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Good morning, it’s Ethan here. Rob is on vacation this week. If the overwhelming success of the “Barbenheimer” at the box office this weekend is any indication, it seems that American consumers are still actively spending. According to a report from the FT, certain theaters experienced shortages of Barbie lunch boxes and sunglasses. From my personal experience, the AMC theater near Times Square was packed. Feel free to send me your thoughts on topics like nuclear extinction or feminist merchandise at [email protected].
Kirschner vs JPMorgan
Leveraged loans, which make up a $1.4tn market, provide expensive financing to less stable companies, often as part of a leveraged buyout. Unlike the $1.35tn high-yield bond market, leveraged loans are not considered securities. As a result, the disclosure requirements typically associated with bonds, stocks, ETFs, and derivatives do not apply. While it doesn’t make the market lawless, proving fraud in the leveraged loan market is much more challenging than securities fraud.
But should this change? Marc Kirschner believes so. He is suing a group of investment banks, including JPMorgan and Citi, on behalf of 400 institutional investors who suffered losses in a $1.8bn leveraged loan deal in 2014. Kirschner lost the case in lower courts and is now appealing.
The lawsuit revolves around Millennium Laboratories, a San Diego-based firm that conducted urine tests. The US Department of Justice accused the company of ordering unnecessary tests to generate bills for private insurers, Medicare, and Medicaid, and providing kickbacks to doctors. Millennium settled with the DOJ for $256mn in 2015 and shortly after filed for bankruptcy, just a year after receiving $1.8bn from investors.
Kirschner, the bankruptcy trustee in the case, argues that the banks were aware of the legal troubles brewing at Millennium, including an ongoing DOJ investigation, but failed to disclose this information. Since leveraged loans are considered securities, the banks’ omission qualifies as securities fraud, according to Kirschner.
Let’s revisit how leveraged lending works. Banks underwrite loans for a company and then sell loan portions to numerous institutional investors, having economic similarities to high-yield bonds but with important practical differences. This has caused concern within the leveraged lending industry. Some market participants view this case as an “existential threat.” In a briefing to the court, industry groups argued that a ruling deeming leveraged loans as securities would profoundly disrupt the origination and trading of loans, which have become a crucial source of capital for modern commerce.
There is a valid point regarding short-term disruptions. Changing the regulatory regime of an asset class is a significant undertaking. It is likely that leveraged lending would encounter challenges as market participants navigate the legal landscape. The longer-term impacts are less certain. Leveraged loans, secured by specific collateral, typically offer lower yields and higher recovery rates compared to high-yield bonds. Would this change? Compliance costs for investors would probably increase, leading to lower yields. Extra disclosure requirements and longer settlement periods may also incur additional expenses. The industry is concerned that loan-market players might have to register as broker-dealers and face oversight from multiple regulatory bodies.
The industry argues that participants in the leveraged loan market are sophisticated enough to protect their interests without the need for securities-law protections. Elliot Ganz, head of advocacy at the Loan Syndications and Trading Association, a trade group, stated, “Kirschner is trying to take advantage of an easier way to find liability. No one in that deal thought they were getting the benefits of the securities laws. They knew what they were buying.”
Investor advocates disagree, asserting that excluding leveraged loans from investor protections provided to other investments is unreasonable. Andrew Park of Americans for Financial Reform stated, “Without securities laws, this market becomes a wild west of sorts.” He added that sophisticated investors could not have known about the DOJ’s investigation into Millennium for Medicare fraud. Park also pointed to the case of Avaya, a small tech company that received fresh leveraged-loan financing while allegedly failing to disclose earnings weakness in 2022.
One major point of contention is that, as non-securities, loans can be traded legally using private information. “Private side” traders who exclusively deal in a company’s loans can access material non-public information. On the other hand, “public side” traders who deal in both a company’s loans and securities are prohibited from such information, willingly accepting an information asymmetry. The industry views these “key features” of leveraged loans as desirable for borrowers and lenders, while critics argue it amounts to legalized insider trading.
So, are leveraged loans legally considered securities? While the industry argues that loans are not marketed to the general investing public and do not currently fall under the definition of securities, Kirschner claims that the banks’ argument relies on a single, weak interpretation of a 1992 precedent. To say that this is a complex issue would be an understatement, which is why the New York appeals court sought the SEC’s opinion. However, after three extensions, the SEC declined to provide a clear stance. Last week, the SEC issued a vague one-page statement stating it was “unfortunately not in a position” to give an opinion.
Speculation is rife regarding the SEC’s decision. One source I spoke with suggested that something suspicious is happening within the SEC, proposing that Gary Gensler, the SEC head, may personally believe that loans are securities but lacks enough internal support for his view. Reuters’ Alison Frankel suggests that the Treasury department may have intervened to prevent disruption in the loan industry. Bloomberg’s Matt Levine speculates that providing an opinion on leveraged loans could undermine the SEC’s separate efforts to regulate cryptocurrencies under securities laws.
The SEC has a strong case to make. Leveraged loans are widely owned investments, with some finding their way into publicly traded ETFs. It is peculiar that they receive special treatment. Todd Phillips, an independent legal consultant, points out that leveraged loans constitute a “capital markets product issued under the bank regulation model meant to address issues with maturity transformation.” Nonetheless, the SEC’s inaction likely supports the industry’s desire to maintain the status quo. If the securities regulator won’t take a clear stance on whether its jurisdiction should expand, it is doubtful that a court would push the matter.
A must-read recommendation: The Economist bemoans the decline of scathing book reviews. (It brings to mind Garrison Keillor’s ruthless critique of Bernard-Henri Lévy’s book on America.)
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