The Demise of Nonrecourse Stock Loans

From 2000-2010 the “nonrecourse stock loan” became popular with securities owners. Today there are few places to obtain one. Here’s why.

Please note: For a full-recourse, no-title-transfer/no-sale-to-fund FINRA/SIPC-member managed credit line against your stock portfolio, please click here. 


Summary:
 While activity involving securities always involves some degree of risk, some activities involve far more than average. Some rise to a level of risk that cannot be defended. Nonrecourse stock loans fall into this category. Today, there is no justification for any client engaging in a loan in which the borrower transfers the ownership and title to an unlicensed “lender” given what we know of the structure of this type of financing.

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In 2012 A. B. Nicholas bought the old domain hedgelender.com and created an information page that outlined what had happened to the marketing company HedgeLender LLC, and why. We did so as a means to help future clients and broker/agents understand the risks of nonrecourse stock loans. It’s an interesting story, too. A. B. Nicholas (the company sponsoring this information page) facilitates recourse-credit lines entirely by and through fully licensed, top-tier, household-name FINRA brokerage and banking firms that do not require the transfer of control over the securities nor the sale of any securities as a precondition to funding – the diametric opposite of nonrecourse stock loans. And while there is at least some risk inherent in any activity involving publicly traded stocks, bonds, or mutual funds (that by definition can vary in value from day to day), the level of risk in a nonrecourse stock loan should be unacceptable to any prospective borrower.

What is a nonrecourse stock loan? In its simplest definition it is a loan for a certain amount of money (typically 50-80%) often by a non-licensed private lender, where the client can walk away from repayment by sacrificing the collateral if they wish. Unlike the A. B. Nicholas program, interest rates are very high with nonrecourse stock loans – as high as 10% – and with nonrecourse stock loans, in most cases the lender sells all or most of the collateral securities as soon as ownership of the securities is transferred to them. Again, contrasting this with the A. B. Nicholas program where ownership remains the clients, in their own account etc. and a simple lender lien by the licensed institution ensures the lender’s interest, with nonrecourse stock loans the lender takes possession in advance and typically sells the securities to generate “loan funds”.

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The HedgeLender LLC story begins back in 1999 with the HedgeLender founders’ desire to assist smaller international trade exporters with an additional source of capital to help build their brands overseas. One of the founders worked on international trade for the government and had seen first hand how American’s attempting to set up shop in, say, Brazil or China, could not depend wholly on government financial assistance to do so. In most every case, particularly with smaller firms, there was insufficient capital — even when their product had excellent prospects in the target country’s market.

A variety of programs were reviewed. In time they settled on the concept of a securities-based loan— a stock loan — that could provide low-cost financing without forcing the client to lose their ownership of their portfolio. Many of the small businesses that sought to expand overseas either had growing stock value themselves, or had principal investors with strong stock positions and did not wish to exit for various reasons, including potential capital gains taxes. Many were privately held companies where individuals owned stock portfolios they did not want to sell for cash. Tapping their portfolio without losing ownership of the portfolio made sense for these clients, at least on a temporary basis, the reasoned.

At the time, a firm called Derivium had been providing nonrecourse stock loans, but had recently (2002) been unable to return some larger portfolios after a few of their clients’ loans were paid off and had wound up in court. In the proceedings, it was revealed that the lender had not done anything to secure the collateral. With no securing of the ability to return the collateral, clients securities would be at unacceptable risk.

This experience led the future HedgeLender founders to ask: suppose there was a way to hedge the portfolios against loss to ensure the portfolio’s return when the loan was paid off? What if it was possible to find could find the “missing piece” – portfolio security – of the Derivium program to ensure return of the client’s assets after repayment?

An options hedge appeared to be the right way to go. The hedge, in theory, placed a “floor” on the portfolio beyond which the price would not fall for purposes of buying or selling the stock. In theory, with the addition of a hedge, the problems Derivium faced could be addressed — it would always be possible to return the portfolios — thereby creating a means of financing to serve the small business export trade firms the founders sought to assist in the beginning.

The founders scoured the forums, contacts, and the securities and banking world with the new product idea and finally found an individual with an MBA from George Washington University and an executive position at what was then called First American Securities in North Carolina. Could he provide a loan like that which Derivium offered, but with a hedge built in? After a week of consideration, he said yes, and the HedgeLender LLC (which, despite its name, was never a lender, but an intermediary marketer) “HedgeLoan” program was born.

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In time the lender hired an assistant with an MBA from Wharton to interface with all brokers and agents referring new clients and to distribute the hedge reports, which the brokers and clients required. HedgeLender, on behalf of its clients, had asked for proof that their clients’ portfolios were hedged. The lender assembled these reports for the clients and broker agents in response.

For awhile it seemed to be working well. Clients seemed to be satisfied, and the (no infamous) “nonrecourse” aspect allowed the client to simply walk away and owe nothing more if they didn’t want to make payments or couldn’t. It felt like it was all but riskless to all concerned; hedged on one end, but free to walk away on the other. That seemed to make sense: why repay the loan just to get back stocks if they are worth a lot less than what I owe? – for example.  Many therefore did walk away, exercising the nonrecourse provision. (Some lenders, it was found, had set the interest rates artificially high, thereby making it more likely for a client to walk away and relieve the lender of having to return shares the lender had already sold!)

In sum, the nonrecourse stock loan seemed to many people to be a great way to obtain needed cash while keeping the option to pay off the loan and have your stocks returned, or to walk away if it could not be repaid.

The HedgeLender lender knew he needed people to refer clients to him for the system to succeed, and so he provided information that the brokers could pass on to their clients to which answered their security fears and made the program appear more attractive and healthy than it actually was. Besides the lender stating the assets were “fully hedged against loss,” his referring brokers (and clients) were told that their clients could “avoid capital gains” taxes because they “owned” the securities still by way of a contract that said so. Interest was average, neither more nor less than most rates at the time. The brokers — like HedgeLender— naturally relayed this information out to the client base.

But then the roof fell in, and the catalyst was the economic recession. The truth, the bare bones of the nonrecourse stock loan program, was laid bare. Soon it became apparent that the shares were never hedged as the lender had stated verbally and in writing, repeatedly, to anyone who had asked. The lender had made bad bets and was trying mightily to cover them up and keep new clients coming in, but doing so without the hedging that underwrote the very concept of the HedgeLoan that HedgeLender and others had required from the outset. This required a full deception of all by the lender.

HedgeLender (which despite its name, was never a lender but just a referring broker) had sent in many clients with single stock positions. So had many other broker agents, all referred into the same nonrecourse stock loan lender. Their clients and HedgeLender and all brokers rightly expected their loans to be as advertised by the lender.

The cracks began with a few clients with loans against oil stocks. When oil prices increased just prior to the mortgage meltdown, several clients decided to pay off their loan principals and get their now-much-more-valuable stocks back. Sounded reasonable: pay off the principal loan cash that was extended to you when the stock price was lower. Get back all your collateral stock, now worth a lot more than when you started, by just paying off the principal. Sensible.

But this was the moment the nonrecourse stock loan house of cards began tumbling down.

You see, the nonrecourse stock loan lender had sold the shares. And not just recently -The shares turned out to have been sold at loan inception.

How? He sold them because they were titled specifically to him as a condition for the loan. A transfer “house”, like Penson Securities for example, had transferred full title and ownership at client’s securities from the actual owner to the lender. Full ownership, and so freedom to sell.

Instead of providing cash from the lender’s own capital resources, the lender provided cash from the sale of the client’s securities, without advising anyone, including brokers, potential clients, HedgeLender and its staff — even his own Wharton-schooled assistant — all needed to be kept in the dark. Instead, he simply advised his assistant that the securities were “hedged” and had his assistant draw up a “hedge report” to disseminate, complete with “hedged portfolio value” and an outline of the loan amount.

The problem was: there was no hedge. The lender was engaging in deception to keep his brokers, including HedgeLender, delivering clients.

This might have been fine even then — if the lender had actually hedged the shares. But the lender had not purchased any options (the definition of a hedge) to t a price on buying back the stock back if necessary. Since he did not purchase any options — since he did not hedge as he told his brokers and clients — he was at the mercy of the market when it came to returning shares to the client after the client had repaid his loan. You can see now how such a lender would want the borrower to “walk away” — relieving the lender of all responsibility to return shares.

Let’s examine how the nonrecourse stock loan house of cards fell in the last decade with a detailed example.

Suppose a client had a portfolio valued at $100,000. Suppose also they received an 80% loan-to-value nonrecourse stock loan at 7% interest. The client is given $80,000 in loan proceeds after the lender receives and sells the portfolio as noted above. The lender then keeps the 20% remaining for himself. (A small portion goes to the brokers as a referral fee too)..

The lender hopes the client will walk away from repayment in most cases. He may set the interest rate high enough to make the loan annoying and increase the chance that the client will think it not worth paying off. Your lender  hopes the value goes down enough such that it will not be worth it for the client to pay it off.

In short, ironically, he the nonrecourse stock loan lender does not want the client to perform.

Again, nobody knows this other than the lender himself. Everyone else assumes it is a normal loan, that the client will seek to pay it off and recoup his shares afterwards. But that is not the reality. The reality is that the lender is praying that the stock doesn’t go up so the client has very little incentive to pay off the loan and regain his shares.

When a client walks away from repayment and gives up his stocks as full satisfaction of his loan, the lender keeps his percentage as his his profit. It’s locked in. In the above example, he’d keep $20,000 (minus a small amount for the referring brokers).   Profit locked in, plus any interest the client paid.

The danger is when that same portfolio rises in value over time. Suppose the same portfolio at $100,000 now rises to $150,000 or $200,000. Now it makes excellent sense for the client to pay off the loan, as soon as possible. In so doing, he’d be paying off the remaining principle (perhaps a little under $80,000) and he’d be getting back his portfolio worth now, say,  $150,000 or more. It makes sense to pay it off.

To the lender, however, this is the worst possible outcome. Now the lender will have the client’s payoff money in hand — say, $80,000 in this example. But to obtain the same number of shares as he sold earlier (the collateral) to return the client, he’d need to buy it in the open market at market rates — say $150,000 or $200,000 in total. He would, in short, have to reach into his own pocket to buy enough shares to reach the original number and return every last one of them to the client.

At first, for a small loan, the lender may have enough cash to do so. But sooner or later, if a large transaction deficit or multiple transaction deficits occur at once when several clients pay their loans off (as in a rising market), the lender goes into full crisis. He must find a way to get enough cash to buy enough now-much-more-expensive shares so as to return them, as promised, to the clients. Where does it come from? How?

As the crisis picked up, HedgeLender and its clients were told that all was fine, that clients had arrangements to receive their stocks back later “with interest”. But the lender was by now going into classic “ponzi scheme” mode. He had to disguise and deceive the HedgeLender staff and other brokers and even his own assistant to ensure that new clients and new portfolios kept rolling in so that the sale of the new portfolios would generate enough cash to buy enough shares to return all of the securities required to people who had paid off their loans. Every nonrecourse stock loan lender to date has followed this model directly to bankruptcy.

And bankruptcy is double painful for the client. Worst still, clients who have transferred ownership to their lender were adjudged by a U. S. Tax Court in 2010 to have in essence, sold their shares at the point where the title and ownership formally changed to that of the lender. This left people who had to accept what was left from the lender’s ruins with a tax liability as well.

Brokers, including the HedgeLender company and its staffs, were forced to “settle” –  neither admitting or denying that they had referred clients into the program in an irresponsible way, despite the concerted effort of the lender to disguise the shaky lending operation’s true mechanics, backing the deception with hedge reports and other documentation designed to keep the flow of new clients coming in.

When the HedgeLender principals learned that their clients’ portfolios were not hedged and that the lender was teetering on insolvency only at the 11th hour.

The Lessons

Understand that your interests and the nonrecourse lender’s interest rarely align.  

Your goal is to obtain low-interest financing without selling your portfolio while remaining safely invested in its future potential growth. If this was not your goal, you would have simply sold your stocks. Your nonrecourse stock loan lender’s goal is to make a profit by hoping you will walk away from repayment so that the lender does not have to go back into the market in the future and buy shares to return.. Since they have sold your shares to obtain the cash to advance you as your “loan”, there are not stocks to return.

Your loan is with your lender, not your broker; ensure that your lender is qualified to offer your financing.

Nonrecourse stock loans are primarily offered by individuals or non-public companies with no publicly available licensed auditing reports. Whereas a fully licensed FINRA/SIPC institution has full public financials available for stock holders and is strictly licensed to ensure its financial health, this is not usually so for a private individual. Operations are in secrecy or privacy, with no third-party verification. Private, unlicensed institutions or individuals are therefore in a far greater place to obscure irregularities or weaknesses that can impact their clients.

Remember that your well-meaning broker, as in the HedgeLender case, may have been kept completely unaware of any wrongdoing; it may have been used by the lending institutions to always verify.

Nonrecourse stock loan lenders require a steady stream of new clients. When they sell securities and do not hedge, and/or engage in other practices that put the client’s assets at risk, they do not want this information in the hands of the brokers because there would be few, if any, who would continue referring clients. This is common sense. HedgeLender’s staff, for example, was intentionally kept in the dark along with everyone else to try to keep the referrals coming in so as to help the lender stay afloat as long as possible.

Today, the lender cited in this report is behind bars and the nonrecourse stock loan has virtually disappeared from the financing world.

All we can say is, good riddance.

 

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Securities based lending may not be suitable for all securities owners. A. B. Nicholas urges all clients to discuss these risks with their licensed lender advisor should they proceed with their LeverageLine. Any activity involving securities, including borrowing, by definition involves certain risks and if the market value of your pledged securities declines to the point that you must add cash or assets, , for example, you may be required to pay down your line of credit, restructure your holdings into more stable securities (which can involve a sale), or both in order to maintain your loan. Although both A. B. Nicholas and each ABN lending partner advisor make maximum effort to ensure that acceptably good quality securities are accepted so as to minimize risk to the extent possible, we cannot guarantee any specific outcome of any securities performance and by proceeding you are acknowledging this. All lending, management and processing is handled solely by fully licensed U. S.-based FINRA/SIPC institutions (and their FDIC-member banking divisions) with which A. B. Nicholas has partnered for this custom program. Please review our disclaimer prior to proceeding. Our privacy policy is located here.