FINRA has issued an Investor Alert to warn investors about stock-based loan programs. Brokers, financial planners, insurance agents and other advisors are pitching these programs as a way for clients to tap into the value of their stock holdings without having to sell their shares. The idea is that the broker will arrange for the shares to be used as collateral by a third-party lender, who will loan the client money based on the value of the stock. If the price of the stock appreciates sufficiently during the term of the loan to cover the principal amount borrowed plus interest, at the end of the loan term, the client can pay off the loan and receives his or her shares back. Clients are told if the stock price falls below the amount owed, the lender can keep the pledged shares, but can’t pursue the customer for the difference. This sounds great, but as FINRA points out, these “non-recourse” stock-based loan programs are fraught with risks and costs to the client.
FINRA’s Alert gave the following example of how stock loan programs are supposed to work:
Suppose a customer owns stock in XYZ Corp. worth $100,000, paying a 2 percent annual dividend. The customer “pledges” the stock to the lender, which in turn provides the customer with a $90,000 loan for three years at 10 percent interest (compounded monthly). At the end of the three years, the customer would owe approximately $115,000: $90,000 in principal, plus $31,000 in interest, less $6,000 in dividends. If the stock has gone up more than 15 percent over the three years, and is worth more than $115,000, then the customer is “in the money”—meaning the stock is worth more than the customer owes to the lender. The customer can then either repay the loan and get back the stock or request that the lender pay the customer the amount by which the value of the stock exceeds the amount due on the loan. For instance, if the stock is worth $125,000, the lender will pay the customer $10,000—the $125,000 value of the stock minus the $115,000 the customer owes the lender. If, on the other hand, the stock is worth less than $115,000, the customer can “walk away”—the lender keeps the stock, and the customers owes, and receives, nothing. In either instance, the customer still has the $90,000, along with the benefits (or losses) from the use or investment of that money.
This sounds like the proverbial “win win” deal, but it isn’t. Investors are seldom informed of the risks of these deals. These risks include the fact that the lenders in stock loan deals may have marginal financial strength or might even be outright crooks. One stock loan promoter, HedgeLender LLC, got in trouble in 2009 for a fraudulent scheme in which pledged stock was sold and the proceeds were misappropriated. As FINRA notes, many of the lenders are not regulated by FINRA, the SEC, or banking authorities. If the lender takes your $100,000 worth of XYZ stock, where is the assurance that it (and your shares) will still be there when the loan term is at end?
Another risk stems from the very high rates of interest many lenders charge–often 10% or more. The higher the cost of borrowed money, the less the likelihood that you can pay off the loan and get your XYZ shares back.
There is also considerable tax risk, especially if you have a low cost basis in your XYZ stock. First off, some lenders may sell your stock, which could result in taxable gains for which you may not have planned. Secondly, even if the lender does not sell the stock, the IRS might still deem the transfer of shares to the lender to be an event that triggers a tax liability. If the stock has a low cost basis, the resulting capital gains tax may be substantial and could negate the value of the transaction altogether.
FINRA is also concerned about the real motivation for financial advisors who are recommending stock loan programs. For example, a broker or insurance agent may want you to get hold of a large amount of cash so that he or she can sell you a variable annuity or some other dubious investment product. You will then be investing with borrowed money. If you are paying 10% interest on your stock loan and the investment you buy with the loan proceeds is not yielding 10%, you are in the hole, but your advisor has picked up a fat fee or commission. The potential conflicts of interest are troubling
Although FINRA’s Alert offers ideas for how investors can protect themselves (for example, check to see if the advisor recommending the loan program is registered, and carefully review the lender’s audited financials), we have another idea: Unless you are an ultra-sophisticated investor and have money to burn, avoid stock loan deals.