When institutional investors bought into a $1.8 billion leveraged loan syndication for Millennium Laboratories in 2014, they had no idea what they were getting into. Unbeknownst to them, the California-based urine testing company had been under investigation by the Department of Justice for years — a fact the investors later alleged was known to the lead banker on the deal, JPMorgan Chase, but not disclosed to the loan’s participants.
A year and a half after the loan proceeds were disbursed, Millennium (which by then had changed its name to Millennium Health) settled with the DOJ for $256 million over a number of fraudulent practices, like unnecessarily testing Medicare patients for PCP, also called “angel dust,” and paying physicians to order those tests. Ten days later the company filed for bankruptcy. But by then, the proceeds of the loan had given its principals a $1.2 billion payday — and paid off an earlier JPMorgan-led term loan of $310 million as well.
Millennium’s investors soon found they had little recourse. In 2021, a lawsuit they had filed against JPMorgan and others involved in the deal was dismissed by a Manhattan federal judge who found that no matter what the banks knew about the DOJ investigation, they weren’t legally required to share the information with the investors.
That case, which is on appeal in the second circuit, is now being closely watched by participants in the leveraged loan market. Its outcome hinges on whether such loans — syndicated loans made to noninvestment grade borrowers — should really be considered securities. That designation would make banks liable for failing to disclose material risks and force numerous changes to how the market operates.
At the request of the appeals court, the Securities and Exchange Commission is expected to weigh in on the topic Tuesday in an amicus brief that has the industry on edge. The request came as a shock to bankers, who have been scrambling to convince the SEC not to disturb this business, especially at a time when rising interest rates have already put the leveraged loan market under the most stress it has encountered in years.
The SEC has given no indication of its position. But in another case some 30 years ago, the regulator did argue that leveraged loans were securities, and many academics agree. “Under the tests that the Supreme Court previously established, leveraged loans, practically speaking, are securities,” said Duke University School of Law professor Elisabeth de Fontenay.
Leveraged loans got their start in the 1980s, alongside the boom in similarly-rated junk bonds that Drexel Burnham Lambert pioneered. At that time, leveraged loans were still primarily traded among banks and used for leveraged buyouts and M&A transactions. But after banks were forced by regulators to bolster their capital in the wake of numerous market failures (including that of Drexel), they began to shed these risky loans from their balance sheets.
Since that shift in the early 1990s, the market has mushroomed to $1.4 trillion, according to the Loan Syndications and Trading Association. The leveraged loan market now rivals that of SEC-regulated junk bonds, which are longer-term, fixed-rate debt instruments that are more expensive for companies to issue. The shorter-term, floating-rate leveraged loans are now actively traded by hedge funds, mutual funds, insurance companies, and pension funds. They are found in ETFs sold to retail investors. And most leveraged loans make their way into collateralized loan obligations, or CLOs, which slice and dice the loans, securitize them, and sell them again.
Such attributes have made some observers argue that leveraged loans should be regulated like securities. And given the activist bent of the SEC under Chairman Gary Gensler — who has already made waves with his view that some crypto coins are securities — banks and their allies are worried the SEC will agree. They have been lobbying heavily to convince the SEC that designating these risky loans as securities would be calamitous, according to individuals familiar with their activities.
“I don’t really have an interest in the facts of the [Millennium] case or whether JPMorgan acted inappropriately or not,” said Elliot Ganz, head of advocacy and co-head of policy for the LSTA. “We’re super hyper-focused on one issue and one issue alone, which is: Is a loan a security or not? Because it has massive implications.”
According to Ganz, a finding that the loans are subject to securities laws would pose “an existential threat to the loan market as we know it.”
He said the appeals court’s decision to ask the SEC to intervene was a “critically important and somewhat surprising” development. “By requesting their input, one can expect the court to take their views quite seriously,” said Ganz.
The LSTA and the banks have been busy making their case to the SEC. According to Ganz, as soon as the court asked the SEC to weigh in on the issue, the regulator reached out to the LSTA, JPMorgan, and Citibank, which is also a defendant in the lawsuit. (The banks declined to comment.)
Representatives from all three have had meetings with the SEC general counsel’s office to discuss the legal issues. The LSTA and the banks have had additional meetings with the chairman’s office, and the LSTA has met with all of the commissioners more than once. The additional meetings largely focused on the policy implications, according to Ganz. He said the SEC has also been meeting with bank regulators, as has the LSTA, although those regulators were not asked to submit an amicus brief in the case.
“We explained to them that there are very serious implications that would occur” if the SEC took the position that these were securities and the court agreed, Ganz said.
If syndicated term loans were deemed to be securities, the loans would be subject to federal and state securities laws, including disclosure requirements and potential liability for issuers and arrangers based on inadequate disclosure. On a practical level, an “extended settlement cycle would implicate margin, net capital, and other rules that apply to the settlement of securities transactions; imposition of these rules would complicate loan transactions and burden market participants with additional costs,” according to the LSTA.
“We’re in a fairly stressed environment right now,” said Ganz. “It would never be the time to do that. It certainly isn’t the time now.”
The fragility of today’s market is part of the problem, according to critics. “The International Monetary Fund, the Federal Reserve, and the Bank for International Settlements have been warning of the risk of the growing leveraged loan market for several years. Despite this it has continued to grow,” said Andrew Park, senior policy advisor at the investor advocacy group Americans for Financial Reform. Park, who is also a member of the SEC’s investor advisory committee, said that the current designation of syndicated loans is a loophole that allows banks to evade securities laws.
Leveraged loan analysts have also begun to ring the alarm bells in this market. By some metrics, the condition of the leveraged loan market is “as dire as financial crisis times,” said Rachelle Kakouris, director of research for Pitchbook LCD, in a webinar last week. Defaults are rising at a pace not seen the pandemic, and those defaults are expected to continue as companies begin to feel the squeeze of higher debt servicing costs, according to Pitchbook.
As fears have grown over the risk of rising defaults, AFR has argued that the global financial system is once again being put at risk, noting that the leverage loan market is now larger than the subprime mortgage collateralized debt obligations market that torpedoed the global financial system in 2008. “We are urging the court to stop this ‘wild west’ market,” Park said.
He noted that another case before the courts involves investors in unsecured convertible notes who are suing tech communications firm Avaya Holdings after allegedly being misled over the company’s finances. Weeks after Avaya issued a $350 million loan syndicated by JPMorgan and Goldman Sachs, the company warned there was “substantial doubt” about its ability to continue “as a going concern.” Avaya filed for bankruptcy seven months later.
“The lack of investor protection under securities laws for these weaker, more heavily indebted borrowers is also repeatedly harming investors who are deceived by the asymmetric information between the loan issuer and themselves,” AFR said in an amicus brief filed with the second circuit in the Millennium case.
AFR wants the courts to overturn a 1992 case, Banco Español de Credito v. Security Pacific National Bank, which found that leveraged loans weren’t securities. In the Banco Español case, the SEC had filed an amicus brief arguing that the loans were securities, and the chief appellate judge in the case agreed, calling the decision “bad banking law and bad securities law.”
Three decades later, the legal and policy implications put the SEC in “an incredibly difficult position,” according to law professor de Fontenay, who said she isn’t convinced more disclosure is necessary. She believes excessive leverage is the real problem plaguing this market.
The SEC is “an already stretched federal agency that is fighting a valiant, but very difficult fight in the crypto space, that is now suddenly saddled with this additional market,” de Fontenay said. She suggested that the prospect of overseeing such a huge market is likely one reason that the SEC has not weighed in on the matter since its initial position some 30 years ago.
The determination of whether leveraged loans are securities is governed by a four-pronged test put forth in a 1990 Supreme Court case, Reves v. Ernst & Young. The tests include the motivation of a reasonable buyer to sell and enter into the loan transaction, the plan of distribution, the reasonable expectations of the investing public, and the existence of another regulatory scheme to reduce the risk to the loan. The federal court found that the Millennium loan did not conclusively pass all these tests, but de Fontenay disagreed.
Leveraged loans, she argued, “have all the hallmarks of securities” as defined by Reves. “The idea is that you have passive investors who are hoping to earn a return from the efforts of others and they are subject to risk — these are the classic features of securities,” she said.
The “plan of distribution” — another key aspect of the Reves test — is that loans “are set up from the outset to be widely distributed and to be traded,” de Fontenay said. (The Millennium loan was “julienned into hundreds of slices and distributed to over 400 investors — few if any was a bank,” according to the AFR brief. The investors included such well-known names as Franklin Templeton, Invesco, BlackRock, Fidelity, Ares Management, Brigade Capital, New York Life Investment Management, Oz Advisors and Oaktree Capital, according to a court filing.)
And when it comes to regulation, the Duke Law professor said that the job of bank regulators is to make sure that the banks remain solvent.
“It’s just very different from protecting investors,” de Fontenay said.
