In-Securities: What Happens When Investors In An Important Market Are Not Protected? Remarks To The Center For American Progress, SEC Commissioner Caroline A. Crenshaw, Washington D.C., Oct. 11, 2023

Thank you, Emily, for your kind introduction. I’m grateful to you and the Center for American Progress for organizing the event, as well as for the invitation to speak to you today. The topic of the event is timely. Private markets are an increasingly large portion of the overall markets. That means solutions to any of the most important issues in the markets today will naturally require consideration of the private markets and the assets that trade in them.

 

Before I begin, I need to give my standard disclaimer: I speak today in my official capacity as a Commissioner of the SEC, but this speech does not necessarily reflect the views of the Commission, the other Commissioners, or members of the staff.

I remember my first few days in private practice. Before joining my firm, I had intended to practice criminal law, not securities law. The learning curve was steep at first. Though I had learned about materiality and the basics of the public offering process, there is a lot you do not learn in law school. The acronyms alone could take years to master. After meetings, I sometimes found myself searching through rule text, academic articles and the Internet to glean context and background on questions or ideas we had discussed.

Things obviously get more familiar with every new experience. And the more I practiced, the more my research delved into complex and nuanced questions. But I’ve found that even as my knowledge base has grown, there will always be questions I don’t know the answer to, areas I don’t know as well as others, and issues I find confusing. Sometimes, this is because the words themselves seem to bear little resemblance to what they are describing.

For example, I spent much of my time in private practice litigating issues that had arisen in securities offerings, with plaintiffs alleging misconduct by one of the participants in the offering. Even when these were termed “private” offerings, I found that they were often sold to hundreds of different investors, often with little financial experience, and none of whom had any relationship with the company in which they were investing. I confess that this still does not make a lot of sense to me, and I have recently spoken on the topic.[1]

Likewise, I knew what a bank was — or, I thought I did — but in the aftermath of the global financial crisis we also began to hear more and more about “shadow banks.” These non-bank entities engaged in many activities associated with the traditional banking system and thus posed similar spillover risks as depository banks.

Shadow banks function by intermediating between borrowers and investors in capital markets, but they had structured themselves in ways that allowed them to evade many of the regulations designed to prevent banks from posing undue risks to the financial system.[2] The resultant lack of oversight was a principal cause of the crisis.[3] As with private offerings, I have also spoken about this topic recently. I believe that as industries become larger, it is important to reevaluate the regulatory framework to ensure it remains fit for its purpose, and allowing parts of the financial system to operate in the shadows creates risks to investors and the financial system.[4]

And this brings me to today — I am growing increasingly concerned with “loans” that look less and less like loans. The syndicated loan market has grown vastly larger in recent years and the loans themselves are far different from traditional loans. Many are sold to hundreds of “passive” investors. They trade frequently and on standardized documentation. And they are used to conduct activities far beyond traditional borrowing to buy a piece of machinery or a new building.

Despite this significant growth, much of this market is not subject to meaningful regulation and investors are being put at risk. In addition, I am concerned that systemic financial issues are lurking in the market, and that if these instruments are not monitored more closely, the risk to the financial system itself will continue to grow.

The Beginnings

Exactly where this story begins is hard to pin down. We are all familiar with the idea of lending memorialized in “It’s a Wonderful Life.” That film is certainly an easy place to think of as a starting point — customers obtained loans from a particular bank, and those loans were made using the deposits at that bank. But as the economy grew and capital needs increased, the business of lending began to shift. Banks kept lending, but more often shared the risk of large transactions with other banks as part of a syndicate. This allowed banks to maintain relationships with their customer rather than losing that customer to the bond market, but not to take on the entire credit risk on their own.

Over time, the link back to “It’s a Wonderful Life” has grown more attenuated. Banks or groups of banks originate loans but quickly syndicate nearly all of the risk to others, either as a participation (meaning the other party’s relationship is only with the bank, not to the underlying borrower) or an assignment (meaning the assignee has direct contractual privity with the borrower).

Syndications, loan participations, and assignments are not new. But whereas in previous decades they were small scale and bespoke — with banks selling interests to a small circle of highly sophisticated institutional investors, often other banks — these practices are now supersized and systematized. We are now a far cry from banks negotiating participations or assignments of one large loan directly, and only with a handful of peers.

Instead, investment banks and other financial institutions have become dominant players. These global institutions source loans from other banks and, increasingly, shadow banks and market them to a range of investors.[5]

Frequently, those investors are institutions like registered investment funds, pension funds, insurance companies, collateralized loan obligations (“CLOs”), or other financial institutions that have large sums of money to deploy but do not have the customer relationships to make loans directly. Helpfully for these counterparties, they are not subject to bank capital regulations. One commentator called this a “symbiotic arbitrage,” with banks arranging loans they are not able to hold on their own books, but instead sell to institutional purchasers.[6]

Some of these changes were due to regulatory developments. For instance, discussions of this trend frequently note that the Basel framework’s risk-based capital rules pushed banks to diversify their portfolios to make them safer, and that this in turn led to banks holding less of any particular loan on their own books.[7] The impacts of the Basel framework and its successors have undoubtedly been positive overall, and have contributed to a safer, more resilient banking system. But the downsides of the originate-to-distribute model— the same model that came to grief with respect to mortgages and triggered the global financial crisis in 2007 and 2008 — have become more apparent over time.

Cracks Begin to Develop

As the industry approach to loan syndication continued to develop, so too did misconduct in these largely unregulated corners of the market. As I mentioned a moment ago, the market and practices of loan syndication began to change dramatically. Driven in part by pressures to compete against investment banks that were able to place short term commercial paper, banks began to market loan participations to their institutional clients.[8] These new structures did not create any relationship with the borrower through which an investor could enforce its claim. They also did not provide a mechanism for investors to conduct their own diligence or information gathering.

Instead, investors were entirely dependent on the efforts of the intermediary bank, which frequently retained little or no risk. The practical result of this structure was to leave investors with no recourse against any party to the transaction, even in the case of intentional misconduct.[9] The results were sadly all too predictable. Certain companies were not able to make good on their debts and defaulted, leaving investors holding the bag with little to no recourse.

For example, in a case in the late 1980s, a California bank marketed participations in loans it had made to a large company called Integrated Resources. The bank’s marketing efforts involved conduct reminiscent of boiler room scams. This included daily cold calls to market the notes to investors who had neither the means nor the ability to conduct diligence on the company. These participations were marketed as investments and looked like securities. Investors, relying on publicly available information, purchased them as yield-enhancing alternatives to money-market investments.[10] There was no other risk-reducing regulatory framework as the investors were not in privity with the underlying borrower and thus had no ability to sue it directly.[11]

But in Banco Espanol de Credito v. Security Pacific National Bank, the Second Circuit ruled that the investments in loan participations were not, in fact securities, and dismissed the investors’ claims.[12] The Banco Espanol opinion applied the four-part test in Reves v. Ernst & Young, which starts with the presumption that an instrument described as a note is a security, but then applies four factors to determine whether the note bears “family resemblance” to another instrument which is not a security and, if so, treats the instrument similarly.[13]

Even in 1992, when the Banco Espanol opinion came down, it was clear that the opinion—which has been variously described by some critics as “puzzling,” “relatively cursory,” and “incorrect”— was meant to be narrow. The Second Circuit retreated from it almost immediately (at least in part).[14] For example, when it denied a petition for rehearing, the court narrowed the scope of its original decision to emphasize that it only ruled with respect to the particular loan participations before it, and it also emphasized that “even if an underlying instrument is not a security, the manner in which participations in that instrument are used, pooled, or marketed might establish that such participations are securities.”[15]

Then, only two years later, a different panel of the same circuit court held that participations in mortgage loans were securities, which required the panel to consider a very similar factual situation and come out the opposite way.[16] But despite the fact that the Banco Espanol opinion was controversial and narrow from the start, and was undermined by a different ruling nearly immediately, it continues to reverberate. A vibrant market for broadly syndicated loans (or “BSLs”) now exists.

After Banco

In some ways, a BSL looks like a loan to a company. Like a loan, companies can use the proceeds for any purpose, including purchasing equipment or issuing a dividend to their equity owners.

In other ways, BSLs look more like bonds. Evidence of the obligation is generally in the form of a “note” purchased by institutional investors (not banks), such as investment funds, insurance companies, pension funds, CLOs, and various other non-bank financial institutions.[17] In addition, like a bond, a company generally will only make interest payments, with a single principal payment due all at once upon maturity.[18] BSLs are frequently structured to accommodate the market into which they are sold, and are designed to be relatively freely tradable among the institutions that invest in them.[19]

In the years since the Banco Espanol decision, the market for BSLs has continued to grow and evolve, including in ways that further undermine investor protections. Indeed, one cause of this undermining of investor protections may be the perception that federal securities laws do not apply. Recently, the SEC was asked to weigh in on whether a particular BSL met the definition of a security. The SEC did not weigh in, and the court ruled without such input.[20] While that case has now been decided, it brought new attention to an issue that had been steadily growing. But will this be the end?

The default assumption under Reves is that a particular instrument marketed as note is a security, and I am concerned that the lack of clear guidance on which factors are sufficient for a BSL to rebut that presumption is resulting in market confusion.[21] This could result in a court, or the SEC, being asked to weigh in again. This matters for both investors and the markets more broadly.[22] Here’s why.

Investor Protection

First, investor protection. I am aware that some commentators have argued that BSL investors do not need the protections of the securities laws because they are sophisticated institutions. Of course, institutional investors also need and deserve the protections of the federal securities laws. Consider the experience of institutional investors who purchased investments based on residential real estate before and during the global financial crisis of 2007 and 2008.[23]

And, to be clear, it is not just institutional investors. Retail investors have enormous exposure to this market. For example, many of the vehicles that purchase BSLs are registered investment companies that focus on these types of assets, and these funds represent an important component of the market for BSLs.[24] These funds, in turn, are owned by retail investors. Even if it is the case that the parties making investment decisions understand the important protections they are giving up, do the underlying investors? Funds investing in BSLs have been heavily marketed to retail investors in recent years as a hedge against rising interest rates.[25] Less prominent, however, have been discussions of the differences in legal status between BSLs and other credit instruments like bonds. I believe it is unlikely that most retail investors in these funds would understand these nuances, and that they would reasonably expect their funds to have more legal protections than in fact exist.

At a minimum, investors benefit from the protections of the crucial antifraud rules of the federal securities laws, such as Rule 10b-5. This rule polices any materially false or misleading statements made to investors. Rule 10b-5 and other rules do more. Consider: do investors in BSLs have sufficient protection from the risks of insider trading? Investors in traditional securities benefit from the knowledge that the SEC has the power to police when insiders trade on the basis of material nonpublic information. The enhanced investor protection results in increased market efficiency because investors do not need to worry that the other side is trading on the basis of inside information.[26]

When a BSL issuer encounters difficulty, it is common for some of the notes it has issued to be purchased by investors specializing in “distressed” assets — that is, assets where the issuer may go bankrupt, and where a savvy investor can make a profit by understanding which parts of the issuer’s capital structure are most likely to have a recovery. These investors also seek to profit by influencing the process by which the issuer seeks new capital to avoid bankruptcy.

In many cases, these distressed investors negotiate for access to nonpublic information about the issuer, which is not available to all holders of its notes. To the degree the underlying assets are not securities, investors may decide to trade on the basis of this inside information without disclosing it to the market. The future of a market rife with insider trading is concerning at best, especially for investors in funds that have not received the inside information (which generally includes the passive vehicles favored by retail investors). Investors will get hurt.

In addition, investors in securities rely on the vigilance of other participants in the process to ensure that an issuer discloses material information about its condition. In registered offerings, these are known as “gatekeepers,” and they exert a heavy influence in favor of investors. Of course, gatekeepers themselves can make mistakes (and we have seen lapses in the gatekeeping role lead to catastrophic results that affect the entire market).[27] As a whole, though, their influence helps promote confidence in the market by providing a second set of eyes on an issuer’s disclosures before they reach investors.

Even in unregistered offerings, where there is less of a role for a formal gatekeeper, the banks, accountants, and other service providers who participate in these offerings are motivated by the securities laws to ensure that the documents they produce are accurate and not misleading. But when the assets themselves are not registered, and are not even securities, do these participants exercise sufficient vigilance? In certain cases, we have seen that the answer is no, and that, when the participants are not subject to the securities laws, they are more willing not to disclose — and in some cases, to affirmatively hide — negative information about a company. They seem to rely on the caveat emptor doctrine that the securities laws were specifically designed to root out.[28]

Instead of a strong gatekeeper, documents marketing BSLs to investors frequently contain what is known in the industry as a “big boy” representation. That acknowledgment is designed to protect the bank intermediating the transaction from liability by requiring investors to represent that they have done their own diligence on the issuer of the notes. But frequently, investors have neither the means nor the time to conduct meaningful diligence. The loan is generally marketed to investors very late in the process after nearly all the terms are settled, and generally an investor’s only real choice is whether to participate. While some might argue that this is evidence of investors exhibiting rational ignorance, meaning the market is working, I think it could also be evidence of a market failure— the vehicles purchasing BSLs are doing so with other people’s money, and the bonuses of the people investing on behalf of those vehicles will be paid long before it is clear whether the BSLs at issue will perform in line with expectations.[29] This is a clear conflict. Shouldn’t the expectations of the party who will actually be harmed be given precedence?

In many contexts, parties are not allowed to waive rights that are central to a particular regulatory scheme. In fact, recognizing the fundamental unfairness and power imbalances that can exist when powerful parties are able to manipulate the circumstances of a transaction, provisions in each of the major securities laws state that attempts to waive the protections of those laws are void.[30] In light of the remedial nature of the securities laws and the identity of many underlying investors, should we take a fresh look at assets that seem structured to avoid these important protections?

Systemic Risk

I am also concerned that risk has accumulated in the BSL market and that it may be reaching a scale that could affect the financial system more broadly.[31] These assets trade privately, preventing regulators like the SEC from fully assessing whether particular institutions have too much exposure, or whether other risks are brewing. Ultimately, the lack of these data could result in us being unable to detect risks that could affect the efficiency, fairness, or orderliness of our capital markets. And, if a negative outcome does ultimately occur, the same lack of data could also hamper our ability to effectively respond.

Worse, the types of BSLs that look most similar to securities also seem to have characteristics that make them especially likely to have procyclical systemic effects on the market. Though BSLs trade regularly, many passive investors will only buy assets that trade on “par docs.” This essentially means that they are not trading at a discount due to distress or potential distress at the borrower. In fact, many investors have strict guidelines that require them to sell BSLs even when they are downgraded below a certain level — well before the issuer is truly in distress. I am concerned that this can result in a procyclical cycle of sales which in turn could cause forced sales of other BSLs market-wide and affect the ability of companies to receive financing even though they are not otherwise distressed. The echoes of the 2008 financial crisis are hard to ignore.

In addition, as BSLs grow larger, they naturally need to be syndicated to more participants. But this also renders them especially vulnerable if problems develop. If investors sour on the market, (for example due to forced sales by market participants depressing prices throughout the market), the largest loans that depend on being especially widely syndicated are the ones that are most likely to get “hung” on bank balance sheets and potentially affect financing to other companies.

As we continue to move into a new era of higher interest rates, these effects may become more apparent. For example, many companies took advantage of the near-zero interest rates of the pandemic and its immediate aftermath to borrow new money using BSLs. The amount of BSLs maturing in the next several years is more than any other comparable period in history.[32]

Though it is still early innings, we are already seeing indications of what could happen when companies crash into this maturity wall. In the aftermath of the financial crisis, many companies engaged in “extend and pretend” transactions. These involved extending the maturity of the company’s debt on the hope that financial conditions would improve but without any meaningful changes to the company’s business. As of earlier this year, extend and pretend transactions were at their highest on record.[33] Though it appears this has not yet resulted in immediate negative effects, will our luck run out in future years?

Many of the traditional passive investors in BSLs are not well-equipped to handle decisions requiring analysis of the issuer’s business prospects. This has led to the rise of the “snooze drag,” where CLOs strategically do not take action on extension requests (allowing them to take effect by default).[34] This has resulted in investor complaints because the CLOs would otherwise be required to return their investors’ money.

To me, a situation where many borrowers are seeking to refinance by extending their existing loans without any real changes, and can only do so by convincing their lenders to “snooze” is a flashing warning sign – what happens when borrowers’ ability to engage in this tactic runs out? Will procyclical forced sales occur? And will regulators and the public be caught by surprise when this begins to affect the real economy?

I should note that the two dynamics I have mentioned — investor protection and systemic risk – are interconnected. Markets in which securities protections are not present mean investors have less information, less confidence in the integrity of the information they do have, and fewer assurances that market participants will not abuse the trust investors place in them.[35] Without these rules, the market runs a higher risk of unraveling, with potentially systemic consequences for the real economy.[36] Greater disclosure and the greater integrity of disclosure that comes with antifraud rules, protections against insider trading, and gatekeepers would guard against the BSL market becoming a proverbial “market for lemons.”[37]

* * * * *

I would also like briefly to touch on several other areas that commentators have raised when discussing whether particular instruments described as notes, such as BSLs, should be regulated as securities. Though I believe consideration of these policy issues would not alter the application of the binding Supreme Court precedent in Reves, I believe they could merit some consideration so that regulators and the industry can work together to develop guidance on areas that may be unclear. In the face of uncertainty about the future development of the BSL market, it could be that regulators have work to do to prepare for a future ruling that certain BSLs are securities for purposes of the Securities Act.

First, BSLs are frequently originated by large, national banks. I am aware that these banks are generally prohibited from underwriting securities, and that some have argued that if a court were to deem these widely syndicated notes securities, it could reduce capital formation. I believe further work is necessary to determine whether this is a realistic concern. Are there other arrangements a bank could make, such as conducting the activity through an affiliate? Would doing so require any additional regulatory actions from the SEC or banking regulators?

Second, these assets are already defined as securities for some purposes and not for others. For example, they are already treated as securities under the Investment Company Act.[38] What would prevent a banking regulator from issuing guidance stating that it would not deem widely syndicated loans to be securities for the purposes of the Volcker rule, even though the assets would be securities for other purposes?

* * * * *

Throughout my remarks today, I have referred to the global financial crisis of 2008. In the years leading up to that crisis, financial institutions had successfully convinced regulators that the laws and regulations enacted in the wake of the Great Depression could be loosened. They were able to point to decades without a crisis to argue that strict regulations were unnecessary and that the business of banking had become safer. Just over 25 years ago, the hedge fund Long Term Capital Management failed. Until its failure, many believed that hedge funds did not to pose a risk to the financial system.[39] This was because investments in these vehicles were privately placed to sophisticated investors who were capable of sustaining large losses. LTCM was run by Wall Street legends (including several Nobel laureates) who were viewed as some of the brightest minds in finance. But despite the apparent safety, the firm melted down over the course of a few weeks and ultimately required a multi-billion dollar bailout from its counterparties (at the strong urging of the Federal Reserve Bank of New York).[40] Its failure is one reminder that the non-occurrence of a crisis does not mean that one could never occur in the future. Regulators must be vigilant about the risks that are around the corner, not just the ones in the past.

I am aware that some may argue that BSLs have only exhibited isolated problems, and that these problems alone are not necessarily evidence of systemic risk. It could be the case that this means BSLs will never cause systemic issues in the financial system. But, as in the years leading up to 2008, a metamorphosis in the system may be occurring before our eyes. I worry that this market is becoming riskier in ways that regulators have not yet fully considered. While some loan syndication may make sense to reduce the risk taken by individual banks, I am concerned that we are now in a world where banks lend, but nearly all the risk is transferred to investors who have no relationship with the borrower, and that investors — including retail investors — frequently have a great deal of exposure to these assets.[41] If that is to be the case, regulators across the board must assess whether investors have sufficient protection, and whether there are other risks to consider. For example, is the risk of BSLs compounded due to the lack of transparency, price discovery, and regulation of the private offerings through which BSLs are distributed to investors?

Consideration of these issues now, before further problems develop, is necessary. Doing so allows us to ensure that a crisis does not threaten the fair, orderly, and efficient markets that we strive to maintain. I look forward to working with the public — including the people in this room today — to ensure that these outcomes do not occur. Thank you.