Regulated Securities Lending
Securities lending refers to the process through which the holder of securities temporarily transfers the securities to another person for a fee and upon such terms as agreed between the parties. While the term “lending” seems to imply that it is a loan, securities lending is not just a loan. In practice, securities lending transactions share similar characteristics with a mortgage as the title in the security actually passes from the lender to the borrower. Section 315 of the Investments and Securities Act (“ISA”) defines securities lending as the temporary exchange of securities, generally for cash or other securities of at least an equivalent value with an obligation to redeliver a like quantity of the same securities on a future date and includes securities loans, repurchase agreements and self buy back agreements.
It must be mentioned that securities in this sense do not only refer to shares and stocks of a company. The ISA defines securities to mean:
(a) debentures, stocks or bonds issued or proposed to be issued by a government;
(b) debentures, stocks, shares, bonds or notes issued or proposed to be issued by a body corporate;
(c) any right or option in respect of any such debentures, stocks, shares, bonds or notes; or
(d) commodities futures, contracts, options and other derivatives,
Securities lending is a common practice in the capital market which helps provide liquidity to the market. It is also used for various trading strategies like hedging and short selling. In a securities lending transaction, once the borrower acquires the securities, he or she also acquires certain rights over the securities. For the period of the lending transaction, the new owner can lend them out and exercise other typical ownership rights so such as the right to attend meetings of the company whose shares are the subject of the securities lending transaction.
Securities lending transactions are typically collateralized, either using other securities or using cash deposits. Where the borrower uses other securities as collateral, the lender is also entitled to receive a fee from the borrower. In the same vein, where the borrower uses cash as collateral, the borrower receives interest from the lender at a rate that is lower than the market rate. The parties to the transaction negotiate pricing and this is dependent on a lot of factors such as the likelihood of the lender recalling the securities and the market demand for the securities.
Securities lending is typically a secondary market activity and usually requires an intermediary between the beneficial owner of the securities and the potential borrower. Under Nigerian law, a securities lending transaction cannot occur between two individuals without a lending agent. Rule 388 of the Securities and Exchange Commission (“SEC”) Rules defines a lending agent to be “a company duly registered as a market maker, custodian, licensed dealing member or any other market participant by the Commission through whom the lender will deposit the securities for lending and the borrower will borrow the securities”.
Rule 399 of the SEC Rules also provides that there shall be no direct agreement between the lender and borrower for the lending and borrowing of securities. Thus, every transaction for securities lending in the Nigerian capital market requires the lender to enter into an agreement with the lending agent for the provision of the security for the purpose of lending them out. The borrower is also required to enter into a separate agreement with the lending agent for the purpose of borrowing the securities. Although the title of the securities lent are temporarily vested in the borrower, the SEC Rules provide that beneficial interest and corporate benefits (such as dividends) shall accrue to the lender. Additionally, only quoted securities qualify for borrowing and lending purposes. The SEC Rules also require the lending agent to guarantee the return of the equivalent securities to the lender along with the corporate benefits accrued during the term of the borrowing.
As with many transactions, the pertinent question is the why. Why would it make sense for any investor to borrow securities and even provide collateral to do same? There are many reasons why investors seek to borrow securities and conversely, there are also many reasons why the holder of a security may also seek to lend out his or her securities. One of the most common reasons for borrowing security is to cover a short position or short sell. Short selling is essentially a bet on the drop in the price of a security. In short selling, the investor borrows the security and sells it on the open market at price X with a plan to buy back the security at a later date at a price lower than price X. This way, if there is a price drop, the investor makes a profit. To better illustrate this, let us put some numbers to the above explanation using a simplified example. Investor A borrows securities from Investor B and uses his shares in another company as collateral. At the time of the transaction, the securities are trading at a price of N10 per share, however, Investor A has reason to believe that they are currently overvalued and forecasts a potential drop in price. So, he enters into a securities lending agreement with Investor B and the lending agent, borrows the securities, and sells them on the open market at a price of N10. Consequently, the price of the security drops to N7. Recall that our investor has N10 from his earlier sale, so he buys back the security for N7 and makes a N3 profit. The lender receives a portion of the profit as agreed and the securities are returned to the lender.
Beyond short selling, the lender may also enter into a securities lending transaction to obtain cash using the borrowed securities. A lender may also enter into a securities lending agreement with a borrower in cases where the borrower is not subject to certain tax payments. For example, in some jurisdictions like Ireland, dividend payments to the National Pensions Reserved fund and government ministers holding shares in their official capacity are exempted from withholding tax. The borrower receives the dividend during the tenure of the loan free of tax and shares some of the benefits with the lender.
The terms of a securities lending transaction in Nigeria are governed by a Securities Lending Agreement (SLA). The SEC Rules prescribe that the SLA between the borrower and the lending agent must contain the following: the period of depositing/lending securities; charges or fees for depositing/lending and borrowing; collateral securities for borrowing; provisions for the return including the premature return of the securities deposited or lent; a mechanism for resolution of disputes through arbitration; where relevant, confirmation that an agent has appropriate prior authority from the beneficial owners, or a party suitably authorized by the beneficial owners, for the securities to be lent; specifications of events of default, among other requirements.
For the purposes of tax, there are a number of incentives that apply to securities lending transactions in Nigeria. Tax has always been a major concern in transactions of this nature and in a bid to deepen the capital markets, a number of changes were made to Nigeria’s tax laws to address the taxation of securities lending transactions. The Finance Act of 2019 amended the schedule to the Stamp Duties Act to the effect that the instruments for the transfer of regulated securities by borrowers and lenders are exempt from stamp duty payments. The Finance Act of 2021 also amended the definition of dividend to include “compensating payments received by a lender from its approved agent or borrower in a Regulated Securities Lending Transaction”. These compensating payments qualify as franked investment income which are exempted from further tax in the hands of the lender under section 23(1) t of the Companies Income Tax Act (“CITA”). The transfers and subsequent return of shares under securities lending transactions are also not treated as disposals of shares, thus, gains arising from the transaction are not subject to tax under section 2(4) of the Capital Gains Tax Act. Additionally, although interest payments are typically subject to withholding tax payments by the paying party, the Finance Act of 2019 introduced section 78(6) CITA which exempts lenders in a regulated securities lending transaction from this obligation. The borrower is also exempted from the obligation to withhold tax when making dividend payments to the lender or the lending agent.
The Federal Inland Revenue Service (“FIRS”) circular on Tax Implications of the Operation of Regulated Securities Lending Transaction (‘SEC Lending’) in Nigeria also further clarified that the interest and other expenses relating to the SEC lending transaction are deductible from income generated through the SEC lending transaction.
Securities lending provides a great opportunity for investors to take different views on the market and it helps to increase liquidity in the market as a whole. In more recent times, the Nigerian capital market seems to be moving in the right direction to facilitate securities lending, deepen the market and also improve liquidity. The Business Facilitation Act of 2023 amended section 89(2) of the Pension Reform Act allowing pension assets to qualify for securities lending subject to guidelines issued by the Pension Commission. Pension Funds are perhaps the largest pool of funds in the Nigerian market and bringing them into the fold of securities lending would certainly contribute immensely to the growth and development of the Nigerian capital market.