The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FED ERAL RESER VE BANK OF NEW YORK r C ircu lar N o . 5 0 4 4 L J u n e S, 1961 INTERPRETATION OF REGULATION U T o A ll B anks in th e Second Federal R eserve D is tr ic t: Printed below is a copy o f an interpretation, issued by the Board of Governors o f the Federal Reserve System, o f the meaning of the phrase “ secured . . . indirectly by any stock” in section 221.1 o f Regulation U. Although the interpretation w ill be published in the Federal R eserve Bulletin, it is being sent to you now so that you may have prompt advice o f its contents. Additional copies o f this circular will be furnished upon request. A lfred H ayes, President. Loan Which is Secured Indirectly by Stock A question has been presented to the B oard as to whether a loan b y a bank to a mutual investment fund is “ secured . . . indirectly by any stock” within the meaning o f section 221.1 o f Regulation U, so that the loan should be treated as subject to the regulation. Briefly, the facts are as follows. F u n d X , an openend investment company, entered into a loan agree ment with Bank Y , which was (an d still is) custodian o f the securities which comprise the portfolio o f F u n d X . The agreement includes the follow ing terms, which are material to the question before the B oa rd : (1) Fund X agrees to have an “ asset coverage” (as defined in the agreements) of 400 per cent of all its borrowings, including the proposed borrowing, at the time when it takes down any part o f the loan. (2) Fund X agrees to maintain an “ asset coverage” of at least 300 per cent o f its borrowings at all times. (3) Fund X agrees not to amend its custody agree ment with Bank Y, or to substitute another custodian without Bank Y ’s consent. (4) Fund X agrees not to mortgage, pledge, or other wise encumber any of its assets elsewhere than with Bank Y. In 1958 Federal Reserve Bulletin, at page 1279, the B oard stated that because o f ‘ ‘ the general nature and operations o f such a eom pany” , any “ loan by a bank to an open-end investment com pany that customarily purchases stocks registered on a national securities exchange . . . should be presumed to be subject to Regulation U as a loan fo r the purpose o f purchasing or carrying registered stocks” (“ purpose lo a n ” ). The B oa rd ’s interpretation went on to say that “ This w ould n ot be altered b y the fact that the open-end com pany had used, or proposed to use, its own funds or proceeds o f the loan to redeem some o f its own shares. . . . ” A ccordin gly, the loan b y Bank Y to F u n d X was and is a “ purpose lo a n ” . However, a loan by a bank is not subject to Regulation U unless (1 ) it is a p u r pose loan and (2 ) it is “ secured directly or indirectly by any stock” . In the present case, the loan is not “ secured d irectly” b y stock in the ordinary sense, since the portfolio o f F u n d X is n ot pledged to secure the credit from Bank Y . B ut the w ord “ in d irectly” must sign ify some form o f security arrangement other than the “ d irect” security which arises from the ordinary “ transaction that gives recourse against a particular chattel or land or against a third party on an obligation” described in the A m erican Law Insti tu te’s Restatem ent o f the Law o f S ecu rity, page 1. Otherwise the word “ in d irectly” would be superflu ous, and a regulation, like a statute, must be construed if possible to give meaning to every word. The B oard has indicated its view that any arrange ( o v e r ) ment under which stock is more readily available as security to the lending bank than to other creditors o f the borrow er may amount to indirect security within the meaning o f Regulation U. In an interpre tation published at 1959 Federal Reserve Bulletin 256 it stated “ The Board has long held, in the . . . ‘purpose’ area, that the original purpose o f a loan should not be deter mined upon a narrow analysis of the technical circum stances under which a loan is made. . . . “ Where security is involved, standards o f interpreta tion should be equally searching.” In its pamphlet issued fo r the benefit and guidance of banks and bank examiners, entitled “ Questions and Answers Illustrating A pp lication o f Regulation U ” , the B oard said “ In determining whether a loan is ‘indirectly’ secured, it should be borne in mind that the reason the Board has thus far refrained . . . from regulating loans not secured by stock has been to simplify operations under the regu lation. This objective o f simplifying operations does not apply to loans in which arrangements are made to retain the substance o f stock collateral while sacrificing only the form.” A wide variety o f arrangements as to collateral can be made between bank and borrow er which will serve, to some extent, to protect the interest o f the bank in seeing that the loan is repaid, without givin g the bank a conventional direct “ secu rity” interest in the col lateral. A m ong such arrangements which have come to the B oa rd ’s attention are the follow in g : such securities as collateral in the making or maintenance o f the particular loan.” does not exempt a deposit o f this kind from the impact o f the regulation unless it is clear that the bank “ has not relied” upon the securities deposited with it. (2) A borrower may not deposit his stock with the bank, but agree not to pledge or encumber his assets elsewhere while the loan is outstanding. Such an agreement may be difficult to police, yet it serves to some extent to protect the interest o f the bank i f only because the future credit standing and business reputation o f the borrow er w ill depend upon his keeping his word. I f the assets covered b y such an agreement include stock, then, as under (1 ) and ( 3 ) , the stock is “ indirect secu rity” fo r the loan within the meaning o f Regulation U. (3) The borrower may deposit stock with a third party who agrees to hold the stock until the loan has been paid off. Here, even though the parties may p u rp ort to provide that the stock is n ot “ secu rity” f o r the loan ( fo r ex ample, b y agreeing that the stock may n ot be sold and the proceeds applied to the debt if the borrow er fails to p a y ), the mere fact that the stock is out o f the borrow er’s control fo r the duration o f the loan serves to some extent to protect the bank. The three instances described above are merely illustrative. Other methods, or combinations o f meth ods, may serve a similar purpose. The conclusion (1) The borrower may deposit stock in the custody that any given arrangement constitutes “ indirect o f the bank. secu rity” may, but need not, be reinforced by facts such as that the stock in question was purchased with A n arrangement o f this kind m ay not, it is true, place proceeds o f the loan, that the lending bank suggests the bank in the position o f a secured creditor in case or insists upon the arrangement, or that the loan would o f bankruptcy, or even o f conflicting claims, but it is probably be subject to criticism b y supervisory auth likely effectively to strengthen the bank’s position. orities were it n ot fo r the protective arrangement. Section 2 2 1 .3 (f) o f Regulation U, which provides that “ A loan need not be treated as collateralled by securi ties which are held by the bank only in the capacity of custodian, depositary or trustee, or under similar circum stances, if the bank in good faith has not relied upon A ccordin gly, the B oard concludes that the loan by Bank Y to F u n d X is indirectly secured by the port folio o f the fu n d and must be treated b y the bank as a regulated loan.
@FedFRASER