In our final installment on the margin regulations, we’ll cover a few more practice points. Hopefully this intro to the US margin regulations will enable you to spot the issues that can arise in the context of financing transactions.
Regulation U contains a provision known as the “single-credit rule” (which is actually four separate rules) that deals with situations in which a lender makes multiple extensions of credit to a borrower at different times. The principal purpose of the single-credit rule is to prevent evasion or circumvention of the requirements of Regulation U by requiring each individual lender to aggregate all extensions of purpose credit to a borrower in order to determine whether collateral securing such extensions of credit meets the requirements of Regulation U.
The first prong of the single credit rule requires a lender to treat all purpose credit extended by that lender to a customer as a “single credit,” regardless of whether the loans were made at different times. All collateral securing the combined credit must be considered in determining whether the credit complies with Regulation U. Unrelated syndicated loans are not required to be aggregated.
Under the second prong of the single-credit rule, if a lender extends purpose credit secured by margin stock and later wants to make an unsecured purpose loan to the same borrower, that second loan is not permitted unless there is sufficient collateral to cover both advances in accordance with Regulation U’s maximum loan-to-value limitation.
The third prong provides that, if a lender makes an unsecured purpose loan and subsequently extends purpose credit to the same customer secured by margin stock, then all of the purpose credit (both secured and unsecured) must be aggregated for purposes of determining whether a withdrawal or substitution of collateral is compliant with Regulation U.
Finally, if a lender extends purpose credit secured by margin stock and nonpurpose credit to the same customer, the purpose credit and the nonpurpose credit must be treated as separate loans. The lender may not rely on the collateral that secures the purpose credit to also secure the nonpurpose credit. The margin stock collateral must be allocated first to the purpose credit in an amount sufficient to meet the requirements of Regulation U. If, after that, there is excess margin stock available, only then can such margin stock be allocated to the nonpurpose credit.
Collateral Valuation: An important component of Regulation U is the determination of the value of the collateral that is used to secure a purpose credit. In general, Regulation U requires that the value of collateral securing a purpose credit be determined at the time the lender enters into a legally binding commitment to extend the credit (not at the time the loan proceeds are actually disbursed). Accordingly, any depreciation in the value of collateral between the time of commitment and the time of disbursement will not affect the amount that can be lent against the collateral. As discussed below, Regulation U has different rules for the timing of collateral valuations for revolving credit or other multiple draw credit facilities.
Under Regulation U, collateral is valued based on “current market value.” For securities, this generally means the closing sale price (as derived from market quotations) on the preceding business day. Where a public quote is not available for a security, the current market value is based on a reasonable estimate of the market value of the security as of the close of the previous business day. For other types of collateral, value is determined by any reasonable method.
Withdrawal and Substitution of Collateral: Regulation U provides that a lender may allow a customer to withdraw or substitute cash or collateral if such withdrawal or substitution does not cause the purpose credit to exceed the maximum loan-to-value ratio. If the credit already exceeds the maximum loan-to-value ratio due to depreciation in the value of the collateral (i.e., a drop in the price of securities collateral after the date of the commitment to lend), then the withdrawal or substitution of collateral cannot increase the amount by which the credit exceeds the maximum allowed amount. This means that each time a borrower withdraws or substitutes collateral that is securing an existing loan, the lender must recalculate the value of the remaining collateral to ensure that the credit remains in compliance with the requirements of Regulation U.
Issues for Revolving Credit Facilities
Revolving credit facilities or multiple draw facilities create unique issues under Regulation U, including issues regarding the timing and content of purpose statements and collateral valuation.
For purposes of Regulation U, a lender and its borrower may treat a revolving credit arrangement either as a single loan or as multiple loans. In either event, if the revolving credit is secured directly or indirectly by margin stock, the purpose statement (Form FR U-1 or Form FR G-3) must be executed at the time the credit arrangement is originally established.
If the lender and borrower elect to treat the revolving credit as a single loan, all of the collateral necessary to ensure compliance with Regulation U would be pledged at the outset of the transaction if the credit is purpose credit. The lender can lend up to the maximum loan value of the collateral pledged at the time the purpose statement is completed, regardless of a subsequent drop in the market value of the collateral. Each disbursement under the revolving credit agreement would be considered part of the larger agreement rather than a separate loan with margin requirements of its own. The purpose statement would not need to be updated while the revolving credit agreement is in force as long as the aggregate amount disbursed does not exceed the maximum loan value of the collateral at the time the commitment to extend the credit was made.
If the lender and borrower elect to treat the revolving credit as a series of separate loans, the lender would only need enough collateral at the outset of the transaction to support the initial disbursement, if it involves the extension of purpose credit. Each subsequent draw under the agreement, however, would require the borrower to provide additional collateral with a loan value sufficient to cover the subsequent draw. Regulation U compliance would be determined by using the current market value of the collateral pledged at the time of each disbursement. In addition, the purpose statement would need to be amended each time a disbursement was made. The “amendment” would not entail the execution of an entirely new purpose statement. An amendment could be made by attaching a current list of collateral to the originally executed purpose statement; this collateral must adequately support the aggregate amount of any of the purpose credit that is extended under the revolver or multiple-draw agreement.