July 20, 2023 - This week, the General Counsel of the Securities and Exchange Commission (“Commission”) notified the Court of Appeals for the Second Circuit hearing the Kirschner case that “[d]espite diligent efforts to respond to the Court’s order and provide the Commission’s views, the staff is unfortunately not in a position to file a brief on behalf of the Commission in this matter.” As we’ve previously noted, the Court had asked the Commission to weigh in with its view as to whether the Term Loan B in the Kirschner case was a security. The original deadline for the SEC’s submission was April 13th but was extended three times, to July 18th, at the Commission’s request.
Since March, when the Court requested the SEC’s view, the LSTA has been actively engaged with the SEC, the banking agencies and the U.S. Treasury, to discuss the materially adverse consequences of suddenly recharacterizing loans as securities. We appreciate that the SEC recognized the complexity of the matter and decided not to weigh in with a brief and instead allow that private litigation to proceed in its normal course.
In the coming months the Court will decide whether to affirm the decision by the District Court that the loan is not a security, or remand back to the District Court for additional discovery. Importantly, as a result of the Commission’s decision to stay on the sidelines, the Court’s deliberations will not include a view expressed by the Commission that the Term Loan B in that case was a security.
Why it Matters
A holding that Term Loan Bs are securities would have devastating effects on the leveraged loan market, both in the short and long term. Subjecting term loans to the securities laws would introduce enormous practical complications and impose very significant compliance costs in all aspects of the loan market including origination, trading, and capital formation. Loan market participants would be obligated to comply with securities laws at the state and federal levels subjecting them to a patchwork of rules that may have different requirements. In addition, the tax and accounting treatment could be significantly altered for many loan market participants.
The potential impacts would include: (i) Without an exemption from the banking agencies, banks might have to hold and trade loans through a broker dealer. In addition to the increased net-capital charges that would apply to trading loans in a broker dealer, since loans are subject to the transfer provisions of credit agreements, such trading would be extremely difficult as a practical matter and almost impossible in the short term; (ii) Loan origination would be subject to the securities laws relating to privately placed securities such as 4(a)(2) and 144A and the banks underwriting and distributing these loans would be deemed securities underwriters subject to increased liability. Transaction execution would be slower, more cumbersome, and more expensive, requiring information memoranda that would include the types and standards of information currently required for high yield bonds. Many borrowers would be unable to access the loan market because they would not be able to comply with the stringent disclosure requirements; (iii) if loans were characterized as securities, they would trade in reliance on Rule 144A. Parties almost certainly would not trade existing loans that have not been registered or are not exempt from registration, which, initially, would be all Term Loan Bs, (iv) Currently, loan market participants in possession of MNPI are generally able to trade with counterparties that do not have such information based on non-reliance provisions (also known as “big boy” provisions). However, in a securities context, the ability to rely on such provisions is extremely limited and the loan market would likely have to convert to the use of public-only information; and (v) It is impossible to precisely predict the impact that a ruling that loans are subject to the securities laws would have on existing CLOs and on the formation of new CLOs. Clearly, CLO managers, arrangers and investors would closely follow developments relating to the underlying loan collateral including how arrangers, borrowers and other stakeholders react. While it does appear that existing CLOs would not be compelled to sell their existing loans, collateral managers may be unable to dispose of, or reinvest the proceeds of, legacy loans until the underlying obligors have complied with the applicable securities laws. .
Critically, a final ruling by the court that loans are subject to the securities laws would apply not only to new loans but to all existing Term Loan Bs. Since those loans would likely not have been registered under the securities laws and would not benefit from an exemption, parties would almost certainly refrain from trading those loans until they were registered or an exemption from registration was available. The LSTA 2ill continue to closely monitor the proceedings and report to membership as appropriate. If you have any questions, please reach out to Elliot Ganz, Tess Virmani or Meredith Coffey.