The Loan Syndications and Trading Association has met with key regulators regarding a lawsuit against major banks that aims to have term loans syndicated to institutional investors treated as securities. A decision supporting plaintiffs would impact all outstanding loans and require significant changes at banks and downstream lenders such as collateralized loan obligations (CLOs).
Taking no chances, the trade association went on the tour in an effort to spare banks and leveraged loan lenders and borrowers the market disruption that could result. It met with Securities and Exchange Commission (SEC) staff and a representative from the Solicitor General's office several weeks ago to discuss the legal technicalities, said Eliot Ganz, co-head of public policy at the LSTA. It has also met with officials at the Office of the Comptroller of the Currency (OCC) and Federal Reserve. He added that the principals in a lawsuit, Kirschner v. J.P. Morgan, have conducted similar meetings, and that the LSTA is seeking to discuss the issue with the Treasury Department.
The case now rests at the United States Court of Appeals for the Second Circuit, which in mid-March asked the SEC to weigh in on whether the loans in the Kirschner case are securities under Reves vs. Ernst & Young, a pivotal Supreme Case decided in 1990 that defines securities. The SEC is scheduled to give its perspective by June 27, and the principals in the case have asked for a subsequent 30 days to respond.
"We've always been concerned that something like this could happen, and now that it has we're very engaged," Ganz said.
In a recent note to members, Ganz said that such a change would have a "devastating" effect on the $1.4 trillion syndicated leveraged loan market, requiring loan market participants to comply with state and federal securities laws and rules from self-regulatory organizations such as FINRA. In addition, he said, loan syndication and trading activity may have to be conducted through registered broker-dealers subject to SEC and FINRA regulations, potentially disrupting loan transactions.
Noting the collateralized loan obligations (CLOs) buy upwards of 65% of leveraged loans, Ganz said they should be able to continue to buy loans that are securities under current indentures, so long as they retain credit agreements.
"But if they morph into something without a credit agreement, something that looks just like a senior secured bond, CLOs can't buy [those] securities," Ganz said. It is worth wondering who is going to pick up the slack, he added.
Concerns about syndicated leveraged loans being treated as securities have increased over time, as deals have adopted so-called covenant-light structures that offer lenders fewer early warnings and they are distributed to and traded among an ever-wider range of nonbank investors.
Defining a security
Schuyler Moore, a partner at Greenberg Glusker, said that under the Reves precedent, term loan B transactions closely match the four factors it lays out to determine whether a financial instrument is a security: 1) The debt was sold to raise capital and investors anticipated profit, 2) there was common trading of the notes, 3) the public reasonably perceived the asset as an investment, and 4) there were no risk-reducing factors that would disqualify application of the securities acts.
"It seems to me that the answer is obviously 'yes' to all of these for any loans sold to a group of investors, whatever name you call the loan," Moore said.
Moore pointed to recent SEC decisions to treat digital assets such as cryptocurrencies and non-fungible tokens (NFTs) as securities that should steer a similar decision for loans.
"A security is really anytime someone gives money to someone else and expects to get money back, unless it falls into some type of exemption," he said, adding, "A rose by any other names still smells like a rose; courts look to the substance of the transaction."
Moore said that the Reves decision provides numerous exceptions, such as home mortgages and consumer loans—transactions between one bank and a borrower—but term loan Bs are syndicated to a broad swathe of investors. He added that the Second Circuit could presumably justify an exception based on the market's longevity and breadth of use, the "everybody is doing it theory," and that could send the case to the Supreme Court.
"The Supreme Court would have to say they are securities, or they would have to reverse a lot of current law," Moore said.
The LSTA emphasizes that syndicated loans is an established market around which banks and investors have built systems and business strategies. In addition, the LSTA notes examples over the last 30 years in which Congress, the SEC and the bank regulators have consistently distinguished broadly syndicated loans and securities.
"The SEC can use its broad exempting authority under Section 36 of the [Securities Exchange Act of 1934] to say, 'They are securities, but it is in the public interest to exempt them and let them trade in the usual way,'" said James Angel, associate professor at Georgetown University.
Ganz noted that the SEC has had literally decades to broach the issue but hasn't, and that there are strong arguments for why that has been the case. Nevertheless, addressing the issue through the regulatory process would be the appropriate way to determine whether changes are necessary and how to pursue them if they are. A court decision, instead, would mean every existing term loan B would be subject to securities laws affecting how loans are amended and traded.
"It would cause immense short-term disruption, followed by an on-the-run process to address these issues while chaos is happening," he said.
