Wall Street’s private equity firms won a reprieve from a regulatory threat that could have upended a debt market they rely on to bankroll billion-dollar buyouts.
The issue, being weighed by a U.S. appeals court, centers on whether leveraged loans should be considered securities. If so, that small shift would have major implications: It would bring along the regulations that come with bond sales, reshaping a market that’s grown alongside the private equity industry.
The Securities and Exchange Commission had been asked by the court for its views and requested three separate extensions over four months, fueling speculation that it would seek to use the venue to expand the reach of U.S. regulations. Then, on Tuesday, the SEC surprised those following the case by opting instead not to get involved.
The regulator’s decision increases the odds that the court will rely on previous rulings and maintain the status quo, lawyers said. That would be welcomed by banks and private equity firms, given that it would spare the loan market from a wave of new investor-protection measures that could make it more cumbersome — or costly — to raise cash.
“The entire private equity industry just breathed a huge sigh of relief,” said Carlo DeHart, a lawyer at Troutman Pepper. He said he expects the development will help maintain the status quo, even though it’s unclear what the court will ultimately decide.
The case involves a $1.8 billion loan that soured soon after it was sold in 2014. A trustee for investors in the debt, Marc Kirschner, said the Wall Street firms that offered it, including JPMorgan Chase & Co., withheld key information that would have tipped off investors about trouble at the company.
The case has drawn heavy attention from the finance industry. The LSTA, a trade group for banks involved in syndicated loans, met over 10 times altogether with the SEC, including three of the five commissioners, to discuss the issues it raises, according to Elliot Ganz, the group’s head of advocacy. It also met with staff for the remaining two commissioners, including Chair Gary Gensler’s.
LSTA has argued that reclassifying loans as securities would upend long-held expectations, posing new risks to still-brittle credit markets.
J. Paul Forrester, senior counsel at Mayer Brown, said that classifying loans as securities would force the market to comply with registration, prospectus-delivery, disclosure and settlement-timing regulations that it’s currently not set up for.
“It’s the primary source of capital” for private equity, said Forrester. “If they want to do deals, they have to have the market functioning.”
“The risk is existential,” he said.
The loan market has just recently started to recover from the toll of last year’s turmoil, when the steep jump in interest rates hammered debt of all types and put sales of some buyout-related deals on hold.
Advocates for reclassifying leveraged loans argue that more regulation would bring long overdue transparency to a notoriously opaque part of financial markets. Without securities laws, “disclosure requirements are diluted and anti-fraud rules are difficult to enforce,” according to a January report by the advocacy group Americans for Financial Reform.
Elisabeth de Fontenay, a law professor at Duke University, said there’s a strong argument, given legal precedent, that leveraged loans should be considered securities. On the other hand, she said the SEC was likely concerned that embracing such a view would disrupt credit markets still steadying from last year’s upheaval.
At the same time, she’s doubtful that any change would have a major impact on the way the private equity industry funds itself. “It would increase transaction costs and slow down timing but I don’t think ultimately it would have a material impact on the amount of leverage” in large private equity buyout deals, she said.
The prospect of leveraged loans becoming securities also raises questions about what could happen to the $1.3 trillion market for collateralized loan obligations. Regulating loans as securities would likely require parts of hundreds of contracts known indentures, which govern the terms of CLOs, to be rewritten, and could lead to reduced issuance of CLOs, legal experts have said. CLOs are financial vehicles formed in many cases specifically to purchase leveraged loans, and in recent years around two-thirds of all loans have been purchased by CLOs.
The SEC’s decision not to intercede in the JPMorgan case was also welcomed in some corners of Washington. U.S. Senator Bill Hagerty, the Tennessee Republican who is the ranking member on an appropriations subcommittee that oversees financial services, told the SEC’s Gensler at a hearing Wednesday that he was glad the SEC refrained from involvement in the case.
“This is a well-functioning market, it’s got sophisticated market participants,” he said. “I was glad to see the commission resist adding any uncertainty into such an important part of the credit markets.”
Gensler declined to comment when asked about the SEC’s decision after the hearing.
