Stock Loan Buyer’s Guide
By Roel Hoekstra
Partner, Global Stock Lending
www.globalstocklending.com
January 2007
Introduction
After spending the past six years in the stock lending business as a consultant,
investor, company manager, and now as a firm Principal I get bombarded every
day with questions about what is stock lending and how to make sure the deal
being proposed is a good deal and a safe deal.
After processing almost 1,000 deals covering more than $500,000,000 in loan
volume over the past decade my partners and I have seen most of the basic
variants of deal structure and we freely pass along our knowledge and experience
to help you become a better educated consumer.
After the basics of deal terms (like loan term, interest rate and points) the biggest
issue for borrowers is what happens to my stock while the loan is outstanding and
when I pay off the loan how can I be assured that I will receive my shares back.
Understanding how the lender looks at the collateral they hold and how they
protect their capital in the event the value of the collateral collapses is critical to
answering the question; “will I get my shares back?”
This buyer’s guide will cover how free trading stocks are handled. We will cover
how restricted shares can be used as collateral in a subsequent article. The
topics we will review here include:
• What is stock lending?
• What to look for in a deal?
• The closing process
• Understanding what happens to your stock while the loan is
outstanding
• Due diligence issues and concerns
What is stock lending?
In our world, stock lending is when someone who has free trading stocks wants to
borrow money and use the shares as collateral for the loan. For the purposes of
discussion, I’ll refer to this as retail stock lending.
Stock lending also exists in the world of short selling. When someone sells stock
short they borrow the shares from the broker/dealer and then sell the borrowed
shares. Their obligation is to return the shares so they are hoping to be able to
buy the shares back when the price is lower.
We are not going to address stock lending for short selling. That is handled by
broker/dealer’s and the person short selling has to prove they can cover the short
position if the stock goes up and still return the shares borrowed.
When a shareholder wants to access the equity in his stock position, he basically
has three options. He can sell his stock and turn the shares into cash or he can
use the stock as collateral for a loan. If he chooses to use his stocks as collateral,
he can take out a margin loan or a non-recourse stock loan.
In my experience, if an investor thinks the stock is going to go down, they will sell
the position to generate cash. If they remain bullish on the stock, they will look to
borrow so they can gain access to the equity while still receive dividends and
participate in the capital appreciation.
Margin loans are relatively simple and safe in the fact that the contract is between
the investor and his broker. The stocks stay in the borrower’s brokerage account
and the loan proceeds can be taken out as cash or used to purchase additional
securities. Of course, the downside is that the loan is a recourse loan and if the
shares go down in value you are forced to either come up with more cash or they
will sell the stocks out from under you to cover the loan balance. And, if at the end
of the day you still owe the broker money then they can come after you to pay the
debt (it is the same as any other unsecured debt at that point).
The non-recourse stock loan operates differently from a margin loan. In the typical
arrangement, the shares are moved to the account of the lender (the collateral)
and it is held there until the loan is paid off. Dividends are still credited but the
contract becomes a standard loan contract with a promissory note. The borrower
definitely loses some control over the stock but in exchange they get higher loan
to value ratios, the option of not having any margin call and the luxury of the loan
being a non-recourse loan. That means that the lender can only look to the
collateral to cover the loan balance upon default and can not come after the
borrower to make up any shortfall. These loans typically give the borrower better
downside protection and the same upside advantages (vs. a margin loan).
What to look for in a deal?
While our firm structures loans around three main products, each stock loan still
remains a highly customized process. Since each stock that is being used as
collateral is different and the loan features can vary significantly, there are quite a
few moving parts to keep track of. I’ll address the main ones here along with
reasonable expectations.
Important Legal Disclaimer
Because of the unique tax and legal issues involved in every stock loan we always
encourage every borrower to consult both tax and legal counsel to make sure the
deal does what they want and does not create unexpected liabilities. This article is
for general informational purposes only and should not be considered to be
offering investment advice, tax or legal advice on any specific transaction.
Loan Term
Where a traditional margin loan can be for a day or essentially indefinitely, stock
loans typically are for a fixed time frame. The most common is 3 to 5 years. It is
rare for the loan to be written for less than one year or for more than 10 years.
A common option for many loans is the ability to roll the loan over at the end of
the term. When the stock portfolio is worth more than the loan payoff amount the
loan can usually be rolled over. This is typically at the discretion of the lender and
essentially involves re-underwriting the loan.
Loan to Value (%)
The loan to value (LTV) is one of the main ways the lender manages the risk of
lending. For penny stocks or other thinly traded stocks LTV’s between 10% and
50% are common. When the stock has strong volume and trading price, but not
on a major market, then LTV’s between 50% and 75% are common. Major stocks
(those traded on NASDAQ or NYSE) will typically get LTV’s between 75% and 90%.
LTV’s above 90% are very rare and should be avoided. If you are getting more
than 90% it is likely that the IRS will consider the deal to be a sale and not a loan.
LTV’s above 50% are also subject to Federal Reserve Regulation U which means
that the proceeds of the loan can not be used to re-invest in margin able
securities.
Interest Rates
It is important to realize that all these loan features act as moving parts in pricing
any deal. Therefore the interest rate offered can vary significantly based on the
other terms and conditions.
As a starting point we look at Prime +1 as the basic interest rate. As the other
terms are adjusted to make the deal more attractive to the borrower (increasing
LTV for example) the rate is often higher.
If features are added to the loan to reduce the lenders principal risk, then interest
rates can be significantly lower. In 2006 we saw individual deals that could be
written with a wide range of interest rates (from 3.99% to 13.5%) depending on
the other loan terms.
When evaluating stock loans it is important to look at what terms can be tweaked if
the interest rate is not what the borrower was expecting.
Points
While no one likes paying points, they are often a necessary part of the lending
process. In the stock lending arena they cover cost of executing the loan. This
begins with marketing, sales, and customer service of course. Also, in many deals
a portion of the points are used too pay for the hedge that is done to protect the
lender’s collateral.
As the size of the deal increases, the number of points obviously decreases. We
see most deals will carry points from 3% to 6%. For deals under $1,000,000, 5%
is fairly standard in the industry. Above $10,000,000 the lower end of the scale
can be expected.
Since we are a direct lender for our Freedom Product and sell directly to
our customers we do not charge any points on that product. For other
individuals or brokers who refer customers to us we are even able to pay
a referral fee without the need to charge points
Points are calculated against the loan amount (not the portfolio amount) and are
withheld at closing. With our loan programs there are no additional fees of any
kind and no surprises. It is not necessary to pay a commitment fee prior to closing.
A stock loan deal is just like any other complex transaction where nothing is
guaranteed prior to closing. Anyone who wants to charge a commitment fee is
really just an intermediary who does not want to waste time with shoppers. While
that is a reasonable desire, it is not necessary if you are a real buyer. There are
plenty of real lenders who do not want to have to sell you twice (once for the
commitment fee, once for the loan) and do not charge commitment fees.
Pre-payment options
With a non-recourse stock loan, the only guarantee that a loan’s principal will be
re-paid resides with the underlying stock that is held as collateral. That means
that all lenders use some kind of hedging strategy to make sure they don’t take a
bath with any individual loan. How they protect the principal is key to what kind of
Pre-payment terms exist.
Many loans involve complex hedging strategies that essentially tie up the
underlying shares for the term of the loan which makes Pre-payment difficult if not
impossible. If Pre-payment is an important feature then be prepared to discuss
that early in the loan pricing process.
Some loan programs operate a little more like a traditional margin loan and do
allow Pre-payment either with a penalty or without a penalty. In either case, loan
pre-payment options will increase the cost of the underlying loan.
If you are holding onto a stock that could see significant short term price
appreciation, it may be worth paying a higher interest rate or accepting a lower
LTV in order to unwind the loan early.
Margin calls
The use of margin calls is one way to lower the interest rate on a loan. This
shares the risk of the stock decreasing in value between the lender and the
borrower. Since each loan is customized, where a margin call is set is often
subject to negotiation.
The downside of a stock loan with a margin call on a thinly traded stock is that it
leaves open the possibility that a less than scrupulous lender may aggressively
sell shares in order to trigger a margin call. This is usually not a problem for a
stock that trades on a major exchange.
The problem with any stock is that no one really knows what will happen to the
stock price in the future. Therefore, one of the primary advantages of a non-
recourse stock loan is the ability to get a high LTV without margin calls. This is not
a feature to be given up lightly and may be worth paying a slightly higher interest
rate so as not to be subject to margin calls in the future.
Upside caps
While many loan programs credit all future price appreciation to the borrower, one
way to dramatically reduce interest rates is to put a cap on the future price of the
stock. This works the same way as a traditional stock collar.
An example may help. If the stock is trading at $10 at the time the loan is taken
out and it is a 90% loan the borrower would receive $9 per share in cash. If there
is a 10% cap (per year) on a 3 year loan then at loan maturity the stock would be
capped at 130% of the closing price or $13.00 in this example. So at loan
maturity, if the stock is trading above the $13 price the excess is added profit for
the lender.
The primary advantage of these deals for the borrower is that they get 90% of the
value today, low interest rates on the loan. They potentially give up some of the
future price appreciation in exchange
Caps typically are set between 7 and 10% appreciation per year on the low side
and 125% appreciation per year on the high side. This is obviously a huge
variance so look closely at where caps are set and make sure that is in line with
your expectations for the stock for the time period.
The impact on interest rates can be substantial. A depending on the stock of
course and where the caps are set, we would expect interest rates on a capped
loan to be 5% to 6% per year and on an uncapped loan to be 9% to 12% per year.
The closing process
In our experience, the closing process is fairly similar with all stock lenders. The
basic principals that apply are;
Legal loan agreements
Transfer of shares to lender
Loan funding
In general, the shares must be in electronic form. If you are holding securities in
certificate form then deposit them at once with a broker dealer. The broker dealer
will hold them in electronic form in street name. Then they can be moved around
the system electronically which reduces the opportunity for fraud and exposure to
market risk while the deal is closing since the shares move almost instantaneously.
We view the closing process as having five distinct steps;
1. Term Sheet
2. Application
3. Loan documents
4. Share transfer
5. Deal funding
Term Sheet
Once the terms and price have been agreed upon, a term sheet should be
produced by the lender that summarizes the agreement. We require the borrower
to initialize the term sheet and return it along with the formal application. While
these documents are not part of the formal loan documents, they make sure
everyone is on the same page regarding the important features of the loan and
that minimizes issues with the loan documents, share transfer and funding.
Application
The borrower must complete a formal application that includes all pertinent
personal information as ell as representations that the stocks have been lawfully
acquired are free trading and if applicable, the use of proceeds is in accordance
with Federal Reserve Regulation U.
We require all applicants to provide proof of identity via a driver’s license or
passport. If the borrower is a corporation then additional information is needed
including a copy of the articles of incorporation and board resolutions showing the
company can enter into a stock loan and that the person signing the loan
documents is authorized to do so.
The application also includes the banking information required to fund the loan.
We wire the loan proceeds directly to the account(s) specified on the application
form.
Loan Documents
The loan documents are the legal contract between the borrower and the lender
regarding the loan. This document should be read closely as it covers important
details such as how long the lender has to fund the loan after receipt of shares,
default provisions and any rights the borrower has to cure default and importantly
loan payoff requirements and options.
This is a legal document and should be treated with care.
After the loan has closed and funded, you should receive an addendum to the
loan document that verifies the loan amount, funding date and funding proceeds.
This is necessary as the price of the stock is almost always different at the time
the loan closes versus when the loan documents are executed (even if only by
pennies).
Share Transfer
Since the shares are the only collateral that the lender can look to in the event of
default, most programs require the shares to be transferred to the lender while
the loan is outstanding. When the loan is paid off, the shares are returned.
Some lending programs will use custodial accounts to hold the shares while other
programs use their own account and create sub-accounts for the borrower. In all
cases, while the stocks are used as collateral the borrower losses control of the
stocks and they can not sell the shares until the loan is paid off.
Before closing on any transaction, the shares should be turned into electronic
form if they are held in certificate form.
Deal Funding
Once the shares are received by the lender, funding typically happens within 24
to 48 hours. The stocks must be received and verified. Then if an active hedging
strategy is employed the hedges must be secured. At that time the loan proceeds
can be wired to the borrower.
Understanding what happens to your stock while the loan is outstanding
Lender’s concerns
Borrowers’ level of concern with what happens to the stock while the loan is
outstanding varies greatly. When they are closely associated with the firm and the
firm has limited trading volume, the issue becomes paramount. If the loan is
against a Fortune 500 company, then the issue is almost non-existent because
whatever hedging strategy the borrower employs will have no effect on the price
of the stock.
Understanding what the lender is doing to protect their capital (ie the collateral) is
critical to avoiding problems down the road.
The lender holds the stock as collateral. Again, remember these are non-recourse
loans and at loan maturity if the stock is worth less than the loan payoff amount
most borrowers will default. The lender has no recourse other than to the
collateral. Therefore it is reasonable to expect that the lender will employ some
strategy to make sure they have some collateral at all to fall back on at loan
maturity. No lender wants to be caught holding ENRON stock as collateral. The
problem is, no one knows what a stocks future price will actually be (never mind,
who will be the next ENRON).
Hedging strategies
Everyone employs some kind of hedging strategies. If you can’t get a straight
answer to the question, look elsewhere. Also know that while you will get a straight
answer from us, the loan documents will still give us the right to do anything we
deem necessary to protect the value of the collateral while the loan is outstanding.
So let’s look at the two primary methods we use to hedge our loans
Active Hedging
With our actively hedged loans we essentially purchase insurance from
investment grade financial institutions on the stock. This obviously costs more
upfront but it has the advantage of essentially creating a fixed asset from a
variable asset and makes the holding easy and share repatriation not a problem
at loan maturity under any scenario. This is a very conservative strategy and
typically costs a little more for the borrower.
Passive Hedging
Our passively hedged loans rely primarily on setting the loan to value at a level we
think we can live with. And then involves the setting of a margin call. If there is no
margin call you should expect that the stocks will be turned into cash if they go
down and then bought back as they rise in order to protect the loan principal. If a
margin call is involved, the first line of defense against a falling price will be the
margin call.
It is important to remember that the selling and buying that goes on behind the
scene is not a taxable event for you. You have lent the shares and will get them
back upon loan maturity (assuming of course that you pay off the loan).
While passive hedging has a lower up front cost, it requires the lender to keep a
close watch on the stock (minute by minute) to manage the collateral and
repatriate the shares at loan maturity. Obviously computers and trading programs
make this easy. With actively hedged shares the work is done upfront and then all
parties can rest easily until loan maturity.
Loan payoff
Most loan programs have four options available to the borrower at loan maturity.
Pay off the loan and get the collateral back
Instruct the lender to sell shares to pay off the loan (and receive excess value in
either cash or shares)
Roll the loan over into a new loan.
Default on the loan
By paying off the loan and getting the collateral back the deal is done. By selling
shares to payoff the loan the deal is also clearly done and the borrower will have
possible tax issues relating to the sale of the shares (no differently than if they
sold the shares directly).
To roll the loan over into a new loan basically requires a re-underwriting of the
loan and is at the lender’s discretion. The stocks must be worth more than the
loan amount and above the LTV requirements.
Defaulting is always a possibility when the stocks are worth less than the loan
payoff amount. Defaulting would be a taxable event (as if you were selling) so it is
important to discuss this with a tax attorney/accountant. Since these are non-
recourse loans, there is no reason (other than tax considerations) to pay more to
get the shares back than you could do buying them back on the open market.
Due diligence issues and concerns
Our team has completed hundreds of loans and the same three questions come
up every time;
Will I get paid after transferring stock?
Are my shares safe?
Will I get my shares back when I pay off the loan?
Will I get paid after transferring stock?
The first step in the loan process is the toughest. You have to send your shares
to the lender and then they will send you cash. This may take minutes or it may
take up to two days. And importantly, it involves trust on the borrower’s side. A
stock loan can not be consummated until the shares are received and hedged
(actively or passively). How do you know you will get paid? Well, track record and
references are a must here. You will have executed loan documents that you are
holding onto that stipulate what the lender must do and that contract is fully
enforceable to the fullest extent of the law. Therefore, your due diligence should
be to make sure the lender is a real company that you can go after in court if you
need to.
Finally don’t wait. If you have not received your cash within two days at the most
start screaming. We fund 90% of our deals within 24 hours and 100% within 48
hours. If you are not paid right away then something is wrong and waiting for a
resolution will not make the situation any better.
Are my shares safe?
As someone involved with stock lending for years my answer is “track record”.
Know who you are doing business with. We discussed hedging strategies above
(active v. passive) but both require the lender to run their business correctly. If
they are doing their job correctly then yes, your shares are safe. Or perhaps more
importantly, they are being managed effectively so when you pay off the loan they
are returned and all that capital appreciation you were hoping for is still there for
your fiscal enjoyment.
A new lender may be perfectly able to do this (we were new lenders once) and
they may be able to give you a great deal in order to get business up and
running. That just means that you must do your due diligence with vigor. Know
who is managing the stocks and check to make sure they have a clean securities
record. Stay close to them and recognize the risks that come with working with a
new lender as well as the rewards.
Traps to avoid
As with any contract, there are certain traps to recognize and avoid. The basic
trap in stock lending involves the lender forcing default early. This is primarily
possible through margin calls and quarterly interest payments.
A loan that has a margin call will give the borrower some time to clear the default
created by the margin call. How much time and how much money or shares
required to clear default are critical. The more flexibility provided to the borrower
the better. If a stock loan has a margin call, proceed with care.
Default can also be triggered by missing an interest payment. If interest is to be
paid monthly or quarterly, make sure to understand the notice requirements of the
lender and make your interest payments in a timely fashion. Missing interest
payments is really the borrower’s problem so don’t be lazy. A good contract will
give the borrower a few days to clear default from a missed interest payment.
When the loan is a non-recourse loan with interest that accrues to maturity and no
margin calls, there really are no traps to avoid. In these situations just make sure
you are dealing with a strong lender and enjoy the peace of mind from having a
conservative stock loan.
Summary
Using your stocks as collateral for a loan can be an excellent way to access the
equity built up in the security, protect your downside risk while continuing to
participate in future dividends and capital appreciation.
The deals are relatively simple yet due to the nature of stocks and the amount of
money involved in these transactions, it is important knowing what is possible in
order to structure a deal that works for the borrower and the lender.
For additional information or to receive a stock loan quote, contact Roel Hoekstra
at (215) 858-8659 or roel@globalstocklending.com