securities lending and what your broker does with your shares

In short

A friend of mine once asked me if the shares in his brokerage account were sitting in a vault with his name on them. I had to tell him gently that they were not. If you hold stock at a broker, the broker may lend some of those shares to other firms and earn a fee. Your account will still show every share you bought. Your dividends and your right to sell stay in place, though the tax treatment of some payments can change. The place to look is your account agreement, which says whether lending is allowed and who gets paid. Ask the broker whether you can opt out or share in the income. A few minutes with that document can save a lot of wondering.

The whole of it

What it is

I once watched a neighbor lend his ladder to a man down the road, and he never thought twice about it, because the ladder came back and the man said thanks. Securities lending works a bit like that, only on a much larger scale. A securities loan is when a firm hands over shares to a borrower for a time, and the borrower gives back the same number of shares later. The borrower is usually a trading firm that wants to sell a stock it does not own, a move called a short sale. To do that, it must first borrow the shares from somebody.

Your broker can be that somebody. Many brokers hold customer shares in what is called street name. That means the broker is the record owner on the books, while you are the beneficial owner, the person who gets the gains and the dividends. Because the broker holds the shares this way, it can lend them out. You probably never signed a separate form for it. The permission is often tucked inside the margin agreement or the main account agreement.

Here is a point many people miss. Lending usually applies to shares held in a margin account, where you can borrow against your holdings. A plain cash account is treated differently. The Securities and Exchange Commission and FINRA, the industry body that oversees brokers, have investor pages that explain this. Your own agreement is still the final word on your own account.

How it works

If you are holding stock at a broker, here is what happens in plain steps. A borrower asks to take a stock on loan. The broker finds shares in its pool, which may include yours. The borrower must hand over collateral, usually cash, worth at least as much as the shares. The loan can be called back at any time, and the borrower has to return the shares when asked.

The borrower pays a fee for the loan. For a stock in high demand, that fee can be large. For a stock nobody wants to short, it can be tiny. The broker keeps the fee, or splits it with you, depending on the agreement. Some brokers run programs that share part of the income with account holders. Others keep all of it and say so in the fine print.

Now think about your dividends. While your shares are out on loan, the company still pays its dividend. The borrower must pass an equal amount back to the lender. That replacement is called a payment in lieu of dividends. It looks like a dividend in your account, but the tax rules can treat it differently. A qualified dividend often gets a lower tax rate. A payment in lieu usually does not qualify for that lower rate. This is worth knowing, and your broker's tax form, the 1099, is where it shows up.

There is also the matter of voting. If your shares are on loan when the company holds a vote, you may lose the right to vote them. The borrower may vote them instead. Some investors do not care. Others care a great deal.

The numbers, and where to find yours

I like a straight answer, so here is where the facts live. Start with your account agreement. Look for words like margin, hypothecation, and securities lending. Hypothecation is a long word for pledging your shares as security. Your broker's website often has a page or a settings menu that shows whether lending is on.

For protection if the broker fails, look at the Securities Investor Protection Corporation. Its site explains what it covers and what it does not. The coverage limit for securities is set by law, and the current figure is the current figure, which the official source publishes each year. SIPC protects against a missing account when a broker fails. It does not protect against a drop in market value. The same limit applies to the cash portion, and you can read it at the SIPC site as the current figure, which the official source publishes each year.

For the rules on short selling and lending, the SEC publishes its regulations and investor bulletins. For how your broker must treat your shares, look at the customer protection rule on the SEC site. FINRA has a plain page on margin accounts too. Your tax form will show any payments in lieu. For the dividend tax rates, check the IRS and the figure listed here as the current figure, which the official source publishes each year.

A worked example

Let me tell you about a woman named Dana. She is a nurse who bought 200 shares of a small company at $40 a share. That is $8,000 of stock in a margin account. She never read the margin agreement closely.

Her broker lent out her 200 shares to a trading firm for a stretch of the year. The borrower paid a lending fee. Suppose the fee worked out to 2 percent a year on the value of the loan. On $8,000, that is $8,000 times 0.02, which comes to $160 a year. If the broker kept all of it, Dana saw none of that $160. If her broker shared half through a program, she would receive $80.

Then the company paid a dividend of $0.50 a share. On 200 shares, that is 200 times $0.50, or $100. Because her shares were on loan on the payment date, she received $100 as a payment in lieu rather than a true dividend. Had it been a qualified dividend, a lower tax rate might have applied. Say her rate on a qualified dividend was 15 percent and her ordinary rate was 22 percent. The tax on a qualified dividend would be $100 times 0.15, or $15. The tax on the payment in lieu would be $100 times 0.22, or $22. The difference is $7. That is small here. It grows with larger holdings.

Dana did not do anything wrong. She simply had not looked. Once she read her agreement, she called her broker. She asked whether she could turn lending off, and she asked how the income was shared. It took one phone call.

Where it goes wrong

I would be a poor friend if I only told you the pleasant parts. Securities lending is a normal and legal part of how markets work, and it helps short sellers and traders do their jobs. Still, a few things can trip a person up.

The first is the tax change on dividends, which I described. It is easy to miss until tax season. The second is the lost vote. If you care about how a company is run, a loaned share may not carry your voice that day.

The third is the risk that a borrower cannot return the shares. Collateral is meant to cover that, and the broker must manage it. Still, collateral can lose value, and no arrangement is perfect. SIPC coverage helps if a broker fails, but it has limits, and it is not a promise against every loss.

The fourth is plain silence. Many people hold an account for years without learning that lending is on. The broker has not hidden it. The disclosure is there, only buried. A little reading goes a long way.

Questions to answer before you leave this page

Have you opened your account agreement and searched for the words margin, hypothecation, and securities lending? Do you know whether your shares sit in a cash account or a margin account, and does that change whether they can be lent? Does your broker lend your shares, and if so, does it share any of the income with you? Can you turn lending off, and what does it cost you to do so? Have you checked your tax form for payments in lieu of dividends, and do you know what rate applies to them? Do you care about voting your shares, and would losing that vote bother you? Have you looked at the SIPC site to see what is covered if your broker fails? And when did you last read the fine print on an account that holds your savings?