WASHINGTON — A federal appeals court will hear arguments for a case that could redefine some loans as securities, a decision that would undercut banks’ businesses in the syndicated loan and collateralized loan obligation markets.
The United States Court of Appeals for the 2nd Circuit will consider an appeal for Kirschner, v. JPMorgan Chase Bank, N.A. The 2020 case held that syndicated term loans are not securities, and aren’t subject to securities laws.
The 2nd Circuit — which covers New York, Connecticut and Vermont — is moving forward with an appeal of that lower court decision and is expected to hear oral arguments in early 2023.
Some large banks, as well as larger regional ones, participate heavily in these trillion-dollar-plus markets. Experts say that subjecting syndicated loans to securities law could make it prohibitively expensive for banks to make these kinds of loans in the future.
“The overlay of costs and risks and liability from the securities laws is massive,” said Gary Simmon, a partner at Hughes Hubbard & Reed, and chair of its securities and capital markets group. “It would be a major game changer for the industry.”
Others believe that the test used to determine what a loan is compared to a security is outdated, and that leaving the syndicated loan market, which some research suggests is larger than the subprime-mortgage collateralized debt obligations market was at its peak, without more stringent regulation could pose risks to the global financial system.
While most experts don’t anticipate that the 2nd Circuit will overturn the decision of the lower court, the stakes are high enough that market players are nervously watching the court’s docket.
“Lawyers, bankers and other secondary loan market participants should all pay close attention to this case,” said Jennifer Pastarnack, a partner at Sullivan & Worcester who leads the firm’s global debt and claims trading practice. “Precedent turned on fact-specific issues. There is a whole new set of facts here. It is careless to disregard and not follow a case of this significance and magnitude.”
Specifically, the financial industry argues that if syndicated loans are treated like securities, market participants would have to comply with a patchwork of state and federal laws, making them significantly more pricey to execute. Loan syndication and trading activity would likely need to be conducted through broker-dealers registered with the Securities and Exchange Commission.
“It would fundamentally change the way that committed financings are underwritten,” said Gregory Lyons, partner and co-chair of Debevoise & Plimpton’s financial institutions group. “I think given the broker-dealer issues, there’s a good chance banks would get disintermediated altogether. But somehow, if they could make it work, then the compliance cost of having to evaluate how this whole new regime overlays and what the disclosure requirements are would seriously cut into the revenue streams of the banks and may make it unpalatable for some of them.”
The Loan Syndications and Trading Association, which filed an amicus brief in May supporting the lower court’s decision, argues that along with the higher cost, regulating syndicated term loans as securities would have other adverse effects.
“To do that would take one of the major tools out of the hands of lenders and investors on one hand and borrowers on the other,” said Elliot Ganz, head of advocacy at the LSTA. “First, borrowers know who their lenders are, they have control over who their lendres are, they know who has their paper, and that’s important to the borrower market. Secondly, they’re very amendable — there’s tremendous flexibility in amending credit agreements, but that’s something that’s not the case in the bond market.”
CLOs would also be heavily affected, the LSTA said in their amicus brief.
Most CLOs only allow some securities to be included in their pools as eligible assets. If syndicated loans were included in that tally, that would limit the number of loans that are eligible for investment by CLOs. It would also restrict banks that need to hold more loans on their books, as opposed to syndicating them out to CLOs in the case of reduced liquidity. That could make it more difficult for businesses to access funding, and for lenders to quickly pool funds for businesses that might have better access to the credit they need.
Part of the concern for critics — and, perhaps, for the court — has been the evolution of syndicated loan and CLO markets, as well as funding options from nonbank lenders that have exploded since the passage of Dodd-Frank.
“We’ve seen an increase in hedge funds, or private credit funds, and CLO participants now involved in the term loan market, where they’re buying the paper from traditional commercial banks that are sending these out,” said Mushfique Shams Billah, a partner at Hughes Hubbard & Reed. “That market has really picked up because of the limitation on commercial banks. The nonbank participation in the market has made this seem more security-like, and it’s probably part of the concern that the 2nd Circuit may be considering.”