Borrowers, agent banks, syndicate members and secondary market purchasers incur, syndicate, sell and buy bank debt on the assumption that bank debt is not a “security.” However, a June 30, 2016, opinion in the General Motors preference litigation1 shows that such an assumption may no longer be valid, at least under the Bankruptcy Code. Whether the implications of the decision will penetrate the realm of the securities laws remains to be seen.
GM’s term lenders had received $28 million in cash interest during the 90 days prior to GM’s filing, and $1.5 billion in full payment during the bankruptcy, subject to disgorgement if the term lenders proved to be undersecured. As it happened, the agent for the term lenders had mistakenly released all personal property, other than fixtures, from the term loan’s security interest under the Uniform Commercial Code. The Unsecured Creditors Committee sued to recover the payments as preferences.2
The interest recipients moved to dismiss under Section 546(e) of the Bankruptcy Code, arguing that the interest was either:
- a “settlement payment, as defined in section 101 or 741 of [the Bankruptcy Code], made by or to (or for the benefit of) a . . . financial institution [or] financial participant” or
- a “transfer made by or to (or for the benefit of) a financial institution [or] financial participant . . . in connection with a securities contract, as defined in section 741(7) [of the Bankruptcy Code].
U.S. Bankruptcy Judge Martin Glenn denied the motion. He held that the payment of interest did not involve the extinguishment of a security and thus was not a “settlement payment,” but he reasoned that payment of interest may qualify as a “transfer . . . in connection with a securities contract”:
The Term Loan Investor Defendants contend that the tradeable interest in the Term Loan is akin to a publicly traded note or bond issued by a public company . . . The Term Loan Investor Defendants argue that the Term Loan and accompanying note were registered and assigned a CUSIP number . . . . Further, they argue that the interest in the Term Loan and accompanying note were widely traded and held by hundreds of different investors (i.e., part of a market). However . . . the current record provides no factual basis to support the defendants’ argument. It is premature for the Court to make a determination on this issue at this time.
The 546(e) defense is actually not important to most interest payments. Interest paid on its scheduled date is a transfer “in the ordinary course” and thus not a voidable preference under Section 547(c)(2)3 – a defense Judge Glenn noted could be raised at a later time. Section 546(e) is important only to defend interest paid out of the ordinary course – i.e., late, or during a grace period.
Of much greater interest, however, are the implications of Judge Glenn’s dicta on the status of bank debt as a security.
The legal basis for the assumption that bank debt is not a security is the Supreme Court case, Reves v. Ernst & Young, 494 U.S. 56 (1990), and its limited (in this context) progeny, particularly Banco Espanol de Credito v. Security Pacific Nat. Bank, 973 F.2d 51 (2d Cir. 1992). Reves excluded notes from the definition of “security” based on four factors:
First, we examine . . . motivations . . . . If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” Second, we examine the plan of distribution of the instrument to determine whether it is an instrument in which there is common trading for speculation or investment. Third, we examine the reasonable expectations of the investing public: The Court will 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 [citing as an example of a “security” 100% of the stock of a business sold to a single buyer]. Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary [citing bank certificates of deposit as notes regulated under banking laws]. (emphasis added).
Banco Espanol held that Security Pacific’s sales of participations in short-term loans were not sales of “securities” because Security Pacific’s motivation was diversification of risk, its plan of distribution was limited by the requirement of its consent for future transfers, the expectations of the buyers were that these loans were not securities and the Comptroller of the Currency’s regulations relating to the sale of participations provided a substitute regulatory scheme.
The arguments of the GM Term Loan Defendants, however, and Judge Glenn’s dicta, show that the world has changed since Reves and Banco Espanol. Today, bank loans are “distributed” and “trade” like, or almost like, securities. Bank loans are – or can be, in the words of the GM Term Loan Defendants – “widely traded and held by hundreds of different investors (i.e., part of a market).” Although not cited by the defendants, the governing law of New York provides that bank loans trade based on oral commitments to buy or sell, N.Y. General Obligations Law § 5-701b(2)(i), just like securities, U.C.C. § 8-113. Bank loans are often rated by Moody’s, Standard & Poor’s or Fitch – and some bank loan agreements (although not the GM Term Loan Agreement) require the borrower to obtain a rating.
Some distinctions remain. Banco Espanol held that participations were not securities, in part because they could not be transferred without the consent of the issuer. The same is true of the GM term loan – which could be transferred only with the agent’s consent (and prior to an event of default, GM’s consent).
In addition, publicly traded securities clear through the Depository Trust Co. (DTC). Bank loans clear through an administrative agent. This remains the case even when the bank loans have a CUSIP number. The Term Loan Defendants implied otherwise – they made much of the fact that the GM term loan had its own CUSIP – but in fact a bank-loan CUSIP is nothing more than an identifier. GM made payments to the holder of the term loan through its agent, not through DTC.
This latter distinction may be material in connection with Section 546(e), which was enacted primarily to protect DTC and its participants from liability arising from their receipt, and pass-through to beneficial holders, of payments later deemed to be preferences or constructively fraudulent transfers. Asserting a Section 546(e) defense may, in the end, be dangerous for the market as a whole and for the defendants who assert it – because the bank loan market does not and probably cannot operate if bank loans are securities.4
If bank loans are securities for general securities law purposes, then a borrower could not “issue” bank loans except through a public offering, a Rule 144A offering or other private placement. Bank loans are syndicated without any of the documentation or approvals required for securities issuance. Worse, the agent bank routinely knows more about the borrower, under its confidentiality agreement, than the syndicate members to whom it sells the loan. Selling syndicate members have access to confidential data rooms and therefore may know more than outside buyers do. Thus if a bank loan is a security, every syndicating agent and every selling member of the syndicate courts liability under Section 10(b) and Rule 10b-5.5 Standard loan transfer agreements do contain disclaimers to eliminate such liability, but it is not clear whether such disclaimers will work where one party has truly material nonpublic information.
Even if the Bankruptcy Court ultimately concludes that the GM term loan was a securities contract under Section 546(e), and the decision is upheld on appeal, the determination would not necessarily carry over to the registration and insider trading provisions of the securities laws. Different regimes may accommodate different definitions of a “security.” For example, commercial loans are routinely treated as a security under the Investment Company Act, even though the definitions of a “security” under the Investment Company Act and the Securities Act are substantially the same.6 Nonetheless, the Bankruptcy Court’s decision on Section 546(e) deserves to be placed on the watchlist, because of its potentially far-reaching implications.