The hedge industry urges that loan participations be excluded from the Dodd-Frank Act definition of swap in order to avoid disrupting, or even destroying, the market for these agreements, and harm to both domestic and EU loan markets. In a letter to the SEC and CFTC, the Managed Funds Association noted that in both the U.S. and Europe, participation agreements, alongside assignment and assumption agreements, are used to transfer the economic benefits and risks of a bank loan from a seller to a buyer. Defining loan participations as a swap will subject these agreements to significant regulatory requirements and adversely impact the loan markets. There is also the extraterritorial impact of the SEC-CFTC proposal.
The MFA believes that the impact imposed on European investors if loan participations were defined as security-based swaps would have a detrimental effect on liquidity in the U.S. market. In both the United States and Europe, loan participations are an alternative form of transfer structure to the conventional loan assignment and serve essentially the same market function. Currently, European banks and institutional investors enter into participations with U.S.-domiciled counterparties as readily as they do with non-U.S. counterparties. The syndicated loan market, of which participations are a vital component, is very much an integrated global market, noted the MFA, and therefore regulating loan participations as security-based swaps would have a damaging effect on the loan markets and all investors in the loan markets, thereby hindering a borrower’s ability to raise capital in the loan markets.
The SEC and CFTC proposal contains interpretive guidance under which a loan participation will not qualify as a swap when the purchaser acquires a current or future direct or indirect ownership interest in the underlying loan and a beneficial ownership interest in the underlying loan, a so-called true participation. The Commissions also propose to exclude from the definition of a swap a loan participation that is regulated as a security under the federal securities laws or identified banking products under section 403(a) of the Legal Certainty for Bank Products Act of 2000, as amended by Dodd-Frank. The MFA urged the Commissions to ensure that all loan participations fall outside the scope of the definition of a swap. The MFA believes that defining any loan participation as a swap could disrupt, or even destroy, the market for these agreements, and harm loan markets.
There are two central features of all loan participations that provide a clear standard to distinguish them from other financial products, said the MFA, such as loan total return swaps, and these features should form the basis of the Commissions guidance as to what constitutes a loan participation. First, a central feature of a loan participation is the grantor’s actual ownership of the underlying loan. A grantor of a loan participation must represent to the participant that it owns the loan that is subject to the participation. However, under a loan total return swap, the total return receiver must acknowledge that the total return payer has no obligation to own the reference loan.
Second, the participant under a loan participation agreement pays the full purchase price for the loan on the transaction closing date. The grantor does not extend financing to the participant and the participant does not lever its purchase by posting collateral to secure a future obligation to pay the full purchase price. However, a loan total return swap is designed to allow the total return receiver to gain synthetic exposure to the reference loan on a levered basis, and is not used as a loan transfer mechanism.
According to the hedge fund association, these features illustrate that loan participations and loan total return swaps are distinct structures that serve entirely different functions in the loan market. To ensure that loan participations are not captured within the definition of swap, the MFA suggested guidance under which the definition of swap would not include loan participations in which the purchaser is acquiring an ownership interest in the related loan or commitment; and the agreement pursuant to which the purchaser is acquiring such an interest is a participation agreement that is customarily entered into in the primary or secondary loan markets; requires the grantor to represent that it is a lender under, or a participant or sub-participant in, the loan, provides that the participant is entitled to receive from the grantor all of the economic benefit of the whole or part of a loan to the extent of payments received by the grantor in respect of such loan and requires that 100 percent of the purchase price of calculated with respect to the loan is paid on the settlement date.