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Banks and others involved in buying and selling loans have won some battles and lost others relating to Dodd-Frank implementing rules. The next fight is over how tough to treat the cash-loan market.
November 21
Banks and loan investors got some rare good news from Washington this month.
The Securities and Exchange Commission and the Commodity Futures Trading Commission have decided not to define loan participation agreements as swaps. That sounds technical, but calling them swaps could have forced buyers to worry more about how much they know about borrowers — and crippled cash trading in loans in the process.
The decision is "an important and clear win" for the loan market, Bram Smith, the executive director of the Loan Syndication and Trading Association, wrote in a letter to members last week.
Regulators took the action in broader derivatives rules prompted by the Dodd-Frank Act.
Loan participations account for an estimated 10% of cash loan trading in the U.S. and a far higher percentage in Europe.
In this kind of transaction, the original lender sells the rights and risks associated with a loan, but remains the lender of record. Any interest paid by the borrower comes to the new investor through the original lender, which acts as an intermediary. (Likewise, in the case of a revolving line of credit, any additional funds the borrower seeks are paid by the new investor via the original lender.)
Loans change hands this way because loan documents often give borrowers the explicit right to consent to, or disallow, the transfer of the loan from one investor to another. When a borrower does not want the loan transferred, perhaps because it prefers to deal with a bank than with an institutional investor, loan participations offer buyers and sellers another way to do business.
Though loan participations have never been treated as derivatives, they had many of the characteristics of swaps as defined in proposed rules. The LSTA and its European counterpart, the Loan Market Association, lobbied regulators since January 2011 to have loan participations specifically excluded from the definition of swap.
The final rules, which defined a "swap" and a "security-based swap" for the purposes of Title VII of Dodd-Frank, make it absolutely clear that what are known as "loan participation agreements" are not subject to the regulation.
The exclusion is important because if loan participations were classified as swaps, they would have been considered securities rather than contracts — and an important convention that the loan market has adopted to facilitate trading
The issue stems from the reality that lenders typically have access to information, such as sales projections, that is not public.
Other investors in a loan syndicate, such as additional banks or institutional investors, may not want to receive this information, because having it would restrict their ability to invest in or trade securities issued by the same company. Investors who use loan derivatives and dealers who trade them may not want to receive private information, for the same reason.
The loan market has developed a convention, known as a "big-boy letter," to deal with the fact that participants who opt not to receive this information may be at a disadvantage when they do business with those who have it. But it is unclear that this kind of a waiver would be enforceable under securities law.
Even though it is far more common for loans to change hands via an outright assignment, rather than a participation agreement, investors can never be certain when they initiate a trade which form it will take. So classifying loan participations as swaps would have hurt all cash trading.
"In a normal trade, you might think initially it would be done as an assignment, then it turns out you can't get consent [from the borrower] and have to do a participation," Elliot Ganz, the LSTA's general counsel, said. "You've got a document that disclaims liability, and after the fact may find out you're wearing that liability."
The rules originally proposed by the SEC and CFTC would have required a loan participation to be "true participation" to avoid being classified as a swap or securities-based swap. But after reviewing comments from the LSTA and LMA, regulators concluded that this definition was too vague.
The final rules state that the analysis as to whether loan participation is outside the swap definitions should be based on whether the loan participation "reflects an ownership interest in the underlying loan or commitment."
The rules list several criteria for evaluating whether a loan participation represents such an ownership interest, including whether the grantor is a lender, whether the aggregate participation does not exceed the principal of the loan or loan commitment and whether the purchase price is paid in full when acquired, rather than financed.
The final rules also clarify that the interpretation applies to loan participations that are entered into both with respect to outstanding loans and with respect to commitments to lend and to fund letters of credit under a revolving credit facility.
