Do the securities laws matter? The rise of the leveraged loan market.

• Author: de Fontenay, Elisabeth

1. INTRODUCTION II. MANDATORY DISCLOSURE: WHAT DO WE KNOW? A. Empirical Testing: Technical Concerns B. Empirical Testing: Doctrinal Concerns--The Benefits and Costs of Mandatory Disclosure III. LOANS VS. BONDS: THE TRADITIONAL PARADIGMS A. Description of Dichotomy B. Treatment Under the Securities Laws IV. LOANS VS. BONDS: CONVERGENCE A. Causes 1. Changes to the Loan Market 2. Changes to the Bond Market B. Evidence 1. Investors 2. Pricing 3. Liquidity 4. Covenants 5. Credit Features C. Are Syndicated Loans Securities? 1. The Reves Framework 2. Banco Espanol 3. Reves Applied to Syndicated Loans 4. Regulatory Stickiness V. THE DEBT-MARKET NATURAL EXPERIMENT A. Natural Experiment B. How We Got Here and What to Do About It 1. Why the Leveraged Loan Market? 2. Why the High-Yield Bond Market? C. Implications D. Final Caveats E. The 144A Red Herring VI. CONCLUSION I. INTRODUCTION

   The Great Depression prompted the modern era of broad, intensive federal regulation of corporate capital raising. The crown jewel and major innovation of this regulatory regime was mandatory disclosure--the requirement that issuers of securities disclose specific information to the public, both upon issuance and on an ongoing basis post-issuance. This disclosure requirement was intended to empower investors to make their own decisions, by ensuring that the public received a baseline of relevant (and uniformly presented) information from issuing companies. (1) U.S. corporate financing has been profoundly shaped by this regulatory design ever since.

   Of course, mandatory disclosure is not costless. The direct transaction costs to issuers, their underwriters, and the government are substantial, to say nothing of the indirect costs. (2) Given the stakes involved, the obvious and crucial question is whether mandatory disclosure actually works. Does it even achieve the goals ascribed to it, and if so, do these benefits outweigh the associated costs? After more than eight decades of federal securities regulation, the answers to these questions remain surprisingly elusive. It turns out that testing the securities laws' effectiveness is extraordinarily difficult, and the limited evidence obtained to date is decidedly mixed.

   This Article asserts that we may finally gain some purchase on this question--if only we look in the right place. Whether implicitly or explicitly, discussions of the merits of securities regulation deal almost exclusively with equity instruments, particularly common stock, rather than with debt. The privileging of equity over debt is ubiquitous in the literature. (3) Yet the corporate debt markets swamp the equity markets in size. (4) Ignoring the debt markets when assessing the securities laws is a surprising omission that this Article seeks to remedy.

   Indeed, recent sweeping changes in the debt markets have created near-perfect conditions for testing mandatory disclosure's effectiveness. Long viewed as contrasting forms of debt, the markets for large corporate loans (referred to as syndicated loans) and corporate bonds are rapidly converging into a single asset class. (5) Yet bonds are treated as securities under the federal securities laws, while loans are not. The existence of two functionally equivalent markets, one regulated and the other unregulated, amounts to a natural experiment testing the federal securities laws' effects on the largest source of corporate financing, the corporate debt markets. Though the convergence is as yet incomplete, it is enough to make the longstanding regulatory distinction between the two untenable under existing doctrine.

   That bonds and loans are now virtually interchangeable is nothing short of remarkable. In the canons of corporate finance, the two instruments have historically been at opposite ends of the debt spectrum. (6) Corporate bonds were typically understood as long-term, passive investments in blue-chip corporations. Bank loans, on the other hand, were short-term extensions of credit most suited to small, opaque companies requiring intensive monitoring by the creditor. Bonds were thus appropriate for dispersed, unsophisticated retail investors, and were highly liquid instruments (that is, readily tradable). By contrast, loans were funded nearly exclusively by banks, which specialized in credit analysis, had the ability and incentives to monitor their borrowers closely, and were themselves tightly regulated entities. Because of the steep information costs associated with these loans, they were typically held to maturity by the bank that funded them, and thus plainly illiquid. These fundamental differences between bonds and loans in the nature and type of their creditors, their liquidity, and the information required by creditors justified the treatment of bonds as securities and loans as non-securities.

   Yet dramatic changes to the corporate loan market have converted it into something closely akin to the bond market. (7) Changes in both supply and demand have radically altered the fundamental nature of corporate loans, transforming them into instruments that can be traded by passive investors. Large corporate loans are no longer funded and held to maturity by a single bank, but instead are syndicated to large groups of creditors and subsequently traded to reach still other creditors. More surprising still, banks represent only a small minority of such creditors. The outcome of this rapid and dramatic metamorphosis of the loan market is a new capital market that is both deep and highly liquid. The convergence of the bond and loan markets is particularly striking at the riskiest end of the spectrum in each. High-yield (or "junk") bonds and leveraged loans refer to the bonds and syndicated loans, respectively, of companies with high ratios of debt to equity in their capital structure. Leveraged loans and high-yield bonds currently feature strikingly similar pricing, non-price terms, participants, and liquidity.

   Unless and until the loan and bond markets become perfectly interchangeable (save for their regulation), the conclusions drawn from this natural experiment will necessarily be tentative. Yet, based solely on the convergence exhibited thus far, we may already derive a crucial result: the very existence of a liquid corporate loan market suggests that the securities laws (8) are not doing the work for which they were intended. Consider the two bedrock goals of mandatory disclosure under the federal securities laws: (1) protecting unsophisticated investors, (9) and (2) remedying the underproduction of material investment information. (10) The first goal is simply inapplicable in today's debt markets, because both the corporate loan and corporate bond markets are, for all intents and purposes, purely institutional. (11) Retail investors have always been absent from the corporate loan market, and recently have all but disappeared from the corporate bond market. (12) Concerns about protecting individuals who cannot absorb losses are thus allayed in these markets.

   The second goal requires some elaboration. The currently dominant theory supporting mandatory disclosure holds that, left to their own devices, companies lack incentives to provide investors with sufficient information, and investors lack incentives to pay for it, due to now familiar free-riding and collective action problems. Armed with too little reliable information, rational investors in an unregulated market will invest less than is efficient--a bad outcome for both investors and issuers. Requiring issuers to disclose material information to the public could thus increase the volume of investment in a market to something closer to its optimal level. In this view, mandatory disclosure is not a burden on investment (as issuers frequently lament), but rather a necessary condition to robust investment.

   Unfortunately, the convergence of the loan and bond markets to date strongly suggests that this second aim of securities regulation is unrealized in the corporate debt markets: mandatory disclosure cannot be a necessary condition to developing a deep and liquid market, simply because the unregulated leveraged loan market, in which disclosure to investors is limited, non-uniform, and purely voluntary, is now significantly larger than the regulated high-yield bond market. (13) Purely through private ordering, the loan market appears to be providing sufficient information for investors to treat syndicated loans as they do bonds--that is, as largely passive investments that do not require intensive monitoring on their part. In summation, this implies that the securities laws are not achieving their principal goal in the markets for corporate debt.

   Admittedly, this sweeping conclusion is unlikely to be well received in a world still scarred by the recent financial crisis. Yet, its normative implications are comparatively mild. Despite the near equivalence of the two markets, issuers have not migrated wholesale from the regulated high-yield bond market to the unregulated syndicated loan market; for the time being, the two markets exist side-by-side. Thus, even if securities regulation is unnecessary for robust investment in the corporate debt markets, it is also unlikely to truly impede investment--the institutional structures to support mandated disclosure are already in place, and investors such as mutual funds are still required to invest some portion of their assets in registered securities. The securities laws applicable to corporate debt may not be effective, yet nor do they appear terribly harmful. The latter point may explain why the regulatory dichotomy between the corporate loan and bond markets persists to this day, despite its now glaring lack of grounding: securities regulators may be tacitly (and cynically) acknowledging that, whether they treat leveraged loans as securities or not, the decision is unlikely to matter.

   However, this Article's skepticism about securities regulation in the debt markets...