• 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?
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
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?
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
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 which means
that the proceeds of the loan can not be used to re-invest in margin able
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.
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.
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
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.
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.
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.
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 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
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
We view the closing process as having five distinct steps;
1. Term Sheet
3. Loan documents
4. Share transfer
5. Deal funding
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.
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.
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
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
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
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.
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
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).
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
So let’s look at the two primary methods we use to hedge our loans
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.
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.
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
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.
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.
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