The Dangers of Nonrecourse Stock Loans
And How To Avoid Them

nonrecourse stock loans

Why an Institutionally Managed, SIPC/FINRA-Member Lending Facility Should Be Your ONLY Securities-based Credit Line Consideration 


A nonrecourse, transfer-of-title securities-based stock loan means exactly what it says: You, the titleholder (owner) of your stocks or other securities are required to transfer ownership of your securities to a third party before you receive your loan proceeds. The loan is “nonrecourse” so that you may, in theory, simply walk away from your loan repayment obligations and owe nothing more if you default. Sounds good no doubt. But in fact, it’s too good. And it is: A nonrecourse, transfer-of-title securities loan structure requires that the securities’ title be transferred to the lender in advance because, in virtually every case, they must sell some or all of the securities in order to obtain the cash needed to fund your loan. They do so because they have insufficient independent sources of funding of their own. Without selling your shares the minute they arrive, they could not stay in business. 

History and Background

For many years ToT loans occupied a “gray area” as far as the IRS was concerned. Many borrowers assumed that these loans therefore were non-taxable. One company, Derivium, touted the loans as free of capital gains until they collapsed in 2004.  As lenders offering these loans began to follow suit with the recent recession, the IRS moved in and notified the borrowers that they may have erroneously assumed their “loan” was non-taxable for capital gains. The IRS then compelled these individuals and companies to refile their taxes if any gain was realized — exactly as if they had placed a sell order — from the point of “loan” closing, and many had new tax bills as a result. Still, there was no final, official tax court ruling or tax ruling by the IRS on the tax status of transfer-of-title stock loans and securities finance. 

But in July of 2010, that all changed. A federal tax court finally ended any doubt over the matter and said that loans in which the client must transfer title and where the lender sells shares are sales of securities, and taxable the moment the title transfers to the lender. (Click here to read what the esteemed Journal of Accountancy says about these stock loans). Some analysts have referred to this ruling as marking the “end of the nonrecourse stock loan” era. Today, any securities owner seeking to obtain such a loan is in effect almost certainly engaging in a taxable sale activity in the eyes of the Internal Revenue Service, regardless of what the nonrecourse “lender” may try to tell you, and tax penalties are likely should if/when you attempt to declare your transfer-of-title stock loan as a true loan, for example, in the same manner, that a car or home loan is treated. 

The IRS Position on Nonrecourse Stock Loans


The U.S. Internal Revenue Service today considers all of these types of transfer-of-title, nonrecourse loan arrangements, regardless of loan-to-value, to be fully taxable sales at loan inception and nothing else and is stepping up enforcement action against them by going after each lender firm one by one to shut them down.

However, some of these lenders continue to state to their clients that this and other rulings apply to everyone but themselves. They often cite proposed differences with the language of the ruling (“We only sell half of them in the first week” etc. or “they are partly recourse”) or say that this only applies to “90% stock loans” and no others to distance themselves from the ruling. However, a wise securities owner will remember that regardless of what your nonrecourse stock loan lender may tell you, the key issue is the transfer of the title of the securities into the lender’s control and the sale of your securities as part of your funding that almost always follows. Those are the two elements that run afoul of the law in today’s financial world.

It is expected that the SEC and/or the new Consumer Financial Products regulatory body will demand full disclosure of the lender’s sale of the securities to lenders, as well as to require every lender to have a stock broker’s or RIA license to better control those who wish to call such structures sales. Meanwhile, it is clear that the IRS will consider these taxable sales at inception regardless. Rather than walking into one of these loan structures unquestioning, we suggest that prospective borrowers first consult a tax attorney or the IRS itself to discuss the “nonrecourse” provision of ToT loans. The ruling and subsequent government actions against transfer-of-title lending operations have made it clear: They have stated that the “nonrecourse” provision of such loans is actually more of a convenience for the lending party than a “benefit” to the client, because when the client walks away from his loan obligation he is actually relieving the lender of any obligation to re-purchase the shares (he would, of course, have to repurchase the shares on the open market in order to return them to the client since he already sold them to fund the loan).

If the client walks away from repayment, the lender also gets to walk away from returning the shares he doesn’t even have anymore, since he sold them early on. 

This may seem a bit confusing, but it really is not. Let’s examine the mechanics. 

How the Nonrecourse Stock Loan Scheme Works


Your shares are transferred to the lender; the lender then immediately sells some or all of them (with your permission via the loan contract where you give him the right to “hypothecate, sell, or sell short”). The nonrecourse ToT lender then sends back a portion to you, the borrower, as his “loan” at specific interest rates. You as borrower pay the interest and if you don’t, the loan defaults, and the lender is relieved of any further obligation to return your shares. At this point, most lenders breathe a sigh of relief, since there is no longer any threat of having those shares rise in value and thereby become very hard to go and purchase on the open market (In fact, ironically, when a lender has to go into the market to purchase a large quantity, it can actually send a market signal and force the price to head upwards – making his purchases even more expensive!) He then keeps the difference between the money he gave you and what he sold the shares for. Thus, if he gives you an 80% loan, he keeps 20% for himself and a portion goes to the brokers as their referral fee.

Key to Success: Lenders Misleading Brokers and Referring Parties


The ToT lender prefers to have broker-agents in the field bring in clients as a buffer should problems arise, so he offers relatively high referral fees to them. He can afford to do so since he has received from 20-25% of the sale value of the client’s securities. This results in attractive referral fees, sometimes as high as 5% or more, to brokers in the field. 

Once attracted to the ToT program, the ToT lender then only has to sell the broker on the security of their program. The most unscrupulous of these “lenders” provide false supporting documentation, misleading statements, false representations of financial resources, fake testimonials, and untrue statements to their brokers about hedging or other security measures – anything to keep brokers in the dark referring new clients.  By manipulating their brokers away from questioning their ToT model and onto selling the loan program openly to their trusting clients, they avoid direct contact with clients until they are already to close the loans. (For example, some of the ToTs get Better Business Bureau tags showing “A+” ratings knowing that prospective borrowers will be unaware that this is an easy rating to obtain simply by paying a $500/yr fee. Those borrowers will also be unaware of the extreme difficulty of lodging a complaint with the BBB, in which the complainant must publicly identify and verify themselves first, which many complainants do not want to do). In so doing, the nonrecourse ToT lenders have created a buffer that allows them to blame the brokers they misled if there should be any problems with any client, such that the brokers take the brunt of criticism from the client (“You should have known”) should anything go wrong with the lender. Many well-meaning and perfectly honest individuals and companies with marketing organizations, mortgage companies, financial advisory firms, etc. begin to offer the ToT loans and as long as their clients appear contented, continue to send clients to the ToT lender even while the lender may disguise weaknesses in their financial health and stability.

Why FINRA & SEC Call Nonrecourse Stock Loans “Ponzi Schemes”


The IRS calls these transfer-of-title stock loans risk-filled “Ponzi schemes” because:   

1) The lender has no real financial resources of his own and is not held to the same buffer; and

2) The repurchase of shares to return to clients who pay off their loans depends 100% on having enough cash from the payoff of the loan PLUS a sufficient amount of other cash from the sale of new clients’ portfolios to maintain solvency

The U.S. Department of Justice has stated in several cases that nonrecourse ToT lenders who:  

1) Do not clearly and open fully disclose that the shares will be sold upon receipt and

2) Do not show the full profit and cost to the client of the ToT loan structure …

…will be potentially guilty of deceptive practices which can have penalties of up to 20 years in jail. In addition, many legal analysts believe that the next step in regulation will be to require any such ToT lender to be an active member of the National Association of Securities Dealers, fully licensed, and in good standing as well — prior to selling a single share. In other words, they will need to be fully licensed before they can sell client shares pursuant to a loan in which the client supposedly is a “beneficial” owner of the shares.

The IRS is expected to continue to treat all ToT loans as sales at the transfer of title regardless of lender licensing. Borrowers concerned about the exact tax status of such loans are urged to consult with the IRS directly or with a licensed tax advisor for more information but be aware that any entry into any loan structure where the title must pass to a lending party is almost certain to be reclassified as a sale by the Internal Revenue Service eventually. 

Nonrecourse Lender Interactions with Brokers


A ToT lender is always exceptionally pleased to get a broker who has an impeccable reputation to carry the ToT “ball” for them. Instead of the lender having to sell the loan program to the clients, the ToT lender can piggyback onto the strong reputation of the broker with no downside. That individual might be semi-retired, perhaps a former executive of a respected institution, or a marketing firm with an unblemished record and nothing but long-standing relationships with long-term clients. ToT lenders who use elaborate deception with their brokers to cloud their funding process, exaggerate their financial resources, claim asset security that is not true, etc. put brokers and marketers in the position of unknowingly making false statements in the market that they believed were true, and thereby unknowingly participating in the ToT lender’s sale-of-securities scheme. By creating victims out of not just borrowers, but also their otherwise well-meaning advisors and brokers (individuals who have nothing to do with the sale, the contracts, the loan, etc.), many firms and individuals with spotless reputations can find those reputations stained. Yet, without those brokers, the ToT lender cannot stay in business, so those lenders will often say or do anything they can to keep them. 

When & How It Breaks Down


The system is fine until the lender is one day repaid at loan maturity, just as the loan contract allows, instead of exercising his nonrecourse rights and “walking away” as most transfer-of-title lenders prefer. The client wants to repay his loan and he does. Now he wants his shares back. Obviously, if the lender receives repayment, and that money received is enough to buy back the shares on the open market and send them back to the client, all is well. But the lender doesn’t want this outcome.  The transfer-of-title lender’s main goal is to avoid any further responsibilities involving the client’s portfolio. After all, the lender has sold the shares.

But problems occur with the ToT lender (as it did originally with the nonrecourse stock loan company Derivium and several ToT lenders who collapsed between 2007 and 2010)… When a client comes in, and repays his loan, the cost to the lender of repurchasing those shares in the open market has gone dramatically up because their portfolio has gone dramatically up. This is what happened with many ToT lenders who had provided nonrecourse stock loans against oil stocks the last time oil prices (and oil company stock prices) went up. Any time a portfolio rises enormously in value when it is pledged for a loan and the client repays, the lender is at risk. He must dip into his own financial reserves — if he has any — to buy back the shares at the current, higher price.

If he does not have enough money, he cannot return the shares and that is when the lender collapses. The nonrecourse ToT lender’s true weakness is then evident. Because he had no independent resources of his own to fall back on, he probably will feel compelled now to deceive or omit facts while pressuring his brokers to pull in new clients so he can sell those new shares and use that money to buy up the stock needed to return shares to other clients who have paid off their loans.

Still More Problems With Nonrecourse Stock Loans


Now the new clients come in, and they are told that funding will take seven days, ten days, or even two weeks since they are using that sale cash to buy back and return the stocks due back to the earlier client. Desperate lenders will offer whatever they can to keep the flow of clients coming in. If the nonrecourse stock loan ToT lender’s clients are patient and the brokers have calmed them believing the lender’s assurances (typically written as well as verbal), the ToT lender might get lucky and bring in enough to start funding the oldest remaining loans and live to lend a little longer. But once in deficit, the entire structure of this Ponzi-like system begins to totter, and the overwhelming majority of such nonrecourse stock lenders went bankrupt, leaving their clients – many of whom had already paid off their loans – high and dry, subject to the mercy of a Court Master tasked with divvying up the lender’s remaining assets, a real nightmare scenario. If a major marketer or broker, or a group of brokers, stops sending new clients to the lender out of concern for their clients, then the nonrecourse stock loan lender can easily go into crisis. Eventually, all brokers terminate their relationship as the weakness in the lender’s program becomes obvious and client complaints of unreturned shares increase. New clients dry up everywhere. Any pre-existing client looking to repay their loan and get their shares back finds out that the lender does not have their shares at all anymore, and worse, no money to buy back the shares in the open market even after the client has paid off his loan (most of those who pay off their loans do so only if they are worth more, too, so they are losing what they thought was a portfolio of stock worth much more than when they started!)

The nonrecourse stock loan lender eventually collapses, leaving brokers and clients to deal with the aftermath.  

The Law Has Spoken: Buyers Beware of Nonrecourse Stock Loans


If you are a broker helping transfer you shares for your client’s securities-backed loan, or if you are a broker calling such structures “loans” instead of the sales that they really are, then you must understand what the structure of this financing is and disclose it fully to your clients at the very least.  (The new Consumer Finance agency has already stated that full disclosure is a priority…) Better, stop having any involvement whatsoever with transfer-of-title securities loans.  There are very strong indications that regulators will very soon rule that those who engage in such loans are deceiving their clients by the mere fact that they are being called “loans”.  If you are a broker who is claiming such loans are “nontaxable” even though shares are sold to fund them, you should expect to be challenged – or worse – by the IRS, which almost certainly does not agree. If you are a client considering such a loan, you are probably entering into something that the IRS almost certainly considers a taxable sale of assets, and you can expect sooner or later to receive a 

Unless your securities-based loan involves assets that remain in your title and account unsold, that allow free prepayment when you wish without penalty, that allows you all the privileges of any modern U.S. brokerage — then you are almost certainly engaging in a very risky or in some cases possibly even illegal financial transaction. Once upon a time, nonrecourse stock loans occupied a legal gray area; today they most certainly do not.

Only those structures that involve fully regulated institutional lenders, SIPC/FDIC-insured personal accounts with full access, and funding from independent sources without the sale of the securities allow clients the security of knowing their financing is sound and without potential problems. The A. B. Nicholas LeverageLine program is one such lending facility. 

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