April 20, 2023 - The Kirschner case has long been hanging over the loan market like the Sword of Damocles, threatening to call loans “securities”, with all the harms that could convey. Most recently following a hearing in the Kirschner case, the Second Circuit asked the SEC to weigh in with whether they believe loans are securities. While the SEC has long said that loans could be securities, subject to certain facts and circumstances, a statement by the SEC that loans are securities could be problematic in both the short and long term.

In the short term, such a statement may be destabilizing to a $1.4 trillion institutional loan market that has been a very important source of capital to American companies.  The attractiveness of loans for both borrowers and lenders is tied to the characteristics that distinguish loans from securities, including, for example, their efficient execution, the ability of borrowers to control their lending group, the ability of borrowers to easily amend loans, and the ability of lenders to access confidential information about the borrowers.

If the SEC were to take the position that loans are securities subject to the securities laws, there could be immediate disruptive and destabilizing impacts on the loan market.  Borrowers, banks and other market participants and their lawyers would be faced with the question whether they could continue to borrow or originate loans without complying with the securities laws; that could lead to a freeze in origination, including the approximately $20 billion of institutional loans currently in the pipeline.  Secondary market trading also could become disrupted until banks figure out whether and how they could continue to trade loans.  If they conclude that they must trade in compliance with the securities laws, which they appear currently unequipped to do, the disruption could last a significant amount of time.  This has knock-on effects for the lenders in the loan market. First, an announcement that the SEC views loans as securities might trigger redemption requests by investors in open-end loan funds. While these funds maintain “Highly Liquid Investment Minimums or HLIMs” that are not comprised of loans, if secondary loan trading were disrupted for several weeks (or more) and redemption requests were high, it might be challenging to sell loans. CLOs likely have a longer window, but if the secondary loan market were to remain disrupted, the ability to actively manage the CLO portfolio – and thus comply with all tests – could become increasingly challenging. This might lead to some CLOs becoming de facto static – because trading isn’t viable – for a period of time.

Of course, the effects would likely be broader.  If the market were to suddenly treats loans as securities – whether based on a broad SEC statement or, perhaps more likely, a broad statement followed by an unfavorable Second Circuit ruling – there would be many other consequences, some of which we know but many of which are difficult to predict. First, potential plaintiffs might scrutinize this shift, which may in turn demand significant resources and attention from financial institutions that properly underwrote and distributed term loans as loans.  We also know that borrowers and lenders would lose many of the benefits they derive from loans as they are currently structured if loans needed to comply with securities laws.  We don’t really know how this market would evolve, what the impact on capital formation would be, or what the costs of such a transition would be.  This is doubly unfortunate because this is not a market that is broken. 

While an immediate shift to a securities framework may be very disruptive, the long-run impact of loans being characterized as securities has material implications as well. This was discussed in detail by Davis Polk and Wilmer Hale in the LSTA Handbook of Loan Syndications and Trading.  Davis Polk notes that if loans were considered securities under the securities laws, they most likely would use an exemption to registration and resales like the Section 4(a)(2) and Rule 144A regimes. This has a number of implications of course but specifically highlighted here that i) the borrower would need to be an eligible issuer and, if a private company, it must provide certain financial information upon request by lenders; ii) buyers of 144A notes must be QIBs; iii) the borrower and arranger would need to make clear to potential syndicate members that they may be relying on 144A and ; and iv) to avoid general solicitation, the borrower, arrangers and agents should avoid talking publicly about the loans prior to completion of the syndication. 

All that may be relatively easy, but then there are the harder nuts to crack. First, the Handbook flags that antifraud liability considerations may be daunting in the shift from a loan regime to a securities regime. Second, loans also could be subject to a number of (but perhaps not all) state securities laws and rules and regulations of FINRA, which Davis Polk details.  Wilmer Hale goes on to highlight several other practical implications. First, cost. It simply is more expensive (and time consuming) to do a 144A offering than a loan. Second, the bifurcated private-public model of loan trading likely would end and the loan market likely would become a public-only market. Third, were loans subject to FINRA rules, secondary trading (and settlement) could become more complex and potentially slower, not faster.

All told, a sudden shift to a securities regime for loans could be destabilizing. And, even over the longer term, the costs of a securities regime could be profound. The LSTA will continue engaging on this issue.

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The Kirschner Case: This is the End

The Supreme Court denied Kirschner's petition for certiorari, finally ending the case. As LSTA's Elliot Ganz explains, this cements that syndicated loans are not securities,…