As private credit funds become more important lenders to big and small corporations and banks edge into the originate-to-distribute model in syndicated lending, making it easier to transfer loans looks like an obvious benefit to all concerned – including borrowers.
But this needs to be done carefully.
The more that participants in the loan market embrace trading platforms, shorter settlement times and greater interoperability between agent banks’ databases and the order execution management systems of private credit funds on the buy side, the darker the shadow from an old controversy hangs over the market.
Should loans not be reclassified as securities?
After all, the loan market seems to be adopting much of the infrastructure and language of that market.
Octaura began as a joint investigation by Bank of America and Citi into simplifying the trade life cycle for loans and enabling investors and dealers to execute trading strategies more efficiently than in a prevailing market dependent on manual processing.
Morgan Stanley, Goldman Sachs, JPMorgan, Credit Suisse and Wells Fargo also invested, as well as Moody’s Analytics. Octaura launched its trading platform in April 2023.
Earlier this month, it integrated list and request-for-quote (RFQ) protocols onto this.
Buy-side loan traders can initiate an RFQ by simultaneously submitting price requests to multiple dealers to transact in a loan.
They receive back live executable bid and offer prices and transact at the best level with the dealer of their choice. Once a single-line item or list is loaded to the platform, investors can view the depth and bid/offer stack and understand which dealers are already indicating their interest to trade.
Dealers benefit from an increase in trade flow with their indications of interest to trade – or ‘axes’ in industry jargon – highlighted to the buy side
“Octaura continues to be a growing component in our loan trading workflow,” stated Tim Maloney, head of loan portfolio trading at Citi, when Octaura announced this new development.
“We are very impressed by what Octaura’s RFQ feature brings to the loan market,” added Jimmy Rong, credit trader at TCW. “The ease of use, improved execution and processing certainly has made day-to-day workflows more efficient, with the added benefit of improved pricing.”
The platform now has 78 buy-side firms and 10 dealers on board.
The language – axes, RFQs, pre-trade analytics, bid-off spreads – is exactly the same as that surrounding electronic bond trading.
And you can now add Cusips (Committee on Uniform Securities Identification Procedures numbers) to that.
Back in August, Cusip Global Services (CGS), the global leader in securities identification, announced the launch of a unique entity identifier created specifically for the syndicated corporate loan market.
The Cusip Entity Identifier (CEI), a unique 10-character code assigned to each legal entity holding corporate loans, was developed in collaboration with the Loan Syndications and Trading Association and Versana.
Cusips are relied upon globally to capture the attributes of debt and equity offerings, and are used to identify and track financial instruments, linking them to the underlying issuing or borrowing entity.
The new CEI for corporate loan holders introduces an entity-level ID that will follow each legal entity participating in the syndicated loan and private credit markets.
Lee Shaiman, executive director of the LSTA, stated in August: “To move the industry forward, we really needed to develop trusted, reliable reference data standards that can be used to take the guesswork out of key administrative and risk-management functions.”
But if loans look like securities, if they sound like securities and trade like securities, shouldn’t they be regulated like securities?
Troubling questions
If they were, that would raise a lot of troubling questions for the leading bank arrangers of large syndicated loans, for other lenders and for borrowers.
Would borrowers have to register a coming syndicated loan ahead of time, and disclose the same kind of information on their underlying financials that the lead banks have access to, to the broader loan market?
Would loan arrangers and borrowers be subject to legal challenge if they omitted from offering circulars on a syndicated loan any key information that might be reasonably expected to impact their credit fundamentals and so, potentially, the future traded price of a loan?
Might loan arrangers with access to privileged non-public information on a borrower be forbidden from trading in its loans? Could there be one rule on this for a bank trading a loan on its own account as principal, but another if it was facilitating customer business for a smaller bank or a non-bank lender?
Would loan traders need to register as broker-dealers with the Securities and Exchange Commission? Would private credit funds have to as well?
While agent banks, lenders and even borrowers may all relish a modern, digital trading infrastructure that promises new efficiency and hopefully greater liquidity and depth to the secondary loan market, none of them want to wrestle with any those questions.
The Kirschner case
They may never have to, or at least not for some time yet.
You don’t have to travel far in the syndicated loan market to find someone with a strong opinion on the Kirschner case, although you could search for ever for someone willing to discuss it on the record.
In April 2014, a laboratory services company called Millennium Health completed a leveraged dividend recapitalization and refinancing, funded mostly from a $1.775 billion term loan. This was marketed to institutional investors even while a government investigation and civil lawsuit were pending against the company.
When both went against Millennium, it filed for bankruptcy in 2015.
As part of the Chapter 11 proceedings, Marc Kirschner, trustee of the Millennium Lenders Claim Trust, alleged that the loan arrangers had failed to provide creditors with adequate information, particularly on the investigation into the company by the Department of Justice – which eventually required it to pay a substantial settlement – and that they had a duty to do so because the term loans were essentially securities.
Kirschner v. JP Morgan Chase Bank N.A., et al became the key test case for the future of an entire asset class.
In May 2020, the US Court for the Southern District of New York ruled that the term loans were not securities and dismissed the case.
But the plaintiffs appealed. And the lead arrangers of bank loans fretted.
Then on August 24, 2023, came good news for them. The three-judge panel on the US Court of Appeals for the Second Circuit unanimously upheld the district court’s earlier decision.
The LSTA trumpeted: “The loan market wins big in Kirschner case” and described this as “a great – and critical – result for the leveraged loan market.”
The market convention that syndicated loans are not securities still holds.
Loan arrangers had worried that the SEC might weigh in and argue to the court that they were. As the plaintiffs pointed out, the loan documentation had at various points described buyers as “investors”.
As the plaintiffs pointed out, the loan documentation had at various points described buyers as 'investors'
The court considered four factors first laid out by the US Supreme Court in 1990 in deciding on whether loans had a family resemblance to securities.
On the first of these, the court agreed with the plaintiffs that the motivation of buyers was to profit from purchasing loans that would deliver a valuable return. That is just like investing in securities.
But on the next three tests it leant in favour of the banks. The loans were not broadly distributed in the primary market to the general public, being sold instead to a limited universe of large buyers and with restrictions on later transferability, with no allowance for distribution to individuals, while assignment to other institutions required the consent of agent banks.
Minimum assignments set at $1 million restricted buyers to experienced credit investors capable of conducting their own due diligence.
And those investors benefited from other protections, including security against the borrower’s assets as well as the fact that all leading bank regulators, including the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, have issued policy guidelines for syndicated loans.
The SEC had requested extensions to the court to give it time to consider submitting an amicus brief, presumably to push for jurisdiction over the loan market. But in the end, it did not do so.
Perhaps the SEC did not want to open a fight on yet another front, or it reasoned that the disruption from reclassifying loans as securities would, even if it could make the case, be too disruptive to an important financing market.
Lawyers advising the banks have since advised them to continue with limited primary distribution, the requirement for agent banks to consent to assignments and for those to be limited to large minimum sizes.
Latham & Watkins, in a client note, also emphasized the importance of language.
It urged banks to use 'borrower,' 'lender', and 'loan' throughout credit documentation, and avoid the terms 'issuer', 'investor', or 'notes' when referring to the instrument and the parties to a financing transaction.
It offered no opinion on the advisability of talking about loan trading, dealers’ axes, bid-offer spreads, or Cusips.
This one may not be over. More defaults are coming. And losers will look for potential recompense wherever they can.
