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Definition of Transfer-of-Title Nonrecourse Securities Loans. A nonrecourse, transfer-of-title securities-based loan (ToT) means exactly what it says: You, the title holder (owner) of your stocks or other securities are required to transfer complete 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. Maybe too good. And it is: A nonrecourse, transfer-of-title securities loan 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 financial resources of their own. Without selling your shares pracitcally the minute they arrive, the could not stay in business.
History and background. The truth is that for many years these “ToT” loans occupied a gray area as far as the IRS was concerned. Many CPAs and attorneys have criticized the IRS for this lapse, when it was very simple and possible to classify such loans as sales early on. In fact, they didn’t do so until many brokers and lenders had established businesses that centered on this structure. Many borrowers understandably assumed that these loans therefore were non-taxable.
That doesn’t mean the lenders were without fault. One company, Derivium, touted their loans openly as free of capital gains and other taxes until their collapse in 2004. All nonrecourse loan programs were provided with insufficient capital resources.
When the recession hit in 2008, the nonrecourse lending industry was hit just like every other sector of the economy but certain stocks soared — for example, energy stocks — as fears of disturbances in Iraq and Iran took hold at the pump. For nonrecourse lenders with clients who used oil stocks, this was a nightmare. Suddenly clients sought to repay their loans and regain their now much-more-valuable stocks. The resource-poor nonrecourse lenders found that they now had to go back into the market to buy back enough stocks to return them to their clients following repayment, but the amount of repayment cash received was far too little to buy enough of the now-higher-priced stocks. In some cases stocks were as much as 3-5 times the original price, creating huge shortfalls. Lenders delayed return. Clients balked or threatened legal action. In such a vulnerable position, lenders who had more than one such situation found themselves unable to continue; even those with only one “in the money” stock loan found themselves unable to stay afloat.
The SEC and the IRS soon moved in. The IRS, despite having not established any clear legal policy or ruling on nonrecourse stock loans, notified the borrowers that they considered any such “loan” offered at 90% LTV to be taxable not just in default, but at loan inception, for capital gains, since the lenders were selling the stocks to fund the loans immediately. The IRS received the names and contact information from the lenders as part of their settlements with the lenders, then compelled the borrowers to refile their taxes if the borrowers did not declare the loans as sales originally — in other words, exactly as if they had simply placed a sell order. Penalties and accrued interest from the date of loan closing date meant that some clients had significant new tax liabilities.
Still, there was no final, official tax court ruling or tax policy ruling by the IRS on the tax status of transfer-of-title stock loan style 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 outright sales of securities for tax purposes, and taxable the moment the title transfers to the lender on the assumption that a full sale will occur the moment such transfer takes place.
Some analysts have referred to this ruling as marking the “end of the nonrecourse stock loan” and as of November, 2011, that would appear to be the case. From several such lending and brokering operations to almost none today, the bottom has literally dropped out of the nonrecourse ToT stock loan market. 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 and tax penalties are certain if capital gains taxes would have otherwise been due had a conventional sale occurred. Any attempt to declare a transfer-of-title stock loan as a true loan is no longer possible.
That’s because the U.S. Internal Revenue Service today has targeted these “walk-away” loan programs. It now considers all of these types of transfer-of-title, nonrecourse stock loan arrangements, regardless of loan-to-value, to be fully taxable sales at loan inception and nothing else and, moreover, are stepping up enforcement action against them by dismantling and penalizing each nonrecourse ToT lending firm and the brokers who refer clients to them, one by one.
A wise securities owner contemplating financing against his/her securities will remember that regardless of what a nonrecourse lender may say, the key issue is the transfer of the title of the securities into the lender’s complete authority, ownership, and control, followed by the sale of those securities that follows. Those are the two elements that run afoul of the law in today’s financial world. Rather than walking into one of these loan structures unquestioning, intelligent borrowers are advised to avoid any form of securities finance where title is lost and the lender is an unlicensed, unregulated party with no audited public financial statements to provide a clear indication of the lender’s fiscal health to prospective clients.
End of the “walkway.” Nonrecourse stock loans were built on the concept that most borrowers would walk away from their loan obligation if the cost of repayment did not make it economically worthwhile to avoid default. Defaulting and owing nothing was attractive to clients as well, as they saw this as a win-win. Removing the tax benefit unequivocally has ended the value of the nonrecourse provision, and thereby killed the program altogether.
Still confused? Don’t be. Here’s the nonrecourse stock loan process, recapped:
Your stocks are transferred to the (usually unlicensed) nonrecourse stock loan 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 ToT lender then sends back a portion to you, the borrower, as your “loan” at specific interest rates. You as borrower pay the interest and cannot pay back part of the principal – after all, the lender seeks to encourage you to walk away so he will not be at risk of having to go back into the market to buy back shares to return to you at loan maturity. So if the loan defaults and the lender is relieved of any further obligation to return your shares, he can lock in his profit – usually the difference between the loan cash he gave to you and the money he received from the sale of the securities.
At this point, most lender’s breathe a sigh of relief, since there is no longer any threat of having those shares rise in value. (In fact, ironically, when a lender has to go into the market to purchase a large quantity of shares to return to the client, his activity can actually send the market a “buy” signal that forces the price to head upwards – making his purchases even more expensive!) It’s not a scenario the lender seeks. When the client exercises the nonrecourse “walkaway” provision, his lending business can continue.
Dependence on misleading brokers: The ToT lender prefers to have broker-agents in the field bringing in new 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 as his own. This results in attractive referral fees, sometimes as high as 5% or more, to brokers in the field, which fuels the lender’s business.
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/or untrue statements to their brokers about safety, hedging, or other security measures – anything to keep brokers in the dark referring new clients. Non-disclosure of facts germane to the accurate representation of the loan program are in the lender’s direct interest, since a steady stream of new clients is fundamental to the continuation of the business.
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 the Better Business Bureau is often notoriously lax and 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.
In so doing, the ToT lenders have created a buffer that allows them to blame the brokers they misled if there should be any problems with any client and with the collapse of the nonrecourse stock loan business in 2009, many brokers — as the public face of loan programs – unfairly took the brunt of criticism. Many well-meaning and perfectly honest individuals and companies with marketing organizations, mortgage companies, financial advisory firms etc. were dragged down and accused of insufficient due diligence when they were actually victimized by lenders intent on revealing on those facts most likely to continue to bring in new client borrowers.
Why the IRS calls Transfer-of-Title loans “ponzi schemes.” So many aspects of business could be called a “ponzi scheme” if one thinks about it for a moment. Your local toy story is a “ponzi scheme” in that they need to sell toys this month to pay off their consignment orders from last month. The U.S. government sells bonds to foreign investors at high interest to retire and payoff earlier investors. But the IRS chose to call these transfer-of-title stock loans “ponzi schemes” because:
1) The lender has no real financial resources of his own and is not held to the same reserve standards as, say, a fully regulated bank; 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. Therefore, they are dependent entirely on new clients to maintain solvency and fulfill obligations to existing clients.
The U.S. Department of Justice has stated in several cases that ToT lenders who:
1) Do not clearly and 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.
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 just as all major brokerages and other financial firms are. 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, but in truth has no legal ownership rights any more whatsoever.
The IRS is expected to continue to treat all ToT loans as sales at transfer of title regardless of lender licensing for the foreseeable future. Borrowers concerned about the exact tax status of such loans they already have are urged to consult with the IRS directly or with a licensed tax advisor for more information. Above all, they should be aware that any entry into any loan structure where the title must pass to a lending party is almost certainly to be reclassified as a sale by the Internal Revenue Service and will pose a huge, unacceptable risk.
More on the fate of ToT 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 directly, the lender can thereby piggyback onto the strong reputation of the broker with no downside, and even blame the broker later for “not properly representing the program” if there are any complaints – even though the program was faithfully communicated as the lender had represented to the broker. Some of these brokers are 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, to exaggerate their financial resources, to 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 activities. 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, or the loan etc) –many firms and individuals with spotless reputations can find those reputations stained or destroyed with the failure of their lending associate. Yet, without those brokers, the ToT lender cannot stay in business. It is no wonder that such lenders will go to extraordinary lengths to retain their best brokers.
When 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 Derivium and several ToT lenders who collapsed between 2007 and 2010) when a client comes in, repays his loan, but the cost to the lender of repurchasing those shares in the open market has gone dramatically up because the stock portfolio’s value has gone dramatically up.
When faced with financial weakness, the lender with no independent resources of his own to fall back on may now pressure his brokers further to pull in new clients so he can sell those new shares and use that money to buy up the stock needed to pay return to the original client. Delays in funding new clients crop up as the lender “treads water” to stay afloat. Promises and features that are untrue or only partly true are used to enhance the program for brokers. Now the new clients come in, and they are told that funding will take seven days, or 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 ToT lender’s clients are patient and the brokers have calmed them because of the assurances (typically written as well as verbal) of the lender or other incentives such as interest payment moratoria, then the ToT lender might get lucky and bring in enough to start funding the oldest remaining loans again. But once in deficit, the entire structure begins to totter.
If a major marketer or broker, or a group of brokers stops sending new clients to the lender out of concern for delays in the funding of their clients or other concerns about their program, then the lender will typically enter a crisis. Eventually all brokers will follow suit and terminate their relationship as the weakness in the lender’s program becomes undeniable and obvious. New clients dry up. Any pre-existing client looking to repay their loan and get their shares back finds out that there will be long delays even after they have paid (most of those who pay off their loans do so only if they are worth more, too!).
The ToT lender collapses, leaving brokers and clients victimized in their wake. Clients may never see their securities again.
Conclusion. 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. Better, stop having any involvement whatsoever with transfer-of-title securities loans and help protect your clients from bad decisions – regardless of fees being dangled as bait. 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 client considering such a loan, you are probably entering into something that the IRS will consider a taxable sale of assets that is decidedly not in your best interest. 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 allow you all the privileges of any modern U.S. brokerage in an SIPC-insured account with FINRA-member advisors and public disclosure of assets and financial health as with most modern U.S. brokerages and banks. — then you are almost certainly engaging in a very risky or in some cases possibly even illegal financial transaction.
Research conducted by student loan company Sallie Mae shows that in 2010, about 5 percent of college students paid an average of more than $2,000 in tuition and other educational expenses using a credit card to avoid taking out student loans. The same study showed that 6 percent of parents used credit cards to pay an average of nearly $5,000 in educational expenses for their college children.
Is using credit cards a smart way to avoid college loan debt? Financial advisors are in near-universal agreement that the answer is no, but that isn’t stopping thousands of families from using credit cards in place of parent and student loans.
Some families might think that all debt is equal; others might think that they won’t qualify for college loans. So what advantages exactly do education loans offer over credit cards?
Particularly in the last few years, as credit card companies have tightened their credit requirements in a retraction of the lax lending that led to the foreclosure crisis, credit cards have become harder to qualify for, available mostly only to consumers with strong credit. Many consumers with weaker credit have had their credit lines reduced or eliminated altogether.
Federal college loans, on the other hand, are available with minimal to no credit requirements. Government-funded Perkins loans and Stafford loans are issued to students in their own name without a credit check and with no income, employment, or co-signer required.
Federal parent loans, known as PLUS loans, have no income requirements and require only that you be free of major adverse credit items – a recent bankruptcy or foreclosure, defaulted federal education loans, and delinquencies of 90 days or more.
In other words, don’t turn to credit cards simply because you think you won’t qualify for school loans. Chances are, these days, you’re more likely to qualify for a federal college loan than for a credit card.
2) Fixed Interest Rates
While most credit cards carry variable interest rates, federal student and parent loans are fixed-rate loans. With a fixed interest rate, you have the security of knowing that your student loan rate and monthly payments won’t go up even when general interest rates do.
Many credit cards will also penalize you for late or missed payments by raising your interest rate. Federal school loans keep the same rate regardless of your payment history.
3) Deferred Repayment
Repayment on both federal student loans and federal parent loans can be postponed until six months after the student leaves school (nine months for Perkins undergraduate loans).
With credit cards, however, the bill is due right away, and the interest rate on a credit card balance is generally much higher than the interest rate charged on federal school loans.
If you’re experiencing financial hardship, federal loans also offer additional payment deferment and forbearance options that can allow you to postpone making payments until you’re back on your feet.
Even most private student loans – non-federal education loans offered by banks, credit unions, and other private lenders – offer you the option to defer making payments until after graduation.
Keep in mind, however, that even while your payments are deferred, the interest on these private student loans, as well as on federal parent loans and on unsubsidized federal student loans, will continue to accrue.
If the prospect makes you nervous of having deferred college loan debt that’s slowly growing from accumulating interest charges, talk to your lender about in-school prepayment options that can allow you to pay off at least the interest each month on your school loans so your balances don’t get any larger while you’re still in school.
4) Income-Based Repayment Options
Once you do begin repaying your college loans, federal loans offer extended and income-based repayment options.
Extended repayment plans give you more time to repay, reducing the amount you have to pay each month. An income-based repayment plan scales down your monthly payments to a certain allowable percentage of your income so that your student loan payments aren’t eating up more of your budget than you can live on.
Credit cards don’t offer this kind of repayment flexibility, regardless of your employment, income, or financial situation. Your credit card will require a minimum monthly payment, and if you don’t have the resources to pay it, your credit card company can begin collection activities to try to recover the money you owe them.
5) Tax Benefits
Any interest you pay on your parent or student loan debt may be tax-deductible. (You’ll need to file a 1040A or 1040 instead of a 1040EZ in order to take the student loan interest deduction.)
In contrast, the interest on credit card purchases, even when a credit card is used for otherwise deductible educational expenses, can’t be deducted.
To verify your eligibility for any tax benefits on your college loans, consult with a tax advisor or refer to Publication 970 of the IRS, “Tax Benefits for Education,” available on the IRS website.
6) Student Loan Forgiveness Programs
Whereas the only way to escape your current credit card debt is to have it written off in a bankruptcy, several loan forgiveness programs exist that provide partial or total student loan debt relief for eligible borrowers.
Typically, these loan forgiveness programs will pay off some or all of your undergraduate and graduate school loan debt in exchange for a commitment from you to work for a certain number of years in a high-demand or underserved area.
The federal government sponsors the Public Loan Forgiveness Program, which will write off any remaining federal education loan debt you have after you’ve worked for 10 years in a public-service job.
Other federal, state, and private loan forgiveness programs will pay off federal and private student loans for a variety of professionals – veterinarians, nurses, rural doctors, and public attorneys, among others.
Ask your employer and do a Web search for student loan forgiveness programs in your area of specialty.
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Jeff Mictabor is an enthusiast on the topic of student loan issues in the news. He has been writing for the past 10 years for a variety of education publications. He now offers his writing services on a freelance basis.