The Corner

Economy & Business

Syndicated Loan Relief

The leveraged-loan market received good (but expected) news in a recent case when a judge threw out a suit seeking to classify syndicated loans as “securities” (on par with stocks and bonds).

A leveraged loan (to oversimplify) is a loan to a borrower with an already substantial amount of debt.

Writing for Bloomberg in early May, Lisa Lee summarized what was at stake:

A group suing JPMorgan Chase & Co. and other Wall Street banks over a loan that went sour four years ago is alleging the underwriters engaged in securities fraud. If successful, the lawsuit could radically transform the $1.2 trillion leveraged lending market.

The defendants say there’s one key problem — unlike bonds, loans aren’t securities. As a result, they’ve filed a petition asking the court to dismiss the suit on those exact grounds.

The debate strikes at the heart of the leveraged loan market, which in recent years has come to look markedly similar to the higher-profile one for junk-rated bonds. The standardization of loan terms, the deterioration of covenants and the growth of secondary trading continue to blur the lines between the two. Should the plaintiff ultimately prevail, it would dramatically alter how American companies raise debt, according to two industry groups that filed a brief supporting the defendants’ argument. . . .

Yet if the courts ultimately decide that syndicated term loans are in fact securities, the repercussions would be significant and widespread, according to the Loan Syndications and Trading Association and the Bank Policy institute:

First off, arranging loans would become more cumbersome and costly amid more stringent disclosure requirements. A slower process would deprive borrowers of quick access to capital, while some may shy away from obtaining financing rather than make public confidential information, according to their brief.

And the market for collateralized-loan obligations — which provide the bulk of leveraged loan funding — would be thrown into chaos, they wrote. Banks are key buyers of CLOs, but Volcker Rule–restrictions bar them from investing in CLOs that own securities. Were loans deemed securities, banks could be forced to offload about $86 billion in existing CLO holdings in the absence of regulatory relief.

Had something like that gone through, it could potentially have ended loan syndication in the United States, where a large number of companies would have been cut off from collateralized-loan funding. Disclosure requirements, regulatory costs, and other burdens would have had a huge impact on this aspect on credit funding in U.S. capital markets, and, as the industry groups pointed out, there would have been ripple effects throughout the economy.

In the event, the judge threw out the case, although it can be appealed, ruling, Bloomberg later reported that “the investors who purchased the loan from JPMorgan and the other banks were sophisticated enough to know the debt would not be covered by securities laws.”

Much of the case revolved around the so-called “family resemblance” established by the Supreme Court in 1990 in Reves v. Ernst & Young.

In essence, the LTSA (the Loan Syndications and Trading Association) noted:

Reves requires courts to begin with a presumption that a note is a security, which presumption may only be rebutted by a showing that the note bears a strong family resemblance to one of an enumerated category of non-security instruments identified in Reves, including “notes evidencing loans by commercial banks”.

Legal mavens can find more discussion of the case in the LTSA comment.

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