What are the Risks of Stock Based Loans?

For real estate purchase, acquisition and investment, while stock-based loan programs may be an attractive source of capital. Investors need be aware of the following risks.

Failure to perform (as promised) by lender: According to Financial Industry Regulatory Authority (FINRA), lenders offering non-recourse stock-based loans were not registered with FINRA or regulated by any banking authority. Once transferred as secured collateral, non-registration makes it difficult to verify financial stability or an ability to verify status of borrower’s stock. While these lenders offer promise to return stock or pay profits (from dividends) at end of the loan period, there is no assurance of lender compliance.

Premature sale of stock: With pledged securities; as in used collateral, rights and control of pledged stock is transferred to the lender. Although a stock loan transaction is designed to hold pledged stock as collateral, lenders are inclined to sell pledged shares. This sale may result in tax consequences and loss of appreciation of the stock(s).

Possible tax consequences: During the loan period, if lender sells the stock, the Internal Revenue Service might consider the transfer of stock a taxable event. Thus, upon receipt of loan proceeds or sale of the stock (as initiated by the lender), a borrower might face unexpected tax liabilities and need pay capital gains tax(es). If stock position was long and shown an increased value, this tax liability can be much. For those who enter a stock-based loan program-attempting to avoid immediate taxation, tax consideration is critical.

Availability of funds to repay loan: Most stock-based loan programs are short-term loans—often as little as two to three years. At end of this period, a borrower might be inclined to pay off loan balance and retrieve shares of stock. Yet, a borrower must have enough liquid funds. If loan proceeds are housed in a long-term investment, a product with a surrender charge or contingent deferred sales charge (CDSC); as in fixed variable or equity-indexed annuities, this pay off demand is more difficult. In such instances, a borrower need liquidate new investment. This new investment may well incur significant charges and a potential tax liability.

Lack of adequate investigation by the promoter: As underscored in FINRA enforcement actions, if a financial professional promotes a stock-based loan program, this does not show intermediary (this professional relied on)-vetted the prospective lender. Absent adequate due diligence, anyone involved in promoting a stock option loan program cannot know how a lender handles pledged stock. This due diligence need determine if the lender holds stock or sells individual shares. Moreover, at end of the loan term, added consideration need confirm lender has adequate liquidity (of cash) to honor its obligations. Invariably, for failing to do adequate due diligence, the Securities and Exchange Commission (SEC) has brought litigation against promoters of stock-loan programs.

Unregistered salespeople: Financial professionals promoting non-recourse stock-based loan programs are not licensed brokers or registered broker-dealers. These non-registered agents are not required to offer assurances these securities transactions are suitable. Still, transactions with non-licensed and non-registered financial professionals increase financial risk.

Restrictions on loan proceeds: Stock loans secured by pledge of certain securities are considered margin loans. Federal Reserve Board regulations restrict these proceeds. This restriction includes limiting the buy of other securities with same loan monies. As a result, stock-based loan customers may not be able to use loan proceeds in the same way-within the course of normal market activity.

With effective due diligence and confirmation of a registered lender’s financial footing, risks might be better mitigated.

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