Regulation U

The purpose of Regulation U follows from that statutory language: preventing the excessive use of securities credit in circumvention of the rules applicable to brokers and dealers and of the statute that authorises those rules. Without Regulation U, an investor wishing to borrow more than fifty percent of the purchase price of marginable securities could simply walk down the street to a bank and obtain an unrestricted loan collateralised by the same shares — defeating the entire purpose of Regulation T. Regulation U closes this gap by imposing equivalent margin requirements on bank lending for securities purchase purposes.

What Section 7(d) Leaves Outside

Section 7(d) does not reach every loan that finances securities. Its own terms exclude credit extended, maintained or arranged by a person not in the ordinary course of business, credit on an exempted security, credit to or for certain members of national securities exchanges and registered brokers or dealers, credit by a bank on a security other than an equity security, and credit the Board exempts by rule, regulation or order. Regulation U is built within those limits.

The ordinary course of business exclusion is narrower than it sounds. Regulation U defines in the ordinary course of business as 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. The test therefore reaches an individual's lending undertaken for profit or in managing his or her property, not only lending by a business, and the registration requirement for non-bank lenders attaches only to persons who extend or maintain credit secured by margin stock in the ordinary course of business.

The bank exclusion turns on the kind of security. Section 7(d) does not apply to credit extended by a bank on a security other than an equity security, but the Act defines equity security to include any security convertible, with or without consideration, into stock, or carrying a warrant or right to subscribe to or purchase stock. A bond convertible into exchange-registered shares is therefore an equity security for this purpose, and Regulation U's definition of margin stock expressly includes any debt security convertible into a margin stock — so a bank loan secured by such a bond and used to buy more of the same issue is purpose credit secured by margin stock, and the bank may lend no more than its maximum loan value.

Who Regulation U Covers

Regulation U applies to two categories of lenders — banks and non-bank lenders — each subject to slightly different procedural requirements but the same fundamental margin restrictions.

A bank for Regulation U purposes has the meaning given in Section 3(a)(6) of the Securities Exchange Act of 1934 — national banks, member banks of the Federal Reserve System and other banking institutions doing business under state or federal law that are supervised and examined by banking authorities — and the definition in 12 CFR Section 221.2 expressly adds any subsidiary of a bank, any corporation organised under Section 25(a) of the Federal Reserve Act, and any agency or branch of a foreign bank located within the United States. The same definition expressly excludes savings and loan associations, credit unions, lending institutions that are instrumentalities or agencies of the United States, and members of national securities exchanges — although a savings and loan association or a credit union that lends against margin stock can still become subject to Regulation U as a non-bank lender. Credit a bank extends outside the United States is an exempted transaction under Section 221.6, so a foreign branch of a United States bank is not itself bound by Regulation U; instead, Regulation X requires a United States borrower who obtains purpose credit from a foreign branch of a bank to conform that credit to Regulation U as it applies to banks.

Non-bank lenders subject to Regulation U are persons other than banks and other than brokers or dealers subject to Regulation T who, in the ordinary course of business, extend or maintain credit secured directly or indirectly by margin stock and who cross the registration thresholds described below. This category was previously governed by the separate Regulation G — adopted in 1968 to cover securities credit extended by lenders other than banks, brokers, and dealers — but Regulation G was merged into Regulation U in 1998, consolidating the non-bank lender provisions into the same regulatory framework. A non-bank lender does not register before lending: it must register on Form FR G-1, with the Federal Reserve Bank of the district in which its principal office is located, within 30 days after the end of any calendar quarter during which the credit it extended secured by margin stock equals two hundred thousand dollars or more, or the credit it has outstanding at any time during that quarter equals five hundred thousand dollars or more.

The Two Triggering Conditions — Purpose Credit and Margin Stock

Regulation U applies only when two conditions are simultaneously present — the credit must be purpose credit and it must be secured directly or indirectly by margin stock.

Purpose credit is defined in 12 CFR Section 221.2 as any credit for the purpose, whether immediate, incidental, or ultimate, of buying or carrying margin stock. Purpose is determined by the use of the loan proceeds — a bank loan to finance a securities purchase is purpose credit regardless of what the bank calls it or how the loan documents characterise it. A loan to finance working capital or real estate that happens to be secured by the borrower's stock portfolio is not necessarily purpose credit — the purpose test looks to the end use of the funds, not the nature of the collateral.

Margin stock means any equity security registered or having unlisted trading privileges on a national securities exchange, any OTC security designated as qualified for trading in the National Market System, any debt security convertible into margin stock or carrying a warrant or right to buy margin stock, any warrant or right to buy margin stock, and any security issued by a registered investment company other than a money market fund, a small business investment company, a company with at least 95 percent of its assets continuously invested in exempted securities, or face-amount certificates. The definition is narrower than Regulation T's margin security, which also reaches non-equity securities and foreign margin stock. The Federal Reserve ceased publishing a separate OTC margin stock list in 1998, relying instead on the listing standards of the Nasdaq National Market as the practical determinant of OTC margin stock status.

Determining Purpose — Original Purpose, Commitments and Acquisitions of Control

Because the purpose test looks through labels to substance, the Board has issued interpretations fixing when purpose is measured and what it includes. Under the interpretation at Section 221.101 the original purpose of a loan is controlling: if a loan is not originally for the purpose of purchasing or carrying margin stock, later changes in the collateral securing it do not change its exempted character. The same interpretation warns that the purpose of a loan cannot be altered by some temporary application of the proceeds, and the Board has applied that principle to arrangements in which borrowing against stock replaces cash that would otherwise have been spent on buying it.

Timing is fixed in the same way where a commitment precedes disbursement. Under Section 221.102 the Board regards the date on which a commitment to extend credit becomes binding as the date on which the credit is extended, for two reasons: on that date the parties should be aware of the law and facts surrounding the transaction, and the date of contract is generally controlling for the purposes of the margin regulations and the federal securities laws, regardless of when cash or securities are delivered.

Nor does the reason for buying the stock matter. The Board was asked whether a loan secured by margin stock and made for the business purpose of purchasing a controlling interest in a corporation was exempt on the ground that Regulation U is directed solely at purchases of stock for speculative or investment purposes. Its answer, recorded at Section 221.110, is that a margin stock secured loan for the purpose of purchasing or carrying margin stock is subject to Regulation U regardless of the reason for which the purchase is made, because the regulation is explicitly inclusive, covering any purpose credit secured directly or indirectly by margin stock.

The Maximum Loan Value — Fifty Percent

The core operational requirement of Regulation U is identical to the initial margin requirement of Regulation T — lenders subject to Regulation U may not extend purpose credit secured by margin stock in excess of the maximum loan value of the collateral, which under the Supplement to Regulation U — Section 221.7 — is fifty percent of the current market value of the margin stock serving as collateral.

A borrower who pledges one hundred thousand dollars in margin stock as collateral for a bank loan for the purpose of purchasing additional securities may borrow no more than fifty thousand dollars — fifty percent of the collateral value. This fifty percent maximum loan value precisely mirrors the fifty percent initial margin requirement under Regulation T, ensuring that an investor cannot obtain greater leverage from a bank than from a broker-dealer.

Non-margin stock pledged as collateral has good faith loan value rather than a specified fifty percent maximum — the bank may lend against non-margin collateral based on its own good faith assessment of the collateral's value, without being bound by the fifty percent limit applicable to margin stock. Options that are not publicly traded have no loan value under Regulation U — they add nothing to the amount that may be lent against the collateral.

Maintaining Credit — Price Declines, Withdrawals and Exchange Offers

Regulation U regulates the extension of credit far more closely than its maintenance. Under Section 221.3(a)(2) a lender may continue to maintain any credit initially extended in compliance with the regulation regardless of a reduction in the customer's equity resulting from changes in market prices, a change in the maximum loan value the Board prescribes, or a change in the status of the security securing an existing purpose credit from non-margin to margin stock. Regulation U itself therefore imposes no maintenance margin and requires no margin call when the collateral falls in value, although Section 221.3(j) confirms that nothing in the regulation prevents a bank from taking any action it deems necessary in good faith for its own protection.

What the regulation does control is the customer's ability to take collateral out. Under Section 221.3(f) a lender may permit a withdrawal or substitution of cash or collateral only if it would not cause the credit to exceed the maximum loan value of the collateral, or increase the amount by which the credit already exceeds it. The maximum loan value used for that test is the value on the day of the withdrawal or substitution, not the value when the credit was first extended — so a credit that has become undermargined through a market decline may stay in place, but the customer may not withdraw collateral from it if the withdrawal would widen the shortfall.

Corporate events that change the collateral are accommodated rather than penalised. To enable a customer to take part in a reorganisation, recapitalisation or exchange offer made to holders of an issue of margin stock, a lender may permit substitution of the securities received, and under Section 221.3(g) a non-margin, non-exempted security acquired in exchange for a margin stock is treated as if it were margin stock for 60 days following the exchange.

The Form FR U-1 — Purpose Statement

One of the most distinctive procedural features of Regulation U is the purpose statement. Whenever a bank extends credit secured directly or indirectly by any margin stock in an amount exceeding one hundred thousand dollars, it must require its customer to execute Form FR U-1 — the Statement of Purpose for an Extension of Credit Secured by Margin Stock — which must be signed and accepted by a duly authorised officer of the bank acting in good faith. The requirement turns on the collateral and the amount rather than on the purpose, so it applies even where the customer certifies that the loan is not purpose credit. A non-bank lender must obtain the equivalent Form FR G-3 for every credit it extends secured by margin stock, with no dollar threshold.

The purpose statement serves two functions. It documents the bank's compliance with the margin requirements for purpose credit — if the borrower certifies that the credit is not for the purpose of buying or carrying margin stock, the bank may rely on that certification only if it accepts it in good faith, which means being alert to the circumstances surrounding the credit and, if in possession of information that would cause a prudent person not to accept the statement without inquiry, investigating and being satisfied that it is correct. A mistake in good faith is not a violation of Regulation U, and Regulation X makes a borrower liable for wilful violations of the margin regulations. It also records the purpose, amount and collateral of the credit, and the lender keeps the form in its own records for at least three years after the credit ends rather than filing it with the Federal Reserve.

Credit is indirectly secured by margin stock where an arrangement with the customer restricts the customer's right or ability to sell, pledge or otherwise dispose of margin stock the customer owns while the credit is outstanding, or makes doing so a cause for accelerating the credit. Such an arrangement does not make the credit indirectly secured if the bank, in good faith, has not relied upon the margin stock as collateral in extending or maintaining the particular credit. This exception, codified in the definition of indirectly secured in Section 221.2, prevents the mechanical application of Regulation U to loans where the margin stock collateral is incidental rather than central to the lending decision.

Indirect Security — Negative Pledges and the Arrangements Excluded

The definition of indirectly secured reaches arrangements that give a lender the substance of stock collateral without the form of a pledge. In its interpretation at Section 221.113 the Board explained that any arrangement under which margin stock is more readily available as security to the lending bank than to the borrower's other creditors may amount to indirect security, and it gave examples: the borrower deposits margin stock in the bank's custody; the borrower does not deposit the stock but agrees not to pledge or encumber its assets elsewhere while the loan is outstanding, where those assets include margin stock; or the borrower deposits margin stock with a third party who agrees to hold it until the loan is repaid, even if the parties say the stock is not security for the loan.

The definition then excludes three kinds of arrangement besides the case in which the lender has not relied on the margin stock. An arrangement is not indirect security if, after the proceeds of the credit are applied, not more than 25 percent of the value of the assets subject to the arrangement is represented by margin stock, so a borrower whose restricted assets are mostly plant, receivables or other non-margin property does not bring the loan within Regulation U merely because some shares are among them. Nor is it indirect security where the lending arrangement permits the lender to accelerate the maturity of the credit as a result of a default or renegotiation of another credit extended to the customer by another lender that is not an affiliate of the lender.

The third exclusion covers a lender that holds the margin stock only as custodian, depositary or trustee, or in similar circumstances, and in good faith has not relied upon it as collateral. The Board has stressed that a deposit of stock in a bank's custody is not exempt unless it is clear that the bank has not relied upon the stock.

The Single Credit Rule

Regulation U looks at the whole of a lender's purpose credit to a customer rather than at each loan in isolation. Under Section 221.3(d)(1) all purpose credit extended to a customer is treated as a single credit, and all the collateral securing that credit is considered in deciding whether the credit complies with the regulation; the one exception is that syndicated loans need not be aggregated with other unrelated purpose credit extended by the same lender.

The rule also closes the obvious way around the loan value limit. A lender that has extended purpose credit secured by margin stock may not afterwards 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. A bank that has lent sixty thousand dollars against one hundred and twenty thousand dollars of margin stock to finance a share purchase therefore cannot add a further unsecured loan to buy more shares, because the combined credit would exceed the maximum loan value of that collateral. Where the order is reversed, so that unsecured purpose credit came first and secured purpose credit followed, the two are combined and treated as a single credit only for the purposes of the rule on withdrawals and substitutions.

Purpose and non-purpose credit to the same customer are handled the opposite way. Under Section 221.3(d)(4) the lender must treat them as two separate loans and may not rely on the collateral required for the purpose credit to support the non-purpose credit. In its interpretation at Section 221.120 the Board added that when a lender extends both kinds of credit to the same customer, any margin stock collateral must first be identified with and attributed to the purpose loan, taking its maximum loan value into account, before any of it can be counted towards the non-purpose loan.

Regulation U Versus Regulation T — Key Differences

While Regulation U and Regulation T impose the same fifty percent margin standard on purpose credit secured by margin stock, the two regulations differ in several procedurally important respects that securities professionals must understand.

Regulation T applies to broker-dealers and governs credit in margin accounts — a specific account type with defined mechanics for initial margin deposits, maintenance margin requirements, and margin calls. Regulation U applies to banks and non-bank lenders and governs the credit extended to a customer — there is no account-level framework comparable to the broker-dealer margin account structure. It also reaches only purpose credit secured directly or indirectly by margin stock, whereas Section 7(c) of the Act bars a broker-dealer from extending credit without collateral or on collateral other than securities except as the Board permits.

Regulation T is more restrictive in some respects because it governs the entire margin account relationship on an ongoing basis, the account within which FINRA Rule 4210 — not Regulation T itself — sets maintenance requirements. Regulation U is less restrictive in the sense that it imposes a loan-by-loan analysis of purpose and collateral value rather than a comprehensive account management regime. The difference reflects the statutory design: Section 7(d) authorises rules to prevent circumvention of the broker-dealer provisions rather than requiring an equivalent comprehensive account management system for banks.

Regulation T also applies to a broader range of activities — including cash accounts, short selling mechanics, and payment period rules — that have no equivalent in Regulation U, which addresses only the credit extension itself rather than the full account management framework.

Regulation X — Closing the Offshore Gap

Regulation X — codified at 12 CFR Part 224 — completes the three-part margin framework by extending the requirements of Regulations T and U to United States persons who obtain purpose credit from outside the United States. Without Regulation X, an investor could circumvent both Regulation T and Regulation U by obtaining a loan from a foreign bank or foreign broker-dealer not subject to either domestic regulation. Regulation X provides that no borrower subject to it — a United States person, or a foreign person controlled by or acting on behalf of or in conjunction with a United States person — shall obtain purpose credit from outside the country unless the credit conforms to Regulation T if obtained from a foreign branch of a broker-dealer, to Regulation U as it applies to banks if obtained from a foreign branch of a bank, or to Regulation U as it applies to non-bank lenders if obtained from any other lender outside the United States, in each case without the purpose statement requirement.

Exempted Bank Credit and Special Purpose Loans to Brokers and Dealers

Some purpose credit is outside Regulation U's limits altogether. Under Section 221.6 a bank may extend and maintain purpose credit without regard to the regulation if the credit is extended to any bank, to any foreign banking institution or outside the United States, as well as to the employee plans described in the next section. Three further exemptions turn on the transaction rather than the borrower: credit to a customer other than a broker or dealer to finance temporarily the purchase or sale of securities for prompt delivery, repaid in the ordinary course of business on completion of the transaction; credit against securities in transit; and credit to meet emergency expenses. The first two are available only if the credit is not extended to enable the customer to pay for securities bought in an account subject to Regulation T.

The emergency exemption is drawn tightly. The credit must be supported by a statement executed by the customer and accepted and signed by an officer of the bank acting in good faith, and emergency expenses are those not reasonably foreseeable, arising from circumstances such as the death or disability of the customer or some other change in circumstances involving extreme hardship that could not reasonably be foreseen when the credit was extended. The regulation states expressly that the opportunity to realise monetary gain or to avoid loss is not a change in circumstances for this purpose.

Separately, Section 221.5 allows a lender to extend and maintain special purpose credit to brokers and dealers without regard to the general requirements and the loan value limits, provided the credit is for one of the listed purposes, among them hypothecation loans, temporary advances in payment-against-delivery transactions, intra-day loans, bona fide arbitrage, market maker and specialist loans, underwriter loans and emergency loans. Before extending such credit for more than a day the lender must obtain and accept in good faith a written notice or certification from the borrower as to the purposes of the loan.

Employee Stock Plans, Guarantees and Arranging Credit

Regulation U makes special provision for credit that helps employees acquire their employer's stock. A plan-lender is a corporation, including a wholly-owned subsidiary or a thrift organisation 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, meaning an employee stock option, purchase or ownership plan adopted by the corporation and approved by its stockholders. Margin stock that secures credit a plan-lender extends under an eligible plan has good faith loan value rather than the fifty percent maximum, and that credit is treated separately from other credit under the regulation.

Credit to a qualified employee stock ownership plan is freer still. A non-bank lender may extend and maintain purpose credit to an employee stock ownership plan qualified under Section 401 of the Internal Revenue Code without regard to Regulation U except for the registration and annual report requirements, and a bank's credit to such a plan is an exempted transaction.

A company can also become a lender without lending money. In the interpretation at Section 221.118 the Board considered a corporation that guaranteed unsecured bank loans taken by employees to exercise stock options, holding the purchased shares as collateral against loss on the guaranty. The Board held that a person who guarantees a loan lends its credit to the borrower, so the guaranty was an extension of credit; that the corporation, having crossed the dollar thresholds, had to register; and that the guaranties could not be given in excess of the maximum loan value of the collateral pledged to secure them. Because no lender may arrange purpose credit except on the terms on which it could itself extend it, the bank that concurred in the arrangement had taken part in arranging credit in excess of the maximum loan value.

Examination Relevance and Key Takeaways

Regulation U is tested on the Series 7 examination in the context of the Federal Reserve's three-part margin regulatory framework, the distinction between Regulation T and Regulation U, and the concept of purpose credit secured by margin stock.

The key points to retain are these.

Regulation U — 12 CFR Part 221 — governs credit extended by banks and non-bank lenders for the purpose of buying or carrying margin stock, effective May 1, 1936 under Section 7(d) of the Securities Exchange Act of 1934. It is the bank-side counterpart to Regulation T — which governs broker-dealer credit — and together they prevent investors from circumventing margin requirements by switching from a broker-dealer margin account to a bank loan. The two triggering conditions are purpose credit — credit for the purpose of buying or carrying margin stock — and direct or indirect security by margin stock. The maximum loan value under the Regulation U Supplement at Section 221.7 is fifty percent of the current market value of margin stock collateral — identical to Regulation T's initial margin requirement. Non-margin stock collateral has good faith loan value set by the bank without a specified fifty percent limit.

Banks must obtain Form FR U-1 — the purpose statement — for credit secured by margin stock exceeding one hundred thousand dollars, and non-bank lenders must obtain Form FR G-3 for every such credit. A mistake made in good faith is not a violation, and Regulation X makes a borrower liable for wilful violations of the margin regulations. Former Regulation G governing non-bank lenders was merged into Regulation U in 1998. Regulation X at 12 CFR Part 224 extends Regulation T and U requirements to United States persons obtaining purpose credit outside the country — closing the offshore circumvention gap. Together Regulations T, U, and X form the Federal Reserve's comprehensive margin credit framework applicable to broker-dealers, banks, non-bank lenders, and overseas borrowing arrangements.