“A loan made with securities as the collateral.”
Securities based lending (SBL) has become increasingly popular in recent years. For both borrowers and lenders, this type of arrangement can offer some potential benefits. At the same time, securities based lending is not appropriate for many investors, as it can dramatically increase the overall risk in a borrower’s investment portfolio.
Here, the experienced securities fraud attorneys at Sonn Law Group discuss securities based lending. We explain the advantages, the drawbacks, important regulations and what investors should do in the event that they incur substantial losses due to a stock based loan.
The Benefits of Securities Based Lending
For borrowers, securities based lending provides two important potential benefits. First, using this method, borrowers are allowed to continue their current investment strategy without needing to cause a disruption by selling off an asset to obtain capital.
Additionally, with certain arrangements, stock based loans allow borrowers to put off potential tax penalties. Selling securities that have produced gains can result in a taxable event. As such, acquiring a loan based off of the securities in question may allow a borrower to avoid those adverse tax consequences.
For lenders, using securities as loan collateral can also be desirable. Notably, this type of loan can provide lenders with access to an additional stream of revenue, with somewhat limited risk. Certainly, making a stock based loan is much less risky than is making an unsecured loan. SBL is generally the most attractive in circumstances in which lenders and borrowers have pre-existing relationships.
The Downside of Securities Based Lending
While securities based lending may sound like a great option, it also comes with tremendous risks. Indeed, many investors should not even consider obtaining this type of loan. The simple fact is that stocks are not a very good form of loan collateral. The price simply varies too much and introduces too much risk into the loan arrangement.
If the market falls, which could happen at any moment, securities based borrowers may face a forced liquidation. With a forced liquidation, the lender is likely to sell the stock, take all of the proceeds and then take additional collection action against the borrower to cover the loan.
Know Your Loan: Recourse vs. Non-Recourse Stock Loans
Before obtaining a loan based on securities, borrowers/investors need to know exactly what they are getting themselves into. With securities based lending, the loans offered will fit into one of the following two categories:
- Recourse loans: A loan in which the lender would have the legal ability to seek repayment for the full value of the loan, even if the value of the underlying collateral (the securities) drops.
- Nonrecourse loans. A loan in which the lender’s only remedy to collect repayment is to seek possession of the securities that were pledged as collateral, regardless of the current market price.
Securities Based Lending: Important Regulations Have Been Enacted
In the current climate, nonrecourse loans should be avoided. New regulations have been enacted, which make these loan undesirable. Following the financial crisis of 2007-2008, the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS) made significant policy changes regarding nonrecourse loans.
Specifically, these loans were reclassified from non-taxable transfers to fully taxable sales. In other words, there are no longer tax advantages associated with nonrecourse loans. Instead, there are major tax penalties. This change in regulation led to FINRA putting out an investor alert warning all consumers to avoid non-recourse securities based lending.
Securities Based Lending is Not Appropriate for Most Investors
For the majority of investors, securities based lending is simply not appropriate. As the market could easily drop, and an investor could be subject to a forced stock sale, this type of arrangement could result in tremendous financial losses. Investors need to be extremely careful before taking out this type of loan.
If your broker-dealer or broker has recommended that you borrow capital through securities based lending, and you suffered serious financial damage as a result, you may have a viable legal claim.
A qualified investment fraud and negligence attorney should review your case in order to determine whether or not your broker misrepresented the lending arrangement in any way or if your broker pushed you into an unsuitable investment.
Act Now: Securities Based Lending Victims Deserve Fair Compensation
At Sonn Law Group, we have extensive experience handling securities based lending claims. To learn more about what we can do for you, please call us today 844-689-5754 to schedule your free initial case evaluation. From our primary office in Aventura, FL, we represent investment fraud victims in Miami, throughout Florida and nationwide.