A lawsuit that went unnoticed by many debt market professionals for years is getting more attention after a US appeals court asked rulemakers to weigh in on whether leveraged loans should be regulated more like bonds.
(Bloomberg) — A lawsuit that went unnoticed by many debt market professionals for years is getting more attention after a US appeals court asked rulemakers to weigh in on whether leveraged loans should be regulated more like bonds.
If judges decide in favor of treating the loans like securities, the $1.4 trillion market might face a series of sweeping changes. Banks selling the debt would have to overhaul their disclosure practices and build systems to speed their trading because bonds have to settle faster, among other shifts.
The US Securities and Exchange Commission is working on a response to a federal appeals court request for comment on whether loans at issue in the case should be regulated like securities. The agency has until June 27 to file its response, and said it’s gathering the views of other federal agencies.
“A case that most loan market participants initially disregarded is becoming closely watched,” said Jennifer Pastarnack, a partner at Sullivan & Worcester.
The court is looking at a $1.8 billion loan that soured soon after it was sold in 2014. A trustee for investors in the debt, Marc Kirschner, said the Wall Street firms that offered the debt, including JPMorgan Chase & Co., withheld key information that would have tipped off investors about trouble at the company. Loans are essentially securities, and banks should have disclosed as much as they would have for a bond sale, Kirschner said.
But the banks said loans aren’t securities, and they were under no obligation to disclose more than they did. So far, courts have ruled in their favor. JPMorgan and a lawyer for Kirschner declined to comment. The SEC declined to comment.
During hearing oral arguments on appeal from a lower court last month, a judge on the federal Court of Appeals for the Second Circuit wondered aloud: “Why don’t we ask the Solicitor General of the United States to submit a brief?”
Within days, the court filed an order requesting comment from regulators — not from the Solicitor General, but from the SEC. The appeals court originally gave the SEC until April, but the agency asked for more time, signaling to some industry watchers that their response could be more than a simple dismissal of the idea that loans are securities.
“I think the SEC asked for more time since this is an important issue with real ramifications to the market and they will want to be very precise with both their analysis and any position they take as it relates to the case,” said Gregg Bateman, a partner at Seward & Kissel LLP.
“Devastating” for Industry?
The Loan Syndications & Trading Association, a trade group, says that deeming loans to be securities would be “devastating” for the industry. It would complicate rules, increase compliance costs for parties in the market and potentially slow the flow of capital to companies.
If loans were deemed to be securities, parties might need to reduce the time it takes to finalize, or settle, any trades of the debt to two days, the required time for securities. That compares with the typical two or three weeks or more.
Any parties receiving transaction-based compensation tied to loan transactions may also have to register as broker-dealers, which can be cumbersome, according to Michael Pierson, a partner at FisherBroyles.
“Becoming a broker-dealer is a very long and involved process,” Pierson said.
Disclosure and handling of corporate information would also change. For example, investors in loans are sometimes privy to closely guarded information about company financials and other data. They’re generally permitted to trade on that information, as long as they inform counterparties that they possess privileged information and as long as it doesn’t cross the line into material non-public information, according to Sullivan & Worcester’s Pastarnack.
But some lawyers say the impact would probably be relatively muted.
“Issuers of loans would need to hire more lawyers, and there would be more disclosure, which is a good thing,” said Schuyler Moore, a partner at Greenberg Glusker. “I don’t see much else that would change.”
And the disclosure requirements tied to securities would help investors, Moore said.
The appeals case litigation that the SEC is looking at stems from a $1.8 billion loan for Millennium Health LLC that JPMorgan and other banks sold in 2014. Soon after that, the company disclosed that federal authorities were investigating its billing practices, and the value of its loans dropped. The company later agreed to pay $256 million to resolve the probe and filed for bankruptcy.
JPMorgan knew the company was under investigation when it sold the loan, but didn’t disclose it because Millennium Health said it wasn’t material, Bloomberg reported in 2015.
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