May 23, 2022 - Last week, the LSTA submitted an amicus brief to the US Court of Appeals for the Second Circuit (2nd Circuit) arguing that syndicated term loans (Term Loan Bs) are not securities subject to state or federal securities laws. The brief was filed in Kirschner v. JPM, on appeal by Kirschner of a decision by the U.S. District Court for the Southern District of New York (SDNY) holding that the Term Loan B in that case was not a security. The LSTA filed the amicus brief because (i) we agree with the SDNY that term Loan Bs are not securities and (ii) treating them as such would have profoundly negative implications for borrowers, lenders and the syndicated loan market and would materially disrupt the formation of capital by US companies. We break down the amicus brief below and discuss what happens next.
I. Term Loan Bs are Not Securities. The US Supreme Court in a 1990 case, Reves v. Ernst & Young, set out four factors to determine whether a particular instrument is a “security” under the securities laws: (1) “the motivations that would prompt a reasonable seller and buyer to enter into” the transaction—that is, whether the transaction has a “commercial” or “investment” purpose; (2) “the ‘plan of distribution’ of the instrument”—that is, “whether it is an instrument in which there is ‘common trading for speculation or investments’”; (3) “the reasonable expectations of the investing public”; and (4) whether “the existence of another regulatory scheme” makes “application of the Securities Act unnecessary. The Court noted that, under these factors, “notes evidencing loans by commercial banks for current operations” are not securities. In Banco Espanol, this Court applied the Reves factors and concluded that short term loan participations were not securities. Applying those factors to syndicated term loans yields the same result.
A. Syndicated Loans Have a Commercial Purpose. From the borrowers’ perspective, the proceeds of syndicated term loans may be used to refinance existing debt or provide dividends to shareholders, but they may also be working capital loans, whose proceeds are used to fund ongoing business operations. And, just as with traditional bank loans, syndicate members are lenders: They have a direct contractual relationship with the borrower, not merely a relationship with the arranger or agent bank in charge of the syndication and administration of the loan. While the lenders in the syndicate are “investing” in the sense that they hope to receive a return on their capital in the form of interest, that is also true of traditional, non-syndicated bank loans, which are unquestionably not securities.
B. Syndicated Term Loans are Not Distributed to the Public. Syndicated term loans are not marketed or available to the general public and no natural person can own part of a syndicated term loan. Rather, the lenders are sophisticated financial institutions. Moreover, a borrower may veto any institution from participating in the syndication. The borrower’s ability to control the entities that hold its debt distinguishes a syndicated loan from bonds, which can trade without meaningful restriction in public markets.
C. Market Participants Understand That Syndicated Term Loans Are Not Securities. A lender that becomes part of a syndicate does so on the express understanding that it is responsible for conducting its own due diligence on the borrower and that it is not relying on any other party to provide it with any information that would be material to its decision to lend. The LSTA’s Code of Conduct, which is broadly accepted in the industry, provides that loan market participants “are expected to have the capacity to independently evaluate their transactions in the loan market, to make informed decisions regarding the amount of due diligence that is appropriate under the circumstances, and to undertake such due diligence.” Standard credit-agreement provisions likewise make clear that “each syndicate member makes its own credit decisions and determinations as to what actions to take under the credit agreement, and … syndicate members do not rely upon the administrative agent or any other lender in that regard.” Moreover, the agent is not “required to disclose information in [its] possession to the lenders, except as specifically provided in the credit agreement.” Similarly, the LSTA’s principles for the use of confidential information in the syndicated loan market recognize that loans may be originated and traded based in part on confidential information or even material non-public information (“MNPI”) and set out guidelines for originating and syndicating loans and trading loans in the secondary market based on such information. Syndicate members and their assignees fully understand when they decide to lend that they are not operating under the securities laws’ disclosure or liability regimes. Market participants know loans may be originated and traded based on confidential information, and they warrant that they can and will decide for themselves what information they need and conduct their own due diligence. Those basic market principles compel the conclusion that syndicated term loans are not securities.
D. The Current Regulatory Scheme Reflects the Understanding That Syndicated Term Loans Are Not Securities. The SEC has been well aware of syndicated term loans for decades and has never taken the position that they are securities for disclosure and liability purposes. Nor has Congress done so, even in the wake of the 2008 financial crisis, when it enacted major financial reforms such as the Dodd-Frank Act. Congress’ enactment of the Volcker Rule and related agency rulemakings further reflect the fundamental distinction between syndicated term loans and securities. The Volcker Rule restricts a banking entity’s ability to have certain ownership interests in, or relationships with, hedge funds or private equity funds (referred to by regulators as “covered funds”) but also provides that “[n]othing in this section shall be construed to limit or restrict the ability of a banking entity … to sell or securitize loans in a manner otherwise permitted by law.” To effectuate this statutory mandate, the agencies have promulgated rules that exclude “loan securitizations” from the definition of “covered fund” and make clear that “loans” and “securities” are distinct. A “[l]oan securitization” vehicle is an entity that issues securities backed primarily by “loans”; it may not own any “security,” with a handful of narrow exceptions. That regulatory scheme reflects the recognition that such loan securitizations “do not raise the same types of concerns as other types of securitization vehicles.” The quintessential loan securitization is a CLO, a vehicle that exists to securitize syndicated term loans. Following enactment of the Volcker Rule in 2014, many CLOs held only syndicated term loans and cash equivalents, to ensure that they fell within the definition of “loan securitization.” Yet regulators have never suggested that CLOs might not be “loan securitizations” because syndicated term loans might be securities. To the contrary, the CLO market rests on the basic premise that syndicated term loans are, in fact, loans and not securities. Finally, banks’ origination and syndication of syndicated term loans are regulated, but under an entirely different regime from the securities laws. Each of the federal banking agencies—the OCC, the FDIC, and the Federal Reserve Board—has promulgated enforceable standards relating to bank internal controls, internal audit systems, loan documentation practices, and credit underwriting. The agencies have created examination manuals and handbooks that provide detailed guidance. They have also issued guidance for regulated institutions highlighting the agencies’ focus on bank leveraged-lending activities in the supervisory and examination context. And the Shared National Credit Program annually reviews and assesses the risk level of syndicated loans of $100 million or more that are shared by three or more regulated financial institutions, to guard against potential systemic risk. The current regulatory scheme demonstrates even more clearly that syndicated term loans are not securities, not only through federal banking regulators’ oversight of such loans, but also through the SEC’s determination not to treat syndicated term loans as securities for disclosure and liability purposes, and the recognition embodied in Volcker Rule regulations that loan securitizations such as CLOs are different from and do not pose the same risks as vehicles that hold securities. Taken as a whole, the regulatory scheme demonstrates that regulators correctly recognize that they are not securities and that loan market participants are adequately protected without the mandatory disclosure regime and liability standard of the securities laws.
II. Treating Term Loan Bs as Securities Would Jeopardize a Trillion-dollar Market That is Vital to the Economy. Holding that loans are securities would have a devastating effect on the $1.4 trillion market for leveraged syndicated term loans. Subjecting syndicated term loans to the securities laws would introduce enormous practical complications and impose very significant compliance costs on loan market participants. Loan market participants would be obligated to comply with securities laws at the state and federal level as well as the rules of securities industry self-regulatory organizations, such as FINRA, subjecting them to a patchwork of rules that may have different requirements. In addition, if syndicated term loans were deemed to be securities, loan syndication and trading activity would have to be conducted through registered broker-dealers, and any market participant that receives compensation tied to loan transactions would have to determine if it needs to register as a broker-dealer. Broker-dealers are subject to extensive SEC and FINRA regulations that could cause significant disruptions to loan transactions. For example, unlike securities transactions, which generally are settled within two days, secondary trades in loans often take ten or more days to settle. If syndicated term loans were securities, their extended settlement cycle would implicate margin, net capital, and other rules that apply to the settlement of securities transactions; imposition of these rules would complicate loan transactions and burden market participants with additional costs. Treating syndicated term loans as securities would also profoundly disrupt customary arrangements between borrowers and other loan market participants that have developed over many years and deprive both borrowers and lenders of the significant benefits that flow from the ability to choose between different instruments with different characteristics and regulatory regimes. Moreover, the syndicated term loan market currently allows borrowers to share with lenders important financial and corporate information that may be MNPI. As discussed above, lenders can choose whether to receive such information (“private side” lenders) or not to receive it, so that the lender can continue trading in the borrower’s securities (“public side” lenders). When a private-side lender trades with a public-side lender, the public-side lender acknowledges that there may be an informational asymmetry due to the other party’s possession of MNPI, but that it is choosing to rely on its own due diligence and enter into the transaction regardless. Such provisions are generally disfavored by securities regulators because they are seen as a way of contracting around the protections provided by the securities laws. As a result, if syndicated term loans were deemed to be securities, the loan market would likely become a “public-only” market, where no lender receives access to confidential information, and borrowers who want to provide potential MNPI to lenders on a confidential basis would be unable to do so—eliminating one of the key features of syndicated term loans that make them desirable to borrowers and lenders. It is no answer to say that borrowers can substitute high-yield bonds for syndicated term loans. Borrowers and lenders—and hence the broader economy— have benefited substantially from the ability to choose the market that best suits their needs. Depriving borrowers and lenders of that choice will make it far more difficult for businesses to gain quick access to funding on flexible, bespoke terms, and for lenders to pool funds quickly and easily to offer financing to borrowers that might not qualify for other types of loans. It would also have tangible effects on the economy. Syndicated term loans support business growth by providing funding for major projects that might otherwise go unfunded. Cutting off an important source of capital could have serious consequences for leveraged companies, as well as significant ripple effects throughout the economy. The American economy has been well served by different regulatory schemes, each suited to the circumstances of the particular financial products at issue. It would be a mistake to hold that syndicated term loans are securities, thus taking a step that the SEC has not taken; overturning the reasonable, settled expectations of market participants and profoundly disrupting the origination and trading of loans that have become a critical source of capital for modern commerce.
III. What’s Next? Briefing on this case concludes in mid-June with the filing of Kirschner’s reply brief. The 2nd Circuit will then hold oral argument on the case, likely sometime in the fall, and would issue its opinion thereafter. The LSTA will continue to closely monitor and report on this critical case.