[Code of Federal Regulations]
[Title 12, Volume 3]
[Revised as of January 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 12CFR221.113]

[Page 46-47]
 
                       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)--Table of Contents
 
Sec. 221.113  Loan which is secured indirectly by stock.

    (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

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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.

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