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Second Circuit Could Upend Syndicated Loan and CLO Markets

Sept. 13, 2022, 8:00 AM

The US Court of Appeals for the Second Circuit is poised to make a decision that will impact how syndicated loan and collateralized loan obligation markets operate.

Loan market participants take one of two positions when assessing the fanfare surrounding a case like the one at the Second Circuit. Some closely watch the case and openly forecast the catastrophic effects a holding to the contrary would have on the markets. Others dangerously toss it up as just another fruitless exercise, believing a court wouldn’t jeopardize the markets by ruling that a syndicated bank loan is a security.

We’ve witnessed courts upend closely held precedent— and we should not take precedent for granted.

The appeals court is reviewing a decision from the Southern District of New York that held a syndicated loan was not a security, which was an important win for the industry. Altering this foundational understanding would upend the loan and CLO markets since a CLO is the vehicle that securitizes syndicated term loans.

A syndicated loan is offered by a group of lenders, or syndicate, whereas a CLO is a type of security where investors purchase an interest in a diversified portfolio of loans.

Marc S. Kirschner, a bankruptcy trustee representing a bankruptcy estate, brought a case before the Southern District of New York against JP Morgan and others. Kirschner argued that notes evidencing certain syndicated term loans constituted a security and that the defendants therefore violated securities laws.

Four-Part Test

The district court, in finding that the loans were not a security, applied a four-part test from Reves v. Ernst & Young. The US Supreme Court in Reves said that since the Securities Acts define a note as a security, the presumption should be that all notes are securities.

This presumption can be refuted with the “family resemblance test.” Under this test, “a note is presumed to be a security unless it bears a strong resemblance” to a “judicially crafted list of categories of instrument that are not securities” such as a “note secured by a mortgage” or “notes evidencing loans by commercial banks for current operations.”

The test includes the the motivations of the buyer and seller, the plan of distribution of the instrument, the reasonable expectations of the investing public, and the existence of another regulatory scheme that reduces risk of the instrument and renders the application of the Securities Act unnecessary.

The test wrestles with each relevant fact to see if the public could be harmed if the note at issue was not protected by securities laws. The district court found the test to ultimately weigh in favor of the notes evidencing the syndicated term loans to not be a security.

However, there are opposing views that argue that syndicated term loans should be governed by securities laws.

What’s the Worst That Could Happen?

The Loan Syndication and Trading Association, a preeminent voice and leader in loan trading, filed an amicus brief with the Second Circuit. The LSTA pointed out that the Securities and Exchange Commission views syndicated term loans differently from securities. The association also enumerated the deleterious effects that a decision to the contrary would have on the loan and CLO markets.

First, compliance costs would go through the roof if syndicated term loans were subject to securities laws. Loan market participants would need to comply with securities laws, and all loans would need to go through a registered broker. A borrower would have to register the syndicated term loan under the securities laws unless the borrower could find an applicable exemption.

The imposition of these rules would complicate loan transactions and burden market participants with additional costs. Arguably, subjecting these loans to securities registration would disrupt loan origination and sales in the secondary market.

Second, the syndicated loan market is already regulated and does not need the protections provided by the securities laws. There are federal banking regulations in place protecting the banking markets. There are also sophisticated investors, rather than public investors. In fact, these types of loans cannot be purchased by a person.

We can only hope that the Second Circuit puts to rest any further discussion or disagreement regarding the status of syndicated bank loans. Doing so will give ongoing certainty to markets and put an end to those who questionably advocate for a revision to the longstanding determination that syndicated loans are not securities.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Jennifer Pastarnack is a partner at Sullivan & Worcester and leads the firm’s Global Debt and Claims Trading practice. She works with hedge funds, investment banks, and asset managers in multi-national trade claim transactions and distressed investing matters. She is an active member of the LSTA.