In a rebuff to the SEC and over a strongly worded dissent, a federal appeals court has held that participations in short-term bank loan notes are not "securities" subject to federal securities laws.
The decision in Banco Espanol de Credito v. Security Pacific National Bank is significant for lead banks, participants, and borrowers alike.
All other appellate courts that had addressed the issue had also concluded that bank loan participation instruments are not securities.
The case in the U.S. Court of Appeals for the Second Circuit, New York, however, was the first to consider the increasingly mechanized and standardized loan participation market that has emerged in recent years and expanded to include many nonbank participants.
SEC's Viewpoint
Indeed, the Securities and Exchange Commission argued in a friend-of-the-court brief that the short-term loan participation "notes" at issue more closely resembled commercial paper, already subject to the federal securities laws, than traditional bank loan participation instruments.
In its brief, filed at the appeals court's request, the SEC said that the lead bank had:
* Advertised its loan participation instruments as competitive with commercial paper.
* Promoted sales with "language used in securities markets."
* Conducted its loan participation program from a trading operations room, rather than from its commercial loan department.
The SEC also noted that loan participants included not only commercial banks but also non-banking institutions. Even commercial banks that participated generally acted through their investing and trading, rather than their lending, departments.
Further, the SEC said, the lead bank had not provided the participants with nonpublic information it had on the borrowers in the underlying loans. Instead the bank furnished the borrowers' with Standard & Poor's and Moody's ratings, among other things.
The appeals court majority applied the four-factor test set forth by the U.S. Supreme Court in Reves v. Ernst & Young and concluded that the participation instruments under consideration bore a strong "family resemblance" to loans issued by banks for commercial purposes. Such loans are not securities.
The court found:
* That "the overall motivation" of the lead bank, the participants, and the borrower was "the promotion of commercial purposes rather than an investment in a business enterprise."
* That sale of participation interests was limited "to sophisticated financial or commercial institutions and not to the general public."
* That the participants "were given ample notice that the instruments were participations in loans and not investments in a business enterprise."
* That application of the federal securities laws was unnecessary in light of existing loan-participation guidelines promulgated by the Office of the Comptroller of the Currency, set forth in its circular 181 (Aug. 2, 1984).
The appeals court's holding precludes, for now, the SEC's attempted venture into an important and expanding commercial credit market that has operated efficiently under federal and state banking laws and regulations.
A Crucial Issue
U.S. Judge Milton Pollack, in the district court decision affirmed by the second circuit, observed that application of the federal securities laws to the loan-participation market "would all but put an end to the flexibility of everyday commercials loans conceived and intended for working capital purposes of business."
Yet the appellate decision does not necessarily preclude future application of the securities laws to loan participations.
The Supreme Court may choose to review the decision, particularly in light of the pointed dissent by Chief Judge Oakes - who wrote that "the majority opinion misreads the facts, makes bad banking law and bad securities law, and stands on its head the law of this circuit and of the Supreme Court in Reves v. Ernst & Young."
The SEC may also actively encourage Supreme Court review, as well as new litigation in other federal courts not bound by Second Circuit precedent.
Moreover, ongoing pressure for federal securities regulation can be expected as the loan-participation market continues to expand beyond commercial banks and becomes increasingly standardized.
This is particularly so because nonbank participants may decline receipt of nonpublic information concerning a borrower's creditworthiness - and thereby forgo the type of independent credit assessment normally undertaken by a lending bank - to avoid "insider" status with respect to any borrower.
It thus remains important for lead banks to consider inclusion in loan participation agreements of terms and acknowledgments most likely to insulate a lead bank, in the event the securities laws do apply, from liability for alleged misrepresentations and omissions.
Such terms might include, for example, acknowledgement that the loan participant has made its own assessment of the creditworthiness of the borrower and a declaration by the participant that it has made its own decision not to review possibly material information in the lead bank's possession.
At the same time, loan participation programs should be regularly monitored to determine whether sales practices, promotional materials, exchange of confidential information, or the character of the participants is changing in a manner that may trigger securities laws.
