Fully Paid Securities Lending

Fully paid securities lending is an arrangement in which a brokerage firm borrows securities a customer owns free of any margin debt and pays the customer for the use of them, lending them on into the wider borrow market. The name comes from the regulatory category rather than from a product catalogue. FINRA Rule 4330(b) is headed "Requirements for Borrowing of Customers' Fully Paid or Excess Margin Securities," and both components are defined in SEA Rule 15c3-3. "Fully paid securities" means, in essence, securities carried in a cash account, plus securities in a margin account that have no loan value for margin purposes, plus margin equity securities in those accounts if they are fully paid. "Excess margin securities" are margin securities with a market value above 140 percent of the customer's total debit balances, which the firm identifies as not constituting margin securities. The programs marketed to retail customers are often called simply fully paid lending, and they sit inside the same securities lending market a short seller borrows from.

The customer's strongest right is an election, and it is statutory. Exchange Act Section 15(e), 15 USC 78o(e), is titled "Notices to customers regarding securities lending" and provides that "[e]very registered broker or dealer shall provide notice to its customers that they may elect not to allow their fully paid securities to be used in connection with short sales. If a broker or dealer uses a customer's securities in connection with short sales, the broker or dealer shall provide notice to its customer that the broker or dealer may receive compensation in connection with lending the customer's securities." Two things follow. The customer chooses whether to participate, and the firm's own compensation from the activity is a disclosed fact rather than a hidden one.

Fully paid securities get a higher bar than margin securities, and the contrast is the clearest way to see what the rules are doing. FINRA Rule 4330(a) says that "[n]o member shall lend securities that are held on margin for a customer and that are eligible to be pledged or loaned, unless such member shall first have obtained a written authorization from such customer permitting the lending of such securities," and the rule's Supplementary Material .02 lets a single account or margin agreement carry that authorization so long as it includes "clear and prominent disclosure that the firm may lend either to itself or others any securities held by the customer in its margin account." Fully paid and excess margin securities are treated differently, because a customer with no margin debt has not asked for anything. Before first entering into such borrows a member must, under Rule 4330(b)(2)(A), "have reasonable grounds for believing that the customer's loan(s) of securities are appropriate for the customer," exercising reasonable diligence as to the customer's "financial situation and needs, tax status, investment objectives, investment time horizon, liquidity needs, risk tolerance and any other information the customer may disclose." The firm must also notify FINRA at least 30 days before it first engages in such borrows.

The disclosure that matters most is about what happens if the firm fails. Rule 4330(b)(2)(B)(i) requires the firm to give the customer, in writing, "clear and prominent notice stating that the provisions of the Securities Investor Protection Act of 1970 may not protect the customer with respect to the customer's securities loan transaction and that the collateral delivered to the customer may constitute the only source of satisfaction of the member's obligation in the event the member fails to return the securities." SEA Rule 15c3-3(b)(3)(iv) requires the same notice in the written agreement. This is the structural difference between holding a security and lending it. A security held in an account is, in the normal case, the customer's property in the firm's possession or control. A security on loan has been replaced in the account by a claim on the firm, secured by collateral. What the Securities Investor Protection Corporation does and does not cover sits with that term; the point here is that the notice exists because the answer is not a simple yes.

Eight disclosures, and they are the honest specification of the product. Rule 4330(b)(2)(B)(ii) requires disclosure of the customer's rights and the risks and financial impact of the loans, including but not limited to loss of voting rights; the customer's right to sell the loaned securities "and any limitations on the customer's ability to do so, if applicable"; the factors that determine the member's own compensation; the factors that determine the compensation paid to the customer "and whether or not such compensation can be changed by the member under the terms of the borrow agreement"; the risks associated with each type of collateral; that the securities may be "hard-to-borrow" because of short-selling or may be used to satisfy delivery requirements resulting from short sales; "potential tax implications, including payments deemed cash-in-lieu of dividend paid on securities while on loan"; and the member's right to liquidate the transaction under Rule 4314(b). Read together, those items say that the fee is not fixed by rule, that the ability to sell may be qualified, and that the tax treatment can differ from simply holding the shares. The first of the eight is also the one most often overlooked: while shares are out on loan the lender is not the holder for voting purposes, so proxy voting on those shares is not available to them.

What arrives in place of a distribution is a substitute payment, and the amount is not the issue. IRC 1058(b)(2) conditions the loan's tax treatment on an agreement requiring "payments shall be made to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive" during the loan. So the lender is not short the cash. The character can change: IRS Publication 550 lists "[p]ayments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends" among the distributions that are not qualified dividends, and Rule 4330 makes that a disclosure item precisely because it can move a payment out of the favorable rate structure. One narrow privacy point runs the other way: Rule 10c-1a(e)(1), which otherwise requires the legal name of each party to a reported securities loan to go to a regulator as a confidential data element, expressly excludes "the customer from whom a broker or dealer borrows fully paid or excess margin securities."

A customer receives the statutory notice about the election and, if they want to participate, signs a lending agreement. The firm makes the appropriateness determination and delivers the required disclosures. Eligible securities are then borrowed from the account, and the firm posts collateral. The customer keeps the economic exposure to the shares and is paid a fee for the loan, at a rate the firm sets under the agreement. Distributions arrive as equivalent substitute payments. When a loan ends, identical securities go back into the account.

A hypothetical, showing both the fee arithmetic and what "excess margin" means. Marcus holds 500 shares trading at $60 in a cash account, so $30,000 of fully paid securities. At a hypothetical fee rate of 0.5 percent a year on that value, a loan running 60 days pays $30,000 x 0.005 x 60/365, which is $24.66. Not a large number on a holding of that size, which is the honest scale of the trade-off for a small account.

Now change one fact. Suppose Marcus instead had $10,000 of margin debt against $30,000 of margin securities. The 140 percent test in Rule 15c3-3(a)(5) applies to the debit balance, so $14,000 of securities is measured against that debt, and up to $16,000 of the remainder can be identified as excess margin securities and therefore borrowed under the same rule. That is the arithmetic behind a program that reaches accounts carrying a balance and not only accounts that are paid in full.

Pros

• It pays something for a holding the customer intends to keep anyway, with no trade and no realized gain.
• The customer keeps the price exposure, so the return on the shares is unaffected by the loan itself.
• Participation is a choice that federal law requires the firm to tell the customer about.
• The disclosures are specific and written, so the terms that matter can be read before enrolling rather than reconstructed afterward.

Cons

• The Securities Investor Protection Act may not protect the customer on the loan, and the collateral may be the only source of satisfaction if the firm fails to return the securities. The firm is required to say so in clear and prominent terms.
• Voting rights are among the things the firm has to disclose the loss of, so a lender should not expect to vote loaned shares.
• No rule fixes how the fee divides between firm and customer, and the rule contemplates that the customer's rate may be changeable under the agreement.
• Distributions arrive as cash-in-lieu payments, which can be taxed less favorably than the dividend they replace.
• The right to sell loaned securities may carry limitations, which is why that is one of the eight required disclosures rather than an assurance.
• Fees on a modest holding are small in absolute terms, so the disclosures deserve more attention than the income does.