What it means
The rule applies when two things are true: the loan is secured by margin stock, and its purpose is buying or carrying margin stock. Margin stock includes most shares listed on a national exchange and certain other securities.
When both conditions are met, the loan is a purpose credit, and the lender must follow the limits. The main limit is on the amount that can be lent against the stock.
The Federal Reserve sets a maximum loan value for margin stock as a percentage of its current market value, and that percentage has traditionally been 50%. A bank lending against shares worth $1,000,000 could therefore lend no more than half of that, for that purpose.
The lender must document the purpose of the loan, usually on a form signed by the borrower that states whether the money will be used to buy margin stock. A lender that has reason to doubt the statement, for example because the borrower's plans look inconsistent with it, must look into the matter before relying on it.
The rule is related to Regulation T, which applies similar limits to brokers and dealers. Both trace back to the lessons of the 1929 market crash and aim to limit leverage in the stock market.
Leverage here means borrowing used to amplify returns, and it can magnify losses as quickly as gains. For businesses, the rule often turns up in transactions such as acquisitions and share buy-backs financed by a bank loan secured by shares.
Lawyers and treasury teams will check whether the shares pledged count as margin stock and whether the loan purpose triggers the rule. The answer can change how much the bank can lend.
The rule also shapes how companies finance share purchases. A business that borrows to buy back its own listed shares, or to acquire a listed target, may find that its bank treats the loan as a purpose credit secured by margin stock.
Planning the financing with the rule in mind avoids last-minute surprises about how much can be borrowed.
In practice
Real-world examples.
Example
An investor asks a bank for a $200,000 loan secured by listed shares, to buy more shares in the same company. The bank completes the purpose statement and limits the loan to the maximum loan value of the shares pledged.
Example
A founder wants a loan secured by her listed shares to fund a home renovation. Since the money is not used to buy or carry margin stock, the loan is not a purpose credit, and the bank applies its normal lending standards.
Example
A company arranges bank financing for a tender offer to buy shares of a listed target, with the target's shares as part of the collateral. The deal lawyers check the rule to see whether the loan is restricted.
Formula
Calculation
Maximum loan value = market value of margin stock x maximum loan value percentage
Assume, for illustration, a 50% maximum loan value percentage. A borrower pledges margin stock with a market value of $300,000 to secure a purpose loan. Maximum loan value = $300,000 x 50% = $150,000. The limit is tested when credit is extended, so a later fall in the share price does not itself breach the rule, although lenders usually add margin call terms of their own. If the stock were worth $240,000 when a new loan was requested, the maximum would be $240,000 x 50% = $120,000, which is $30,000 less.Case study
Seen in the real world.
Stonehaven Capital is an illustrative, fictional investment partnership that borrowed from a bank to build a larger stake in a listed company. The partners assumed the bank would lend up to 80% of the shares' value because that was what their previous lender had offered.
The bank told them that the loan was a purpose credit and was limited to 50% of the value of the stock. The partners had to contribute extra cash for the shortfall, and they reduced the size of the stake they purchased. The illustrative lesson is that the permitted borrowing against shares depends on the purpose of the loan as well as on the quality of the collateral.
Stonehaven's lawyers also noted that the partnership could use a different structure, such as raising more equity from its own investors, to fund the gap. The partners chose a mix of both and closed the purchase a few weeks later than planned.
Watch out
Common mistakes.
- Assuming any loan secured by shares falls under the rule, when it applies only if the purpose is buying or carrying margin stock.
- Using last year's share price to measure collateral, when the value must reflect the current market value.
- Mixing up Regulation U with Regulation T, when Regulation T governs brokers and dealers and Regulation U covers banks and other lenders.
Questions
People also ask.
What is margin stock?
It is mainly stock listed on a national securities exchange, along with certain over-the-counter stocks and mutual funds that invest heavily in such shares.
What is a purpose statement?
It is a document, usually signed by the borrower, stating how the loan proceeds will be used, so that the lender can tell whether the rule applies.
Does the maximum loan value ever change?
Yes, the Federal Reserve Board sets the percentage and can change it, although it has historically stayed at 50%.
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