Investors who need cash—or who want to tap the value of their portfolios without selling their investments—might be tempted to apply for a “stock-based loan,” pledging fully paid securities as collateral for the loan. As recent FINRA enforcement actions confirm, stock-based loan programs can be risky, especially when they involve “non-recourse” loans from unregistered, unregulated, third-party lenders.  With a non-recourse loan, the lender has limited options if a borrower fails to repay the amount owed. Generally, the lender’s only remedy is to accept the securities pledged as collateral, even if their value has dropped. The lender cannot require the borrower to pledge additional securities or otherwise pay back the full amount of the loan.

From time to time, brokers and other financial professionals have presented investors with a purportedly low-risk opportunity to “borrow” against their stock portfolios through a non-recourse stock-based loan program. As with any strategy promising high upside potential with little risk, these programs can involve costs and dangers that investors should know about. These include the potential failure of the lender to return your stock when you repay the loan, possible tax consequences if the Internal Revenue Service considers the transaction a taxable event or sales loads and fees and surrender charges if you use the proceeds to purchase another financial product, such as a fixed or equity-indexed annuity.

FINRA is issuing this Alert to educate investors about non-recourse stock-based loan programs, including risks and rewards and key questions to ask.

What Are Non-Recourse Stock-Based Loan Programs?

Stock-based loan programs allow investors to pledge fully-paid stock as collateral for “non-recourse” loans from third-party lenders, who are generally unregistered and unregulated. With a non-recourse loan, the lender’s only remedy in the event of a default is to collect the stock pledged as collateral, even if its value has dropped.

Some pitches for these programs promise that you can tap the value of your portfolio for any purpose without incurring the tax consequences of a sale. Others encourage you to “leverage” an existing (or perhaps a new) stock position to purchase additional financial products. Regardless of the hook, these programs supposedly allow you to borrow money against a substantial percentage of your portfolio without giving up the benefits of owning the stock—particularly the potential increase in the stock’s value—and while limiting your risk of loss to only a small fraction (often as little as 10 percent) of the value of the stock.

Who Markets Stock-Based Loan Programs?

These programs may be marketed by financial planners, investment advisers, insurance agents, accountants, attorneys and others—as well as by representatives of traditional broker-dealers. In some instances, financial professionals and others offer the program as a way for their customers to raise cash to buy other financial products the professionals sell—such as annuities or other financial products that might or might not be securities—without requiring the customer to sell his or her existing stocks. Alternatively, the program might be offered as a way to use the same money for two purposes—buying new stock, and then borrowing against that stock and using the proceeds to make another investment, such as an annuity.

How Do Non-Recourse Stock-Based Loan Programs Work?

Different promoters offer stock-based loan programs with varying features. In general, an investor “pledges” stock that he or she owns as collateral to a lender, which lends the investor cash—often as much as 90 percent of the value of the stock—for a set period of time, such as two or three years. The customer agrees to pay interest, which accrues during the loan term, and is credited with any dividends paid on the stock pledged by the customer. The interest rates charged for the loan can be relatively high, often above 10 percent. At the end of the loan period, the customer generally has several options:

• Extend the loan—If allowed, the customer can renew the loan for an additional fixed time period.
• Get the stock back—The customer can get the stock back by paying off the loan balance (plus accrued interest and less any dividends paid).
• Cash in on any upside profits—If the value of the pledged stock has increased above the total amount due on the loan, including interest, then the customer can elect to receive a cash payment equal to this profit—meaning the current value of the stock, minus the amount the customer owes the lender.
• Walk away from downside losses—If the value of the pledged stock has fallen below the amount the customer owes (including interest), then the customer can simply “walk away” from the loan, turning over the stock to the lender and keeping the money that had been loaned. In this last scenario, the lender cannot try to recover any of the loaned amount or interest from the customer.

Depending on the terms of the program, the customer can either use existing stock as collateral or buy new stock to pledge as collateral. In some cases, the lender will reduce the interest charges if the customer agrees to a cap on potential gains. For example, in exchange for paying a lower interest rate, a customer might agree to limit any gains to 50 percent above the value of the stock at the time of the loan.

To illustrate, suppose a customer owns stock in XYZ Corp. worth $100,000, paying a 2 percent annual dividend. The customer “pledges” the stock to the lender, which in turn provides the customer with a $90,000 loan for three years at 10 percent interest (compounded monthly). At the end of the three years, the customer would owe approximately $115,000: $90,000 in principal, plus $31,000 in interest, less $6,000 in dividends.  If the stock has gone up more than 15 percent over the three years, and is worth more than $115,000, then the customer is “in the money”—meaning the stock is worth more than the customer owes to the lender. The customer can then either repay the loan and get back the stock or request that the lender pay the customer the amount by which the value of the stock exceeds the amount due on the loan. For instance, if the stock is worth $125,000, the lender will pay the customer $10,000—the $125,000 value of the stock minus the $115,000 the customer owes the lender. If, on the other hand, the stock is worth less than $115,000, the customer can “walk away”—the lender keeps the stock, and the customers owes, and receives, nothing. In either instance, the customer still has the $90,000, along with the benefits (or losses) from the use or investment of that money.

What Are the Risks and Other Considerations?

While stock-based loan programs could be attractive for some investors, investors should be aware of the following risks and other potential concerns:

Failure to perform by lender: In some of the cases FINRA has seen, the lenders offering the non-recourse stock-based loans were not registered with FINRA or regulated by any banking authority. That makes it difficult to ascertain their financial stability or to verify what they are doing with your stock once you transfer it to them. While the lenders promise to return the stock or pay the profits, if any, at the end of the loan period, there is no assurance that they will be able to do so. In that situation, you would lose that portion of the value of the stock (generally 10 percent) kept by the lender when the loan was initiated, as well as any profits to which you are entitled.

Premature sale of stock: When you pledge your securities as collateral, you generally transfer the stock to the lender, who then has total control over it. Although the transactions are designed to look like the lenders hold the “pledged” stock for the customers, some lenders sell the stock almost immediately. Not only might this result in tax consequences, but you also can lose the benefit of any appreciation of the stock you thought you still owned.

Possible tax consequences: Whether or not the lender sells the stock during the loan period, the Internal Revenue Service might consider the transfer of the stock to be a taxable event. That means you might face unexpected tax liabilities and have to pay capital gains taxes upon receipt of the proceeds of the loan or upon the sale of the stock by the lender. These taxes can be substantial, particularly if you held the stock for a long time and it increased significantly in value. This is a critical issue for those who enter into a stock-based loan program to avoidimmediate taxation.

Availability of funds to repay loan: Most stock-based loan programs are relatively short-term loans—often as little as two to three years. If, at the end of the period, you want to pay off your loan balance and get back the exact number of shares of stock pledged, you must have sufficient liquid funds. This can be difficult if you invested the loan proceeds in a long-term investment or a product with a surrender charge or contingent deferred sales charge (CDSC), such as a fixed, variable or equity-indexed annuity. In such instances, you would either have to liquidate the new investment (which could mean incurring significant charges and a potential tax liability) or tap money from other sources.

Lack of adequate investigation by the promoter: As was underscored in recent FINRA enforcement actions, the fact that a financial professional promotes a stock-based loan program doesn’t mean that he or she—or any intermediary the professional relied on—vetted the lender. Absent adequate due diligence, neither you, your financial professional nor anyone involved in promoting the program can know for certain what the lender actually does with your pledged stock—specifically, whether it holds it for your benefit or sells it—or whether the lender has adequate cash on hand to honor its obligations at the end of the loan term. Unfortunately, some stock-loan programs have turned out to be scams. For example, in September 2009, the Securities and Exchange Commission sued the promoter of a stock loan program, HedgeLender LLC, and two of its principals for promoting a fraudulent loan program. The lender in that case allegedly sold the pledged stock, misappropriated the sales proceeds and could not return stock or pay profits to participants in the program.

Unregistered salespeople: Unlike broker-dealers, many of the financial professionals promoting non-recourse stock-based loan programs are not licensed brokers or registered broker-dealers and are not required to make certain that securities transactions are suitable for their customers. Dealing with unlicensed, unregistered financial professionals increases your risk.

Possible conflicts of interest: FINRA is aware of stock-based loans being promoted by financial professionals as a way to free up cash for their customers to purchase products offered by the professional. Be aware of the possibility that a broker or other financial professional might recommend a stock-based loan program to generate commissions on the new products you purchase with the loan proceeds.

Restrictions on the use of the loan proceeds: Loans secured by the pledge of certain securities, including most stock, are generally considered margin loans. Federal Reserve Board regulations restrict the use of those proceeds, including limiting the purchase of securities with the proceeds. As a result, stock-based loan customers may not be able to use the proceeds of the loans in the same way they could if they simply the sold the stock.

High costs and high interest charge: In order to be “in the money” at the end of the loan period, the “pledged” stock would have to appreciate enough to exceed the interest charges that accrued during the loan period.  The interest rates charged by stock-based loan lenders tend to be high—higher than margin rates typically charged by brokerages for loans over $100,000 (the minimum portfolio value for at least some stock-based loan programs). You can walk away if the stock drops, but it can be harder to profit if the stock rises.

How Can I Protect Myself?

The bottom line is that while a non-recourse stock loan program might sound good at first blush, these programs involve significant risk, can be costly and can result in unintended tax consequences. The best step you can take to protect yourself is to ask questions and independently verify the answers. When considering a stock loan program, be sure to ask:

1. Are the lender and promoters registered with FINRA or with bank regulators? UseFINRA BrokerCheck to verify the registration and licensing status of the lender and any promoter or other intermediary in the transaction—and to check their backgrounds. You can also verify whether the entity extending the loan is a regulated bank or credit union by visiting the website of the Federal Financial Institutions Examination Council. Be extremely wary of borrowing from an entity that is neither a brokerage firm nor a bank.
2. Does the lender have audited financials? Check the Securities and Exchange Commission’s website to see whether the lender files reports with audited financial statements. If the lender is publicly traded, you can review its financial statements to independently assess its financial strength, including whether it has sufficient cash reserves to return pledged collateral to borrowers who pay their loans.
3. What happens to my stock once I pledge it as collateral? Verify who owns the stock, who receives dividend payments (and whether and how dividend payments get credited to your loan balance) and what tax consequences, if any, the loan might entail. Separately check with an independent tax professional to ask about your particular tax situation.
4. What benefit does the promoter receive for recommending the program? This is especially important if the financial professional touting the program (or his or her firm) receives compensation on any financial product you purchase with the proceeds of the loan. You want to be sure the transaction is in your best interest, not merely the promoter’s.
5. If you purchase a financial product with the proceeds: What are the costs and risks? Ascertain whether the product involves upfront sales charges, ongoing fees, potential surrender charges or back-end loads, some combination of these or other costs. Ask about any sort of holding period and whether you will have to pay to cash out of the investment when the loan comes due. How easy or difficult is it to sell the investment? What are the specific risks of that investment?

Finally, if the person promoting the stock-based loan program is not affiliated with the brokerage firm where you hold your stock—or if the lender does not appear to affiliated with the firm—be sure to check with the firm’s compliance officer to learn how, if at all, the loan program is connected to the firm.

Where to Turn for Help

If you have suffered losses as a result of a stock-based loan program recommended to you by your financial professional, the securities attorneys of The White Law Group may be able to help.  To speak with a securities attorney, please contact the firm’s Chicago office at 312/238-9650.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.  The firm handles FINRA arbitration cases throughout the country.

For more information on The White Law Group, please visit our website at http://whitesecuritieslaw.com.