The Impact Of Costello v. Grundon: Margin Rules And The Enforceability Of Loan Documents In Financing Transactions

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...