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FED ERAL RE SE R V E BANK OF NEW YORK f Circular No. 4 0 1 5 1 L September 9, 1953 J IN T E R P R E TA T IO N S OF REG U LATIO N S T AN D U To all Banks, M em bers o f N ational Securities E xchanges, and Others In terested , in th e Second Federal R eserve D istrict: The Board o f Governors of the Federal Reserve System has issued two interpretations, one of Regulations T and U and the other o f Regulation U. These interpretations are repro duced below. Although the interpretations will be printed in early issues o f the F ed era l R eserv e Bulletin and the F ed eral R eg ister, they are being sent to you now so that you may have prompt advice of their contents. Additional copies of this circular will be furnished upon request. A llan S peoul, P resident. IN T E R P R E T A T IO N OF R E G U LATIO N S T A N D U Arranging fo r Extensions o f Credit to be Made by a Bank The B oard has recently had occasion to express opinions regarding the requirements which apply when a person subject to Regulation T— for con venience, called here sim ply a broker— arranges for a bank to extend credit. The matter is treated generally in section 7 (a) o f Regulation T, and is also subject to the general rule o f law that any person who aids or abets a violation o f law by another is himself guilty o f a violation. It may be stated as a general principle that any person who arranges fo r credit to be extended by someone else has a responsibility so to conduct his activities as not to be a participant in a violation o f Regulation T which applies to brokers, or Regulation U, which applies to banks. More specifically, in arranging an extension of credit that may be subject to Regulation U, a broker must act in good faith and, therefore, must question the accuracy o f any non-purpose statement (i.e., a statement that the loan is not for the purpose of purchasing or carrying registered stocks) given in connection with the loan where the circumstances are such that the broker from any source knows or has reason to know that the statement is incomplete or otherwise inaccurate as to the true purpose of the credit. The requirement o f “ good fa ith ” is o f vital importance. W hile the application o f the re quirement will necessarily vary with the facts of the particular case, the broker, like the bank for whom the loan is arranged to be made, must be alert to the circumstances surrounding the loan. Thus, fo r example, if a broker or dealer is to deliver registered stocks to secure the loan or is to receive the proceeds o f the loan, the broker arranging the loan and the bank making it would be put on notice that the loan would probably be subject to Regula tion U. In any such circumstances they could not in good faith accept or rely upon a statement to the contrary without obtaining a reliable and satisfac tory explanation o f the situation. The foregoing, o f course, applies the principles published at page 27 o f the 1947 Bulletin (12 C FR , 222.101). In addition, when a broker is approached by another broker to arrange extensions o f credit for customers o f the approaching broker, the broker approached has a responsibility not to arrange any extension o f credit which the approaching broker could not himself arrange. A ccordin gly, in such cases the statutes and regulations forb id the approached broker to arrange extensions o f credit on unregis tered securities fo r the purpose o f purchasing or carrying either registered or unregistered securities. The approaching broker would also be violating the applicable requirements if he initiated or otherwise participated in any such forbidden transactions. The above expression o f views to the effect that certain specific transactions are forbidden, o f course, should not in any way be understood to in dicate approval of any other transactions which are not mentioned. ( over) IN T E R P R E T A T IO N O F R E G U L A T IO N U R eliance in “ G ood Faith” on Statement o f Purpose o f Loan Certain situations have arisen from time to time under Regulation U wherein it appeared doubtful that, in the circumstances, the lending banks may have been entitled to rely upon the statements ac cepted b y them in determ ining whether the p u r poses o f certain loans were such as to cause the loans to be not subject to the regulation. registered stocks to secure the loan or is to receive the proceeds o f the loan, the bank would be put on notice that the loan would probably be subject to the regulation. It could not accept in good faith a statement to the contrary without obtaining a reliable and satisfactory explanation o f the situa tio n ” . The use by a lending bank o f a statement in determining the purpose o f a particular loan is, o f course, provided fo r by section 3 (a ) o f the regula tion. However, under that section a lending bank may “ rely ” upon any such statement only i f it is “ accepted b y the bank in good fa ith ” . A s the B oard stated in the interpretation published in the 1947 Federal Reserve Bulletin, p. 27 and at 12 C .F.R., 221.101, the “ requirement o f ‘ good fa ith ’ is o f vital im portance” ; and, to fulfill such require ment, “ it is clear that the bank must be alert to the circumstances surrounding the loa n ” . Moreover, and as also stated by the aforemen tioned interpretation, the “ purpose” o f a loan, o f course, “ cannot be altered by some tem porary ap plication o f the proceeds. F o r example, if a bor row er is to purchase Government securities with the proceeds o f a loan, but is soon thereafter to sell such securities and replace them with registered stocks, the loan is clearly fo r the purpose o f purchasing or carrying registered stocks” . The purpose o f a loan, therefore, should not be determined upon a narrow analysis o f the immediate use to which the proceeds o f the loan are put. A ccordin gly, a bank acting in “ good fa ith ” should carefu lly scrutinize cases in which there is any indication that the bor row er is concealing the true purpose o f the loan, and there would be reason fo r special vigilance if registered stocks are substituted fo r bonds or un registered stocks soon after the loan is made, or on more than one occasion. Obviously, such a statement would not be ac cepted by the bank in “ good fa ith ” if at the time the loan was made the bank had knowledge, from any source, o f facts o r circumstances which were contrary to the natural p urp ort o f the statement, or which were sufficient reasonably to put the bank on notice o f the questionable reliability or complete ness o f the statement. Furthermore, the same requirement o f “ good fa ith ” is to be applied whether the statement ac cepted by the bank is signed by the borrow er or by an officer o f the bank. In either case, ‘ ‘ good faith ’ ’ requires the exercise o f special diligence in any instance in which the borrower is not personally known to the bank o r to the officer who processes the loan. The interpretation mentioned above contains an example o f the application o f the “ good fa ith ” test. There it was stated that “ if the loan is to be made to a customer who is not a broker or dealer in securities, but such a broker or dealer is to deliver Similarly, the fact that a loan made on the borrow er’s signature only, fo r example, becomes secured by registered stock shortly after the dis bursement o f the loan usually would afford reason able grounds fo r questioning the bank’s apparent reliance upon merely a statement that the purpose o f the loan was not to purchase or carry registered stock. These examples are, o f course, by no means ex haustive. They sim ply illustrate the fundamental fact that no statement accepted by a bank is o f any value fo r the purposes o f the regulation unless “ accepted b y the bank in good fa ith ” , and that ‘ ‘ good faith ’ ’ requires, among other things, reason able diligence to learn the truth.
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