When the Securities and Exchange Commission punted on the controversial legal question of whether leveraged loans are securities in a federal appeals court last summer, people close to the case were stunned. After all, the SEC had previously claimed such loans — now a $3 trillion market — are securities. And when the appeals court judges asked the regulator to offer its opinion, the SEC took a deep dive of the subject, eventually asking for three extensions to file its brief.
But after an intense lobbying effort by banks and their regulators, suddenly the SEC demurred. “Despite diligent efforts to respond to the court’s order and provide the commission’s views, the staff is unfortunately not in a position to file a brief on behalf of the commission in this matter,” SEC General Counsel Megan Barbero wrote in a terse letter to the court in July.
Without the SEC to weigh in, the court denied the appeal just a few weeks later.
But that may not be the end of the matter. Last month, attorneys for investors in the case whose appeal was denied petitioned the U.S. Supreme Court to hear the case and reverse the decision. And last week two amicus briefs supporting that view were filed — by University of Pennsylvania Wharton School of Business fellow Joseph Mason and the Americans for Financial Reform Education Fund.
“This should not have been been a cloak and dagger behind the scene lobbying effort,” one attorney familiar with the case told Institutional Investor. “It’s unseemly what happened. As II previously reported, the SEC had prepared a brief, but decided against filing it at the last minute, according to an individual familiar with the matter.
The case pits institutional investors against JPMorgan and Citi, which had led a 2014 $1.8 billion leveraged loan for Millennium Laboratories, which went bankrupt a year and a half later after the company reached a $256 million settlement with the SEC over fraudulent practices. But investors found they had no recourse against the banks that sold them the loan because leveraged loans are not deemed subject to securities laws. The appeal hinges on the technical interpretation of an earlier court ruling — not a statute — that established a four-factor rule to determine whether securities laws should apply.
If the Supreme Court decides to take the case, its outcome could have tremendous impact on this market. That is one reason the high court may decide to hear it, say attorneys. If such loans are deemed to be securities, the banks could be liable for failure to disclose material facts to investors — a prospect that the industry has claimed would present an “existential” threat.
Individuals familiar with the case believe the SEC backed down because regulators were worried about the impact on the market and the banks, at a time when interest rates and defaults were rising. “The timing wasn’t great” for the appeal to be heard, said the aforementioned attorney. He noted that the bank failures early last year also “worked against” the plaintiffs.
“Investors got screwed by the banks and this snowballed into a much bigger issue, then got caught up in political intrigue and wrangling,” he said.
In its recent brief, the Americans for Financial Reform Education Fund said the industry’s fears about being subject to securities laws should create even more cause for concern. “If the allegations are to be believed, the banks and their executives involved are lucky they aren’t paying millions in restitution, forfeiture, and fines while serving life sentences for wire fraud,” attorney Thomas Burns said in the conclusion to the group’s brief.
While the SEC did not take a position last summer, at least one of the commissioners — Caroline Crenshaw — did so after the appeal was denied. In its petition to the high court, attorneys for the investors leaned heavily on the views of Crenshaw, whom they noted had “highlighted the risks of these ‘loans’ that look less and less like loans” in a speech last October.
“[T]he loans themselves are far different from traditional loans,” Crenshaw said in that speech. “Many are sold to hundreds of ‘passive’ investors. They trade frequently and on conduct activities far beyond traditional borrowing to buy a piece of machinery or a new building.”
She added that “much of this market is not subject to meaningful regulation and investors are being put at risk. “[F]requently, investors have neither the means nor the time to conduct meaningful diligence. The loan is generally marketed to investors very late in the process after nearly all the terms are settled.”
In quoting Crenshaw, the attorneys argued that their case “illustrates those shortcomings. Banks lent Millennium over $300 million, but when they learned about the company’s legal risks, they offloaded that debt onto unsuspecting investors through a syndicated loan.”
In addition to the risks to investors, Crenshaw pointed out concerns that “systemic financial issues are lurking in the market, and that the risk to the financial system itself will continue to grow.”
The evolution and tremendous growth of the market is not dissimilar to what happened with mortgage- backed securities—which is further cause for worry, Mason suggested in his brief.
He wrote that the increased standardization of settlement procedures facilitated the trading, bundling and reselling of syndicated loans similar to what happened with mortgages.
But “those purchasing the securities in secondary markets had substantially less insight into the nature of the borrowers and the degree of investment risk,” Mason said. “[T]he market for syndicated loans is thus potentially ripe for the kind of manipulation, fraud, and systemic financial harm the securities laws are designed to address.”
As is common in such petitions to the Supreme Court, the defendants — in this case the banks — waived their right to respond.
The court will convene on Feb. 16 to consider the petition and, if it does grant certiorari, will ask the banks for their response.
