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The second circuit could disrupt the markets for syndicated loans and CLOs

By on September 13, 2022 0

The United States Court of Appeals for the Second Circuit is set to make a decision that will impact the functioning of the syndicated loan and secured loan markets.

Loan market participants take one of two positions when assessing the fanfare surrounding a case like the Second Circuit. Some are watching the matter closely and openly foreseeing the catastrophic effects that a contrary position would have on the markets. Others are tossing it dangerously as another fruitless exercise, arguing that a court wouldn’t jeopardize the markets by ruling that a syndicated bank loan is collateral.

We have seen courts overturn well-established precedents – and we should not take precedents for granted.

The appeals court is reviewing a ruling by the Southern District of New York that a syndicated loan was not collateral, which was a significant win for the industry. Changing this fundamental understanding would disrupt 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 buy a stake in a diversified portfolio of loans.

Marc S. Kirschner, a bankruptcy trustee representing a bankruptcy, filed suit in the Southern District of New York against JP Morgan and others. Kirschner argued that the notes evidencing certain syndicated term loans constituted collateral and therefore the defendants violated securities laws.

Four-part test

The District Court, in finding that the loans were not collateral, applied a four-part test from Reves v. Ernst & Young. The Supreme Court of the United States in dreams stated that since the Securities Acts define a note as a security, the presumption should be that all notes are securities.

This presumption can be rebutted by the “family resemblance test”. Under this test, “a note is presumed to be a security unless it bears a close resemblance” to a “judicially established list of classes of instruments that are not securities” such as a “mortgage-backed security” or “Securities attesting to loans by commercial banks for current operations.

The test includes the motivations of the buyer and the seller, the distribution plan for the instrument, the reasonable expectations of the investing public, and the existence of an alternative regulatory regime that reduces the risk of the instrument and makes the unnecessary Securities Act enforcement. .

The test grapples with every relevant fact to see if the public could be harmed if the note in question were not protected by securities laws. The district court found that the test ultimately weighed in favor of the notes certifying that the syndicated term loans did not constitute security.

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

What’s the worst that can happen?

The Loan Syndication and Trading Association, a preeminent voice and leader in the loan business, 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 listed the deleterious effects that a contrary decision would have on the credit and CLO markets.

First, compliance costs would skyrocket if syndicated term loans were subject to securities laws. Participants in the loan market should comply with securities laws and all loans should go through a registered broker. A borrower should register the syndicated term loan under securities laws unless an applicable exemption can be found.

Imposing such rules would complicate lending operations and impose additional costs on market participants. Arguably, subjecting these loans to title registration would disrupt the origination and sale of the loans in the secondary market.

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

We can only hope that the Second Circuit puts an end to any further discussion or disagreement regarding the status of syndicated bank loans. This will provide permanent certainty to the markets and put an end to those who dubiously advocate a review of the long-standing determination that syndicated loans are not securities.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., 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 receivables and receivables trading practice. She works with hedge funds, investment banks and asset managers on multinational trade receivables transactions and distressed investments. She is an active member of the LSTA.