or carry Margin Stock.

Conclusion

Violation of Regulations T, U and X can result in significant consequences for lenders. For this reason, care should be taken to ensure that no portion of the Collateral being transferred to the SPV borrower in a warehouse facility includes Margin Stock. Therefore, a prohibition on Margin Stock should be included in the eligibility criteria for any such warehouse, with a mandatory repurchase obligation in the event of a violation of that criteria.