Are Syndicated Loans Securities?

Notes are securities and loans are not securities. Simple enough. Except, our financial system doesn’t operate in such a black and white manner. Syndicated loans kind of fall in the middle.

Your traditional loan is a single lender who holds and controls the debt. Notes and bonds get issued into a more fungible format to more than one investor, with control centralized with a trustee or loan administrator. There are lots of different structures on the notes and bond side of the spectrum.

Syndicated loans involve a group of lenders. Typically it’s a smaller group of lenders and they have some amount of control, collectively, over the administration of the loan.

There a fight in the Second Circuit in Kirschner v. JP Morgan Chase Bank on whether a particular syndicated loan issuance was a security. There is enough uncertainty that the court asked the Securities and Exchange Commission to offer its opinion. A few days ago, the SEC declined to do so.

While we are used to a discussion of the Howey test when talking about securities, it’s important to note that it is focused on the definition of an “investment contract.” There is a whole other line of cases on the “loan” versus “note” definition lead by the Reves v. Ernst & Young case which established the “family resemblance test.”

The analysis is whether the note in question is like any of these notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

In determining whether the note in question has a family resemblance to one of the seven, there are four factors to consider:

  1. The motivation of seller and buyer – If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, then its more likely to be a security.
  2. The plan of distribution of the note – If the note instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.
  3. The reasonable expectations of the investing public – If the investors think that the securities laws and their anti-fraud provisions apply to the note, then it’s more likely to be a security.
  4. Alternative regulatory regime – Is there another regulatory scheme, like banking regulation, that applies to the note, then its less likely to be a security.

The case as hand involves a $1.775 billion syndicated loan to Millennium Laboratories. As you might expect, Millennium defaulted. The loan participants are suing the loan syndicator to try get some additional recovery. The district court ruled that the syndicated loan interests were not securities and the loan participants appealed to the Second Circuit.

As mentioned above, the Second Circuit is mulling over the appeal and asked the SEC to opine on the treatment of this loan syndication. The SEC’s failure to say that the syndicated loan interests are not securities has created a bit of a panic in the syndicate loan markets.

We’ll keep an eye out for this decision.

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The One with the Girlfriend’s Laptop

The Securities and Exchange Commission actually uses the term “romantic partner”, not girlfriend in this complaint. I guess the SEC doesn’t want to impose labels on the relationship. Based on this case, I assume the relationship is over. The COVID pandemic was hard on a lot of relationships with couples isolated at home. Stealing information from your “romantic partner” seems likely to end the relationship.

That’s just what Steven Teixeira did. While working at home during the pandemic, Teixeira would access her laptop while she was out of the room or outside their Queens apartment.

She was an executive assistant at an investment bank. She was responsible for scheduling meetings of the investment bank’s valuation and fairness committees concerning potential transactions involving the investment bank’s clients. She had access to material nonpublic information relating to dozens of the investment bank’s transactions.

Teixeira had a friend who knew a guy who was a stock trader, Jordan Meadow. The three met and Teixeira offered up his access to the information to Meadow. The three plotted an insider trading scheme, with Meadow offering to buy Teixeira and the third friend Rolex watches. Teixeira and Meadows began trading on the flow of transaction information that Teixeira was snooping from his romantic partner’s laptop.

Their aggressive trading caught the attention of the regulators and Meadow’s compliance department. The scheme came to an end in January 2023 when the romantic partner returned to working in the office rather than from home.

Teixeira pled guilty in a cooperation agreement. The DOJ and SEC are pursuing more serious charges against Meadow.

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Ripple is Sometimes a Security (?)

The big challenge with crypto is how it fits into regulatory schemes that were drafted almost a century a go. Add in the politically driven split between the regulation of commodities by the CFTC and the regulation of securities by the SEC and you get a mess. Slap in the variable structures used by crypto issuers when selling crypto tokens and you get a tangled mess.

This challenge just got messier with the recent decision in the case of the Securities and Exchange Commission v Ripple Labs.

The definition of a “security” includes an “investment contract.” The meaning behind that term was established in the 1946 case of the SEC v. W.J. Howey. The decision created a three prong test:

(1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.

Bitcoin largely falls outside the definition. You don’t expect a dividend on Bitcoin. You’re investing for the rise in price alone. There is no meaningful company behind it trying to find a way to make a profit. Bitcoin is more like a commodity.

Some will argue a currency. But currencies are used as a store of value to buy things. I don’t think Bitcoin is being used to buy many legal goods.

Ripple Labs comes along and sells the XRP token to generate cash to build out the Ripple platforms, some of which will use the XRP token. The facts are a bit murky about whether the XRP coin holders would get some of the profit from the Ripple platforms.

The court looked first at the past sales of XRP tokens directly to institutional buyers and decisively finds that the XRP tokens are securities. “When the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.” (page 18)

For some weird reason, the court then finds that indirect sales and sales on exchanges are not investment contracts. Since they were blind bid/ask transactions, the buyers didn’t know if the money was going to Ripple or to a secondary seller.

So institutional buyers get more protection than retail buyers under the court’s reasoning. That seems to be the opposite approach of the protective regulatory approach of the SEC.

That also seems weird in the reality of exchanges for “securities.” An investment would be a security if it’s bought directly from the issuer and possibly not a security if it’s purchased from a secondary seller.

Under the court’s decision, crypto is looking very good. Sales of “investment contracts” to institutional investors can rely on the private placement regime. Sales to retail investors through an exchange would not be an investment contract.

Weird result. The product’s status as a security is dependent on how it’s sold. Doesn’t sound right to me. I assume the SEC will appeal this result. I think this will just be a temporary win for Crypto.

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The One with Insider Trading, Pharma and the Police Chief

Joseph Dupont was a senior executive at Alexion Pharmaceuticals and reserve officer with the Dighton police force. (Dighton’s most notable attraction is Dighton Rock, covered in petroglyphs.) Dupont worked on Alexion’s acquisition of Portola Pharmaceuticals.

Dupont knew he couldn’t trade in the stock of Portola with all of the inside information he had. But that apparently didn’t stop him from leaking the information to his buddy, Shawn Cronin, who was a sergeant on the Dighton police force. (He has since become Chief.) Cronin then told two other mutual buddies, Stanley Kaplan and Jarett Mendoza. Kaplan then told a colleague, Paul Feldman, who spread the information even further.

The SEC Complaint and US Attorney Indictment have some compelling facts. Dupont had Alexion meeting to hammer out the details of the acquisition on April 8. That night Dupont had a long conversation with Cronin. Cronin texted Kaplan that night:

“Good evening, sir. If you need something to take your mind off of the everyday battle, remember that stock I told you about? Good time to buy.”

Cronin then opened a new brokerage account and placed an order to buy shares in Portola. Kaplan did the same. They continued to buy more shares in the following weeks.

The criminal indictment has a bunch of incriminating messages among the defendants:

“I need more inside information.”
“Knowing of a buyout or an news beforehand is gol[d].”
“Let’s hope our golden goose will continue laying golden eggs!”

When the acquisition was announced the stock price of Portola jumped 130%.

All of this suspicious trading caught the attention of the regulators after the merger and launched an inquiry. Alexion was forced to ask its employees whether they knew any of the names on the list of suspicious traders. Cronin lied and said he didn’t know any, even though Cronin, Kaplan and Mendoza were on the list.

The gains they made:

  • Cronin – $72,000
  • Mendoza – $39,000
  • Kaplan – $472,000
  • Feldman – $1.73 million (He put the most money in)

All are facing disgorgement of the gains, civil penalties and significant jail time. Mendoza has already plead guilty.

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SEC’s Regulatory Agenda

The Securities and Exchange Commission has published the Spring update to its agency rule list: Agency Rule List – Spring 2023 Securities and Exchange Commission. While none of this is carved in stone it does give us some sense of what the SEC is working on, what it has given up on, and when things may come out.

The first item on my mind is the proposed Private Fund Rule. That was first proposed in the first quarter of 2022 with a Buffet of Private Fund Regulations piled into one proposed rule. I have heard little about what end up in the rule. It’s still on the agenda and has a proposed final action in October 2023.

Cybersecurity for investment advisers is also still on the agenda. This was another of the first quarter 2022 rulemaking. My biggest concern is that the rule would likely make a cyber breach a fraud violation. Seems like that’s a problem given that the US government is noting a widespread cyberattack today: US government agencies hit in global cyberattack. Nonetheless, the rule still on the agenda and has a proposed final action in October 2023.

Outsourcing by investment advisers remains on the agenda. Any final action is pushed off to April 2024. I think the SEC is struggling with how to scope the rule.

“A covered function is defined in the proposed rule as a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.”

If I hire a bad elevator contractor for my private real estate fund’s assets and all the elevators stop working, I think that makes it a “covered function” that would be subject to the proposed rule.

The new Safeguarding Advisory Client Assets rule looks like it its on the fast track. It was just published in the first quarter of 2023 and is scheduled for final action in October 2023. That rule is targeting at killing crypto. In the process, it’s taking a sledgehammer to all alternative investments.

It looks like we’ve got three big regulatory changes coming out this fall. Sounds like we should rest up this summer to get ready.

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New Risk Alert on the Marketing Rule

The Division of Examination released a risk alert on additional areas of emphasis during examinations focused on the new Marketing Rule (Rule 206(4)1): Examinations Focused on Additional Areas of the Adviser Marketing Rule. This is identified as a follow up to the September 19, 2022, Risk Alert describing the initial areas of review related to examining advisers for compliance with the Marketing Rule: Examinations Focused on the New Investment Adviser Marketing Rule.

The new areas of focus are:

  1. Testimonials and Endorsements
  2. Third-Party Ratings
  3. Form ADV

Testimonials and Endorsements

The focus seems to be just on the key compliance areas. You need to make sure you have good disclosures about whether the person is an actual client/investor, whether the person is compensated and any material conflicts of interest.

I’m seeing placement agents struggling with how to disclose their role in the marketing and fundraising. They all have good disclosures and procedures. I assume there will some move towards standardization in the industry.

Third-Party Ratings

Compliance needs to keep a close eye on these and the substance behind them. The Risk Alert makes it clear that the SEC wants the time frame to be clear, who did the rating and whether there was any compensation.

An interesting note is that the SEC wants to see that the:

“adviser has a reasonable basis for believing that such questionnaire or survey is structured to make it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result.”

Form ADV

The SEC wants to make sure you are checking the right boxes in the new Form ADV questions regarding marketing. Not much substance here, just easy for the SEC to review and grade. I assume the examiners have seen a bunch of advisers who checked the wrong boxes.

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Back from a hiatus on the blog. I thought it prudent to shut down during an examination. The end result was just fine. Exams are just nerve-wracking.

A New Marketing Rule FAQ

It’s been two months and the SEC finally issued a substantive FAQ on the Marketing Rule for investment advisers. https://www.sec.gov/investment/marketing-faq

Gross and Net Performance

Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1] Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2] In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

This has been an issue that private equity fund managers have been trying to clarity on for over a year. There has been conflicting advice from consultants and lawyers about the best way to deal with case studies that highlight the type of investing and managing by the private equity fund manager.

I think showing the net overall returns for the fund is more important that coming up with some jiggered calculation of net return for a single investment. But the SEC clearly thinks the opposite.

This will impact many fund managers who took the opposite advice from the SEC position. Marketing materials will need to be revised. Policies and procedures will need to be re-written. A formula for estimating net returns for an individual investment will need to be created.

Happy Marketing Rule Day

The new Marketing Rule for Registered Investment Advisers takes effect today. (Nov 4) Hopefully you’ve got your policies and procedures in place and operational, if the rule applies to you.

Many were hoping for some clarifications and updates. Only two questions were ever answered.

  1. An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule.
  2. The staff would not object if you are unable to calculate your one-, five-, and ten-year performance data in accordance with rule 206(4)-1(d)(2) immediately following a calendar year-end and you use performance information that is at least as current as the interim performance information in an advertisement until you can comply with the calendar year-end requirement. 

There are several unanswered questions out there. I’ve seen two floating around with lots of discussion these last few weeks.

One is for private equity fund managers using extracted performance in a case study for a fund. I’ve seen conflicting advice from different consultants and law firms about whether you need to generate some kind of a net return for that single investment or whether you can use the net return for the fund.

The second is whether you need to update Form ADV Part 2 Question 14 regarding placement agents or solicitors right away to comply with the Marketing Rule. The SEC has said conflicting things about this update.

The Division of Examinations has already stated it will start a sweep exam on compliance with the Marketing Rule. (See the Risk Alert) Keep an eye on your phone Monday morning.

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Custody Crackdown

Earlier this year, the SEC’s Division of Examinations published its priorities for 2022. There was a significant focus area on private funds. In particular, looking at:

“compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors”.

Earlier today the SEC announced a swath of actions against firms for custody rule failures. The charged advisors advisers failed to have audits performed or to deliver audited financials to investors in private funds in a timely manner, thereby violating the Investment Advisers Act’s Custody Rule.

The SEC added on a technical filing violation as well.

Firms are strongly encouraged to ensure their compliance with the Custody Rule and the related Form ADV reporting and amending obligations. In particular, private fund advisers registered with the SEC are reminded that per the instructions to Form ADV, Part 1A, Schedule D, Section 7.B.23.(h), “If you check ‘Report Not Yet Received,’ you must promptly file an amendment to your Form ADV to update your response when the report is available.”

The Custody Rule for private funds have some bright lines, making it easy to comply with (if you ignore the costs of audits). It also makes failure to comply with the Custody Rule very obvious. You either deliver the audited financial statements on time or you don’t.

If you don’t deliver on time, the SEC is going to notice.

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The One with the Miscalculated Fees

The Securities and Exchange Commission has made it clear that one of its primary points of interest with private funds is fees and expenses. Some of that is well-deserved. Some private funds had a history of being opaque about fees and expenses.

A recent enforcement case by the Securities and Exchange Commission highlights mistakes that could easily be made by a fund manager if not paying attention to what the fund documents say. The case against Energy Innovation Capital Management, LLC is illustrative of items to pay attention to when checking management fee calculations.

The first thing to note is that Energy Innovation is a venture capital firm and is an exempt reporting adviser. Those types of firms are not subject to routine examination. I’m intrigued how the SEC came across the fee calculation problems at the firm.

As with most non-hedge private funds, the fund management fee calculation changes after the equity commitment period ends. During the commitment period, the fee is a percentage of committed capital while the fund deploys the capital. Once the commitment period ends, the fund is limited in its ability to make investments and the fee basis is reduced to an amount that generally equates to the amount of capital deployed.

In the Energy Innovation fund the commitment period ended in the first quarter of 2020. The firm changed the calculation as of the end of the quarter. That was inaccurate. The fee should have been pro-rated as of the actual date. Of course, by waiting until the end of the quarter the firm had a higher fee basis for a longer time.

The second problem was that the firm included accrued, but unpaid, interest attributed to certain individual portfolio company securities in the fee basis. Without the language of the fund agreement its hard to tell what went wrong. It may be that the fund documents did not specifically allow it to be included so the SEC took the position that it can’t be included.

The biggest problem is that the firm wrote down individual portfolio company securities and wrote off certain others for valuations, but did not incorporate any of these write-downs into its post-commitment period fee basis.

The final corollary issue was that the firm aggregated invested capital at the portfolio company level in fee basis, instead of at the individual portfolio company security level. The fund documents did not permit aggregation of invested capital at the portfolio company level. I assume this is tied to the treatment of write-downs.

The net result of these problems was that the firm earned $678,861 in excess management fees. Interestingly, the the order did not require repayment of those excess fees. The order notes that “the Commission considered remedial acts promptly undertaken.” I assume the firm had already repaid the excess fees during the examination.

This enforcement action is a warning to other firms that the SEC is laser focused on management fees.

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