Regulation U, promulgated by the Federal Reserve Board (the “Board”), governs extensions of credit by entities other than broker-dealers 1 that are both (i) for the purpose of purchasing “margin stock” (or refinancing, known as “carrying,” such extensions of credit) and (ii) are secured, directly or indirectly,2 by margin stock. Most large syndicated commercial loans do not involve the acquisition of, or are not secured directly or indirectly by, margin stock, and therefore do not trigger any requirements under Regulation U. However, in the past year, several large syndicated commercial loans issued in the U.S. market have involved the direct use of loan proceeds to purchase margin stock, potentially triggering Regulation U registration or filing obligations for some lenders, including those that purchase in the primary syndication or in secondary-market transactions. Accordingly, nonbank lenders and purchasers of loans, including asset managers, should pay careful attention to any suggestion in the marketing materials for a new loan that the loan may be secured directly or indirectly by publicly-traded securities, as well as any disclaimer regarding Regulation U compliance by members of the lender group/syndicate.
REGULATION U: SUBSTANTIVE REQUIREMENTS
Regulation U limits leverage in the securities markets by regulating the collateral coverage ratio for loans that (i) are for the purpose, directly or indirectly, of acquiring or carrying margin stock (called “purpose credits”), and (ii) are secured, directly or indirectly, by margin stock. “Margin stock” is defined as equity securities that are traded on a national exchange but also includes most shares issued by registered investment companies, over-the-counter securities that are traded on the Nasdaq Stock Market’s National Market, and certain securities that are convertible into or confer a right to acquire margin stock. Regulation U bars the extension of purpose credit secured by margin stock in an amount greater than the “maximum loan value” of the collateral securing the loan (i.e., a percentage of the market value, set by the Board). The Board has set the maximum loan value for margin stock at 50% of market value. So, for example, a loan for the acquisition of margin stock, secured only by the stock to be acquired, would be limited to approximately 50% of the purchase price of the stock.3 In addition, Regulation U imposes reporting, record-keeping, and filing requirements on both borrowers and lenders in respect of credits that are secured by margin stock.
REGULATION U IN THE SYNDICATED COMMERCIAL LOAN MARKET
Very few large, syndicated commercial loans are affected by the substantive requirements of Regulation U, because very few large, syndicated commercial loans involve the use of loan proceeds to acquire or carry publicly-traded securities. Most acquisition-finance loans only help one private buyer or group replace another and thus do not involve margin stock: “going-private” acquisitions and acquisitions of one public company by another are relatively rare in this space. Indeed, credit agreements will typically attempt to protect lenders from Regulation U risk by (i) excluding margin stock from the collateral package (including from any negative pledge), (ii) causing the borrower to represent that it is not in the business of buying or carrying margin stock, and/or (iii) causing the borrower to covenant not to use any loan proceeds to acquire or carry margin stock.
When a syndicated commercial loan is a “purpose credit” to be secured by margin stock for the purpose of Regulation U, that fact may or may not be flagged adequately in the relevant marketing materials when the book is being built for the primary syndication. In the credit agreement itself, the issue will probably not be flagged explicitly. Prospective lenders should look for (i) the absence of the exclusions, representations, and covenants discussed in the preceding paragraph4, (ii) a covenant requiring the borrower to complete the relevant forms required to comply with Regulation U, and/or (iii) a representation or deemed representation by each lender or assignee that (A) it has complied or will comply with the requirements of Regulation U in connection with the loan and/or (B) it is not in the businesses of extending loans secured by margin stock in the ordinary course.5
PURPOSE STATEMENTS AND REGISTRATION REQUIREMENTS FOR SYNDICATE MEMBERS
If a syndicated commercial loan is secured directly or indirectly by margin stock (even if it is not a purpose credit), the borrower must complete and deliver to the lender(s) a “purpose statement” describing the amount of the loan, the intended use of the loan proceeds, and the collateral for the loan. If the lender is a bank, the borrower should use Form FR U-1; if a non-bank entity, Form FR G-3. The borrower completes the purpose statement, signs it, and delivers it to the lender, which counter-signs it and maintains it in its record. The purpose statement (U-1 or G-3) is not filed with the Board. The relevant form should be signed and maintained by the lender, and the form used should be determined by the lender’s status as a bank or non-bank. A transferee or assignee of an existing loan is not required to obtain a new purpose statement from the borrower, but instead obtains and maintains a copy of the purpose statement that was delivered by the borrower to the original lender.
In addition to the purpose statement requirement, Regulation U requires that a U.S. non-bank lender that extends or acquires credit (whether or not purpose credit) secured by margin stock in an amount above a specified threshold register and file annual reports with its local Federal Reserve Bank and maintain a copy of the U-1 or G 3 held by the original lender.6 (Non-U.S. lenders with no “principal office” or place of business, in the United States are not required to register, file, or maintain records.) A U.S. non bank lender must register if (i) it extends at least $200,000.00 of credit secured by margin stock in a calendar quarter or (ii) it at any time maintains at least $500,000.00 outstanding principal amount of such credit, in each case as determined in the aggregate for all such loans extended or maintained. Registration is accomplished by filing Form FR G-1 with the Federal Reserve Bank in the district of which it is located, within 30 days of the end of the calendar quarter in which either such threshold was met. After Form FR G-1 is filed, the relevant lender must file annual reports on Form FR G-4, within 30 days after June 30 of each year. A registered lender may de-register by filing Form FR G-2 if it has not held more than $200,000.00 outstanding principal amount of purpose credit secured by margin stock for the previous six months.
I BOUGHT A LOAN THAT TRIGGERS REGULATION U - NOW WHAT?
By the standards of the syndicated commercial loan market, the registration thresholds under Regulation U are quite low: any U.S. nonbank lender (including a fund or separate account client) with an allocation of $200,000.00 or more of a loan subject to Regulation U will become subject to the registration and related requirements described above. If the marketing materials for the loan fail to expressly and emphatically warn prospective buyers that purchasing the credit (or a portion of the credit) may trigger such requirements, or if any such warnings are passed over by the reviewing personnel on the assumption that the loan is probably the same as the hundred others that cross the reviewer’s desk, an asset manager may find that it has agreed to purchase a loan, and allocated the loan to U.S. funds and separate accounts, without becoming aware of the registration requirement. In addition, at least some structuring counsel appear to be taking the position (erroneous, in our view7) that registration is only necessary if the lender or assignee is regularly engaged in extending or maintaining purpose credit secured by margin stock, rather than merely doing so in the ordinary course of its business, in which case the relevant materials might avoid stark warnings about the registration requirement.
An asset manager that finds itself with an unsettled primary or secondary purchase of a loan subject to the registration and purpose statement requirements of Regulation U, allocated in whole or in part to U.S. funds and separate accounts in allocations of $200,000.00 or more, has several options:
(1) It can reallocate the trade to non-U.S. funds and separate accounts, or in such a manner that each U.S. fund or separate account participating has an allocation of less than $200,000.00. Once the trade has been booked, however, reallocation may be difficult or impossible owing to internal policies and/or regulatory issues.8
(2) It can settle the trade as originally contemplated and cause any applicable funds and separate accounts to register with the relevant Federal Reserve Bank(s). There is probably no adverse consequence to registering other than the nuisance of the registration process itself and the ongoing record-keeping and annual filing obligations. However, because an asset manager may not have designated personnel or procedures to handle the initial and ongoing filings, and because removing a single loan from a large portfolio is seldom materially problematic, the filing burden itself may well be sufficient reason to stay out of the loan rather than going through with the purchase and registering. Moreover, an asset manager may not view itself as having the authority to obligate its clients to register, and may in any event not want to do so from a client-relations perspective.
(3) It can trade out of the position from the entity that would be obligated to register, and settle by bilateral netting (if sold back to the entity selling to it) or multilateral netting (if sold to a third party). If the buy trade never settles, and the relevant funds and separate accounts never actually acquire ownership of the loans, no registration obligation would be triggered.
It should be noted that purchasing the loans and then selling them quickly without registering is not an option: if a lender holds the loans even for an instant (e.g., a purchase and a sale that settle simultaneously), it will be deemed to have “maintained” the loans for the purpose of Regulation U.
There is no epidemic of syndicated commercial loans secured by margin stock: large loans with Regulation U issues remain very rare. But it happens often enough that asset manager personnel who review new deals should be aware of Regulation U, its triggers, and its requirements, and should include it in their review checklists. An asset manager that finds that it has bought, for its U.S. funds and separate accounts, a loan subject to Regulation U has several options at its disposal to avoid the registration requirement if the issue is spotted before the purchase of the loan settles, but none may be quite as palatable as avoiding the issue in the first place.
1 Regulation T governs such extensions of credit secured by margin stock by broker-dealers.
2 Subject to exceptions contained in the definition of “indirectly secured,” loans are deemed secured indirectly by margin stock when there is a negative pledge on the borrower’s margin stock or other arrangements under which the borrower’s right to dispose of margin stock held by it is restricted while the loan is outstanding.
3 Collateral other than margin stock has a maximum loan value equal to its market value, or the amount that a lender, exercising good faith judgment, would lend against without regard to any other assets held as collateral.
4 These sorts of provisions, which appear in syndicated loan agreements in various combinations and with varying phrasing, may or may not actually be effective at ensuring that the loan does not trigger Regulation U filing requirements. But they do indicate that structuring counsel believed that the loan would not trigger such requirements, and that counsel to the borrower concurred (although, as discussed above, a representation that the loan is not a purpose credit does not itself necessarily demonstrate that other requirements of Regulation U do not apply). The same applies to the question of whether the loan may be secured “indirectly” by margin stock. That analysis is subject to a body of interpretations and requires a case by case, fact-specific review, which review should be undertaken by structuring counsel and borrower’s counsel. The presence of exclusions, representations, and covenants intended to guarantee that the registration and filing requirements of Regulation U do not apply thus indicate that structuring counsel and borrower’s counsel did not believe the loan to be secured “directly or indirectly” by margin stock.
5 For the reasons discussed in footnote 4 below, this second representation is not, in our view, apposite.
6 Commercial banks are always subject to the substantive requirements of Regulation U when extending purpose credit secured directly or indirectly by margin stock but are not subject to registration requirements.
7 This position appears to be based on the language of Section 221.3(b)(1) of Regulation U, which states that a non bank lender that “in the ordinary course of business, extends or maintains credit secured, directly or indirectly, by any margin stock [emphasis added]” in excess of the specified thresholds must register. If a loan secured by margin stock is only extended “in the ordinary course of business” where the lender routinely extends or owns loans secured by margin stock, then a lender that regularly extends or owns loans the vast majority of which are not secured by margin stock would not (the argument runs) become subject to the registration requirement, even if it extends or acquires a few loans secured by margin stock in excess of the specified threshold.
“In the ordinary course of business” is defined in Section 221.2 of Regulation U to mean, “occurring or reasonably expected to occur in carrying out or furthering any business purpose, or in the case of an individual, in the course of any activity for profit or the management or preservation of property.”
In our view, the better reading of this definition and of the language of Section 221.3(b)(1) is that a loan secured by margin stock is extended or maintained “in the ordinary course of business” where the lender is in the business of making or purchasing loans and the loan in question is extended or acquired by the lender in the same general manner as other loans.
8 Although this should, in principle, serve to avoid the registration and purpose statement requirements of Regulation U, it is possible that the substantive requirements of Regulation U might still apply to the borrower (including by virtue of Federal Reserve Regulation X).
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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