An opinion that an extension of credit does not violate margin regulations is sometimes requested in loan transactions and certain debt offerings as an aspect of an opinion that the transaction does not violate applicable laws. A typical opinion expressly covering margin regulations may be stated as follows:
The execution and delivery by [the Company] of each [Loan Document] to which it is a party do not, and the performance by [the Company] of its obligations thereunder will not, result in violation of Regulations T, U or X of the Board of Governors of the Federal Reserve System.
Opinion Coverage as a Matter of Customary Practice
The laws that a lawyer exercising customary professional diligence would identify as being applicable when giving an opinion depend on the type of the transaction. In a lending transaction, particularly a loan that will be used to acquire margin stock or that is secured by margin stock, a lawyer might identify the margin regulations as being applicable, and a lender might reasonably expect those regulations to be addressed by the opinion letter, but the coverage of the margin regulations, as part of the securities laws in general, in an opinion letter is not entirely clear. For that reason, when the margin regulations may be applicable to the transaction, a lender may request the margin regulations to be expressly addressed in the opinion letter. On the other hand, if the transaction does not involve margin stock, the opinion letter may not be expected to address the margin regulations. In that case, although the margin regulations may be understood as a matter of customary practice not to be covered unless done so expressly, some lawyers choose to exclude expressly the margin regulations from the opinion letter’s covered law, especially when they are expressly excluding other laws from coverage.
Margin Regulations; Applicability and Definitions
The margin regulations are Federal Reserve Regulations T, U and X, 12 C.F.R. §220.1 et seq., §221.1 et seq. and §224.1 et seq., respectively, issued by the Federal Reserve Board under Section 7 of the Securities Exchange Act of 1934 (the “Exchange Act”). That section authorizes the Board to issue rules and regulations “for the purpose of preventing excessive use of credit for the purchase and carrying of securities.” Section 7 of the Exchange Act also prohibits banks and broker dealers, with certain exceptions, from extending credit or arranging the extension of credit in contravention of those rules and regulations, and prohibits U.S. persons and foreign persons controlled by or acting on behalf of a U.S. person from obtaining such credit.
Regulation T applies to brokers and dealers as defined in the Exchange Act and members of a national securities exchange, and certain related persons. Regulation U applies to banks and to non-bank lenders who in the ordinary course of business extend credit secured directly or indirectly by margin stock in the amount of $200,000 or more during a calendar quarter or have $500,000 or more of such credit outstanding at any time during a calendar quarter. Regulation X applies to borrowers. It was added to the margin regulations after some borrowers tried to use a violation of the margin regulations applicable to lenders as a defense to payment of the credit.
Regulations T and U prohibit a covered lender from entering into or arranging an extension of credit for the purpose of purchasing or carrying margin stock in an amount in excess of the maximum loan value of the margin stock if the loan is secured directly or indirectly by margin stock. Regulation X prohibits a borrower from entering into a transaction that violates the margin regulations. Credit that is extended for the purpose of buying or carrying margin stock is referred to as “purpose credit.” Margin stock includes equity securities listed or traded on a national securities exchange or qualified for trading in the National Market System. Margin stock also includes warrants or rights to subscribe to margin stock or debt securities convertible into margin stock or carrying a warrant or right to subscribe to margin stock, and certain securities issued by a registered investment company. Margin stock does not include the stock of a borrower’s wholly-owned operating subsidiaries that is not traded in the market.
An opinion that an extension of credit does not violate the margin regulations will turn on whether the credit is purpose credit and whether the credit is directly or indirectly secured by margin stock.
Not Purpose Credit
In a general lending transaction, the loan agreement may include the stated purposes of the loan and may include a provision that the loan may not be used to purchase or carry margin stock. A lawyer’s reliance on the borrower’s obligation to comply with the provisions of the loan agreement may form the basis for the lawyer to conclude that the credit is not purpose credit and thus permit the lawyer to give the opinion that the transaction will not violate the margin regulations. For revolving or multiple draw loans secured directly or indirectly by margin stock, a covered lender is required to obtain from the borrower a completed form FR U-1 (banks), FR T-1 (brokers and dealers) or FR G-3 (other covered lenders) in which the borrower states whether or not any part of the credit is a purpose credit and if not, the purpose of the credit. A representation of the borrower on such a form, or in a separate certificate on which the opinion giver can rely, that the credit will not be used to purchase or carry margin stock may also be the basis for an opinion that the transaction does not violate the margin regulations based on the credit not being a purpose credit. An example of a non-purpose loan representation is:
No proceeds of the [Loan] will be used for the immediate, incidental or ultimate purpose of buying or carrying margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System).
Purpose Credit Indirectly Secured by Margin Stock
If credit is purpose credit and the borrower owns or will acquire margin stock, even if the credit is not explicitly secured, the transaction may still run afoul of the margin regulations if the credit is deemed to be indirectly secured by margin stock. A credit may be deemed to be indirectly secured by margin stock if the borrower has agreed not to pledge any of its assets to secure any other obligation and if the borrower has no other substantial assets than the margin stock. Examples of such a borrower would be a shell acquisition subsidiary with no assets other than the acquired margin stock or a company that is an investment company that has invested in margin stock. On the other hand, if the borrower has substantial assets or cash flow without regard to the margin stock, the unsecured loan with a negative pledge clause may not be deemed to be indirectly secured by the margin stock.
The definition of “indirectly secured” in Regulation U has several exceptions. One of the exceptions is that, if after applying the proceeds of the credit, “not more than 25% of the value (as determined by any reasonable method) of the assets” subject to the negative pledge clause is margin stock. 12 C.F.R. § 221.2. In a close valuation case, the choice of a method for valuing the assets may make a difference whether the 25% safe harbor is available, but where the value of the margin stock is negligible in relation to the other assets of the borrower, the opinion giver may be confident that the safe harbor is available. Depending on the values, a simple certificate from the borrower may be sufficient, or the conclusion in the certificate may need to be supported by calculations showing how the values of margin stock and the borrower’s other assets were calculated. The conclusion of the certificate might state:
As of the Closing Date, the value of the margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System) constitutes less than 25% of the value of the assets of the [Borrower] that are subject to any limitation on sale, pledge or other restriction under the [Loan Documents].
An additional exception in the definition of “indirectly secured” in Regulation U is that the lender “in good faith, has not relied upon the margin stock as collateral in extending or maintaining the particular credit.” 12 C.F.R. § 221.2. The specific evidence sufficient to support an opinion that the lender is not relying on the margin stock as collateral may depend on the particular facts of the transaction, and might include statements of the lender to this effect on which the opinion giver could rely. Such evidence is more persuasive if other valuable assets of the borrower have been pledged to secure the credit, and the negative pledge clause creating the indirect security on the margin stock is clearly not intended as additional collateral. As an alternative, a lender may accept an opinion that the transaction does not violate the margin regulations based on an expressly stated assumption in the opinion letter as to the lender’s non-reliance on the margin stock as security.
This article originally appeared in the Winter 2021–2022 issue of In Our Opinion, the newsletter of the ABA Business Law Section’s Legal Opinions Committee. Read the full issue and previous issues on the Legal Opinions Committee webpage.