JPMorgan wins court ruling that leveraged loans are not securities

By Bob Van Voris and Scott Carpenter

JPMorgan Chase & Co. won a federal appeals court ruling that a $1.8 billion leveraged loan at issue in a court case was not a security, a victory for the banking and private equity industries.
 

The decision Thursday by the Second Circuit US Court of Appeals in Manhattan came in a securities fraud lawsuit brought by a trustee for note purchasers in a 2014 syndicated loan deal led by JPMorgan. Soon after the notes began trading, the borrower, drug-testing company Millennium Health, ran into legal troubles and filed for bankruptcy the next year.

Loan notes are not currently considered securities, so a ruling against JPMorgan would have had sweeping ramifications for regulation of the leveraged loan market. If loans were securities, then borrowers would need to submit additional disclosures and produce more financial data, and any subsequent trades would need to be settled far more quickly than they currently are.

The court’s decision is welcome news for banks but also private equity firms, which often make use of leveraged loans in buyout deals. They might have become less attractive if the court ruled they had to comply with securities laws.

‘Great Relief’
 

The trustee, Marc Kirschner, declined to comment on the decision. JPMorgan didn’t immediately respond to a request for comment.

“It’s a great relief to the market because it avoids what would have been a huge disruption,” said Elliot Ganz, head of advocacy for the Loan Syndications and Trading Association, an industry group that had lobbied in favor of the banks.

Advocates for reclassifying leveraged loans have argued that regulating loans as securities would bring long overdue transparency to a notoriously opaque part of financial markets. Industry observers point out that loans were excluded from securities laws decades ago in large part because companies at the time typically only borrowed from a single bank, which held onto a loan for its entire term, as opposed to the syndication and trading typical in today’s market.

Without regulation under securities laws, “disclosure requirements are diluted and anti-fraud rules are difficult to enforce,” according to a January report by researchers at the advocacy group Americans for Financial Reform.

A lower court had previously dismissed Kirschner’s fraud claims on the grounds that the notes were not securities. The appeals court agreed, finding that purchasers of loan notes became lenders themselves. 

“The District Court did not erroneously dismiss plaintiff’s state-law securities claims because plaintiff failed to plausibly suggest that the notes are securities,” Circuit Judge Jose Cabranes wrote on behalf of the three-judge appellate panel.

Heavy Lobbying
 

The appeals court in March asked for the Securities and Exchange Commission to offer its opinion on whether the syndicated loan notes are securities under a 1990 Supreme Court decision. In July, the SEC declined to weigh in on the question.

The LSTA lobbied the SEC heavily over spring and early summer, holding over 10 meetings with SEC staff and three of its five commissioners. The SEC also met with both parties in the case and consulted with other federal agencies. Its decision not to submit a brief came as a surprise, and was widely seen as making it less likely that the court would overturn the status quo.

Kirschner claimed JPMorgan and the other banks withheld key information that would have tipped off investors about trouble at Millennium. The company in May 2015 announced it had reached a $246 million settlement with the Justice Department and other parties over billing fraud allegations.

The trustee represented the interests of 70 groups of investors, made up of about 400 mutual funds, hedge funds and other institutional investors.

In its decision, the appeals court found that the notes failed to meet three out of the four factors set by Supreme Court to determine whether an investment constitutes a security under US law: they were unavailable to the general public, the purchasers were sophisticated institutional investors and they were secured by collateral. 

The case is Kirschner v. JPMorgan Chase Bank, 21-2726, Second US Circuit Court of Appeals (Manhattan).