The Impact of Costello v. Grundon: Margin Rules and the Enforceability of Loan Documents in Financing Transactions

05 August 2013 Publication
Authors: Emory Ireland Kathleen E. Wegrzyn

Legal News Alert: Finance & Financial Institutions

A recent decision of the Seventh Circuit Court of Appeals has significant implications for lenders in commercial loan transactions and for law firms that give legal opinions about the enforceability of loan documents.

It has been well established by case law in the Seventh Circuit that no private right of action exists for a borrower to assert a margin regulation violation as a means to avoiding its obligations under loan documents.1 However, in Costello v. Grundon,2 a recent case decided by the Seventh Circuit, the Court held that a violation of margin regulations by the lender may be used as an affirmative defense by the borrower to avoid payment on a loan under Section 29(b) of the Securities Exchange Act. Section 29(b) of the Securities Exchange Act3 provides that “[e]very contract made in violation of any provision of this chapter or of any rule or regulation thereunder ... the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this chapter or any rule or regulation thereunder, shall be void … as regards the rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract … .”4 Accordingly, lenders risk losing the ability to collect principal or interest on the offending loan, and law firms risk liability if they give enforceability opinions about loan documents that are not enforceable because of a margin violation.5

This article explores two separate aspects of the margin loan rules implicated by Costello that may affect the enforceability of loan documents: (1) the general prohibition against arranging or extending credit secured directly or indirectly by margin stock6 in an amount that exceeds the maximum loan value of the collateral securing the credit, for the purpose of purchasing or carrying margin stock7 and (2) the general requirement that both bank and non-bank lenders obtain purpose statements from the borrower (Forms FR U-1 and FR G-3) whenever they extend credit secured directly or indirectly by margin stock.8

Factual Background of Costello v. Grundon

In Costello, the defendants-appellants (the Borrowers) were high-level employees of Comdisco Inc. (the Company) who participated in the Company’s shared investment plan (SIP) program (the SIP Program), pursuant to which the Borrowers purchased shares of stock of the Company with the proceeds of personal loans from participating banks (the Lenders) represented and arranged by Bank One (the Bank), which loans were evidenced by notes (the Notes) from the Borrower to the Lenders.9 The Company guaranteed payment on the Notes by a Facility and Guaranty Agreement (the Facility Agreement) between the Bank and the Company.10 The principal amounts of the loans ranged from $276,000 to $1,725,000, including a loan in excess of $1,000,000 to a Borrower who reported no net worth to the Bank and to another Borrower for almost ten times his net worth.11 The Notes were payable at a fixed maturity date12 and placed certain restrictions on the transfer of the shares, including, among other things, requiring the Company to hold the Borrowers’ shares until the loan was discharged, delivery of a stock power endorsed in blank and inclusion of a legend on the stock noting its restricted status.13 In July of 2001, the Company went bankrupt, triggering an event of default under the Notes and the Facility Agreement, causing the amounts outstanding to be accelerated and the Bank to file a proof of claim.14

Violation of Regulation U by Extension of Purpose Credit Secured Directly or Indirectly by Margin Stock

Regulation U15 sets forth certain rules regarding loans secured by margin stock, including providing that “[n]o lender ... shall extend any purpose credit, secured directly or indirectly by margin stock, in an amount that exceeds the maximum loan value of the collateral securing the credit.”16 As a practical matter, this provision should not be a problem if it is clear that (a) the loan is not made for the purpose of purchasing or carrying margin stock, or (b) the loan is well secured by collateral other than margin stock. The maximum loan value of collateral other than margin stock (and puts, calls, and combinations thereof) is its good faith loan value.17

Margin stock must secure the loan either directly or indirectly for a violation of Regulation U to arise.18 In determining whether margin stock is directly or indirectly securing a loan, the Court in Costello looked at several factors, including whether the lender placed restrictions on the transfer of the stock.19 Many loan agreements have covenants restricting or prohibiting the sale or pledge of assets (including margin stock), which can mean that a loan is indirectly secured by margin stock, even though the lender does not have a security interest in the stock. However, the definition of “indirectly secured” expressly excludes situations where not more than 25 percent of the value of the assets is represented by margin stock, or where the lender, when extending or maintaining (but not arranging) a loan, in good faith, has not relied on the margin stock as collateral.20

The Costello decision makes clear that the issue of good-faith non-reliance depends on all of the circumstances, including whether the lender had obtained financial statements of the borrower that demonstrated that the borrower could reasonably support the loan, whether the loan was payable on demand or with fluctuations in the market, and whether restrictions were placed on the transfer or sale of the shares.21 In looking to such factors, the Court cited Section 221.117(b) of Title 12 of the Code of Federal Regulations, which states that “the question of whether or not a bank has relied upon particular stock as collateral is necessarily a question of fact to be determined ... in the light of all relevant circumstances.”22

Violation of Regulation U by Failure to Obtain Purpose Statements

Regulation U generally requires both bank and non-bank lenders to obtain purpose statements (Forms FR U-1 and FR G-3) from a borrower whenever they extend credit secured directly or indirectly by any margin stock, whether or not the purpose of the loan is to purchase or carry margin stock.23

Article 9 of the Uniform Commercial Code permits the creation and perfection of security interests in investment property, including margin stock,24 by including a reference to “investment property” in a description of collateral in a security agreement and by filing a financing statement.25 As a result, if a borrower happens to own margin stock, a lender may inadvertently directly secure a loan with margin stock even though it has no intention of relying on stock as collateral and so has not obtained a purpose statement. Many companies own stock of public competitors as a way of keeping track of such competitors’ activities and many public companies hold shares of their own stock as treasury shares, so inadvertent violations of Regulation U are not difficult to imagine.

Section 29(b) of the Securities Exchange Act raises the possibility of a defense to enforceability of loan documents based upon a violation of “any provision” of the margin regulations, which includes the requirement to obtain a purpose statement. Nevertheless, loan documents should not be unenforceable merely because margin stock is inadvertently included in the scope of a general security agreement that includes investment property. Section 29(b) of the Securities Exchange Act provides in pertinent part:

“Nothing in this chapter shall be construed (1) to affect the validity of any loan or extension of credit ... unless at the time of the making of such loan or extension of credit ... the person making such loan or extension of credit ... shall have actual knowledge of facts by reason of which the making of such loan or extension of credit ... is a violation of the provisions of this chapter or any rule or regulation thereunder, or (2) to afford a defense to the collection of any debt or obligation ... by any person who shall have acquired such debt [or] obligation ... in good faith for value and without actual knowledge of the violation of any provision of this chapter or any rule or regulation thereunder affecting the legality of such debt [or] obligation.” 15 U.S.C. § 78cc(c) (emphasis added).

Moreover, it would be an extraordinarily draconian result to find loan documents to be unenforceable merely because of failure to obtain a purpose statement if there is no more substantive violation of the margin regulations. The Costello case itself recognizes that it may be necessary to weigh the pros and cons, or the equities, of enforcement of a contract affected by an issue of illegality.26

Lenders may still want to consider excluding margin stock from the description of collateral in security agreements to avoid having this issue arise. Actual knowledge is an issue of fact, and lenders will not want to have to litigate margin issues when a borrower is in financial trouble.

Practical Application of Costello for Borrower’s Counsel in Legal Opinions

When making a large loan or other extension of credit, lenders typically require the law firm representing the borrower to issue a legal opinion that the loan documents are enforceable in accordance with their terms and that the loan transaction does not violate applicable law. When issuing such opinions, the opining law firm may not pay attention to the margin regulations unless the lender specifically requests a margin regulation opinion, perhaps because a borrower has no private right of action to assert a margin regulation violation.27

However, Costello’s acknowledgement of the right of a borrower to use a margin violation by a lender as an affirmative defense28 implicates every opinion addressing enforceability of the loan documents even where the opining law firm does not specifically give an opinion on margin regulations. Should a law firm give an opinion that certain loan documents are enforceable when in fact there have been margin violations that allow the borrower to avoid paying the loan, the lender may seek a remedy directly against the law firm that issued the opinion. The possible need for a purpose statement also comes up in connection with an opinion that the transaction does not violate applicable law.

As a result, lawyers issuing financing opinions should take extra precautions to avoid this risk. Such precautions may include assumptions in the legal opinion that the collateral does not include margin stock; that the lenders in good faith have not relied on margin stock as collateral; and that none of the proceeds of the loans will be used to purchase or carry margin stock. To further support the legal opinion, these assumptions may be buttressed by a certification made by an officer of the borrower addressed to the law firm that the borrower does not own margin stock and/or will not use any of the proceeds of the loan to purchase or carry margin stock.


In Costello,29 the Seventh Circuit has held that a borrower in a financing transaction has an affirmative defense that the loan documents are void and unenforceable if the borrower can show that the transaction violated Regulation U.30 As a result, a lender and its counsel must be careful to avoid violations of margin regulations, which may include more robust representations and covenants and strict adherence to the technical requirements of the margin regulations, including obtaining purpose statements when required. For borrower’s counsel, the result of Costello31 is to implicate Regulation U and the margin loan rules in every legal opinion that opines that loan documents are legally enforceable, whether or not the opinion explicitly addresses a violation of Regulation U.

This article originally appeared in the March 2013, Vol. No. 32 Issue No. 1 edition of the Business Law Section, State Bar of Wisconsin and is reprinted with permission.

1 Bassler v. Central National Bank, 715 F.2d 308, 313 (7th Cir. 1983).
2 651 F.3d 614 (7th Cir. 2011).
3 Id. at 622-26. “Section 29(b) of the Securities Exchange Act provides the Borrowers with the right to raise violations of the Act and margin regulations defensively to preclude enforcement of a contract.” Id. at 625.
4 15 U.S.C. § 78cc(b).
5 Id. at 623 (“Neither Blair nor Bassler offers authority for the proposition that the Borrowers need a private right of action under Section 7(d) or Section 29(b) [of the Securities Exchange Act] in order to assert an affirmative defense that the Notes are void and unenforceable because they violate” the margin regulations.).
6 12 C.F.R. § 221.2 defines “margin stock” as follows:

a Any equity security registered or having unlisted trading privileges on a national securities exchange;
b Any OTC security designated as qualified for trading in the National Market System under a designation plan approved by the Securities and Exchange Commission (NMS security);
c Any debt security convertible into a margin stock or carrying a warrant or right to subscribe to or purchase a margin stock;
d Any warrant or right to subscribe to or purchase a margin stock; or
e Any security issued by an investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. § 80a-8), other than:

i A company licensed under the Small Business Investment Company Act of 1958, as amended (15 U.S.C. § 661); or
ii A company which has at least 95 percent of its assets continuously invested in exempted securities (as defined in 15 U.S.C. 78c(a)(12)); or
iii A company which issues face-amount certificates as defined in 15 U.S.C. § 80a-2(a)(15), but only with respect of such securities; or
iv A company which is considered a money market fund under SEC Rule 2a-7 (17 C.F.R. § 270.2a-7).

7 12 C.F.R. § 221.3(a).
8 12 C.F.R. § 221.3(c).
9 651 F.3d at 618.
10 Id.
11 Id.
12 Id. at 619.
13 Id. at 618.
14 Id. at 620.
15 12 C.F.R. Part 221.
16 12 C.F.R. § 221.3(a)(1).
17 12 C.F.R. § 221.7.
18 12 C.F.R. § 221.3.
19 651 F.3d 614, 630.
20 12 C.F.R. § 221.2(g)(2).
21 Id. at 630.
22 Id. (citing 12 C.F.R. § 221.117(b)).
23 § 12 C.F.R. § 221.3(c). For banks, a purpose statement is required only for loans in excess of $100,000.
24 U.C.C. § 9-102(a)(49).
25 U.C.C. § 9-312(a).
26 651 F.3d 614, 628.
27 Bassler, 715 F.2d at 313 (7th Cir. 1983).
28 651 F.3d 614.
29 Id.
30 Id. at 622-26.
31 Id.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss the topic further, please contact your Foley attorney or the following:

Emory Ireland
Milwaukee, Wisconsin

Kathleen E. Wegrzyn
Milwaukee, Wisconsin

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