Are leveraged loans securities? | Financial Times

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Good morning. Ethan here; Rob is away for the week. If this weekend’s “Barbenheimer” box office blowout is any evidence, the US consumer is nowhere near done spending. The FT reports that some theatres faced shortages of Barbie lunch boxes and sunglasses. I can report that the AMC theatre near Times Square was stuffed. Send me your thoughts on nuclear extinction and/or feminist merchandise: [email protected].

Kirschner vs JPMorgan

Like high-yield bonds, leveraged loans — a $1.4tn market — offer pricey financing to less-than-rock-solid companies, often as part of a leveraged buyout. But unlike HY (a $1.35tn market in issuance outstanding), leveraged loans are not securities. In leveraged-loan land, none of the disclosure requirements a bond (or stock or ETF or derivative) investor might enjoy apply. This does not make it a lawless market, but plain-old fraud is much harder to prove than securities fraud.

Should that change? Marc Kirschner thinks so. He is suing a group of investment banks, including JPMorgan and Citi, on behalf of 400 institutional investors who lost out in a $1.8bn leveraged loan deal in 2014. Kirschner lost in the lower courts, and is now appealing the case.

The suit centres on a firm, San Diego-based Millennium Laboratories, which ran urine tests. The US Department of Justice accused it of ordering unnecessary tests to rack up bills to private insurers, Medicare and Medicaid, and giving kickbacks to doctors. Millennium settled with the DOJ for $256mn in 2015, and shortly thereafter fell into bankruptcy — just a year after getting $1.8bn from investors.

Kirschner, the bankruptcy trustee in the case, argues the banks knew about brewing legal problems at Millennium, including an active DOJ investigation, but said nothing. And since leveraged loans are securities, the banks’ omission counts as securities fraud, he says.

Remember how leveraged lending works. Banks underwrite loans to a company, and then sell loan slices to dozens or even hundreds of institutional investors. This has economic similarities to HY, but important practical differences, which is what has the leveraged lending industry alarmed. Some market participants are calling the case an “existential threat”. In a briefing to the court, industry groups say a ruling that leveraged loans are securities would end up “profoundly disrupting the origination and trading of loans that have become a critical source of capital for modern commerce”. 

On short-term disruptions, the industry has a point. Changing an asset class’s regulatory regime is a big deal. Leveraged lending would presumably seize up as market participants worked out what’s legal and what’s not. 

The longer-term impacts are less clear. Typically, leveraged loans, secured by a specific piece of collateral, have lower yields and higher recovery rates than HY bonds. Would that change? Compliance costs would probably go up (and yields for investors down) as well, but by how much? Extra disclosure requirements are one new source of expense. Another is transaction settlement. Loans take a week or more to settle, compared to HY’s two days, and the companies involved might have to hold capital against the unsettled transactions. Loan-market players, the industry fears, may also have to register as broker-dealers. They’d then have state securities regulators, Finra and the SEC all breathing down their necks.

The industry argues that participants in the leveraged loan market are sophisticated, fully capable of enforcing their rights without security-law protections. “Kirschner is trying to take advantage of an easier way to find liability,” says Elliot Ganz, head of advocacy at the Loan Syndications and Trading Association, a trade group. “No one in that deal thought they were getting the benefits of the securities laws. They knew what they were buying.”

Investor advocates counter that cutting out leveraged loans from the investor protections nearly all other investments enjoy is ridiculous. “Without securities laws, this market becomes a wild west of sorts,” says Andrew Park of Americans for Financial Reform. “The issue is not sophistication. Sophisticated investors couldn’t know themselves that the DOJ was investigating Millennium for Medicare fraud.” Nor is the Millennium case a one-off, Park added, citing the example of Avaya, a small tech company that was accused of failing to disclose earnings weakness in 2022 while raising fresh leveraged-loan financing.

One big point of contention is that, as a non-security, loans can be legally traded using private information. “Private side” traders who deal only in a company’s loans can receive material non-public information. “Public side” traders who deal in both a company’s loans and its securities cannot, and so voluntarily opt into an information asymmetry. Ganz calls these “key features” of leveraged loans “that make them desirable to borrowers and lenders”. Park calls it legalised insider trading.

So, legally, are leveraged loans securities? To hugely oversimplify, the industry’s argument is that loans are not marketed to the general investing public, no one currently thinks of them as securities and they already slot into a non-securities regulation framework, namely bank regulation. To simplify even more, Kirschner says the banks’ argument relies on a single, flimsy, misinterpreted 1992 precedent.

In other words, it’s complicated, which is why the New York appeals court asked the SEC for its view. Yet after getting three extensions, the SEC punted. It issued a weird one-page statement last week saying it is “unfortunately not in a position” to give an opinion. 

Speculation about the SEC’s non-decision is running wild. “Something fishy is going on inside the building,” said one source I spoke with, who speculated that Gary Gensler, the SEC head, may personally believe that loans are securities, but couldn’t muster enough internal support for his view. Alison Frankel at Reuters thinks the Treasury department may have gotten involved, for fear of disrupting the loan industry. Matt Levine at Bloomberg thinks that giving an opinion on leveraged loans could undermine the SEC’s separate attempt to bring crypto into the securities-law firmament. 

The SEC would seem to have a strong case to make. Leveraged loans are a widely owned investment, with some ending up in publicly traded ETFs, and it is odd that they get special treatment. As Todd Phillips, an independent legal consultant, notes, what we have is a “capital markets product being issued under the bank regulation model meant to address issues with maturity transformation”.

But the SEC’s inaction probably lends weight to the industry’s preserve-the-status-quo stance. If the securities regulator won’t take a position on whether its own jurisdiction should expand, a court seems unlikely to force the issue.

One good read

The Economist laments the decline of the hatchet-job book review. (I’m reminded of Garrison Keillor’s 2006 flaying of Bernard-Henri Lévy’s book on America.)