May 1, 2019 - Are broadly syndicated term loans securities for the purposes of federal and state securities laws? That critical question, which has been percolating around the loan market for decades, is the subject of an amicus brief that the LSTA filed this week in a federal district court in New York. The LSTA (joined by the Bank Policy Institute) argues vehemently that they are not and explains the materially negative consequences to borrowers and other stakeholders in the $1.2 trillion market for institutional term loans (and the $600MM+ CLO market) were a court to reach the opposite conclusion. Below we explain the background and unpack why loans are not securities and what could happen if the court disagreed.
Background. The LSTA filed the amicus brief in a case brought by a litigation trust that arose from the Millennium bankruptcy. In a nutshell, the trustee alleges that the banks that underwrote the “Term Loan B” in that deal violated state “Blue Sky Laws” which are the state equivalent of the federal securities laws. (The case was brought in New York State court but removed to the federal District Court for the Southern District of New York). The banks brought a motion to dismiss on a number of grounds, including that the loans in question are not “securities” under state or federal law and are therefore not subject to state Blue Sky laws. The LSTA’s amicus weighs in on that question alone.
Loans are not securities. The LSTA’s brief notes that the U.S. Court of Appeals for the Second Circuit, in a 1992 case called Banco Espanol, held that a loan participation that was in relevant respects very similar to modern syndicated term loans was not a security. While the loan market has changed significantly since 1992, the Second Circuit’s reasoning in Banco Espanol applies equally to syndicated term loans like the one in this case. In some respects, the growth and standardization of the syndicated term loan market in recent years and the settled expectations of market participants that have developed over that time—along with the SEC’s determination not to treat syndicated term loans as securities for disclosure and liability purposes—militate even more strongly against deeming such loans to be securities. Borrowers, lenders, and regulators understand that syndicated term loans are not securities and participate in (or oversee) the loan market on that understanding.
While syndicated term loans share some features with high-yield bonds, they have several key characteristics that are not found in bonds and that are incompatible with the regulatory scheme governing securities. To start, each member of a loan syndicate has its own direct contractual lending relationship with the borrower. Likewise, syndicated term loans are not marketed to the public. Rather, the participants in a loan syndicate are sophisticated institutions who are charged with conducting their own due diligence and agree by contract to do so. And, in contrast to investors in securities, participants in a syndicate may rely on confidential information—which sometimes includes material non-public information under the securities laws—in deciding whether to lend.
Borrowers and lenders that choose to enter the syndicated term loan market could often issue or purchase high-yield bonds instead. But the two separate markets exist because the two types of debt are different, and both borrowers and lenders can have good reasons for choosing loans over bonds (or vice versa). Borrowers may also prefer a syndicated term loan to issuing bonds precisely because loans are not subject to the restriction on trading securities based on material non-public information, and borrowers thus may disclose confidential information to syndicate members without making that information public to the world. Moreover, borrowers typically have much more control over who can participate in their syndicates with the right to consent to new syndicate members and to disqualify others.
Regulators, too, recognize the difference between syndicated term loans and securities. Syndicated term loans are subject to prudential safety and soundness review of the banking agencies through the Leveraged Lending Guidance and bi-annual Shared National Credit reviews. In contrast, bonds are subject to an entirely different kind of regulatory regime. The SEC has implicitly recognized by declining to regulate syndicated term loans under the securities disclosure and fraud laws, that treating such loans as securities would not serve the main purpose of the securities laws, i.e., to protect investors who cannot conduct their own due diligence and thus must rely on public information. The heightened disclosure regime applicable to securities, intended to correct that informational disadvantage, is unnecessary in a market where the “investors” are sophisticated institutions that decide based on their own due diligence, and often based on confidential information, to lend large sums of money to a particular borrower.
The Implications of an adverse decision. If syndicated term loans were securities, the principal source of funding for such loans—CLOs—would be jeopardized. Banks provide a substantial amount of capital to CLOs, commonly by buying and holding the “triple A.” notes. However, regulations implementing the “Volcker Rule” bar banks from acquiring or retaining “ownership interests” in “covered funds”. Regulators have interpreted that provision to mean that banks may not invest in notes issued by CLOs that own securities. Because bank capital is so important to CLOs, holding that syndicated term loans should be treated as securities would jeopardize many CLOs’ ability to participate in such lending. Moreover, under regulators’ current view, it could mean that U.S. banks would immediately have to divest themselves of approximately $86 billion in interests in CLOs holding syndicated term loans—25% of CLOs’ AAA notes.
In addition, if participants in the syndicated term loan market were subject to liability under the securities laws, the standard practices and code of conduct that the industry has developed over many years would have to be discarded. The process of syndicating a loan would be far more cumbersome, as every information memorandum would need to contain the same exhaustive information as the offering documents for a security. It would thus be more costly, and those increased transaction costs would presumably be passed onto the borrower in the form of higher interest rates or fees. It would also be slower, depriving borrowers of quick access to the capital markets in time-sensitive situations. Moreover, if loans traded solely based on public information, some borrowers would lose the ability to obtain financing based on information they want to keep confidential, and some lenders would lose the ability to assess credit risk based on information that borrowers choose not to make public.
What’s next? The plaintiffs in the litigation will have the opportunity to respond to the banks’ motion to dismiss as well as the LSTA’s brief. The District Court will in due course render a decision on whether this case should go forward based largely on how he decides the question of whether syndicated term loans are securities. The LSTA will continue to closely follow this case. The LSTA was represented on the amicus brief by Danielle Spinelli of WilmerHale.