We ask the prospective nonrecourse stock loan client to consider one fundamental principle:
Let’s ask this question hypothetically. If you had in your possession a valuable necklace given to you by your grandmother as a keepsake, would you hand that to an unlicensed person you do not know, simply on the promise of a third party that it’s OK to do so? Would you trust that you would get it back someday?
Chances are you would not. Yet, people have taken their valuable stocks and bonds and readily handed them over to third parties they do not really know on the promise that they will be returned some day after their loan is paid off.
Why? Any program that forces a securities owner to transfer their securities’ title and ownership prior to funding is by its very definition highly risky. Yet people do this all the time.
The risk and of loss and taxation rises if that lender can offer no audited financial statements to verify their overall financial health and their likelihood of being able to return your shares when you pay off your loan in the future. Again, many people think this doesn’t matter. But it matters to the mainline, licensed and trusted brokerage lenders such as Merrill Lynch, UBS, Schwab and others. It’s a level of security that their clients demand, too. (It is also the reason why we at A. B. Nicholas will only refer clients to institutions like these).
It rises still further if the institution if the loan contract allows them to sell your shares whenever they wish, as all such lenders’ contracts do (typically in hidden, small print) unless they are intentionally omitting this basic feature of all nonrecourse stock loans so as to deceive.
Understand that your interests and the nonrecourse lender’s interest rarely align.
Your nonrecourse lender is not likely to tell you that they hope you walk away from your loan obligation-but in fact they do. Why?
Remember: they have sold some or all of your stocks to “fund” your “loan”. They don’t have them any more, certainly not the same stocks you started with or the same number. When you pay the loan off, they must go back into the market and buy them back at whatever the market price may be. If that price is much higher that your repayment amount, they will have to reach into their own pockets to buy all the shares they have to return to you.
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This is why they hope you will exercise your “nonrecourse” provision and walk away. It’s to relieve them of the obligation to go back into the market to buy whatever number of shares they need to return to you. Therefore, they want you to lose your incentive or reason to pay off your loan, and that only happens if your collateral stock portfolio goes down. (If it goes up, you’ll naturally want them back, and that’s bad news for your lender, because he has sold some/all and doesn’t have enough of them any more).
Not so with the no-title-transfer, no-sale-to-fund programs offered through mainline institutions such as those that work with A. B. Nicholas’ clients. The client’s stocks stay in the SIPC account where they were deposited, with a simple lien on the account from the lending institution.
When nonrecourse lenders get worried and scared; anatomy of a nonrecourse loan disaster
In fact, if your portfolio goes up with your nonrecourse lender, that’s a pretty scary proposition to him. It’s scary to the lender, because you are more likely to want to pay off your loan if your portfolio is worth more. Makes sense from your perspective, doesn’t it? Pay it off, and now you can get back a portfolio worth a lot more than when you started. Who wouldn’t want to pay off their loan if the asset they were getting back was worth a lot more than when you started?
So you pay it off. The lender get your cash payoff amount, and your loan is supposedly paid off. But now he must return your portfolio.
But if your payoff was, say, $200,000 @$20 a share for your 10,000 shares, but now your portfolio is worth, say, $400,000 @ $40 a share for your 10,000 shares, your lender must now come up with much more than the $200,000 with which you paid off your loan! In fact, he needs have a total in-hand of $400,000 to buy all those 10,000 stocks back up to give back to you as client borrower. So he needs to come up with an additional $200,000 to go with what you paid back – in other words, more of his own money. Or, if he has none — and none do — he needs willing, well-meaning brokers to keep sending new clients in so he can sell those securities and use THOSE proceeds to round up the money he needs to pay off the first client.
No big deal? Doesn’t really matter? Well, it does matter. It matters a lot. It’s the making of a ponzi scheme, essentially. And it requires dupes not only in the form of clients, but also lied-to brokers who think they are promoting a healthy, solid financial product when in reality it is not.
After all, you have placed your stocks with somebody who sold them, and now that “somebody” had better be financially sound enough to reach into his pocket and find an extra $200,000 immediately to buy enough stocks to return your 10,000 shares to you. If he does not have that much cash — for example, if his management of the company was so poor that he cannot afford it — then you may not get your stocks back. Maybe you’ll get an IOU. Maybe you will get a few of them back to keep you temporarily happy and an IOU. But you won’t get all of them them back, even though you abided by your loan terms and paid off the loan, once the lender goes into financial crisis as they eventually all do. .
When nonrecourse lenders teeter on the brink – and how you pay
If that lender has three or four clients like you, or maybe one other big loan where the price/value has gone through the roof (requiring the lender to come up with another huge amount of his own money to buy back that client’s stocks to return to client) — then you are just plain out of luck. Unlike the major institutions that A. B. Nicholas works with — institutions with their own, publicly audited, major reserves — the private, unlicensed, non-FINRA lender has no such resources and must depend on the sale of new client securities for the cash to stay afloat.
Ultimately, these unregulated private lenders typically receive a lawsuit from one or more clients who could not get their shares back as promised. Federal authorities then take notice — the FBI, IRS or SEC or maybe even all three — and the loan company is shut down. Bankruptcy and regulatory actions ensue. Any stock the lender has not yet received back after paying off his loan, and any cash remaining with the lender (including your payoff cash) simply becomes part of the overall bankruptcy estate and likely to be doled out to ALL the creditors and the IRS, not just you, by the bankruptcy master. There is in fact no guarantee of any kind that you will get any of it back at all! You might get a fraction of your cash and a few stocks back, especially if the lender has many unpaid debts (as is usually the case). Most nonrecourse clients suffer quite a bit when this happens. Some never get their money OR their stocks back, a particularly tragic situation.
How a lender depends on brokers, intermediaries, and marketers to survive.
Remember that the lenders — the people who take possession of the title to your stocks — cannot survive without new clients. They need brokers, intermediaries, and marketers to keep feeding clients into their nonrecourse loan programs. No brokers = no transactions = no lender profits. This situation is ripe for lender fraud and deception perpetrated on brokers and marketers who trust that the loan program is exactly as advertised when they speak to prospective clients.
It is common sense that very few well-meaning, legitimate brokers, having built up their reputations and networks of clients through hard work and sacrifice over time, would ever send their clients into these programs if they were aware that the stocks were all being sold to fund the loans and that the lenders had no independant financial resources of their own. This means that the nonrecourse lender must disguise, withhold, or outright lie about this aspect of their loan program to both client and broker alike, so that the brokers keep referring clients. (As an example, the HedgeLender company that once resided at the domain you are now on – once one of the largest firms of its type — told that it’s lender, Alexander Capital Markets, had “hedged” the clients’ portfolios to prevent loss and ensure return if paid off. Alexander put out “hedge reports” and guaranteed “hedging” in its contracts, even though they did neither.)
The importance of outright deception of everyone to maintain the market.
Therefore, in order to obtain a flow of new clients, these lenders must find reputable brokers and tell a candy-coated version of the truth about their loan programs. Brokers in disrepute will not do as they will not be able to provide clients. The better the reputation of the marketer, the better chance of successful closings.
So the nonrecourse private lender concocts a rosy, risk-free version of their loan program, giving their brokers only what they want the brokers to hear and even less to their clients. In some cases they assure the brokers that huge financial resources back their loan programs. Warehouse accounts, for example. They may assure the brokers that they hedge every portfolio against loss with difficult-to-trade “European” style options contracts, just as Alexander Capital did to its lenders several years ago.
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These lenders never describe their financing program as a sale of the securities, but instead say that “selling, or selling short” is “just one” contractual “risk-reduction option” that is “open to them.” Some of the nonrecourse lenders even pay a lawyer or accountant to write a letter stating in general language that the nonrecourse lending company has no legal issues and plenty of assets. Such letters are paid for by the lender, are based on sometimes false information provided by the lender to the lawyer or CPA, and are no replacement for valid, audited financial statements and licensure. Still, many clients fall for this form of validation even though a reasonable person should find such funding suspicious at the very least.
Again, contrast this with the extensive legal and compliance requirements of a major U. S. brokerage such as those used by A. B. Nicholas for its securities-based credit line program.
Why does all this matter? Because the broker you may be working might be a really great guy who goes to church on Sunday and plays golf with you. But they may also be an unwitting pawn in the nonrecourse lender’s game. Lied to, or provided with only a fraction of the truth about the stability of the lender’s programs or his methods, the broker may be innocently pressing you to proceed with your loan without any real clue as to the actual risks involved. Trusting your loan broker because he/she seems personable or is in every way reputable— is no replacement for examining the actual lender and their program. And even when your broker feels that his background checks and lender’s loan contracts are legitimate, there is no substitute for getting FINRA information on your lender.
We at A. B. Nicholas always ensure that our client’s lending institution provides full FINRA information along with licensing in a welcome letter from the licensed lending institution to the client well in advance of any lending contract phase.
In the end, and though it may seem unfair, regulators make only a small distinction between a duped broker and an unscrupulous lender. The former will be fined by the SEC for negligence and possibly accused of participating in a “scheme” even if they were nothing of the sort. Most are actually victims of that very same scheme. Most, like HedgeLender, will settle “without admitting or denying” any guilt in order to save money. All are put out of business, but you as a client of the nonrecourse loan lender (such as Alexander) are left ironically with “no recourse” but to accept your fate.
Brokers and markets have a responsibility to thoroughly check out all aspects of their lender, and though sophisticated deceptions — such as those practiced by Alexander Capital Markets in the past — are extremely hard to discern — brokers remain responsible for portraying this funding accurately.
The Right Way
There is no substitute for placing your loan with a licensed, fully regulated, SIPC/FDIC/FINRA-member lender. No matter who your consultant or broker may be, you as prospective borrower have the responsibility to make sure your lender is a stable, transparent, and licensed operation.
Your lender should never require transfer of title to them in advance of funding or even after. Your SIPC-insured account should be your own, nobody else’s, accessible online as with any modern brokerage account. A simple lien on the account should cover your lender’s interest perfectly well. He should be a FINRA member in good standing. He should have audited, publicly available financing.
If your lender does not offer these features, you should not provide your business to that lender. It’s as simple as that.
Be informed. Avoid any nonrecourse loan involving stocks or other securities.
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