Why the SEC Blew Off the Leveraged Loan Debate

Amid lobbying by banks and their regulators, the SEC declined to weigh in on whether these loans are securities.


Illustration by II

In a surprise move Tuesday, the Securities and Exchange Commission declined to say whether leveraged loans are securities — to the relief of bankers and, just as importantly, their regulators.

The SEC had been expected to file an amicus brief on the subject in the Second Circuit Court of Appeals in a case that had institutional investors pitted against JPMorgan and Citi, which had led a $1.8 billion leveraged loan for Millennium Laboratories in 2014. The company went bankrupt soon after Millennium reached a $256 million settlement with the SEC over fraudulent practices — and investors had no legal recourse.

If such loans were deemed to be securities, however, the banks could be liable for failure to disclose material facts — a prospect that bankers claimed would present an “existential” threat to the $1.4 trillion leveraged loan industry, especially at time when defaults are rising.

The appeals court asked the SEC to weigh in on the matter in March. As Institutional Investor previously reported, the SEC was then hit with a barrage of lobbying from JPMorgan, Citi, and the Loan Syndications and Trading Association, which claimed that changing the designation of these loans to securities would have “massive implications.” The SEC had asked for three extensions to file its brief, which market sources said was an indication the regulator was grappling with complaints about the thorny issue. The last extension was for one week — from July 11 to July 18 — which left some observers wondering what happened during that period. According to an individual familiar with the matter, the SEC had prepared a brief, but decided against filing it at the last minute.

On July 18, SEC General Counsel Megan Barbero wrote a terse letter to the court, stating that “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.”

Why did it take the SEC so long to do nothing? It wasn’t just the banks and their trade association that were engaging with the SEC. Bank regulators were also involved, according to the LSTA, which said it also met with the Treasury to voice its concerns.

One of the reasons the SEC took so long “is because the SEC is required to engage in this process with the other agencies,” said Elliot Ganz, head of advocacy and co-head of policy for the LSTA. “They’re not bound by what the banking agencies say. But I think they need to take what the banking agencies say seriously.”

In fact, JPMorgan’s attorney — Sullivan & Cromwell partner Jeffrey Wall, a former acting solicitor general under President Trump — had specifically asked the appeals court to request amicus briefs from the banking regulators (the Office of the Comptroller of the Currency, Treasury Department, Federal Deposit Insurance Corporation, and Federal Reserve). This indicates that JPMorgan believed those regulators agreed with its position that leveraged loans aren’t securities.

Although the court did not make that request, banking regulators did press their concerns to the SEC, Ganz said.

Those regulators would not be inclined to want to treat leveraged loans as securities, according to Duke University School of Law professor Elisabeth de Fontenay.

Bank regulators are worried about the health of the banks, not about investors in these loans, she said. In fact, as II previously explained, that’s the main reason why leveraged loans aren’t held on the banks’ own balance sheets. Now, rising interest rates are expected lead to more defaults on these risky loans, and forcing the banks to be liable for failing to properly disclose those risks would be costly to the banking system, de Fontenay explained.

“I’m sure that the bank regulators are worried that it would essentially be kicking the banks when they’re down if we have all these defaults and then people start suing on these defaults — suing the lead arrangers,” de Fontenay said.

Meanwhile, the SEC “desperately” did not “want to go on record either as saying that these things are securities, or as saying that these things are not securities,” she said. “The court put them in a really, really problematic position.”

Still, de Fontenay believes that “the correct interpretation of the law is that these things are securities. The market, as it exists today, is not in any way, shape, or form comparable to the original commercial loans.”

The LSTA, meanwhile, applauded the SEC’s move. “We appreciate that the SEC recognized the complexity of the matter and has decided not to weigh in and instead allow a private litigation to proceed in its normal course.”

JPMorgan and Citi declined to comment.