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The Case for a Uniform Definition
of a Leveraged Loan

Zachary L. Pechter^*

Over the past twenty years, leveraged loans and high yield bonds have converged into similar instruments, sparking a debate as to whether leveraged loans should be regulated as securities like high yield bonds. This Note recognizes problems with the current regulatory framework for leveraged loans and shows that leveraged loans are not securities and should not be regulated as such. Instead of regulating leveraged loans as securities, which would likely be more costly than beneficial and contrary to the SEC’s mission statement, the SEC should promulgate a uniform definition of a leveraged loan. This solution would alleviate problems such as regulatory arbitrage and the opaqueness of the market while avoiding the costs associated with securities regulation. This Note concludes by offering a definition of a leveraged loan to provide a model for the SEC if it decides to adopt this solution.

Introduction

“The ‘leveraged loan’ time bomb just exploded.”¹ In the summer of 2015, business-focused media outlets began publishing articles about the risks posed by the largely unregulated market for leveraged loans­—syndicated loans to companies with high debt-to-equity ratios.² One example of a leveraged loan gone wrong is particularly salient. In 2014,

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JPMorgan syndicated a leveraged loan for Millennium Health.³ This process involves a highly leveraged company (in this case, Millennium) raising money on the debt market. A large financial institution, such as an investment bank, syndicates the loan by bringing together a group of institutional investors to finance the loan. Then, the syndicate of investors sells the loan on the debt markets, which, for leveraged loans, consists of banks, financial companies, and other institutional investors.⁴ At the time of Millennium’s leveraged loan, both Millennium and JPMorgan knew that Millennium was the subject of an ongoing federal investigation that placed the company at risk of serious financial repercussions.⁵ However, they decided this information was immaterial and did not pass it on to institutional buyers, such as Oppenheimer Funds, Fidelity Investments, and Franklin Resources.⁶ When Millennium agreed to settle the federal claims for $250 million, an amount Millennium could not pay, the value of its loan plummeted to forty-five cents on the dollar and eventually down to forty-one cents on the dollar.⁷ Some in the media predict that situations like this have the potential to affect retail investors, such as those with 401(k) or pension plans and those invested in mutual funds.⁸ This Note will examine whether the current regulatory system is sufficient to protect investors from a potential downturn in the leveraged loan market and whether any regulatory changes should be made.

The Securities and Exchange Commission (SEC) does not regulate most loans, leaving transactions like this largely unregulated.⁹ One potential reason the SEC generally does not regulate loans is that bad loans historically affect banks and institutional investors who can take care of themselves.¹⁰ Banks and institutional investors have political

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clout,¹¹ a high level of sophistication, teams of lawyers on the payroll, and seemingly unlimited resources. But those calling for the SEC to regulate leveraged loans worry that the development of a robust unregulated market for leveraged loans puts individual investors at risk.¹² After Oppenheimer Funds, Fidelity Investments, and Franklin Resources bought Millennium’s leveraged loan, they put parts of it into mutual funds owned by retail investors.¹³ Supporters of regulating leveraged loans argue that the bank and institutional investors have less incentive to monitor debtors like Millennium either before or during the term of the leveraged loan.¹⁴ This reduced incentive to monitor occurs because the banks are not keeping the debt on their books.¹⁵ Each investor in the original syndicate is selling its portion of the loan to investors on the debt market.¹⁶ Thus, if the value of the loan decreases or the debtor defaults on the loan, the initial syndicate of investors does not suffer financially (or does not suffer as much as those holding the loans).¹⁷ Without mandatory disclosures or proper monitoring, situations like that of Millennium are much more likely to occur and take the market by surprise.¹⁸ Now that the leveraged loan market is nearing $1 trillion,¹⁹ a spike in the default rate for leveraged loans could seriously harm investors.

The argument outlined above is flawed because secondary market purchasers have strong incentives to investigate and monitor the debtor. Leveraged loans are, by definition, risky investments and defaults will happen, but that risk is reflected in the price of the loan. However, arguments calling for the regulation of leveraged loans as securities lead to an interesting observation: The modern leveraged loan does not look like the prototypical loan of twenty years ago.²⁰ In fact, its characteristics and provisions are strikingly similar to those of a high-yield bond, which is

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regulated as a security.²¹ Bank loans are traditionally issued by a single bank, are secured, have low liquidity, involve intensive borrower monitoring, and carry tight covenants.²² On the other hand, traditional public bonds have dispersed investors, are unsecured, have high liquidity, have limited borrower monitoring, and carry loose covenants.²³ But modern leveraged loans and high-yield bonds both involve dispersed investors (mostly non-bank institutional investors), high liquidity, limited monitoring of the borrower, and an intermediate level of covenants.²⁴ Additionally, an increasing number of leveraged loans are unsecured and an increasing number of high-yield bonds are secured.²⁵ Loans and bonds were once distinct categories of debt, but they have converged over time in the form of leveraged loans and high-yield bonds.

Of course, differences still exist between leveraged loans and high-yield bonds. For example, leveraged loans are usually secured while high-yield bonds are usually unsecured; high-yield bonds are still generally more liquid than leveraged loans; and leveraged loans are sold almost exclusively to institutional investors, while high-yield bonds are often bought by smaller investors.²⁶ The question becomes whether the similarities between these two instruments justify the regulation of leveraged loans as securities. The SEC must also decide whether regulating leveraged loans as securities will serve the SEC’s three-prong mission to (1) “protect investors,” (2) “maintain fair, orderly, and efficient markets,” and (3) “facilitate capital formation.”²⁷

The SEC should not regulate leveraged loans as securities because the similarities between leveraged loans and high-yield bonds do not justify similar regulation, and such regulation would not advance the SEC’s mission. Despite the convergence of leveraged loans and high-yield bonds, their differences remain important. Additionally, regulating leveraged loans as securities would not advance any of the three prongs in the SEC’s mission. First, institutional investors in the leveraged loan market do not need the protection of securities regulations, and downstream retail investors are sufficiently protected by other regulations. Second, securities regulation would have little effect because most, if not all, leveraged loans would be exempt from registration requirements. Fi-

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nally, capital formation through leveraged loans is flourishing without securities regulations.

But the SEC should provide a uniform definition of a leveraged loan. The current framework for regulating leveraged loans is plagued by gaps and inconsistencies between regulations,²⁸ which creates problems that include regulators’ inability to track leveraged loans,²⁹ a lack of transparency in the market,³⁰ and the opportunity for regulatory arbitrage.³¹ A uniform definition of a leveraged loan would alleviate all three of these problems by coordinating the various market participants and regulators in determining when a loan is leveraged. This would create consistency in the reporting of these transactions, allow regulators to accurately track leveraged loans as they are traded on the market, and help remove the opportunity for regulatory arbitrage. In summary, this Note argues that the SEC should not regulate leveraged loans as securities, but should facilitate the current regulatory regime by providing a uniform definition of a leveraged loan.

Part II of this Note provides background on leveraged loans, high-yield bonds, and the markets for these two instruments. Part III describes the current framework under which leveraged loans are regulated. It will show the gaps and inconsistencies in the current regime. Part IV describes and analyzes the legal framework for regulating notes (such as those evidencing leveraged loans) as securities. It focuses on the foundational case of Reves v. Ernst & Young,³² which set forth the family resemblance test, and Banco Espanol de Credito v. Security Pacific National Bank³³ in which the Second Circuit ruled that the loan participations at issue were not securities. This Part of the Note will show the similarities between the modern leveraged loan and the loan participations at issue in Banco Espanol. Part V details why regulating leveraged loans as securities would not advance the SEC’s missions of “protect[ing] investors,” “maintain[ing] fair, orderly, and efficient markets,” and “facili-

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tate[ing] capital formation.”³⁴ Finally, Part VI concludes this Note and suggests a uniform definition for a leveraged loan.

II. Leveraged Loans vs. High-Yield Bonds

In the 1980s, loans and bonds were clearly distinct instruments. Most bank loans at the time involved a single bank lending money to a small or mid-sized company.³⁵ The bank would keep that loan on its books, spend considerable resources monitoring the company, and use tight covenants to ensure the company would be able to repay its debt.³⁶ There was no real secondary market for trading loans, so liquidity was almost non-existent.³⁷ Leveraged loans were becoming a popular method of financing leveraged buyouts,³⁸ but they were still distinct from bonds. Leveraged loans were secured by the target company’s assets, involved tight covenants and extensive monitoring, and were largely illiquid due to the lack of a secondary market for loans.³⁹

Bonds, on the other hand, are usually issued by large companies with established track records.⁴⁰ Retail investors buy corporate bonds despite the loose covenants and the fact that they are typically unsecured.⁴¹ Bonds are highly liquid instruments that trade on robust markets among all kinds of investors.⁴² In the 1980s, high-yield bonds (issued by companies with a higher risk of defaulting on their obligations), became a popular means of financing leveraged buyouts.⁴³ For a long time, bonds and

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loans remained on opposite sides of the spectrum of debt instruments; however, in the last fifteen years, high-yield bonds and leveraged loans have become more flexible and converged into very similar instruments.⁴⁴

The convergence of high-yield bonds and leveraged loans started in 1999 with the repeal of the Glass-Steagall Act.⁴⁵ Glass-Steagall prohibited commercial banks from engaging in investment banking activities, which include underwriting and securities trading;⁴⁶ its repeal created competition among commercial banks, investment banks, and financial services companies.⁴⁷ Consumers and businesses had more options for debt financing, which forced commercial banks into new lines of business to maintain profits in a more competitive environment.⁴⁸ Additionally, bank regulators encouraged portfolio diversification.⁴⁹ Banks could not originate a large enough number of loans to diversify their portfolios, so they needed a mechanism by which they could hold small portions of a large number of loans originated by other banks and financial institutions.⁵⁰

Loan syndication and the resulting creation of a secondary market for loans solved this problem. The loan syndication process involves a lead bank, called the arranger or the agent, which gathers a group of institutional investors to jointly originate a loan. The introduction of non-bank institutional investors into the loan originating business, coupled with regulatory encouragement to trade these loans, created a secondary market for leveraged loans. Banks and other investors diversified their portfolios by selling syndicated loans—in whole or in part—to other banks and investors. Thus, banks pivoted from an originate-and-hold model, in which they would fund, monitor, and hold the loan, to an originate-to-distribute model, in which they would find investors for the loan and administer the credit relationship.⁵¹ This change makes the loan

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market look more like the bond market: highly liquid, lightly monitored debt instruments that are held and traded by dispersed, predominantly non-bank investors.⁵²

High-yield bonds and leveraged loans have converged along four main dimensions: the demographics of their investors, the liquidity of their markets, the features of their contractual covenants, and prices of the instruments. Investors in the leveraged loan market are all institutional investors, including commercial banks, investment banks, insurance companies, mutual funds, and other financial services firms.⁵³ These institutional investors also make up the vast majority of the high-yield bond market. However, retail investors also play a role in the high-yield bond market, which cannot be said of the leveraged loan market.⁵⁴ This is an important distinction because the SEC focuses on protecting retail investors, not institutional investors. There is no need for the SEC to regulate leveraged loans as securities, at least in part, because institutional investors do not need the protection of federal securities laws.⁵⁵

Regulators like the SEC also consider the liquidity of an instrument when deciding whether and how to regulate.⁵⁶ The bond market, including high-yield bonds, is well known for being robust and highly liquid. But in recent years, the leveraged loan market has taken off as well. In fact, the S&P/LSTA Index reported the value of leveraged loans outstanding at $724 billion in April 2014;⁵⁷ Bloomberg reported that figure at $830 billion.⁵⁸ At this point, there is no reason to make a distinction between the two instruments based on their markets or other measures of liquidity. However, similar markets do not alone justify similar regulation.

The covenants used in leveraged loan and high-yield bond contracts have also started converging. Leveraged loans usually have maintenance covenants, meaning the debtor must meet certain criteria (e.g., leverage ratios or limits on interest coverage) regardless of any corporate action taken.⁵⁹ High-yield bonds, on the other hand, usually have incurrence-based covenants, meaning the debtor must meet the criteria in the covenant by taking certain corporate actions (e.g., mergers and acquisitions,

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incurring new debt, or paying a dividend).⁶⁰ Thus, corporate bonds are typically covenant-lite debt instruments relative to leveraged loans. Leveraged loans have recently begun trending toward looser covenants as well. Just over one-third of leveraged loans currently outstanding are now covenant-lite.⁶¹  Still, the vast majority of leveraged loans have tighter covenants than the prototypical high-yield bond. So even the modern iterations of these two instruments are generally structured differently when it comes to covenants.

Over the last five-to-ten years, market prices and yields have been very similar for high-yield bonds and leveraged loans. In fact, Sankaty Advisors published a primer on leveraged loans showing that yields on the two instruments have tracked one another almost exactly since 2007.⁶²  Hugh Thomas and Zhiqiang Wang found a similar phenomenon back in 2004, noting that the prices of leveraged loans and high-yield bonds move together.⁶³  However, the methodology of the pricing for these two instruments remains distinct. Leveraged loans pay a floating rate based on some benchmark (often LIBOR plus a certain number of basis points); high-yield bonds pay a fixed rate based on the bond’s coupon.⁶⁴  Despite the similarities between leveraged loans and high-yield bonds, their differences are important in determining whether the SEC should regulate leveraged loans similarly to high-yield bonds. The similarities do not justify similar regulation. Instead, we must look to the current regulatory framework for leveraged loans to determine whether a change is warranted.

III. The Regulatory Framework for Leveraged Loans

Loans have a piecemeal regulatory framework with gaps and inconsistencies between the various regulations. The multiplicity of regulators in the financial industry creates a system in which the form of the originating entity affects which regulations apply.⁶⁵  The list of federal financial industry regulators includes the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve

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System (the Fed), among others.⁶⁶  Initially, the OCC took the lead role regulating and publishing guidelines for leveraged lenders because large national banks, supervised by the OCC, play such a major role in the leveraged loan market.⁶⁷ The first of these guidelines, called the Shared National Credit Program, was issued in 1975.⁶⁸ This program largely stood alone until 1988. That year, in response to changing market conditions,⁶⁹ the OCC “flag[ged] [h]ighly [l]everaged [t]ransactions . . . for special regulatory attention.”⁷⁰ In 1989, the OCC published a study on various leveraged lending practices of national banks.⁷¹ In 1991, the OCC started “requir[ing] banks carrying leveraged loans to maintain a well-conceived and effective workout plan for the borrower.”⁷² Starting in 1999 with the Fed’s leveraged lending letter,⁷³ other agencies saw the need to regulate leveraged lending as well. Over the past fifteen years, the OCC, the Fed, and other regulators have periodically issued joint guidelines on leveraged lending practices. The most recent interagency guideline is the 2013 Interagency Leveraged Lending Guidance.⁷⁴ Despite these efforts, the multiplicity of regulatory frameworks overseeing the leveraged loan market continues to be problematic: leveraged lenders are free to engage in regulatory arbitrage,⁷⁵ regulators are unable to track the loans as they are traded on the secondary market,⁷⁶ and there is a lack of transparency in the leveraged loan market.⁷⁷

The lack of a uniform definition for a leveraged loan plays a central role in the lack of consistency in the regulation of leveraged loans. The 2013 Interagency Leveraged Lending Guidance suggests a definition, but many lenders and regulators do not abide by that suggestion.⁷⁸ Current-

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ly, each originator, regulator, and participant in the secondary market has its own definition of a leveraged loan.⁷⁹ Thus, one originator may consider a loan to be leveraged, while other members of the originating syndicate do not. This problem is compounded when one of the originators sells the loan to another entity, which may or may not characterize the loan as leveraged. Additionally, regulators are faced with the task of determining whether a loan is leveraged. Some regulators focus on the characteristics of the entities syndicating and trading the loans, but others focus on the characteristics of the loans.⁸⁰ This misalignment creates yet another scenario in which a loan may be regulated as leveraged when held by one entity, but not when held by another. The lack of consistency among both regulators and market participants creates a fertile environment for regulatory arbitrage. Leveraged loans have become very flexible instruments, so an originating syndicate can structure the loan to take advantage of its choice of regulatory frameworks.

Critics of the current regulatory framework point to the opaque world of shadow banking to illustrate the regulatory gaps occupied by many leveraged loans.⁸¹ A shadow bank is a financial institution that acts like a bank but is not supervised like a bank.⁸² Many of the institutional investors in the leveraged loan market are shadow banks and, as Sung Eun (Summer) Kim points out, “[a] leveraged loan is no longer supervised once it leaves the books of supervised banks . . . .”⁸³ However, the loan itself does not need continued supervision because the entities buying and selling the loan are supervised. The leveraged loan market consists entirely of institutional investors that are highly sophisticated and regulated entities.⁸⁴ They understand the risks inherent in leveraged loans and are able to demand sufficient disclosures to assess these risks before entering into a transaction. The main non-bank players—mutual funds, pension funds, and other financial services firms—are subject to

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the Investment Company Act of 1940⁸⁵ or the Investment Advisers Act of 1940.⁸⁶ These Acts provide a litany of protections for downstream investors, including mandatory registration and disclosures, fiduciary duties of the board of directors, and causes of action for fraud (in addition to common law fraud claims).⁸⁷ Regulating leveraged loans as securities might bring uniformity to the regulatory framework. However, it would burden the market with increased costs, and it would not provide any additional protection for investors.

Rather than regulating leveraged loans as securities, the SEC should promulgate a uniform definition of a leveraged loan. This would allow regulators to track leveraged loans as they are originated and traded on the markets, increase the transparency of the leveraged loan market, and allow various regulators to coordinate their efforts to eliminate opportunities for regulatory arbitrage.⁸⁸ Currently, the most widely used definition is not applied uniformly to all market participants, because it is merely a suggestion for those who want to use it.⁸⁹ It is also overly narrow for purposes of tracking these instruments on the secondary market and gathering information pertinent to regulators. According to the OCC’s handbook on leveraged lending, bank regulators define a shared national credit (also known as a syndicated loan) as “a loan of $20 million or more syndicated among three or more regulated institutions.”⁹⁰ This definition is sufficiently narrow to exclude some transactions that might otherwise be considered leveraged loans, for instance, small loans of less than $20 million dollars. But the most glaring hole exists where the original syndicate of investors includes only one or two regulated in-

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stitutions (i.e., banks). The introduction of non-bank institutions spurred the growth of the leveraged loan market, and these institutional investors continue to play an integral role in the market.⁹¹ Such exclusions allow the leveraged loan market to remain opaque and prevent regulators from effectively tracking these instruments as they are originated and traded on the markets.

The Test for Regulating Notes as Securities

A. The Family Resemblance Test

The SEC regulates a subset of notes as securities, but leveraged loans are not currently in that subset.⁹² In general, notes issued in an investment context are securities, while notes issued in a commercial or consumer context are not. Courts use the family resemblance test, as set out in the foundational case of Reves v. Ernst & Young,⁹³ to determine whether a note is a security. Under this test, courts begin with a rebuttable presumption that all notes are securities.⁹⁴ They then devise or use a list of notes that are obviously not securities. The list includes the following:

The court will compare the note at issue with the notes that are not securities to find a “family resemblance.” If there is a family resemblance, then the note at issue is not a security. If there is no family resemblance between the note at issue and any of the listed non-security notes, then the court must determine whether it should add a new instrument to the list of non-security notes.⁹⁷

When determining whether leveraged loans bear a family resemblance to any of the listed non-security notes, it is easy to eliminate some of the options. Leveraged loans often finance a leveraged buyout or general operations of businesses with a large amount of debt. Thus, they do not look like notes delivered in consumer financing or notes secured by a

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mortgage on a home. Leveraged loans do not look like character loans to bank customers either; they are syndicated by a group of lenders, including non-bank institutional investors with no prior relationship with the debtor. Leveraged loans do not involve the assignment of accounts receivable, so they do not look like notes secured by an assignment of accounts receivable. Finally, leveraged loans are not open-account instruments (such as revolving loan facilities⁹⁸), so they do not look like notes formalizing open-account debt incurred in the ordinary course of business. The two remaining categories of non-security notes require a more in-depth analysis.

Leveraged loans do not bear a family resemblance to short-term notes secured by a lien on a small business or some of its assets. First, leveraged loans are often long-term loans.⁹⁹ However, even leveraged loans with a relatively short term do not seem to bear a family resemblance to notes secured by a lien on a small business or some of its assets. Leveraged loans are more common among larger businesses than smaller ones. Syndications of large financial institutions would not be necessary to fund a small business’s current operations for a short time. This category of non-security notes does not encompass leveraged loans, which generally involve larger companies selling tens of millions or hundreds of millions of dollars in high-yield debt.¹⁰⁰ Thus, leveraged loans do not bear a family resemblance to short-term loans to small businesses.

Some leveraged loans may bear a family resemblance to loans by commercial banks for current operations. Many, but not all, leveraged loans are originated by commercial banks.¹⁰¹ Additionally, some leveraged loans are used to fund current operations while others are used to fund large transactions.¹⁰² A court would have to look at the specific details of a leveraged loan to find out whether a family resemblance exists. It is also unclear whether leveraged lending is a commercial banking activity or an investment banking activity. On the one hand, commercial banks are heavily involved in this market and leveraged lending started in the commercial banking sector.¹⁰³ On the other hand, the modern leveraged loan came into being because investment banks and other finan-

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cial institutions were able to enter the loan market.¹⁰⁴ Leveraged lending relies on the liquidity created by a robust secondary market.¹⁰⁵ This makes it seem more like an investment banking activity. A court deciding whether leveraged loans bear a family resemblance to commercial loans financing a business’s current operations would likely have to decide based on the specific transaction at issue.

In addition to comparing the characteristics of leveraged loans with the characteristics of the listed non-security instruments, a court would use four factors to clarify whether a note bears a strong resemblance to a non-security instrument: (1) the motivation of the buyer and seller, (2) “the plan of distribution,” (3) “the reasonable expectations of the investing public,” and (4) the presence of alternate regulatory regimes that may protect investors.¹⁰⁶

When analyzing the motivations of the buyer and seller, courts will examine the transaction to determine what “would prompt a reasonable seller and buyer to enter into it.”¹⁰⁷ This is an objective standard using the hypothetical reasonable person, not a subjective inquiry into the actual thoughts of the parties.¹⁰⁸

The motivations of the buyer and seller in a leveraged lending transaction are not uniform across the market. Thus, this factor could cut either way, depending on the details of the leveraged loan at issue. Some sellers (i.e., borrowers) might need a leveraged loan for the general use of a business enterprise,¹¹⁰ which would make the transaction seem more like a security. Other borrowers use the funds from a leveraged loan to finance a leveraged buyout,¹¹¹ which a court may or may not consider an investment for purposes of this analysis. Thus, the first factor in the Court’s analysis does not definitively weigh in favor of (or against) treating a leveraged loan as a security.

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When analyzing the plan of distribution for the note, courts will attempt “to determine whether [the note] is an instrument in which there is ‘common trading for speculation or investment.’ ”¹¹² A note that is held by the initial lender is less likely to be regulated as a security than a note that is sold and resold by unrelated parties on a secondary market.¹¹³ As noted above, leveraged loans are liquid instruments that are often sold in the secondary market after their origination.¹¹⁴ This factor weighs in favor of regulating leveraged loans as securities.

When analyzing the reasonable expectations of the investing public, courts will look to public opinion to inform their decision.¹¹⁵ “Court[s] . . . consider instruments to be ‘securities’ on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not ‘securities’ as used in that transaction.”¹¹⁶ In this case, the investing public includes only sophisticated institutional investors.¹¹⁷ These investors have been buying and selling leveraged loans for years with the knowledge that these instruments are not regulated as securities. This factor weighs against regulating leveraged loans as securities.

Lastly, when analyzing whether an alternate regulatory regime protects investors, courts determine whether regulating the note as a security would be redundant.¹¹⁸ “[T]he existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Act unnecessary.”¹¹⁹ The necessity prong of this analysis would likely carry substantial weight with a court. It mirrors the analysis from International Brotherhood of Teamsters v. Daniel,¹²⁰ in which the Court relied on language from both section 2(a)(1) of the Securities Act and section 3(a)(10) of the Exchange Act, stating that the definition for a security applies “unless the context otherwise requires.”¹²¹ In Daniel, the Court held that because the Employee Retirement Income Security Act of 1974 (ERISA) regulated the employment dispute at issue, context dictated that the Securities Act did not apply.¹²² In the case of a leveraged loan, context requires that the Securities Act does not apply,

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because the Investment Company Act was passed to “protect investors entrusting their savings to others for expert management and diversification of investments which would not be available to them as individuals.”¹²³ Banking is a highly regulated industry, and the Investment Company Act and Investment Advisers Act regulate other financial institutions participating in the leveraged loan market.¹²⁴ The current regulatory scheme sufficiently protects investors, rendering the potential regulation of leveraged loans under the Securities Act redundant. This factor weighs strongly against regulating leveraged loans as securities.

If the court does not find a strong family resemblance between a leveraged loan and a listed non-security instrument, the court must decide whether to add another category to the list of non-security notes.¹²⁵ The court will decide whether such an addition is necessary by examining the same four factors mentioned above.¹²⁶ However, the analysis will not take place within the framework of comparing the note at issue to any existing category of notes. The court will analyze the factors in the abstract to decide whether the factors, in the aggregate, point toward notes sold in an investment context or notes sold in a commercial or consumer context.¹²⁷ In the case of leveraged loans, a court might make such an addition. The analysis above demonstrates that notes evidencing leveraged loans are notes sold in a commercial context. Furthermore, regulating leveraged loans as securities would be redundant in light of the regulations already in place.¹²⁸ Lastly, a court might use the opinion in Banco Espanol de Credito v. Security Pacific National Bank¹²⁹ as precedential support for a decision to add an instrument to the list of non-security notes. Banco Espanol is a contentious but influential case in which the Second Circuit grappled with the question of whether certain loan participations—instruments similar to leveraged loans—were securities.¹³⁰

B. Banco Espanol de Credito v. Security Pacific National Bank

In Banco Espanol, the Second Circuit Court of Appeals ruled that the loan participations at issue were not securities under federal securities laws.¹³¹ Loan participation is “[t]he practice of selling loans [from banks] to other institutions.”¹³² In Banco Espanol, Security Pacific National

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Bank (Security Pacific) made a series of short-term loans to Integrated Resources, Inc. (Integrated) and then sold those loans, in whole or in part, to various other institutions.¹³³ Each purchaser of a loan participation signed a Master Participation Agreement (MPA), stating that the purchaser made its own credit analysis, acknowledging that Security Pacific was not responsible for Integrated’s repayment of its loans, and agreeing that the purchaser could not sell the loan participation without Security Pacific’s written consent.¹³⁴ Eventually, Integrated began defaulting on its loans and declared bankruptcy.¹³⁵ Investors who had purchased the loan participations filed a lawsuit, alleging that the loan participations were securities and that Integrated had violated federal securities laws by failing to disclose material information.¹³⁶

The Second Circuit applied the family resemblance test to determine whether the notes at issue­—the loan participations—were securities.¹³⁷ The court analyzed the motivations of the parties involved under the first factor of the test.¹³⁸ It found that:

In summary, the parties were motivated by “ ‘the promotion of commercial purposes’ rather than an investment in a business enterprise.”¹⁴⁰

Under the second factor of the test, the court focused on the distribution plan’s prohibition against resale of the loan participation without Security Pacific’s written consent.¹⁴¹ This provision “prevent[ed] the loan participations from being sold to the general public” and limited the market only to buyers with the ability “to acquire information about the debtor.”¹⁴² The court also noted that the resale prohibition ensured there would be no secondary market for the instruments.¹⁴³

Analyzing the third factor—the reasonable perceptions of the investing public—the court stated that all of the investors were sophisticated parties

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who signed MPAs and were given ample notice that the loan participations were not investments in a business enterprise.¹⁴⁴

Lastly, analyzing the fourth factor, the court noted that “the Office of the Comptroller of the Currency ha[d] issued specific policy guidelines addressing the sale of loan participations,”¹⁴⁵ making the application of federal securities laws unnecessary.¹⁴⁶

While the Second Circuit found that all four factors weighed against considering the loan participations securities, there is some debate as to whether the majority opinion correctly applied the family resemblance test.¹⁴⁷ This leaves some uncertainty about how a future court might apply this precedent to a case involving leveraged loans. Furthermore, the court specifically recognized that “even if an underlying instrument is not a security, the manner in which participations in that instrument are used, pooled, or marketed might establish that such participations are securities.”¹⁴⁸ This statement emphasizes that the family resemblance test requires each instrument to be analyzed on a case-by-case basis.

Applying Banco Espanol in the Context of Leveraged Loans

The Banco Espanol court analyzed the four factors in the family resemblance test but did not directly compare the loan participations with any of the instruments on the list of non-security notes.¹⁴⁹ Thus, it is possible to treat the loan participations at issue in that case as an addition to the list set out in Reves.¹⁵⁰

The Second Circuit defines loan participation as “[t]he practice of selling loans [from banks] to other institutions.”¹⁵¹ Leveraged loans are “loans made to companies with high levels of debt on their balance sheets.”¹⁵² At the time Banco Espanol was decided, leveraged loans, like most other loans, could not be considered securities.¹⁵³ In fact, many leveraged loans could properly be described as notes evidencing character loans to bank customers.¹⁵⁴ Even notes evidencing loan participations were drafted in such a way as to differentiate them from bonds—the prot-

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otypical debt securities.¹⁵⁵ The bank’s sale of the loans (in the form of loan participations) did not change the nature of the instrument. Each purchaser took on the role of the bank, understanding the credit risk of holding the loan participation with the hope of collecting interest payments.¹⁵⁶ Leveraged loans did not begin converging with high-yield bonds until a true secondary market developed in 1999, seven years after the Banco Español decision and eleven years after the issuance of the loan participations involved in that case.¹⁵⁷

Twenty-five years after Banco Espanol, leveraged loans look very different. Leveraged loans are sometimes referred to as syndicated loans because they are not originated by a single bank. Rather, a bank takes the role of lead arranger, finding a syndicate of investors (often institutional investors, such as pension funds, mutual funds, hedge funds, insurance companies, finance companies, and foreign institutions) to fund the leveraged loan.¹⁵⁸ These investors then originate the leveraged loan, often with the goal of selling it on the secondary market, which has become surprisingly robust.¹⁵⁹

Thus, leveraged loans no longer resemble prototypical loans. The question is whether leveraged loans bear a family resemblance to the loan participations at issue in Banco Espanol. The parties involved in the loan participation agreements were motivated by commercial objectives,¹⁶⁰ while the motivations of the parties in a leveraged lending transaction are not uniform across the market.¹⁶¹ As noted above, some borrowers use the funds from a leveraged loan for general use in the business and others use the funds for a specific transaction, like a leveraged buyout, which may or may not be considered an investment.¹⁶² The motivations of the lenders are not uniform either, as some hope to profit from trading leveraged loans on the secondary market while others prefer to hold the loans to collect a fixed stream of income.¹⁶³ This factor could cut either way, depending on the details of the leveraged loan at issue.

The distribution plan for the loan participations was a single sale to parties who understood the credit risk inherent in the transaction and who agreed not to resell the loan participations without the originator’s consent.¹⁶⁴ Leveraged loans, on the other hand, are highly liquid instru-

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ments with a robust secondary market;¹⁶⁵ there are generally no resale restrictions.¹⁶⁶ But all of the parties involved in the primary and secondary markets are sophisticated institutional investors who understand the risks involved in originating, buying, or selling leveraged loans.¹⁶⁷ Still, this factor probably does not point toward a family resemblance between the loan participations at issue in Banco Espanol and leveraged loans.

Regarding the reasonable perceptions of the investing public, investors in the loan participations were sophisticated parties who were on notice that the loan participations were not investments in a business enterprise.¹⁶⁸ Similarly, the investing public for a leveraged loan includes only sophisticated institutional investors¹⁶⁹ who are aware that leveraged loans are not considered to be or regulated as securities. This factor weighs in favor of finding a family resemblance between the loan participations and leveraged loans.

Analyzing the fourth factor of the family resemblance test—the presence of an alternative regulatory scheme protecting investors—the Second Circuit stated that “the Office of the Comptroller of the Currency ha[d] issued specific policy guidelines addressing the sale of loan participations,”¹⁷⁰ making the application of federal securities laws unnecessary.¹⁷¹ An even more extensive alternate regulatory scheme exists for leveraged loans. The OCC has issued policy guidelines for leveraged lending; the National Credit Program has been set up to track leveraged loans; several regulatory agencies have joined together to issue interagency guidelines on leveraged lending; and downstream investors are protected by banking regulations, the Investment Company Act, and the Investment Advisers Act.¹⁷² This factor weighs in favor of finding a family resemblance between the loan participations and leveraged loans.

While an analysis of the four factors of the family resemblance test do not uniformly point to a clear conclusion, a court might determine that a leveraged loan bears a family resemblance to the leveraged loans at issue in Banco Espanol. However, the totality of the analysis under both Reves and Banco Espanol more clearly demonstrates that leveraged loans should not be regulated as securities.

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The SEC’s Mission

Regulating leveraged loans as securities would not advance the SEC’s three-prong mission to protect investors; facilitate capital formation; and maintain fair, orderly, and efficient markets.¹⁷³ First, investors in the leveraged loan market are sufficiently protected by the current regulatory framework. In the SEC’s mission statement, the word “investors” likely refers to retail investors because banks and institutional investors can take care of themselves.¹⁷⁴ Banks and institutional investors are very sophisticated, and they have political clout, teams of lawyers on the payroll, and seemingly unlimited resources. If the SEC were to regulate leveraged loans as securities, it would likely do so to protect downstream retail investors who participate only indirectly in the leveraged loan market. But current regulations already exist to protect retail investors who invest through mutual funds, pension funds, and other financial services firms.¹⁷⁵ Those institutions are subject to the Investment Company Act or the Investment Advisers Act, which mandate registration and disclosures, impose fiduciary duties on the board of directors, and provide causes of action for fraud (in addition to common law fraud claims), among other protections.¹⁷⁶ Furthermore, if leveraged loans were regulated as securities, they would be issued as private placements, which are exempt from the registration requirements of the Securities Act. Securities issued in private placements are still subject to anti-fraud provisions, but anti-fraud protections are already available to retail investors through the Investment Company Act and the Investment Advisers Act.¹⁷⁷ Regulating leveraged loans as securities would be redundant and inefficient.

Regulating leveraged loans as securities would hamper, rather than facilitate, capital formation. Securities regulations impose costs on regulated entities that make it more expensive to raise capital.¹⁷⁸ Thus, regulations should not be imposed unless the benefits of regulation outweigh the costs. Elizabeth de Fontenay used leveraged loans and high-yield bonds as a case study to determine whether securities laws are effective.¹⁷⁹ She concluded that “[i]f leveraged loans, which continue to be treated as non-securities, can surpass high-yield bonds in depth and li-

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liquidity, mandatory disclosure is not the optimal mechanism for investment information that it purports to be.”¹⁸⁰ In the case of leveraged loans, imposing securities regulations would not provide significant benefits but would cause redundancies and inefficiencies, as noted above.¹⁸¹ Thus, the SEC should not regulate leveraged loans as securities because it would needlessly hamper capital formation.

Regulating leveraged loans as securities would not help maintain fair, orderly, and efficient markets either. The leveraged loan market would become less efficient with the imposition of costs associated with securities regulations. Furthermore, the investor protections and disclosures required by the securities regulations are already in place in the form of banking regulations, the Investment Company Act, and the Investment Advisers Act.¹⁸² Thus, regulating leveraged loans as securities would not advance any of the three prongs in the SEC’s mission statement. However, the SEC can improve the regulatory framework without treating leveraged loans like high-yield bonds. A uniform definition of a leveraged loan would alleviate some of the problems plaguing the market much more efficiently than securities regulations.

Promulgating a uniform definition of a leveraged loan would provide some transparency to the market and help lessen regulatory arbitrage.¹⁸³ It would provide the information regulators need to properly track leveraged loans as they are originated and then traded on the secondary market. This would increase transparency in the leveraged loan market by improving the accuracy and consistency of data regarding issuances of leveraged loans, trading data, market movements, and other useful information. Furthermore, agency guidelines on leveraged lending would become more meaningful and have more impact, because all parties involved in the leveraged loan markets (originators, buyers and sellers, downstream retail investors, and regulators) would know when the guidelines apply and when they do not. This would alleviate the issue of regulatory arbitrage, because a loan would be considered leveraged (or not) regardless of which regulator you ask or which entity currently holds the instrument.

In summary, regulating leveraged loans as securities would not advance any of the three prongs in the SEC’s mission statement. Instead, the SEC should provide a uniform definition of a leveraged loan because it is the most efficient and effective way to address some of the salient problems with the regulatory framework for the leveraged loan market.

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Conclusion

While arguments calling for the regulation of leveraged loans as securities are flawed, they give rise to increased scrutiny of the regulatory framework currently in place. Critics point to the framework’s weaknesses arising from the multiplicity of regulators. The market lacks transparency;¹⁸⁴ regulators are unable to track leveraged loans as they are traded on the market,¹⁸⁵ and institutional investors are able to take advantage of various regulators’ inconsistent categorizations of these instruments.¹⁸⁶ This Note proposes that, rather than regulating leveraged loans as securities, the SEC should facilitate consistency and transparency in the market by promulgating a uniform definition of a leveraged loan.

While the definition suggested in the OCC’s handbook is a good start, it is not uniformly applied, and it is overly narrow.¹⁸⁷ Instead, this author proposes that the SEC might use the following definition:

This definition does not share the shortcomings of the OCC’s suggested definition. First, it includes leveraged loans of all sizes, not just those of $20 million or more. Second, it encompasses loans originated by a combination of the various institutional investors involved in the leveraged lending market, not just banks. Third, it would be uniformly applied, not just suggested. This definition might not be a panacea for the leveraged loan market,¹⁸⁹ but it would bring much needed uniformity to leveraged lending regulators, decrease opportunities for regulatory arbitrage, and improve transparency in the leveraged loan market. For these reasons, the SEC should promulgate this definition of a leveraged loan and all leveraged lending regulators should adopt it.