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Last time we looked at the contractual and collateral rules pertaining to securities lending by prime brokers. We’ll next explore fees, dividends and defaults as they relate to securities lending.

Fees

Recall that a Securities Lending Agreement is the contract required before shares are loaned. The agreement states that in the event that cash collateral is pledged, the borrower is entitled to a rebate on the cash at such rates as the borrower and lender agree.  In the event that non-cash collateral is pledged, the borrower agrees to pay a fee to the lender at rates agreed upon by the borrower and lender.  The fees and rebates are computed daily based on each trades value.  This is the equivalent to the quantity (or par value in the case of government securities) multiplied by the rate in basis points annualized usually on an actual/360 basis.

The agreement may state that the fees are due by the fifteenth of the following business month (though most pay within thirty days), while for repo trades, the fee in the form of interest is due upon termination, re-price, or partial return of the repo.

Premiums are an additional fee on top of the borrow fee which is applied to high demand securities. It is in the form of dollars per share, not affected by varying market value.

The agreement will state that the Borrower may terminate a loan on any business day by giving notice to the Lender (usual cut off time for notification is 11:30 a.m. EST).   Additionally, the Lender may terminate the loan, known as a recall. However, the Lender must give the Borrower enough notice to replace the recalled security, which would be the standard settlement date for the type of security borrowed.  For U.S. Government securities, this would be one business day, while for all other securities, it would be three business days. It would be prudent to get five business days notice for foreign securities, if the counterpart agrees

Dividends and Other Distributions

Basically, the Securities Lending Agreement will state that the Lender is entitled to all cash and security distributions on the loaned security that is would have benefited from if the security had been in the possession of the Lender.   Cash dividends are to be paid to the Lender upon distribution and are to be in the same currency as the underlying distribution.  Non-cash distributions are added to the loaned security balance as of the distribution date.  The additional loan will have the same properties of the original loan and will require collateral be transferred to the Lender on distribution date.  The security will remain on loan until such time that the loan is terminated.  Additionally, the Borrower is entitled to any cash or non-cash distributions on any security that has been pledged as collateral.

In regards to the distribution, the borrower must reimburse the Lender for any withholding tax, levy or charge made to the borrower that would not have been incurred by the Lender if the security had been in the possession of the Lender.  The same holds true for the Lender for such charges made to the Lender on any distributions made on behalf of the collateral pledged by the Borrower.  The Lender (or borrower in the case of collateral) states the withholding rate at the time of the loan.  If this changes, the Lender (or borrower) must notify the counterparty, or else the counterparty will not be liable for the change.

Event of Default

Loans can be terminated in the event of certain defaults.  Event of default occurs when the borrower fails to deliver collateral; the Lender fails to deliver the loaned security; either party fails to transfer collateral in the event of a substitution; either party fails to transfer distributions to the counter party; either party declares bankruptcy or the like; either party is expelled from membership or participation in any national exchanges or associations, or self regulatory organization; or either party loses its charter or license to conduct such business.  Default may also occur if any false representations are made in the Security Lending Agreement; either party notifies the other that it cannot meet its obligations under the agreement or either party fails to meet its obligations under the agreement. This includes not paying fees or distributions in a timely manner.

In the event of default, the Lender, rather than recalling the security loaned, may purchase the like amount on the open market using the collateral pledged by the borrower.    This is referred to as a Buy In. This cannot occur unless written notice in the form of a recall was first submitted to the counterparty.  If the collateral is a security, the Lender may sell the security and use the proceeds to purchase the like amount of the loaned security.  If the collateral value is insufficient to purchase the security, then the borrower is liable to pay the additional proceeds on the purchase.  This may include interest on the additional proceeds; accrued daily until the Borrower pays the Lender.  If the collateral value was sufficient to purchase the like amount of the loaned security, the Lender may use the excess collateral to cover the purchase of the like amount of any other loaned security where the collateral was insufficient for the purchase.  Additionally, excess collateral may also be used to offset any fees or distributions due to the Lender. If there is any collateral remaining when the entire Lender’s rights to it are satisfied, the remainder will be returned or paid to the borrower.

Additionally, the borrower, in the event of default, rather than returning loaned securities in exchange for the pledged collateral, may sell the loaned securities and use the proceeds to purchase the like amount of collateral pledged.  If the proceeds from the sale of the loaned securities do not meet the cost of the purchase of the like amount of the collateral, then the Lender is liable to the Borrower for the excess proceeds, plus interest. If the sale proceeds exceed the cost of the purchase of the like amount of the collateral, the excess may be used against any other purchase like amounts of collateral on any other loan.  The borrower also has the right to offset excess proceeds with any fees and other distributions related to the collateral.  Any remaining excess when all the Borrower’s rights are satisfied is paid to the Lender.