Title 12--Banks and Banking

CHAPTER II--FEDERAL RESERVE SYSTEM

PART 221--CREDIT BY BANKS AND PERSONS OTHER THAN BROKERS OR DEALERS FOR THE PURPOSE OF PURCHASING OR CARRYING MARGIN STOCK (REGULATION U)

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Sec. 221.1 Authority, purpose and scope.
    

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    (a) Authority. Regulation U (this part) is issued by the Board of 
Governors of the Federal Reserve System (the Board) pursuant to the 
Securities Exchange Act of 1934 (the Act) (15 U.S.C. 78a et seq.).
    (b) Purpose and scope. (1) This part imposes credit restrictions 
upon persons other than brokers or dealers (hereinafter lenders) that 
extend credit for the purpose of buying or carrying margin stock if the 
credit is secured directly or indirectly by margin stock. Lenders 
include ``banks'' (as defined in Sec. 221.2) and other persons who are 
required to register with the Board under Sec. 221.3(b). Lenders may not 
extend more than the maximum loan value of the collateral securing such 
credit, as set by the Board in Sec. 221.7 (the Supplement).
    (2) This part does not apply to clearing agencies regulated by the 
Securities and Exchange Commission or the Commodity Futures Trading 
Commission that accept deposits of margin stock in connection with:
    (i) The issuance of, or guarantee of, or the clearance of 
transactions in, any security (including options on any security, 
certificate of deposit, securities index or foreign currency); or
    (ii) The guarantee of contracts for the purchase or sale of a 
commodity for future delivery or options on such contracts.
    (3) This part does not apply to credit extended to an exempted 
borrower.
    (c) Availability of forms. The forms referenced in this part are 
available from the Federal Reserve Banks.

Sec. 221.2 Definitions.
     

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    The terms used in this part have the meanings given them in section 
3(a) of the Act or as defined in this section as follows:
    Affiliate means:
    (1) For banks:
    (i) Any bank holding company of which a bank is a subsidiary within 
the meaning of the Bank Holding Company Act of 1956, as amended (12 
U.S.C. 1841(d));
    (ii) Any other subsidiary of such bank holding company; and
    (iii) Any other corporation, business trust, association, or other 
similar organization that is an affiliate as defined in section 2(b) of 
the Banking Act of 1933 (12 U.S.C. 221a(c));
    (2) For nonbank lenders, affiliate means any person who, directly or 
indirectly, through one or more intermediaries, controls, or is 
controlled by, or is under common control with the lender.
    Bank. (1) Bank. Has the meaning given to it in section 3(a)(6) of 
the Act (15 U.S.C. 78c(a)(6)) and includes:
    (i) Any subsidiary of a bank;
    (ii) Any corporation organized under section 25(a) of the Federal 
Reserve Act (12 U.S.C. 611); and
    (iii) Any agency or branch of a foreign bank located within the 
United States.
    (2) Bank does not include:
    (i) Any savings and loan association;
    (ii) Any credit union;
    (iii) Any lending institution that is an instrumentality or agency 
of the United States; or
    (iv) Any member of a national securities exchange.
    Carrying credit is credit that enables a customer to maintain, 
reduce, or retire indebtedness originally incurred to purchase a 
security that is currently a margin stock.
    Current market value of:
    (1) A security means:
    (i) If quotations are available, the closing sale price of the 
security on the preceding business day, as appearing on any regularly 
published reporting or quotation service; or

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    (ii) If there is no closing sale price, the lender may use any 
reasonable estimate of the market value of the security as of the close 
of business on the preceding business day; or
    (iii) If the credit is used to finance the purchase of the security, 
the total cost of purchase, which may include any commissions charged.
    (2) Any other collateral means a value determined by any reasonable 
method.
    Customer excludes an exempted borrower and includes any person or 
persons acting jointly, to or for whom a lender extends or maintains 
credit.
    Examining authority means:
    (1) The national securities exchange or national securities 
association of which a broker or dealer is a member; or
    (2) If a member of more than one self-regulatory organization, the 
organization designated by the Securities and Exchange Commission as the 
examining authority for the broker or dealer.
    Exempted borrower means a member of a national securities exchange 
or a registered broker or dealer, a substantial portion of whose 
business consists of transactions with persons other than brokers or 
dealers, and includes a borrower who:
    (1) Maintains at least 1000 active accounts on an annual basis for 
persons other than brokers, dealers, and persons associated with a 
broker or dealer;
    (2) Earns at least $10 million in gross revenues on an annual basis 
from transactions with persons other than brokers, dealers, and persons 
associated with a broker or dealer; or
    (3) Earns at least 10 percent of its gross revenues on an annual 
basis from transactions with persons other than brokers, dealers, and 
persons associated with a broker-dealer.
    Good faith with respect to:
    (1) The loan value of collateral means that amount (not exceeding 
100 per cent of the current market value of the collateral) which a 
lender, exercising sound credit judgment, would lend, without regard to 
the customer's other assets held as collateral in connection with 
unrelated transactions.
    (2) Making a determination or accepting a statement concerning a 
borrower means that the lender or its duly authorized representative is 
alert to the circumstances surrounding the credit, and if in possession 
of information that would cause a prudent person not to make the 
determination or accept the notice or certification without inquiry, 
investigates and is satisfied that it is correct;
    In the ordinary course of business means occurring or reasonably 
expected to occur in carrying out or furthering any business purpose, or 
in the case of an individual, in the course of any activity for profit 
or the management or preservation of property.
    Indirectly secured. (1) Includes any arrangement with the customer 
under which:
    (i) The customer's right or ability to sell, pledge, or otherwise 
dispose of margin stock owned by the customer is in any way restricted 
while the credit remains outstanding; or
    (ii) The exercise of such right is or may be cause for accelerating 
the maturity of the credit.
    (2) Does not include such an arrangement if:
    (i) After applying the proceeds of the credit, not more than 25 
percent of the value (as determined by any reasonable method) of the 
assets subject to the arrangement is represented by margin stock;
    (ii) It is a lending arrangement that permits accelerating the 
maturity of the credit as a result of a default or renegotiation of 
another credit to the customer by another lender that is not an 
affiliate of the lender;
    (iii) The lender holds the margin stock only in the capacity of 
custodian, depositary, or trustee, or under similar circumstances, and, 
in good faith, has not relied upon the margin stock as collateral; or
    (iv) The lender, in good faith, has not relied upon the margin stock 
as collateral in extending or maintaining the particular credit.
    Lender means:
    (1) Any bank; or
    (2) Any person subject to the registration requirements of this 
part.
    Margin stock means:
    (1) Any equity security registered or having unlisted trading 
privileges on a national securities exchange;

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    (2) Any OTC security designated as qualified for trading in the 
National Market System under a designation plan approved by the 
Securities and Exchange Commission (NMS security);
    (3) Any debt security convertible into a margin stock or carrying a 
warrant or right to subscribe to or purchase a margin stock;
    (4) Any warrant or right to subscribe to or purchase a margin stock; 
or
    (5) Any security issued by an investment company registered under 
section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), other 
than:
    (i) A company licensed under the Small Business Investment Company 
Act of 1958, as amended (15 U.S.C. 661); or
    (ii) A company which has at least 95 percent of its assets 
continuously invested in exempted securities (as defined in 15 U.S.C. 
78c(a)(12)); or
    (iii) A company which issues face-amount certificates as defined in 
15 U.S.C. 80a-2(a)(15), but only with respect of such securities; or
    (iv) A company which is considered a money market fund under SEC 
Rule 2a-7 (17 CFR 270.2a-7).
    Maximum loan value is the percentage of current market value 
assigned by the Board under Sec. 221.7 (the Supplement) to specified 
types of collateral. The maximum loan value of margin stock is stated as 
a percentage of its current market value. Puts, calls and combinations 
thereof that do not qualify as margin stock have no loan value. All 
other collateral has good faith loan value.
    Nonbank lender means any person subject to the registration 
requirements of this part.
    Purpose credit is any credit for the purpose, whether immediate, 
incidental, or ultimate, of buying or carrying margin stock.

Sec. 221.3 General requirements.
     

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    (a) Extending, maintaining, and arranging credit--(1) Extending 
credit. No lender, except a plan-lender, as defined in Sec. 221.4(a), 
shall extend any purpose credit, secured directly or indirectly by 
margin stock, in an amount that exceeds the maximum loan value of the 
collateral securing the credit.
    (2) Maintaining credit. A lender may continue to maintain any credit 
initially extended in compliance with this part, regardless of:
    (i) Reduction in the customer's equity resulting from change in 
market prices;
    (ii) Change in the maximum loan value prescribed by this part; or
    (iii) Change in the status of the security (from nonmargin to 
margin) securing an existing purpose credit.
    (3) Arranging credit. No lender may arrange for the extension or 
maintenance of any purpose credit, except upon the same terms and 
conditions under which the lender itself may extend or maintain purpose 
credit under this part.
    (b) Registration of nonbank lenders; termination of registration; 
annual report--(1) Registration. Every person other than a person 
subject to part 220 of this chapter or a bank who, in the ordinary 
course of business, extends or maintains credit secured, directly or 
indirectly, by any margin stock shall register on Federal Reserve Form 
FR G-1 (OMB control number 7100-0011) within 30 days after the end of 
any calendar quarter during which:
    (i) The amount of credit extended equals $200,000 or more; or
    (ii) The amount of credit outstanding at any time during that 
calendar quarter equals $500,000 or more.
    (2) Deregistration. A registered nonbank lender may apply to 
terminate its registration, by filing Federal Reserve Form FR G-2 (OMB 
control number 7100-0011), if the lender has not, during the preceding 
six calendar months, had more than $200,000 of such credit outstanding. 
Registration shall be deemed terminated when the application is approved 
by the Board.
    (3) Annual report. Every registered nonbank lender shall, within 30 
days following June 30 of every year, file Form FR G-4 (OMB control 
number 7100-0011).
    (4) Where to register and file applications and reports. 
Registration statements, applications to terminate registration, and 
annual reports shall be filed with the Federal Reserve Bank of the 
district in which the principal office of the lender is located.

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    (c) Purpose statement--(1) General rule--(i) Banks. Except for 
credit extended under paragraph (c)(2) of this section, whenever a bank 
extends credit secured directly or indirectly by any margin stock, in an 
amount exceeding $100,000, the bank shall require its customer to 
execute Form FR U-1 (OMB No. 7100-0115), which shall be signed and 
accepted by a duly authorized officer of the bank acting in good faith.
    (ii) Nonbank lenders. Except for credit extended under paragraph 
(c)(2) of this section or Sec. 221.4, whenever a nonbank lender extends 
credit secured directly or indirectly by any margin stock, the nonbank 
lender shall require its customer to execute Form FR G-3 (OMB control 
number 7100-0018), which shall be signed and accepted by a duly 
authorized representative of the nonbank lender acting in good faith.
    (2) Purpose statement for revolving-credit or multiple-draw 
agreements or financing of securities purchases on a payment-against-
delivery basis--(i) Banks. If a bank extends credit, secured directly or 
indirectly by any margin stock, in an amount exceeding $100,000, under a 
revolving-credit or other multiple-draw agreement, Form FR U-1 must be 
executed at the time the credit arrangement is originally established 
and must be amended as described in paragraph (c)(2)(iv) of this section 
for each disbursement if all of the collateral for the agreement is not 
pledged at the time the agreement is originally established.
    (ii) Nonbank lenders. If a nonbank lender extends credit, secured 
directly or indirectly by any margin stock, under a revolving-credit or 
other multiple-draw agreement, Form FR G-3 must be executed at the time 
the credit arrangement is originally established and must be amended as 
described in paragraph (c)(2)(iv) of this section for each disbursement 
if all of the collateral for the agreement is not pledged at the time 
the agreement is originally established.
    (iii) Collateral. If a purpose statement executed at the time the 
credit arrangement is initially made indicates that the purpose is to 
purchase or carry margin stock, the credit will be deemed in compliance 
with this part if:
    (A) The maximum loan value of the collateral at least equals the 
aggregate amount of funds actually disbursed; or
    (B) At the end of any day on which credit is extended under the 
agreement, the lender calls for additional collateral sufficient to 
bring the credit into compliance with Sec. 221.7 (the Supplement).
    (iv) Amendment of purpose statement. For any purpose credit 
disbursed under the agreement, the lender shall obtain and attach to the 
executed Form FR U-1 or FR G-3 a current list of collateral which 
adequately supports all credit extended under the agreement.
    (d) Single credit rule. (1) All purpose credit extended to a 
customer shall be treated as a single credit, and all the collateral 
securing such credit shall be considered in determining whether or not 
the credit complies with this part, except that syndicated loans need 
not be aggregated with other unrelated purpose credit extended by the 
same lender.
    (2) A lender that has extended purpose credit secured by margin 
stock may not subsequently extend unsecured purpose credit to the same 
customer unless the combined credit does not exceed the maximum loan 
value of the collateral securing the prior credit.
    (3) If a lender extended unsecured purpose credit to a customer 
prior to the extension of purpose credit secured by margin stock, the 
credits shall be combined and treated as a single credit solely for the 
purposes of the withdrawal and substitution provision of paragraph (f) 
of this section.
    (4) If a lender extends purpose credit secured by any margin stock 
and non-purpose credit to the same customer, the lender shall treat the 
credits as two separate loans and may not rely upon the required 
collateral securing the purpose credit for the nonpurpose credit.
    (e) Exempted borrowers. (1) An exempted borrower that has been in 
existence for less than one year may meet the definition of exempted 
borrower based on a six-month period.
    (2) Once a member of a national securities exchange or registered 
broker or dealer ceases to qualify as an exempted borrower, it shall 
notify its lenders of this fact. Any new extensions of credit

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to such a borrower, including rollovers, renewals, and additional draws 
on existing lines of credit, are subject to the provisions of this part.
    (f) Withdrawals and substitutions. (1) A lender may permit any 
withdrawal or substitution of cash or collateral by the customer if the 
withdrawal or substitution would not:
    (i) Cause the credit to exceed the maximum loan value of the 
collateral; or
    (ii) Increase the amount by which the credit exceeds the maximum 
loan value of the collateral.
    (2) For purposes of this section, the maximum loan value of the 
collateral on the day of the withdrawal or substitution shall be used.
    (g) Exchange offers. To enable a customer to participate in a 
reorganization, recapitalization or exchange offer that is made to 
holders of an issue of margin stock, a lender may permit substitution of 
the securities received. A nonmargin, nonexempted security acquired in 
exchange for a margin stock shall be treated as if it is margin stock 
for a period of 60 days following the exchange.
    (h) Renewals and extensions of maturity. A renewal or extension of 
maturity of a credit need not be considered a new extension of credit if 
the amount of the credit is increased only by the addition of interest, 
service charges, or taxes with respect to the credit.
    (i) Transfers of credit. (1) A transfer of a credit between 
customers or between lenders shall not be considered a new extension of 
credit if:
    (i) The original credit was extended by a lender in compliance with 
this part or by a lender subject to part 207 of this chapter in effect 
prior to April 1, 1998, (See part 207 appearing in the 12 CFR parts 200 
to 219 edition revised as of January 1, 1997), in a manner that would 
have complied with this part;
    (ii) The transfer is not made to evade this part;
    (iii) The amount of credit is not increased; and
    (iv) The collateral for the credit is not changed.
    (2) Any transfer between customers at the same lender shall be 
accompanied by a statement by the transferor customer describing the 
circumstances giving rise to the transfer and shall be accepted and 
signed by a representative of the lender acting in good faith. The 
lender shall keep such statement with its records of the transferee 
account.
    (3) When a transfer is made between lenders, the transferee shall 
obtain a copy of the Form FR U-1 or Form FR G-3 originally filed with 
the transferor and retain the copy with its records of the transferee 
account. If no form was originally filed with the transferor, the 
transferee may accept in good faith a statement from the transferor 
describing the purpose of the loan and the collateral securing it.
    (j) Action for lender's protection. Nothing in this part shall 
require a bank to waive or forego any lien or prevent a bank from taking 
any action it deems necessary in good faith for its protection.
    (k) Mistakes in good faith. A mistake in good faith in connection 
with the extension or maintenance of credit shall not be a violation of 
this part.

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    (a) Plan-lender; eligible plan. (1) Plan-lender means any 
corporation, (including a wholly-owned subsidiary, or a lender that is a 
thrift organization whose membership is limited to employees and former 
employees of the corporation, its subsidiaries or affiliates) that 
extends or maintains credit to finance the acquisition of margin stock 
of the corporation, its subsidiaries or affiliates under an eligible 
plan.
    (2) Eligible plan. An eligible plan means any employee stock option, 
purchase, or ownership plan adopted by a corporation and approved by its 
stockholders that provides for the purchase of margin stock of the 
corporation, its subsidiaries, or affiliates.
    (b) Credit to exercise rights under or finance an eligible plan. (1) 
If a plan-lender extends or maintains credit under an eligible plan, any 
margin stock that directly or indirectly secured that credit shall have 
good faith loan value.
    (2) Credit extended under this section shall be treated separately 
from credit extended under any other section of this part except 
Sec. 221.3(b)(1) and (b)(3).

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    (c) Credit to ESOPs. A nonbank lender may extend and maintain 
purpose credit without regard to the provisions of this part, except for 
Sec. 221.3(b)(1) and (b)(3), if such credit is extended to an employee 
stock ownership plan (ESOP) qualified under section 401 of the Internal 
Revenue Code, as amended (26 U.S.C. 401).

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    (a) Special purpose loans. A lender may extend and maintain purpose 
credit to brokers and dealers without regard to the limitations set 
forth in Secs. 221.3 and 221.7, if the credit is for any of the specific 
purposes and meets the conditions set forth in paragraph (c) of this 
section.
    (b) Written notice. Prior to extending credit for more than a day 
under this section, the lender shall obtain and accept in good faith a 
written notice or certification from the borrower as to the purposes of 
the loan. The written notice or certification shall be evidence of 
continued eligibility for the special credit provisions until the 
borrower notifies the lender that it is no longer eligible or the lender 
has information that would cause a reasonable person to question whether 
the credit is being used for the purpose specified.
    (c) Types of special purpose credit. The types of credit that may be 
extended and maintained on a good faith basis are as follows:
    (1) Hypothecation loans. Credit secured by hypothecated customer 
securities that, according to written notice received from the broker or 
dealer, may be hypothecated by the broker or dealer under Securities and 
Exchange Commission (SEC) rules.
    (2) Temporary advances in payment-against-delivery transactions. 
Credit to finance the purchase or sale of securities for prompt 
delivery, if the credit is to be repaid upon completion of the 
transaction.
    (3) Loans for securities in transit or transfer. Credit to finance 
securities in transit or surrendered for transfer, if the credit is to 
be repaid upon completion of the transaction.
    (4) Intra-day loans. Credit to enable a broker or dealer to pay for 
securities, if the credit is to be repaid on the same day it is 
extended.
    (5) Arbitrage loans. Credit to finance proprietary or customer bona 
fide arbitrage transactions. For the purpose of this section bona fide 
arbitrage means:
    (i) Purchase or sale of a security in one market, together with an 
offsetting sale or purchase of the same security in a different market 
at nearly the same time as practicable, for the purpose of taking 
advantage of a difference in prices in the two markets; or
    (ii) Purchase of a security that is, without restriction other than 
the payment of money, exchangeable or convertible within 90 calendar 
days of the purchase into a second security, together with an offsetting 
sale of the second security at or about the same time, for the purpose 
of taking advantage of a concurrent disparity in the price of the two 
securities.
    (6) Market maker and specialist loans. Credit to a member of a 
national securities exchange or registered broker or dealer to finance 
its activities as a market maker or specialist.
    (7) Underwriter loans. Credit to a member of a national securities 
exchange or registered broker or dealer to finance its activities as an 
underwriter.
    (8) Emergency loans. Credit that is essential to meet emergency 
needs of the broker-dealer business arising from exceptional 
circumstances.
    (9) Capital contribution loans. Capital contribution loans include:
    (i) Credit that Board has exempted by order upon a finding that the 
exemption is necessary or appropriate in the public interest or for the 
protection of investors, provided the Securities Investor Protection 
Corporation certifies to the Board that the exemption is appropriate; or
    (ii) Credit to a customer for the purpose of making a subordinated 
loan or capital contribution to a broker or dealer in conformity with 
the SEC's net capital rules and the rules of the broker's or dealer's 
examining authority, provided:
    (A) The customer reduces the credit by the amount of any reduction 
in the loan or contribution to the broker or dealer; and

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    (B) The credit is not used to purchase securities issued by the 
broker or dealer in a public distribution.
    (10) Credit to clearing brokers or dealers. Credit to a member of a 
national securities exchange or registered broker or dealer whose 
nonproprietary business is limited to financing and carrying the 
accounts of registered market makers.

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    A bank may extend and maintain purpose credit without regard to the 
provisions of this part if such credit is extended:
    (a) To any bank;
    (b) To any foreign banking institution;
    (c) Outside the United States;
    (d) To an employee stock ownership plan (ESOP) qualified under 
section 401 of the Internal Revenue Code (26 U.S.C. 401);
    (e) To any plan lender as defined in Sec. 221.4(a) to finance an 
eligible plan as defined in Sec. 221.4(b), provided the bank has no 
recourse to any securities purchased pursuant to the plan;
    (f) To any customer, other than a broker or dealer, to temporarily 
finance the purchase or sale of securities for prompt delivery, if the 
credit is to be repaid in the ordinary course of business upon 
completion of the transaction and is not extended to enable the customer 
to pay for securities purchased in an account subject to part 220 of 
this chapter;
    (g) Against securities in transit, if the credit is not extended to 
enable the customer to pay for securities purchased in an account 
subject to part 220 of this chapter; or
    (h) To enable a customer to meet emergency expenses not reasonably 
foreseeable, and if the extension of credit is supported by a statement 
executed by the customer and accepted and signed by an officer of the 
bank acting in good faith. For this purpose, emergency expenses include 
expenses arising from circumstances such as the death or disability of 
the customer, or some other change in circumstances involving extreme 
hardship, not reasonably foreseeable at the time the credit was 
extended. The opportunity to realize monetary gain or to avoid loss is 
not a ``change in circumstances'' for this purpose.

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    (a) Maximum loan value of margin stock. The maximum loan value of 
any margin stock is fifty per cent of its current market value.
    (b) Maximum loan value of nonmargin stock and all other collateral. 
The maximum loan value of nonmargin stock and all other collateral 
except puts, calls, or combinations thereof is their good faith loan 
value.
    (c) Maximum loan value of options. Except for options that qualify 
as margin stock, puts, calls, and combinations thereof have no loan 
value.

                             Interpretations

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    (a) Under this part the original purpose of a loan is controlling. 
In other words, if a loan originally is not for the purpose of 
purchasing or carrying margin stock, changes in the collateral for the 
loan do not change its exempted character.
    (b) However, a so-called increase in the loan is necessarily on an 
entirely different basis. So far as the purpose of the credit is 
concerned, it is a new loan, and the question of whether or not it is 
subject to this part must be determined accordingly.
    (c) Certain facts should also be mentioned regarding the 
determination of the purpose of a loan. Section 221.3(c) provides in 
that whenever a lender is required to have its customer execute a 
``Statement of Purpose for an Extension of Credit Secured by Margin 
Stock,'' the statement must be accepted by the lender ``acting in good 
faith.'' The requirement of ``good faith'' is of vital importance here. 
Its application will necessarily vary with the facts of the particular 
case, but it is clear that the bank must be alert to the circumstances 
surrounding the loan. For example, 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 margin stock to secure the loan or is to receive 
the proceeds of

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the loan, the bank would be put on notice that the loan would probably 
be subject to this part. It could not accept in good faith a statement 
to the contrary without obtaining a reliable and satisfactory 
explanation of the situation.
    (d) Furthermore, the purpose of a loan means just that. It cannot be 
altered by some temporary application of the proceeds. For example, if a 
borrower is to purchase Government securities with the proceeds of a 
loan, but is soon thereafter to sell such securities and replace them 
with margin stock, the loan is clearly for the purpose of purchasing or 
carrying margin stock.

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    The Board has concluded that the date a commitment to extend credit 
becomes binding should be regarded as the date when the credit is 
extended, since:
    (a) On that date the parties should be aware of law and facts 
surrounding the transaction; and
    (b) Generally, the date of contract is controlling for purposes of 
margin regulations and Federal securities law, regardless of the 
delivery of cash or securities.

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    Questions have arisen as to the adequacy of statements received by 
lending banks under Sec. 221.3(c), ``Purpose Statement,'' in the case of 
loans to brokers or dealers secured by margin stock where the proceeds 
of the loans are to be used to finance customer transactions involving 
the purchasing or carrying of margin stock. While some such loans may 
qualify for exemption under Secs. 221.1(b)(2), 221.4, 221.5 or 221.6, 
unless they do qualify for such an exemption they are subject to this 
part. For example, if a loan so secured is made to a broker to furnish 
cash working capital for the conduct of his brokerage business (i.e., 
for purchasing and carrying securities for the account of customers), 
the maximum loan value prescribed in Sec. 221.7 (the Supplement) would 
be applicable unless the loan should be of a kind exempted under this 
part. This result would not be affected by the fact that the margin 
stock given as security for the loan was or included margin stock owned 
by the brokerage firm. In view of the foregoing, the statement referred 
to in Sec. 221.3(c) which the lending bank must accept in good faith in 
determining the purpose of the loan would be inadequate if the form of 
statement accepted or used by the bank failed to call for answers which 
would indicate whether or not the loan was of the kind discussed 
elsewhere in this section.

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    For text of the interpretation on Federal credit unions, see 12 CFR 
220.110.

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    For text of the interpretation on Arranging for extensions of credit 
to be made by a bank, see 12 CFR 220.111.

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    (a) Certain situations have arisen from time to time under this part 
wherein it appeared doubtful that, in the circumstances, the lending 
banks may have been entitled to rely upon the statements accepted by 
them in determining whether the purposes of certain loans were such as 
to cause the loans to be not subject to the part.
    (b) The use by a lending bank of a statement in determining the 
purpose of a particular loan is, of course, provided for by 
Sec. 221.3(c). However, under that paragraph a lending bank may accept 
such statement only if it is ``acting in good faith.'' As the Board 
stated in the interpretation contained in Sec. 221.101, the 
``requirement of `good faith' is of vital importance''; and, to fulfill 
such requirement, ``it is clear that the bank must be alert to the 
circumstances surrounding the loan.''
    (c) Obviously, such a statement would not be accepted by the bank in 
``good faith'' if at the time the loan was made the bank had knowledge, 
from any source, of facts or circumstances which were contrary to the 
natural purport of the statement, or which were sufficient reasonably to 
put the bank on notice of the questionable

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reliability or completeness of the statement.
    (d) Furthermore, the same requirement of ``good faith'' is to be 
applied whether the statement accepted by the bank is signed by the 
borrower or by an officer of the bank. In either case, ``good faith'' 
requires the exercise of special diligence in any instance in which the 
borrower is not personally known to the bank or to the officer who 
processes the loan.
    (e) The interpretation set forth in Sec. 221.101 contains an example 
of the application of the ``good faith'' 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 margin stock to 
secure the loan or is to receive the proceeds of the loan, the bank 
would be put on notice that the loan would probably be subject to this 
part. It could not accept in good faith a statement to the contrary 
without obtaining a reliable and satisfactory explanation of the 
situation''.
    (f) Moreover, and as also stated by the interpretation contained in 
Sec. 221.101, the purpose of a loan, of course, ``cannot be altered by 
some temporary application of the proceeds. For example, if a borrower 
is to purchase Government securities with the proceeds of a loan, but is 
soon thereafter to sell such securities and replace them with margin 
stock, the loan is clearly for the purpose of purchasing or carrying 
margin stock''. The purpose of a loan therefore, should not be 
determined upon a narrow analysis of the immediate use to which the 
proceeds of the loan are put. Accordingly, a bank acting in ``good 
faith'' should carefully scrutinize cases in which there is any 
indication that the borrower is concealing the true purpose of the loan, 
and there would be reason for special vigilance if margin stock is 
substituted for bonds or nonmargin stock soon after the loan is made, or 
on more than one occasion.
    (g) Similarly, the fact that a loan made on the borrower's signature 
only, for example, becomes secured by margin stock shortly after the 
disbursement of the loan usually would afford reasonable grounds for 
questioning the bank's apparent reliance upon merely a statement that 
the purpose of the loan was not to purchase or carry margin stock.
    (h) The examples in this section are, of course, by no means 
exhaustive. They simply illustrate the fundamental fact that no 
statement accepted by a lender is of any value for the purposes of this 
part unless the lender accepting the statement is ``acting in good 
faith'', and that ``good faith'' requires, among other things, 
reasonable diligence to learn the truth.

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    For text of the interpretation on Arranging loan to purchase open-
end investment company shares, see 12 CFR 220.112.

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    (a) The Board recently was asked whether a loan by a bank to enable 
the borrower to purchase a newly issued nonmargin stock during the 
initial over-the-counter trading period prior to the stock becoming 
registered (listed) on a national securities exchange would be subject 
to this part. The Board replied that, until such stock qualifies as 
margin stock, this would not be applicable to such a loan.
    (b) The Board has now been asked what the position of the lending 
bank would be under this part if, after the date on which the stock 
should become registered, such bank continued to hold a loan of the kind 
just described. It is assumed that the loan was in an amount greater 
than the maximum loan value for the collateral specified in this part.
    (c) If the stock should become registered, the loan would then be 
for the purpose of purchasing or carrying a margin stock, and, if 
secured directly or indirectly by any margin stock, would be subject to 
this part as from the date the stock was registered. Under this part, 
this does not mean that the bank would have to obtain reduction of the 
loan in order to reduce it to an amount no more than the specified 
maximum loan value. It does mean, however, that so long as the loan 
balance exceeded the specified

[[Page 44]]

maximum loan value, the bank could not permit any withdrawals or 
substitutions of collateral that would increase such excess; nor could 
the bank increase the amount of the loan balance unless there was 
provided additional collateral having a maximum loan value at least 
equal to the amount of the increase. In other words, as from the date 
the stock should become a margin stock, the loan would be subject to 
this part in exactly the same way, for example, as a loan subject to 
this part that became under-margined because of a decline in the current 
market value of the loan collateral or because of a decrease by the 
Board in the maximum loan value of the loan collateral.

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    In response to a question regarding a possible loan by a bank to an 
open-end investment company that customarily purchases stocks registered 
on a national securities exchange, the Board stated that in view of the 
general nature and operations of such a company, any loan by a bank to 
such a company should be presumed to be subject to this part as a loan 
for the purpose of purchasing or carrying margin stock. This would not 
be altered by the fact that the open-end company had used, or proposed 
to use, its own funds or proceeds of the loan to redeem some of its own 
shares, since mere application of the proceeds of a loan to some other 
use cannot prevent the ultimate purpose of a loan from being to purchase 
or carry registered stocks.

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    (a) This part governs ``any purpose credit'' extended by a lender 
``secured directly or indirectly by margin stock'' and defines ``purpose 
credit'' as ``any credit for the purpose, whether immediate, incidental, 
or ultimate, of buying or carrying margin stock, `` with certain 
exceptions, and provides that the maximum loan value of such margin 
stock shall be a fixed percentage ``of its current market value.''
    (b) The Board of Governors has had occasion to consider the 
application of the language in paragraph (a) of this section to the two 
following questions:
    (1) Loan secured by stock. First, is a loan to purchase or carry 
margin stock subject to this part where made in unsecured form, if 
margin stock is subsequently deposited as security with the lender, and 
surrounding circumstances indicate that the parties originally 
contemplated that the loan should be so secured? The Board answered that 
in a case of this kind, the loan would be subject to this part, for the 
following reasons:
    (i) The Board has long held, in the closely related purpose area, 
that the original purpose of a loan should not be determined upon a 
narrow analysis of the technical circumstances under which a loan is 
made. Instead, the fundamental purpose of the loan is considered to be 
controlling. Indeed, ``the fact that a loan made on the borrower's 
signature only, for example, becomes secured by registered stock shortly 
after the disbursement of the loan'' affords reasonable grounds for 
questioning whether the bank was entitled to rely upon the borrower's 
statement as to the purpose of the loan. 1953 Fed. Res. Bull. 951 (See, 
Sec. 221.106).
    (ii) Where security is involved, standards of interpretation should 
be equally searching. If, for example, the original agreement between 
borrower and lender contemplated that the loan should be secured by 
margin stock, and such stock is in fact delivered to the bank when 
available, the transaction must be regarded as fundamentally a secured 
loan. This view is strengthened by the fact that this part applies to a 
loan ``secured directly or indirectly by margin stock.''
    (2) Loan to acquire controlling shares. (i) The second question is 
whether this part governs a margin stock-secured loan made for the 
business purpose of purchasing a controlling interest in a corporation, 
or whether such a loan would be exempt on the ground that this part is 
directed solely toward purchases of stock for speculative or investment 
purposes. The Board answered that a margin stock-secured loan for the 
purpose of purchasing or carrying margin stock is subject to this part, 
regardless of the reason for which the purchase is made.

[[Page 45]]

    (ii) The answer is required, in the Board's view, since the language 
of this part is explicitly inclusive, covering ``any purpose credit, 
secured directly or indirectly by margin stock.'' Moreover, the 
withdrawal in 1945 of the original section 2(e) of this part, which 
exempted ``any loan for the purpose of purchasing a stock from or 
through a person who is not a member of a national securities exchange . 
. .'' plainly implies that transactions of the sort described are now 
subject to the general prohibition of Sec. 221.3(a).

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    (a) The Board considered the question whether a joint venture, 
structured so that the amount of capital contribution to the venture 
would be disproportionate to the right of participation in profits or 
losses, constitutes an ``extension of credit'' for the purpose of this 
part.
    (b) An individual and a corporation plan to establish a joint 
venture to engage in the business of buying and selling securities, 
including margin stock. The individual would contribute 20 percent of 
the capital and receive 80 percent of the profits or losses; the 
corporate share would be the reverse. In computing profits or losses, 
each participant would first receive interest at the rate of 8 percent 
on his respective capital contribution. Although purchases and sales 
would be mutually agreed upon, the corporation could liquidate the joint 
portfolio if the individual's share of the losses equaled or exceeded 
his 20 percent contribution to the venture. The corporation would hold 
the securities, and upon termination of the venture, the assets would 
first be applied to repayment of capital contributions.
    (c) In general, the relationship of joint venture is created when 
two or more persons combine their money, property, or time in the 
conduct of some particular line of trade or some particular business and 
agree to share jointly, or in proportion to capital contributed, the 
profits and losses of the undertaking.
    (d) The incidents of the joint venture described in paragraph (b) of 
this section, however, closely parallel those of an extension of margin 
credit, with the corporation as lender and the individual as borrower. 
The corporation supplies 80 percent of the purchase price of securities 
in exchange for a net return of 8 percent of the amount advanced plus 20 
percent of any gain. Like a lender of securities credit, the corporation 
is insulated against loss by retaining the right to liquidate the 
collateral before the securities decline in price below the amount of 
its contribution. Conversely, the individual--like a customer who 
borrows to purchase securities--puts up only 20 percent of their cost, 
is entitled to the principal portion of any appreciation in their value, 
bears the principal risk of loss should that value decline, and does not 
stand to gain or lose except through a change in value of the securities 
purchased.
    (e) The Board is of the opinion that where the right of an 
individual to share in profits and losses of such a joint venture is 
disproportionate to his contribution to the venture:
    (1) The joint venture involves an extension of credit by the 
corporation to the individual;
    (2) The extension of credit is to purchase or carry margin stock, 
and is collateralized by such margin stock; and
    (3) If the corporation is not a broker or dealer subject to 
Regulation T (12 CFR part 220), the credit is of the kind described by 
Sec. 221.3(a).

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    (a) The Board's advice has been requested whether a bank's 
activities in connection with the administration of an employees' 
savings plan are subject to this part.
    (b) Under the plan, any regular, full-time employee may participate 
by authorizing the sponsoring company to deduct a percentage of his 
salary and wages and transmit the same to the bank as trustee. Voluntary 
contributions by the company are allocated among the participants. A 
participant may direct that funds held for him be invested by the 
trustee in insurance,

[[Page 46]]

annuity contracts, Series E Bonds, or in one or more of three specified 
securities which are listed on a stock exchange. Loans to purchase the 
stocks may be made to participants from funds of the trust, subject to 
approval of the administrative committee, which is composed of five 
participants, and of the trustee. The bank's right to approve is said to 
be restricted to the mechanics of making the loan, the purpose being to 
avoid cumbersome procedures.
    (c) Loans are secured by the credit balance of the borrowing 
participants in the savings fund, including stock, but excluding (in 
practice) insurance and annuity contracts and government securities. 
Additional stocks may be, but, in practice, have not been pledged as 
collateral for loans. Loans are not made, under the plan, from bank 
funds, and participants do not borrow from the bank upon assignment of 
the participants' accounts in the trust.
    (d) It is urged that loans under the plan are not subject to this 
part because a loan should not be considered as having been made by a 
bank where the bank acts solely in its capacity of trustee, without 
exercise of any discretion.
    (e) The Board reviewed this question upon at least one other 
occasion, and full consideration has again been given to the matter. 
After considering the arguments on both sides, the Board has reaffirmed 
its earlier view that, in conformity with an interpretation not 
published in the Code of Federal Regulations which was published at page 
874 of the 1946 Federal Reserve Bulletin (See 12 CFR 261.10(f) for 
information on how to obtain Board publications.), this part applies to 
the activities of a bank when it is acting in its capacity as trustee. 
Although the bank in that case had at best a limited discretion with 
respect to loans made by it in its capacity as trustee, the Board 
concluded that this fact did not affect the application of the 
regulation to such loans.

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    (a) A question has been presented to the Board as to whether a loan 
by a bank to a mutual investment fund is ``secured * * * indirectly by 
margin stock'' within the meaning of Sec. 221.(3)(a), so that the loan 
should be treated as subject to this part.
    (b) Briefly, the facts are as follows. Fund X, an open-end 
investment company, entered into a loan agreement with Bank Y, which was 
(and still is) custodian of the securities which comprise the portfolio 
of Fund X. The agreement includes the following terms, which are 
material to the question before the Board:
    (1) Fund X agrees to have an ``asset coverage'' (as defined in the 
agreements) of 400 percent of all its borrowings, including the proposed 
borrowing, at the time when it takes down any part of the loan.
    (2) Fund X agrees to maintain an ``asset coverage'' of at least 300 
percent of its borrowings at all times.
    (3) Fund X agrees not to amend its custody agreement with Bank Y, or 
to substitute another custodian without Bank Y's consent.
    (4) Fund X agrees not to mortgage, pledge, or otherwise encumber any 
of its assets elsewhere than with Bank Y.
    (c) In Sec. 221.109 the Board stated that because of ``the general 
nature and operations of such a company'', any ``loan by a bank to an 
open-end investment company that customarily purchases margin stock * * 
* should be presumed to be subject to this part as a loan for the 
purpose of purchasing or carrying margin stock'' (purpose credit). The 
Board's interpretation went on to say that: ``this would not be altered 
by the fact that the open-end company had used, or proposed to use, its 
own funds or proceeds of the loan to redeem some of its own shares * * 
*.''
    (d) Accordingly, the loan by Bank Y to Fund X was and is a ``purpose 
credit''. However, a loan by a bank is not subject to this part unless: 
it is a purpose credit; and it is ``secured directly or indirectly by 
margin stock''. In the present case, the loan is not ``secured 
directly'' by stock in the ordinary sense, since the portfolio of Fund X 
is not pledged to secure the credit from Bank Y. But the word 
``indirectly'' must signify some form of security arrangement other than 
the ``direct'' security which arises from the ordinary ``transaction 
that gives recourse

[[Page 47]]

against a particular chattel or land or against a third party on an 
obligation'' described in the American Law Institute's Restatement of 
the Law of Security, page 1. Otherwise the word ``indirectly'' would be 
superfluous, and a regulation, like a statute, must be construed if 
possible to give meaning to every word.
    (e) The Board has indicated its view that any arrangement under 
which margin stock is more readily available as security to the lending 
bank than to other creditors of the borrower may amount to indirect 
security within the meaning of this part. In an interpretation published 
at Sec. 221.110 it stated: ``The Board has long held, in the * * * 
purpose area, that the original purpose of a loan should not be 
determined upon a narrow analysis of the technical circumstances under 
which a loan is made * * * . Where security is involved, standards of 
interpretation should be equally searching.'' In its pamphlet issued for 
the benefit and guidance of banks and bank examiners, entitled 
``Questions and Answers Illustrating Application of Regulation U'', the 
Board 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 regulation. This objective of simplifying 
operations does not apply to loans in which arrangements are made to 
retain the substance of stock collateral while sacrificing only the 
form''.
    (f) A wide variety of arrangements as to collateral can be made 
between bank and borrower which will serve, to some extent, to protect 
the interest of the bank in seeing that the loan is repaid, without 
giving the bank a conventional direct ``security'' interest in the 
collateral. Among such arrangements which have come to the Board's 
attention are the following:
    (1) The borrower may deposit margin stock in the custody of the 
bank. An arrangement of this kind may not, it is true, place the bank in 
the position of a secured creditor in case of bankruptcy, or even of 
conflicting claims, but it is likely effectively to strengthen the 
bank's position. The definition of indirectly secured in Sec. 221.2, 
which provides that a loan is not indirectly secured if the lender 
``holds the margin stock only in the capacity of custodian, depositary 
or trustee, or under similar circumstances, and, in good faith has not 
relied upon the margin stock as collateral,'' does not exempt a deposit 
of this kind from the impact of the regulation unless it is clear that 
the bank ``has not relied'' upon the margin stock deposited with it.
    (2) A borrower may not deposit his margin 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 of the bank if only because the 
future credit standing and business reputation of the borrower will 
depend upon his keeping his word. If the assets covered by such an 
agreement include margin stock, then, the credit is ``indirectly 
secured'' by the margin stock within the meaning of this part.
    (3) The borrower may deposit margin stock with a third party who 
agrees to hold the stock until the loan has been paid off. Here, even 
though the parties may purport to provide that the stock is not 
``security'' for the loan (for example, by agreeing that the stock may 
not be sold and the proceeds applied to the debt if the borrower fails 
to pay), the mere fact that the stock is out of the borrower's control 
for the duration of the loan serves to some extent to protect the bank.
    (g) The three instances described in paragraph (f) of this section 
are merely illustrative. Other methods, or combinations of methods, may 
serve a similar purpose. The conclusion that any given arrangement makes 
a credit ``indirectly secured'' by margin stock may, but need not, be 
reinforced by facts such as that the stock in question was purchased 
with proceeds of the loan, that the lender suggests or insists upon the 
arrangement, or that the loan would probably be subject to criticism by 
supervisory authorities were it not for the protective arrangement.
    (h) Accordingly, the Board concludes that the loan by Bank Y to Fund 
X is indirectly secured by the portfolio of the fund and must be treated 
by the bank as a regulated loan.

[[Page 48]]

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    (a) The Board of Governors interpreted this part in connection with 
proposed loans by a bank to persons who are purchasing shares of stock 
of American Telephone and Telegraph Company pursuant to its Employees' 
Stock Plan.
    (b) According to the current offering under the Plan, an employee of 
the AT&T system may purchase shares through regular deductions from his 
pay over a period of 24 months. At the end of that period, a certificate 
for the appropriate number of shares will be issued to the participating 
employee by AT&T. Each employee is entitled to purchase, as a maximum, 
shares that will cost him approximately three-fourths of his annual base 
pay. Since the program extends over two years, it follows that the 
payroll deductions for this purpose may be in the neighborhood of 38 
percent of base pay and a larger percentage of ``take-home pay.'' 
Deductions of this magnitude are in excess of the saving rate of many 
employees.
    (c) Certain AT&T employees, who wish to take advantage of the 
current offering under the Plan, are the owners of shares of AT&T stock 
that they purchased under previous offerings. A bank proposed to receive 
such stock as collateral for a ``living expenses'' loan that will be 
advanced to the employee in monthly installments over the 24-month 
period, each installment being in the amount of the employee's monthly 
payroll deduction under the Plan. The aggregate amount of the advances 
over the 24-month period would be substantially greater than the maximum 
loan value of the collateral as prescribed in Sec. 221.7 (the 
Supplement).
    (d) In the opinion of the Board of Governors, a loan of the kind 
described would violate this part if it exceeded the maximum loan value 
of the collateral. The regulation applies to any margin stock-secured 
loan for the purpose of purchasing or carrying margin stock 
(Sec. 221.3(a)). Although the proposed loan would purport to be for 
living expenses, it seems quite clear, in view of the relationship of 
the loan to the Employees' Stock Plan, that its actual purpose would be 
to enable the borrower to purchase AT&T stock, which is margin stock. At 
the end of the 24-month period the borrower would acquire a certain 
number of shares of that stock and would be indebted to the lending bank 
in an amount approximately equal to the amount he would pay for such 
shares. In these circumstances, the loan by the bank must be regarded as 
a loan ``for the purpose of purchasing'' the stock, and therefore it is 
subject to the limitations prescribed by this part. This conclusion 
follows from the provisions of this part, and it may also be observed 
that a contrary conclusion could largely defeat the basic purpose of the 
margin regulations.
    (e) Accordingly, the Board concluded that a loan of the kind 
described may not be made in an amount exceeding the maximum loan value 
of the collateral, as prescribed by the current Sec. 221.7 (the 
Supplement).

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    (a) The Board has been asked whether the acceptance of a purpose 
statement submitted through the mail by a lender subject to the 
provisions of this part will meet the good faith requirement of 
Sec. 221.3(c). Section 221.3(c) states that in connection with any 
credit secured by collateral which includes any margin stock, a nonbank 
lender must obtain a purpose statement executed by the borrower and 
accepted by the lender in good faith. Such acceptance requires that the 
lender be alert to the circumstances surrounding the credit and if 
further information suggests inquiry, he must investigate and be 
satisfied that the statement is truthful.
    (b) The lender is a subsidiary of a holding company which also has 
another subsidiary which serves as underwriter and investment advisor to 
various mutual funds. The sole business of the lender will be to make 
``non-purpose'' consumer loans to shareholders of the mutual funds, such 
loans to be collateralized by the fund shares. Most mutual funds shares 
are margin stock for purposes of this part. Solicitation and acceptance 
of these consumer

[[Page 49]]

loans will be done principally through the mail and the lender wishes to 
obtain the required purpose statement by mail rather than by a face-to-
face interview. Personal interviews are not practicable for the lender 
because shareholders of the funds are scattered throughout the country. 
In order to provide the same safeguards inherent in face-to-face 
interviews, the lender has developed certain procedures designed to 
satisfy the good faith acceptance requirement of this part.
    (c) The purpose statement will be supplemented with several 
additional questions relevant to the prospective borrower's investment 
activities such as purchases of any security within the last 6 months, 
dollar amount, and obligations to purchase or pay for previous 
purchases; present plans to purchase securities in the near future, 
participations in securities purchase plans, list of unpaid debts, and 
present income level. Some questions have been modified to facilitate 
understanding but no questions have been deleted. If additional inquiry 
is indicated by the answers on the form, a loan officer of the lender 
will interview the borrower by telephone to make sure the loan is ``non-
purpose''. Whenever the loan exceeds the ``maximum loan value'' of the 
collateral for a regulated loan, a telephone interview will be done as a 
matter of course.
    (d) One of the stated purposes of Regulation X (12 CFR part 224) was 
to prevent the infusion of unregulated credit into the securities 
markets by borrowers falsely certifying the purpose of a loan. The Board 
is of the view that the existence of Regulation X (12 CFR part 224), 
which makes the borrower liable for willful violations of the margin 
regulations, will allow a lender subject to this part to meet the good 
faith acceptance requirement of Sec. 221.3(c) without a face-to-face 
interview if the lender adopts a program, such as the one described in 
paragraph (c) of this section, which requires additional detailed 
information from the borrower and proper procedures are instituted to 
verify the truth of the information received. Lenders intending to 
embark on a similar program should discuss proposed plans with their 
district Federal Reserve Bank. Lenders may have existing or future loans 
with the prospective customers which could complicate the efforts to 
determine the true purpose of the loan.

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    (a) In a situation considered by the Board of Governors, a business 
concern (X) proposed to purchase mutual fund shares, from time to time, 
with proceeds from its accounts receivable, then pledge the shares with 
a bank in order to secure working capital. The bank was prepared to lend 
amounts equal to 70 percent of the current value of the shares as they 
were purchased by X. If the loans were subject to this part, only 50 
percent of the current market value of the shares could be lent.
    (b) The immediate purpose of the loans would be to replenish X's 
working capital. However, as time went on, X would be acquiring mutual 
fund shares at a cost that would exceed the net earnings it would 
normally have accumulated, and would become indebted to the lending bank 
in an amount approximately 70 percent of the prices of said shares.
    (c) The Board held that the loans were for the purpose of purchasing 
the shares, and therefore subject to the limitations prescribed by this 
part. As pointed out in Sec. 221.114 with respect to a similar program 
for putting a high proportion of cash income into stock, the borrowing 
against the margin stock to meet needs for which the cash would 
otherwise have been required, a contrary conclusion could largely defeat 
the basic purpose of the margin regulations.
    (d) Also considered was an alternative proposal under which X would 
deposit proceeds from accounts receivable in a time account for 1 year, 
before using those funds to purchase mutual fund shares. The Board held 
that this procedure would not change the situation in any significant 
way. Once the arrangement was established, the proceeds would be flowing 
into the time account at the same time that similar amounts were 
released to purchase the shares, and over any extended period of time 
the result would

[[Page 50]]

be the same. Accordingly, the Board concluded that bank loans made under 
the alternative proposal would similarly be subject to this part.

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    (a) The Board has received questions regarding the circumstances in 
which an extension or maintenance of credit will not be deemed to be 
``indirectly secured'' by stock as indicated by the phrase, ``if the 
lender, in good faith, has not relied upon the margin stock as 
collateral,'' contained in paragraph (2)(iv) of the definition of 
indirectly secured in Sec. 221.2.
    (b) In response, the Board noted that in amending this portion of 
the regulation in 1968 it was indicated that one of the purposes of the 
change was to make clear that the definition of indirectly secured does 
not apply to certain routine negative covenants in loan agreements. 
Also, while the question of whether or not a bank has relied upon 
particular stock as collateral is necessarily a question of fact to be 
determined in each case in the light of all relevant circumstances, some 
indication that the bank had not relied upon stock as collateral would 
seem to be afforded by such circumstances as the fact that:
    (1) The bank had obtained a reasonably current financial statement 
of the borrower and this statement could reasonably support the loan; 
and
    (2) The loan was not payable on demand or because of fluctuations in 
market value of the stock, but instead was payable on one or more fixed 
maturities which were typical of maturities applied by the bank to loans 
otherwise similar except for not involving any possible question of 
stock collateral.

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    (a) The Board considered the questions whether:
    (1) The guaranty by a corporation of an ``unsecured'' bank loan to 
exercise an option to purchase stock of the corporation is an 
``extension of credit'' for the purpose of this part;
    (2) Such a guaranty is given ``in the ordinary course of business'' 
of the corporation, as defined in Sec. 221.2; and
    (3) The bank involved took part in arranging for such credit on 
better terms than it could extend under the provisions of this part.
    (b) The Board understood that any officer or employee included under 
the corporation's stock option plan who wished to exercise his option 
could obtain a loan for the purchase price of the stock by executing an 
unsecured note to the bank. The corporation would issue to the bank a 
guaranty of the loan and hold the purchased shares as collateral to 
secure it against loss on the guaranty. Stock of the corporation is 
registered on a national securities exchange and therefore qualifies as 
``margin stock'' under this part.
    (c) A nonbank lender is subject to the registration and other 
requirements of this part if, in the ordinary course of his business, he 
extends credit on collateral that includes any margin stock in the 
amount of $200,000 or more in any calendar quarter, or has such credit 
outstanding in any calendar quarter in the amount of $500,000 or more. 
The Board understood that the corporation in question had sufficient 
guaranties outstanding during the applicable calendar quarter to meet 
the dollar thresholds for registration.
    (d) In the Board's judgment a person who guarantees a loan, and 
thereby becomes liable for the amount of the loan in the event the 
borrower should default, is lending his credit to the borrower. In the 
circumstances described, such a lending of credit must be considered an 
``extension of credit'' under this part in order to prevent 
circumvention of the regulation's limitation on the amount of credit 
that can be extended on the security of margin stock.
    (e) Under Sec. 221.2, the term in the ordinary course of business 
means ``occurring or reasonably expected to occur in carrying out or 
furthering any business purpose. * * *'' In general, stock option plans 
are designed to provide a company's employees with a proprietary 
interest in the company in the form of ownership of the company's stock. 
Such plans increase the company's

[[Page 51]]

ability to attract and retain able personnel and, accordingly, promote 
the interest of the company and its stockholders, while at the same time 
providing the company's employees with additional incentive to work 
toward the company's future success. An arrangement whereby 
participating employees may finance the exercise of their options 
through an unsecured bank loan guaranteed by the company, thereby 
facilitating the employees' acquisition of company stock, is likewise 
designed to promote the company's interest and is, therefore, in 
furtherance of a business purpose.
    (f) For the reasons indicated, the Board concluded that under the 
circumstances described a guaranty by the corporation constitutes credit 
extended in the ordinary course of business under this part, that the 
corporation is required to register pursuant to Sec. 221.3(b), and that 
such guaranties may not be given in excess of the maximum loan value of 
the collateral pledged to secure the guaranty.
    (g) Section 221.3(a)(3) provides that ``no lender may arrange for 
the extension or maintenance of any purpose credit, except upon the same 
terms and conditions on which the lender itself may extend or maintain 
purpose credit under this part''. Since the Board concluded that the 
giving of a guaranty by the corporation to secure the loan described 
above constitutes an extension of credit, and since the use of a 
guaranty in the manner described could not be effectuated without the 
concurrence of the bank involved, the Board further concluded that the 
bank took part in ``arranging'' for the extension of credit in excess of 
the maximum loan value of the margin stock pledged to secure the 
guaranties.

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    (a) The Board has been asked whether the plan-lender provisions of 
Sec. 221.4(a) and (b) were intended to apply to the financing of stock 
options restricted or qualified under the Internal Revenue Code where 
such options or the option plan do not provide for such financing.
    (b) It is the Board's experience that in some nonqualified plans, 
particularly stock purchase plans, the credit arrangement is distinct 
from the plan. So long as the credit extended, and particularly, the 
character of the plan-lender, conforms with the requirements of the 
regulation, the fact that option and credit are provided for in separate 
documents is immaterial. It should be emphasized that the Board does not 
express any view on the preferability of qualified as opposed to 
nonqualified options; its role is merely to prevent excessive credit in 
this area.
    (c) Section 221.4(a) provides that a plan-lender may include a 
wholly-owned subsidiary of the issuer of the collateral (taking as a 
whole, corporate groups including subsidiaries and affiliates). This 
clarifies the Board's intent that, to qualify for special treatment 
under that section, the lender must stand in a special employer-employee 
relationship with the borrower, and a special relationship of issuer 
with regard to the collateral. The fact that the Board, for convenience 
and practical reasons, permitted the employing corporation to act 
through a subsidiary or other entity should not be interpreted to mean 
the Board intended the lender to be other than an entity whose 
overriding interests were coextensive with the issuer. An independent 
corporation, with independent interests was never intended, regardless 
of form, to be at the base of exempt stock-plan lending.

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    (a) A bank proposes to extend two credits (Credits A and B) to its 
customer. Although the two credits are proposed to be extended at the 
same time, each would be evidenced by a separate agreement. Credit A 
would be extended for the purpose of providing the customer with working 
capital (nonpurpose credit), collateralized by margin stock. Credit B 
would be extended for the purpose of purchasing or carrying margin stock 
(purpose credit), without collateral or on collateral other than stock.

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    (b) This part allows a bank to extend purpose and nonpurpose credits 
simultaneously or successively to the same customer. This rule is 
expressed in Sec. 221.3(d)(4) which provides in substance that for any 
nonpurpose credit to the same customer, the lender shall in good faith 
require as much collateral not already identified to the customer's 
purpose credit as the lender would require if it held neither the 
purpose loan nor the identified collateral. This rule in 
Sec. 221.3(d)(4) also takes into account that the lender would not 
necessarily be required to hold collateral for the nonpurpose credit if, 
consistent with good faith banking practices, it would normally make 
this kind of nonpurpose loan without collateral.
    (c) The Board views Sec. 221.3(d)(4), when read in conjunction with 
Sec. 221.3(c) and (f), as requiring that whenever a lender extends two 
credits to the same customer, one a purpose credit and the other 
nonpurpose, any margin stock collateral must first be identified with 
and attributed to the purpose loan by taking into account the maximum 
loan value of such collateral as prescribed in Sec. 221.7 (the 
Supplement).
    (d) The Board is further of the opinion that under the foregoing 
circumstances Credit B would be indirectly secured by stock, despite the 
fact that there would be separate loan agreements for both credits. This 
conclusion flows from the circumstance that the lender would hold in its 
possession stock collateral to which it would have access with respect 
to Credit B, despite any ostensible allocation of such collateral to 
Credit A.

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    Questions have been raised as to whether certain stock option and 
stock purchase plans involve extensions of credit subject to this part 
when the participant is free to cancel his participation at any time 
prior to full payment, but in the event of cancellation the participant 
remains liable for damages. It thus appears that the participant has the 
opportunity to gain and bears the risk of loss from the time the 
transaction is executed and payment is deferred. In some cases brought 
to the Board's attention damages are related to the market price of the 
stock, but in others, there may be no such relationship. In either of 
these circumstances, it is the Board's view that such plans involve 
extensions of credit. Accordingly, where the security being purchased is 
a margin security and the credit is secured, directly or indirectly, by 
any margin security, the creditor must register and the credit must 
conform with either the regular margin requirements of Sec. 221.3(a) or 
the special ``plan-lender'' provisions set forth in Sec. 221.4, 
whichever is applicable. This assumes, of course, that the amount of 
credit extended is such that the creditor is subject to the registration 
requirements of Sec. 221.3(b).

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    (a) The Board has been asked numerous questions regarding purpose 
credit in connection with insurance premium funding programs. The 
inquiries are included in a set of guidelines in the format of questions 
and answers. (The guidelines are available pursuant to the Board's Rules 
Regarding Availability of Information, 12 CFR part 261.) A glossary of 
terms customarily used in connection with insurance premium funding 
credit activities is included in the guidelines. Under a typical 
insurance premium funding program, a borrower acquires mutual fund 
shares for cash, or takes fund shares which he already owns, and then 
uses the loan value (currently 50 percent as set by the Board) to buy 
insurance. Usually, a funding company (the issuer) will sell both the 
fund shares and the insurance through either independent broker/dealers 
or subsidiaries or affiliates of the issuer. A typical plan may run for 
10 or 15 years with annual insurance premiums due. To illustrate, 
assuming an annual insurance premium of $300, the participant is 
required to put up mutual fund shares equivalent to 250 percent of the 
premium or $600 ($600 x 50 percent loan value equals $300 the amount of 
the insurance premium which is also the amount of the credit extended).

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    (b) The guidelines referenced in paragraph (a) of this section also:
    (1) Clarify an earlier 1969 Board interpretation to show that the 
public offering price of mutual fund shares (which includes the front 
load, or sales commission) may be used as a measure of their current 
market value when the shares serve as collateral on a purpose credit 
throughout the day of the purchase of the fund shares; and
    (2) Relax a 1965 Board position in connection with accepting purpose 
statements by mail.
    (c) It is the Board's view that when it is clearly established that 
a purpose statement supports a purpose credit then such statement 
executed by the borrower may be accepted by mail, provided it is 
received and also executed by the lender before the credit is extended.

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    (a) Section 221.4(a) and (b), which provides special treatment for 
credit extended under employee stock option plans, was designed to 
encourage their use in recognition of their value in giving an employee 
a proprietary interest in the business. Taking a position that might 
discourage the exercise of options because of tax complications would 
conflict with the purpose of Sec. 221.4(a) and (b).
    (b) Accordingly, the Board has concluded that the combined loans for 
the exercise of the option and the payment of the taxes in connection 
therewith under plans complying with Sec. 221.4(a)(2) may be regarded as 
purpose credit within the meaning of Sec. 221.2.

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    (a) Petitions have been filed with the Board raising questions as to 
whether the margin requirements in this part apply to two types of 
corporate acquisitions in which debt securities are issued to finance 
the acquisition of margin stock of a target company.
    (b) In the first situation, the acquiring company, Company A, 
controls a shell corporation that would make a tender offer for the 
stock of Company B, which is margin stock (as defined in Sec. 221.2). 
The shell corporation has virtually no operations, has no significant 
business function other than to acquire and hold the stock of Company B, 
and has substantially no assets other than the margin stock to be 
acquired. To finance the tender offer, the shell corporation would issue 
debt securities which, by their terms, would be unsecured. If the tender 
offer is successful, the shell corporation would seek to merge with 
Company B. However, the tender offer seeks to acquire fewer shares of 
Company B than is necessary under state law to effect a short form 
merger with Company B, which could be consummated without the approval 
of shareholders or the board of directors of Company B.
    (c) The purchase of the debt securities issued by the shell 
corporation to finance the acquisition clearly involves purpose credit 
(as defined in Sec. 221.2). In addition, such debt securities would be 
purchased only by sophisticated investors in very large minimum 
denominations, so that the purchasers may be lenders for purposes of 
this part. See Sec. 221.3(b). Since the debt securities contain no 
direct security agreement involving the margin stock, applicability of 
the lending restrictions of this part turns on whether the arrangement 
constitutes an extension of credit that is secured indirectly by margin 
stock.
    (d) As the Board has recognized, indirect security can encompass a 
wide variety of arrangements between lenders and borrowers with respect 
to margin stock collateral that serve to protect the lenders' interest 
in assuring that a credit is repaid where the lenders do not have a 
conventional direct security interest in the collateral. See 
Sec. 221.124. However, credit is not ``indirectly secured'' by margin 
stock if the lender in good faith has not relied on the margin stock as 
collateral extending or maintaining credit. See Sec. 221.2.
    (e) The Board is of the view that, in the situation described in 
paragraph (b) of this section, the debt securities would be presumed to 
be indirectly secured by the margin stock to be acquired by the shell 
acquisition vehicle. The staff has previously expressed the view that 
nominally unsecured credit extended to an investment company, a

[[Page 54]]

substantial portion of whose assets consist of margin stock, is 
indirectly secured by the margin stock. See Federal Reserve Regulatory 
Service 5-917.12. (See 12 CFR 261.10(f) for information on how to obtain 
Board publications.) This opinion notes that the investment company has 
substantially no assets other than margin stock to support indebtedness 
and thus credit could not be extended to such a company in good faith 
without reliance on the margin stock as collateral.
    (f) The Board believes that this rationale applies to the debt 
securities issued by the shell corporation described in paragraph (b) of 
this section. At the time the debt securities are issued, the shell 
corporation has substantially no assets to support the credit other than 
the margin stock that it has acquired or intends to acquire and has no 
significant business function other than to hold the stock of the target 
company in order to facilitate the acquisition. Moreover, it is possible 
that the shell may hold the margin stock for a significant and 
indefinite period of time, if defensive measures by the target prevent 
consummation of the acquisition. Because of the difficulty in predicting 
the outcome of a contested takeover at the time that credit is committed 
to the shell corporation, the Board believes that the purchasers of the 
debt securities could not, in good faith, lend without reliance on the 
margin stock as collateral. The presumption that the debt securities are 
indirectly secured by margin stock would not apply if there is specific 
evidence that lenders could in good faith rely on assets other than 
margin stock as collateral, such as a guaranty of the debt securities by 
the shell corporation's parent company or another company that has 
substantial non-margin stock assets or cash flow. This presumption would 
also not apply if there is a merger agreement between the acquiring and 
target companies entered into at the time the commitment is made to 
purchase the debt securities or in any event before loan funds are 
advanced. In addition, the presumption would not apply if the obligation 
of the purchasers of the debt securities to advance funds to the shell 
corporation is contingent on the shell's acquisition of the minimum 
number of shares necessary under applicable state law to effect a merger 
between the acquiring and target companies without the approval of 
either the shareholders or directors of the target company. In these two 
situations where the merger will take place promptly, the Board believes 
the lenders could reasonably be presumed to be relying on the assets of 
the target for repayment.
    (g) In addition, the Board is of the view that the debt securities 
described in paragraph (b) of this section are indirectly secured by 
margin stock because there is a practical restriction on the ability of 
the shell corporation to dispose of the margin stock of the target 
company. Indirectly secured is defined in Sec. 221.2 to include any 
arrangement under which the customer's right or ability to sell, pledge, 
or otherwise dispose of margin stock owned by the customer is in any way 
restricted while the credit remains outstanding. The purchasers of the 
debt securities issued by a shell corporation to finance a takeover 
attempt clearly understand that the shell corporation intends to acquire 
the margin stock of the target company in order to effect the 
acquisition of that company. This understanding represents a practical 
restriction on the ability of the shell corporation to dispose of the 
target's margin stock and to acquire other assets with the proceeds of 
the credit.
    (h) In the second situation, Company C, an operating company with 
substantial assets or cash flow, seeks to acquire Company D, which is 
significantly larger than Company C. Company C establishes a shell 
corporation that together with Company C makes a tender offer for the 
shares of Company D, which is margin stock. To finance the tender offer, 
the shell corporation would obtain a bank loan that complies with the 
margin lending restrictions of this part and Company C would issue debt 
securities that would not be directly secured by any margin stock. The 
Board is of the opinion that these debt securities should not be 
presumed to be indirectly secured by the margin stock of Company D, 
since, as an operating business, Company C has substantial assets or 
cash flow without regard to the margin stock of Company

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D. Any presumption would not be appropriate because the purchasers of 
the debt securities may be relying on assets other than margin stock of 
Company D for repayment of the credit.

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    (a) The National Securities Markets Improvement Act of 1996 (Pub. L. 
104-290, 110 Stat. 3416) restricts the Board's margin authority by 
repealing section 8(a) of the Securities Exchange Act of 1934 (the 
Exchange Act) and amending section 7 of the Exchange Act (15 U.S.C. 78g) 
to exclude the borrowing by a member of a national securities exchange 
or a registered broker or dealer ``a substantial portion of whose 
business consists of transactions with persons other than brokers or 
dealers'' and borrowing by a member of a national securities exchange or 
a registered broker or dealer to finance its activities as a market 
maker or an underwriter. Notwithstanding this exclusion, the Board may 
impose such rules and regulations if it determines they are ``necessary 
or appropriate in the public interest or for the protection of 
investors.''
    (b) The Board has not found that it is necessary or appropriate in 
the public interest or for the protection of investors to impose rules 
and regulations regarding loans to brokers and dealers covered by the 
National Securities Markets Improvement Act of 1996.

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