Thursday, June 23, 2005
HF Insider Trading Through Lender Info?
The New Insider Trading?
Carolyn Sargent
June 20, 2005
Insider trading" may conjure up visions of Martha Stewart selling shares of ImClone Systems Inc. after being tipped by the company founder, but today it's not the stock market that's under the most intense scrutiny for potential abuse of material nonpublic information. Even greater opportunity for misdeeds may lie in the more arcane world of bank, bond and credit derivative capital markets.
That hasn't always been the case. But the rapid evolution of the leveraged loan business, which originates and trades speculative-grade bank loans, has profoundly altered the credit landscape. In the past three years or so, the secondary loan market has grown from a fiefdom controlled by tightly regulated commercial banks and insurance companies to a fast-moving, highly liquid market played aggressively by hedge funds and Wall Street's proprietary trading desks. And this full-throated participation by new, lightly regulated investors in an instrument that increasingly trades like a security is raising serious questions about standards of trading conduct.
"So far, nothing terrible has happened. There have been no big blowouts. Now everyone is just hoping that something terrible doesn't happen before the industry figures it out on its own, so the regulators don't end up coming in," says Marc Baum, the founder of Solel Group, a consulting firm that counsels hedge funds on legal compliance and regulatory issues.
The crux of the issue is this: Companies have a much closer relationship to their lenders than to investors in their public securities, and they give those lenders private information that public investors never see. Called syndicate-level information, it might include a whole bunch of items that aren't "material" to a company's financial position-like quarterly compliance certificates. But it can also include material information, such as updated projections of revenues and earnings, or plans for an acquisition or divestiture. In the hands of a reasonable investor, such info would likely cause a change in the price of a public security.
Lenders of all stripes-commercial banks, insurance companies, mutual funds and hedge funds-have an obligation to keep all syndicate information confidential. But investors in syndicated loans are often also traders, and many trade bank loans next to high-yield bonds and credit derivatives. Some, especially hedge funds, use the same professional to trade all the financial instruments across a company's capital structure. Keeping private information private under such porous circumstances obviously is a challenge.
"Is private information being used to trade public securities? Or are these investors really on the up-and-up?" one hedge fund manager asks. "The rumors and innuendos are definitely out there. And that is the key issue. Until you can get some resolution, or a slightly thicker Chinese wall, there will continue to be speculation."
Finger pointing
Both investors and universal banks have ample opportunity to trade on material inside information. "If you talk to the commercial bank people, they'll point to the hedge funds and say they don't have good Chinese walls, that they're getting private information from the other side. And hedge funds say the trading desks at the commercial banks aren't very good at keeping information separate," says a market source who declined to be identified. "So there's a lot of finger pointing out there, and as a result increasing concern."
Often fingered first are hedge funds, who became major players in the leveraged loan market in the recent economic downturn, when many credits deteriorated and couldn't be held any longer by traditional pools of capital-those held by commercial banks and insurance companies. Because hedge funds are only lightly regulated, and because so many of them are start-ups with small staffs, many have not established rigid internal control and compliance functions like the universal banks, which are regulated by a host of entities, from the Federal Reserve Board to the Securities and Exchange Commission and even state regulators. "Hedge funds are frequently just eight people sitting in a room. They're just not staffed at the same size [as more established, regulated entities]. What that means is that historically, they just haven't thought through the issues," Solel's Baum says.
Worse, it is often a single trader at a hedge fund who deals in all of a company's debt instruments. "You can't put a Chinese wall through someone's head," says Michael Kaplan, a partner in the corporate practice at law firm Davis Polk & Wardwell.
Buyside sources say a trader could use the material nonpublic information received through a loan participation to trade the company's bonds, convertibles or even stocks. A trader could also use that knowledge to write credit protection in the credit default swaps market.
Traders can gain access to this information easily, and with just a small capital commitment. "A hedge fund might get into the loan business by buying very small amounts of loan syndications of various borrowers. And in so doing, the fund gets access to any information a bank would have access to: financial statements, growth projections and any renegotiations of covenants, or new covenants, or an update on the state of some type of negotiation" such as an acquisition, says one credit investor. "The temptation is great, and there is no barrier to entry."
Chris Dialynas is a managing director and portfolio manager at Pacific Investment Management Co., one of the world's top bond investors. He has written about the possible misuse of private information in the credit markets. Indeed, research that Dialynas authored in October 2002 "was directly responsible for the Joint Market Practices Forum," a consortium of industry associations that a year later introduced guidelines for the handling of material nonpublic information by broker/dealers, says Marjorie Gross, regulatory counsel for the Bond Market Association.
Dialynas believes that "the probability of acting on the temptation increases as the reward to people who might do the misdeeds increases." A large part of a hedge fund manager's compensation is based on a percentage of performance, he notes, "and that would give them a greater incentive to cross the barrier." The same principle would apply to a trader making bets for the proprietary account of a universal bank.
Such behavior would be less likely to occur at traditional investment managers, Dialynas argues. That's because most asset managers have a longer-term horizon, they don't get compensated strictly on performance, and generally they have more franchise risk, he says.
The information divide
That's not to say traditional credit investors don't have to cross this potential minefield, too. 40/86 Advisors, a Carmel, Ind., asset manager, invests in bank loans, high-yield bonds and collateralized bond obligations, or pools of corporate credit that have been repackaged into new securities bearing various levels of risk.
40/86 employs separate portfolio managers to run its bank loan and high-yield bond investments, but its managers share the same headquarters. To avoid the possibility of mishandling private, material information, 40/86-like a growing number of loan investors-chooses not to receive private, syndicate information in most cases. "We have a policy of remaining public, and if and when we make the decision to become private on a name, the name is identified and tracked on a restricted list. My concern is that these policies and procedures may not be in place universally to avoid the misuse of material nonpublic information," says Amy Gibson, vp in charge of 40/86's high-yield group.
An investor who chooses to be a "private" lender may receive material nonpublic information about the borrower. Antifraud provisions of the securities laws prohibit any investor from using private, price-sensitive information to trade the public securities.
But just because an investor refuses to receive syndicate information doesn't mean it isn't readily available, should he have a change of heart. "It's a little bit too much on the honor system right now," said one portfolio manager who declined to be identified. "Even though we are public right now, we could go out and ask for private information-and get it."
Self-policing, then, does not seem to be the answer, in part because private information can be so tantalizing. One hedge fund manager who focuses solely on credit opportunities says that he, too, refuses to receive private loan information-except in rare instances when a company has no outstanding public securities, and the only way to participate in a loan is to receive syndicate information. "When you participate in those deals, you get a glimpse of what other [investors] might be seeing about public companies, and it piques your curiosity, particularly on a complicated deal."
Given that insight, he says, he sometimes has to walk away from a deal if he thinks the playing field isn't level: in short, if he faces an information disadvantage that prevents him from making an effective judgment about the investment.
At least one big loan information provider has recognized the problem-and come up with a solution. IntraLinks Inc. makes information about many large U.S. bank loans available through an Internet-based document distribution system. Historically, investors agree, it has been very easy for so-called public loan investors to receive private information via IntraLinks simply by clicking on the icon for a folder that contained private documents. "The information is all on IntraLinks, and in theory it has been very easy to press the wrong button" to receive private information, says a loan investor.
But in late March, IntraLinks launched a redesign of the system's architecture to try to prevent investors from being accidentally exposed to private, material information. Now, lenders are required to self-declare as public or private investors before they gain access to any loan documents. Fund managers who identify themselves as public have access only to loan documents that the agent bank deems appropriate for public investors. The same goes for the correspondence they receive from the agent bank.
"This system allows syndicating agents to feel better about how they disclose information to their investors. And from an investor's standpoint, it provides them with greater safeguards to ensure they don't get accidentally tainted," says Andy Fieweger, IntraLinks' product marketing manager for debt capital markets.
The IntraLinks innovation does help agent banks and investors manage their information flow, but it isn't fool-proof-nor was it expected to be.
For one, as an increasing number of lenders have chosen to be public, agent banks and borrowers have found it difficult in some cases to secure the requisite number of approvals on credit amendments, according to market sources.
A good many credit amendments require approval from a simple majority, or 51%, of a company's lenders. But those that involve serious changes to a loan's terms-such as one that would decrease pricing-require approval from all investors. "If the company has designated the amendment as private, and the bulk of its lenders have designated themselves as public, then you have a quandary because there aren't enough lenders to vote" on the amendment, says Gibson of 40/86.
When that is the case, banks end up calling investors individually to solicit votes-an interaction that the buyside says can cause confusion. In April, Six Flags Inc. was looking for approval of an amendment to its $1 billion credit facility that would expand its letter of credit capacity and permit a separate financing for its Montreal facility, allowing the company to have Canadian dollar-denominated debt. The company designated the amendment as private and posted it as such on IntraLinks, says James Dannhauser, Six Flags's chief financial officer.
Looking for approval from the majority of the Six Flag lenders, agent bank Lehman Brothers wound up calling investors to solicit votes, a practice market participants say is not uncommon. One "public" lender was told that while the amendment was marked private, it didn't contain any material information, and thus it was okay to receive. The lender found that advice confusing. "If it didn't contain material information in the first place, why not make it public?" the lender asks.
Traditionally, banks have used standard language regarding confidentiality agreements when they launch a syndicated loan deal on IntraLinks. But banks are starting to customize that confidentiality language. Bank of America, for example, is implementing changes to include the requirement that lenders designate a recipient either inside or outside the firm-an attorney, for instance-to receive private information from the borrower or agent, which would ensure that the bank doesn't have trouble getting approvals in the future. "We felt we needed to explicitly require each lender to declare that they would have the ability to receive all communications from the borrowers," says Alex Spiro, associate general counsel.
IntraLinks is also testing a feature with a handful of buyside firms that would provide greater visibility to compliance officers and counsel on activities within their firm. "We have seen a growth in the number of investment firms wanting the ability to monitor activity with regard to what specific individuals are looking at what documents," says IntraLinks' Fieweger. For those clients, IntraLinks is now providing daily reports on activity across the firm's user base. It is planning to offer this service to a much wider audience, perhaps as early as this year.
Definitions misunderstood
To further complicate matters, many investors get confused about the definition of materiality, and exactly what "public" information means.
While well defined in securities laws, in practice the interpretation of materiality is always subjective. "One never knows whether something is really material until it is challenged or disputed," says one credit investor. "What might affect the value of a security in one situation might not affect it in another. If I saw a company's projections a year ago, am I still private, or has that point passed?"
The securities laws define public information as that which is widely disseminated. But what constitutes widely disseminated? Consider the information coming out of a bank meeting, in which commercial bankers meet with investors to share information about a borrower. These days, it is standard practice to ask public investors to leave midway through the meeting so that syndicate-level information can be provided to private investors.
"Clearly, a lot of things happen after a bank meeting ends. Calls get made, and loans start to move in the market," Baum says. "Based on which direction trades are taking, it becomes rather obvious to public investors what is happening. That raises the question as to whether that information is then really public."
The permeability of some information walls is underscored by the fact that more companies are choosing not to provide as much information to private investors as they have in the past. Notes Gibson of 40/86: "Too often the information in a private' lender call got out on the press wires within 20 minutes. So companies are now erring on the side of not sharing as much information, even though it is supposedly to private lenders." Some companies are also further stratifying information disclosure, choosing to share the most private information with only the managing-agent level of banks, market insiders say.
The tension is that "everybody wants to be on the safe side," Gibson says. "Our policies prohibit me from acquiring or accessing certain information, so, if I am not sure, I am not going to open an e-mail, and if a company is not sure, it will mark that correspondence private. Each party is asking the other to make the determination, which in some cases is forcing everybody into inaction."
Six Flags' Dannhauser concurs. "We mark everything private because we'd be stupid not to," he says.
Street questions, too
Investors aren't the only market participants under fire. "To the extent that a bank participates in the CDS market and is an underwriter or lender to that same name, it presents a natural conflict and a potential regulatory concern," says Pimco's Dialynas.
"We are not aware of any specific situations of abuse, but it is certainly a question that people ask," Gibson says. And, says a hedge fund manager: "Many investors have lingering questions with regard to banks' behavior."
In October 2003, a consortium of industry associations led by the BMA put out a statement of principles and recommendations regarding the handling of material nonpublic information for the U.S. market. Among others, those best practices include establishing written and formalized policies and procedures, an independent compliance function, the physical and functional separation of departments, procedures for communications across Chinese Walls and for restricted lists, watch lists and trading reviews.
In part due to those best practices, investors say they have more confidence now that broker/dealers have adequate safeguards to prohibit the transfer of material nonpublic information from their lending business units to the desks that trade bank debt, bonds and credit derivatives. By and large, banks are also perceived to have walled off from lending their credit portfolio management activities, or those operations undertaken to offset risk in their loan portfolios.
But no single model is evolving. When the BMA guidelines came out, Gross says, "firms were debating whether their loan traders and credit portfolio managers should be on the public side or the private side of the wall."
Earlier this year, JPMorgan Chase moved its bank-debt trading operations to the public side of the house, an effort that could avoid the perception of wrongdoing. But the fact that Citigroup, an archrival in both loan origination and debt underwriting, has chosen to keep trading bank debt on the private side simply underscores how fluid best practices may be.
Gross says a universal bank "can be in compliance either way, but it needs policies and procedures for making sure it is not misusing material nonpublic information, as outlined in the 2003 paper."
That said, a proprietary trader working for a broker/dealer could very easily find himself in rough seas. For example, says one market participant, that trader might consistently work with a certain hedge fund, and might have a strong suspicion-from seeing the fund's participations in lending syndicates and subsequent trades-that the fund is acting on material nonpublic information. "The second the fund puts on a series of trades-say, buying a small piece of a loan and then buying protection on it-it has transferred that information" to the trader, says one market participant. The trader who then puts on the same trades as the hedge fund could be viewed as having violated antifraud provisions of the securities laws, lawyers say.
Warnings in Europe
The potential for mishandling private, price-sensitive information is also getting attention in Europe. In late April, European banking groups warned members dealing in credit derivatives to maintain strong Chinese walls between their lending and trading departments or potentially face insider dealing charges. In May, those banking groups-including the International Swaps and Derivatives Association, the Loan Market Association and the BMA-published a manual of best practices similar to those introduced in the U.S. 20 months ago.
As in the U.S., there haven't been any public cases of insider dealing in credit derivatives brought against European banks thus far, but the measure may not be totally pre-emptive. A report published earlier this month by two researchers at the London Business School concluded that over the past four years, price movements in the CDS market indicate that some banks could be misusing private information to take trading positions.
Richard Metcalfe, senior policy director and co-head of ISDA's European office, says the paper's particular emphasis is on credit portfolio management, "because that is where the nub of the issue is. Questions are being raised about whether banks in the lending business could gain some advantage that would ultimately aid their credit portfolio management activities."
The guidelines were triggered in part by the European Union's Market Abuse Directive, which goes into effect on July 1. The paper tightens the definition of insider trading in many European countries and explicitly brings credit derivatives into the regulatory regime. As it stands, insider trading laws in some EU member states do not extend to securities not traded on public exchanges, such as credit derivatives, Metcalfe says.
Ahead of the curve'
In 2004, the Securities and Exchange Commission is said to have conducted a sweep of the major universal banks, including Citigroup, JPMorgan Chase, UBS and Credit Suisse First Boston, with the aim of examining the way leveraged loans are traded. The questions raised in that sweep have subsequently shown up in routine examinations of other broker/dealers, sources say. The agency's continuing interest in this topic has spurred the loan industry to be very proactive in formulating appropriate internal policies and procedures to prevent misuse of private, price-sensitive information.
A spokesman for the SEC, following its customary practice, declined to confirm or deny any investigative actions.
The BMA guidelines, aimed at the broker/dealer community, are seen by some as a good start. Those recommendations suggest that Chinese walls should exist between the people who are privvy to inside information through the bank loan market and those who are trading the securities and credit derivatives, and that those policies should be very rigid. Gross, the BMA's regulatory counsel, notes that the October 2003 forum paper-formally released by the Joint Market Practices Forum-"had nothing to do with pressure from regulators and everything to do with staying ahead of the curve with regard to all the legal and reputational issues that arise when a bank hedges its credit exposure to a company that gives it nonpublic credit information, by trading securities and security-based derivatives of the same company."
Pimco's Dialynas is impressed with parts of the proposal. But he and others have criticized the BMA guidelines because they don't include a mechanism to ensure that the recommendations are being implemented. "That begs the question whether there was anything significant to come out of [the guidelines] in a real sense. The recommendation was quite good, but again, if there is no policing mechanism, and penalties are not well stipulated, then there is always the temptation to cheat."
As a trade association, the BMA does not see itself as having a regulatory role. "The law provides penalties for misuse of material nonpublic information," says Gross. "We don't need to."
Meanwhile, the Loan Syndications and Trading Association is in the midst of a confidential process to "determine what guidelines, if any, should be developed in the broader loan capital markets," according to spokesman Jon Teall. Because the association takes in all participants in the loan market, it has a tough, and possibly long, road ahead to build consensus among players with a disparity of interests.
Materials handed out in an April LSTA seminar on the subject outlined an ambitious goal: "to establish general standards of trading conduct that are applicable to all market participants in connection with all loan market activities."
Are loans securities?
Heightened regulatory oversight of hedge funds could put the brakes on some dodgy trading practices. In February 2006, the investment advisers to most hedge funds must register with the SEC. As such, at least in theory, the funds will be subject to a physical walkthrough once a year by an agency examiner. Among other things, says Baum, "that means the SEC will look through a fund's records to figure out whether the fund has given the best execution to its accounts. And it will look at basic documentation, to make sure they're trading properly."
And then there's the possibility that loans traded in the secondary market will be deemed securities, which would cut off the flow of private information to lenders. It's a possibility former SEC Chairman Harvey Pitt believes is sufficiently real-and told LSTA members as much at its annual conference in late October.
The Supreme Court has ruled that traditional commercial loans are not securities. But that decision was premised on a number of assumptions, one of which was that there was an alternative regulatory apparatus-the Fed and the OCC-to oversee commercial banks, which at that time held the loans, securities lawyers said.
Today, "the real question is, Are these loans really loans, or are they securities?'" says one securities lawyer. The types of loans that hedge funds and mutual funds buy-called B-term loans-are structured more like a bond than a loan, with a bullet maturity and minimal amortization schedule, of, say, 1% a year.
"When you look at a term loan B, you don't have the alternative regulatory scheme that you have with commercial bank loans, because you don't have commercial lenders, you have hedge funds, which are all lightly regulated," the lawyer explains. "So now you have a whole bunch of people who are basically high-yield bond buyers who are buying loans and high-yield bonds and effectively viewing them as fungible. Clearly, the question arises as to whether they really may be securities."
And that's an outcome, however unlikely, that the leveraged loan market will fight at any cost.
(c) 2005 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.
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Carolyn Sargent
June 20, 2005
Insider trading" may conjure up visions of Martha Stewart selling shares of ImClone Systems Inc. after being tipped by the company founder, but today it's not the stock market that's under the most intense scrutiny for potential abuse of material nonpublic information. Even greater opportunity for misdeeds may lie in the more arcane world of bank, bond and credit derivative capital markets.
That hasn't always been the case. But the rapid evolution of the leveraged loan business, which originates and trades speculative-grade bank loans, has profoundly altered the credit landscape. In the past three years or so, the secondary loan market has grown from a fiefdom controlled by tightly regulated commercial banks and insurance companies to a fast-moving, highly liquid market played aggressively by hedge funds and Wall Street's proprietary trading desks. And this full-throated participation by new, lightly regulated investors in an instrument that increasingly trades like a security is raising serious questions about standards of trading conduct.
"So far, nothing terrible has happened. There have been no big blowouts. Now everyone is just hoping that something terrible doesn't happen before the industry figures it out on its own, so the regulators don't end up coming in," says Marc Baum, the founder of Solel Group, a consulting firm that counsels hedge funds on legal compliance and regulatory issues.
The crux of the issue is this: Companies have a much closer relationship to their lenders than to investors in their public securities, and they give those lenders private information that public investors never see. Called syndicate-level information, it might include a whole bunch of items that aren't "material" to a company's financial position-like quarterly compliance certificates. But it can also include material information, such as updated projections of revenues and earnings, or plans for an acquisition or divestiture. In the hands of a reasonable investor, such info would likely cause a change in the price of a public security.
Lenders of all stripes-commercial banks, insurance companies, mutual funds and hedge funds-have an obligation to keep all syndicate information confidential. But investors in syndicated loans are often also traders, and many trade bank loans next to high-yield bonds and credit derivatives. Some, especially hedge funds, use the same professional to trade all the financial instruments across a company's capital structure. Keeping private information private under such porous circumstances obviously is a challenge.
"Is private information being used to trade public securities? Or are these investors really on the up-and-up?" one hedge fund manager asks. "The rumors and innuendos are definitely out there. And that is the key issue. Until you can get some resolution, or a slightly thicker Chinese wall, there will continue to be speculation."
Finger pointing
Both investors and universal banks have ample opportunity to trade on material inside information. "If you talk to the commercial bank people, they'll point to the hedge funds and say they don't have good Chinese walls, that they're getting private information from the other side. And hedge funds say the trading desks at the commercial banks aren't very good at keeping information separate," says a market source who declined to be identified. "So there's a lot of finger pointing out there, and as a result increasing concern."
Often fingered first are hedge funds, who became major players in the leveraged loan market in the recent economic downturn, when many credits deteriorated and couldn't be held any longer by traditional pools of capital-those held by commercial banks and insurance companies. Because hedge funds are only lightly regulated, and because so many of them are start-ups with small staffs, many have not established rigid internal control and compliance functions like the universal banks, which are regulated by a host of entities, from the Federal Reserve Board to the Securities and Exchange Commission and even state regulators. "Hedge funds are frequently just eight people sitting in a room. They're just not staffed at the same size [as more established, regulated entities]. What that means is that historically, they just haven't thought through the issues," Solel's Baum says.
Worse, it is often a single trader at a hedge fund who deals in all of a company's debt instruments. "You can't put a Chinese wall through someone's head," says Michael Kaplan, a partner in the corporate practice at law firm Davis Polk & Wardwell.
Buyside sources say a trader could use the material nonpublic information received through a loan participation to trade the company's bonds, convertibles or even stocks. A trader could also use that knowledge to write credit protection in the credit default swaps market.
Traders can gain access to this information easily, and with just a small capital commitment. "A hedge fund might get into the loan business by buying very small amounts of loan syndications of various borrowers. And in so doing, the fund gets access to any information a bank would have access to: financial statements, growth projections and any renegotiations of covenants, or new covenants, or an update on the state of some type of negotiation" such as an acquisition, says one credit investor. "The temptation is great, and there is no barrier to entry."
Chris Dialynas is a managing director and portfolio manager at Pacific Investment Management Co., one of the world's top bond investors. He has written about the possible misuse of private information in the credit markets. Indeed, research that Dialynas authored in October 2002 "was directly responsible for the Joint Market Practices Forum," a consortium of industry associations that a year later introduced guidelines for the handling of material nonpublic information by broker/dealers, says Marjorie Gross, regulatory counsel for the Bond Market Association.
Dialynas believes that "the probability of acting on the temptation increases as the reward to people who might do the misdeeds increases." A large part of a hedge fund manager's compensation is based on a percentage of performance, he notes, "and that would give them a greater incentive to cross the barrier." The same principle would apply to a trader making bets for the proprietary account of a universal bank.
Such behavior would be less likely to occur at traditional investment managers, Dialynas argues. That's because most asset managers have a longer-term horizon, they don't get compensated strictly on performance, and generally they have more franchise risk, he says.
The information divide
That's not to say traditional credit investors don't have to cross this potential minefield, too. 40/86 Advisors, a Carmel, Ind., asset manager, invests in bank loans, high-yield bonds and collateralized bond obligations, or pools of corporate credit that have been repackaged into new securities bearing various levels of risk.
40/86 employs separate portfolio managers to run its bank loan and high-yield bond investments, but its managers share the same headquarters. To avoid the possibility of mishandling private, material information, 40/86-like a growing number of loan investors-chooses not to receive private, syndicate information in most cases. "We have a policy of remaining public, and if and when we make the decision to become private on a name, the name is identified and tracked on a restricted list. My concern is that these policies and procedures may not be in place universally to avoid the misuse of material nonpublic information," says Amy Gibson, vp in charge of 40/86's high-yield group.
An investor who chooses to be a "private" lender may receive material nonpublic information about the borrower. Antifraud provisions of the securities laws prohibit any investor from using private, price-sensitive information to trade the public securities.
But just because an investor refuses to receive syndicate information doesn't mean it isn't readily available, should he have a change of heart. "It's a little bit too much on the honor system right now," said one portfolio manager who declined to be identified. "Even though we are public right now, we could go out and ask for private information-and get it."
Self-policing, then, does not seem to be the answer, in part because private information can be so tantalizing. One hedge fund manager who focuses solely on credit opportunities says that he, too, refuses to receive private loan information-except in rare instances when a company has no outstanding public securities, and the only way to participate in a loan is to receive syndicate information. "When you participate in those deals, you get a glimpse of what other [investors] might be seeing about public companies, and it piques your curiosity, particularly on a complicated deal."
Given that insight, he says, he sometimes has to walk away from a deal if he thinks the playing field isn't level: in short, if he faces an information disadvantage that prevents him from making an effective judgment about the investment.
At least one big loan information provider has recognized the problem-and come up with a solution. IntraLinks Inc. makes information about many large U.S. bank loans available through an Internet-based document distribution system. Historically, investors agree, it has been very easy for so-called public loan investors to receive private information via IntraLinks simply by clicking on the icon for a folder that contained private documents. "The information is all on IntraLinks, and in theory it has been very easy to press the wrong button" to receive private information, says a loan investor.
But in late March, IntraLinks launched a redesign of the system's architecture to try to prevent investors from being accidentally exposed to private, material information. Now, lenders are required to self-declare as public or private investors before they gain access to any loan documents. Fund managers who identify themselves as public have access only to loan documents that the agent bank deems appropriate for public investors. The same goes for the correspondence they receive from the agent bank.
"This system allows syndicating agents to feel better about how they disclose information to their investors. And from an investor's standpoint, it provides them with greater safeguards to ensure they don't get accidentally tainted," says Andy Fieweger, IntraLinks' product marketing manager for debt capital markets.
The IntraLinks innovation does help agent banks and investors manage their information flow, but it isn't fool-proof-nor was it expected to be.
For one, as an increasing number of lenders have chosen to be public, agent banks and borrowers have found it difficult in some cases to secure the requisite number of approvals on credit amendments, according to market sources.
A good many credit amendments require approval from a simple majority, or 51%, of a company's lenders. But those that involve serious changes to a loan's terms-such as one that would decrease pricing-require approval from all investors. "If the company has designated the amendment as private, and the bulk of its lenders have designated themselves as public, then you have a quandary because there aren't enough lenders to vote" on the amendment, says Gibson of 40/86.
When that is the case, banks end up calling investors individually to solicit votes-an interaction that the buyside says can cause confusion. In April, Six Flags Inc. was looking for approval of an amendment to its $1 billion credit facility that would expand its letter of credit capacity and permit a separate financing for its Montreal facility, allowing the company to have Canadian dollar-denominated debt. The company designated the amendment as private and posted it as such on IntraLinks, says James Dannhauser, Six Flags's chief financial officer.
Looking for approval from the majority of the Six Flag lenders, agent bank Lehman Brothers wound up calling investors to solicit votes, a practice market participants say is not uncommon. One "public" lender was told that while the amendment was marked private, it didn't contain any material information, and thus it was okay to receive. The lender found that advice confusing. "If it didn't contain material information in the first place, why not make it public?" the lender asks.
Traditionally, banks have used standard language regarding confidentiality agreements when they launch a syndicated loan deal on IntraLinks. But banks are starting to customize that confidentiality language. Bank of America, for example, is implementing changes to include the requirement that lenders designate a recipient either inside or outside the firm-an attorney, for instance-to receive private information from the borrower or agent, which would ensure that the bank doesn't have trouble getting approvals in the future. "We felt we needed to explicitly require each lender to declare that they would have the ability to receive all communications from the borrowers," says Alex Spiro, associate general counsel.
IntraLinks is also testing a feature with a handful of buyside firms that would provide greater visibility to compliance officers and counsel on activities within their firm. "We have seen a growth in the number of investment firms wanting the ability to monitor activity with regard to what specific individuals are looking at what documents," says IntraLinks' Fieweger. For those clients, IntraLinks is now providing daily reports on activity across the firm's user base. It is planning to offer this service to a much wider audience, perhaps as early as this year.
Definitions misunderstood
To further complicate matters, many investors get confused about the definition of materiality, and exactly what "public" information means.
While well defined in securities laws, in practice the interpretation of materiality is always subjective. "One never knows whether something is really material until it is challenged or disputed," says one credit investor. "What might affect the value of a security in one situation might not affect it in another. If I saw a company's projections a year ago, am I still private, or has that point passed?"
The securities laws define public information as that which is widely disseminated. But what constitutes widely disseminated? Consider the information coming out of a bank meeting, in which commercial bankers meet with investors to share information about a borrower. These days, it is standard practice to ask public investors to leave midway through the meeting so that syndicate-level information can be provided to private investors.
"Clearly, a lot of things happen after a bank meeting ends. Calls get made, and loans start to move in the market," Baum says. "Based on which direction trades are taking, it becomes rather obvious to public investors what is happening. That raises the question as to whether that information is then really public."
The permeability of some information walls is underscored by the fact that more companies are choosing not to provide as much information to private investors as they have in the past. Notes Gibson of 40/86: "Too often the information in a private' lender call got out on the press wires within 20 minutes. So companies are now erring on the side of not sharing as much information, even though it is supposedly to private lenders." Some companies are also further stratifying information disclosure, choosing to share the most private information with only the managing-agent level of banks, market insiders say.
The tension is that "everybody wants to be on the safe side," Gibson says. "Our policies prohibit me from acquiring or accessing certain information, so, if I am not sure, I am not going to open an e-mail, and if a company is not sure, it will mark that correspondence private. Each party is asking the other to make the determination, which in some cases is forcing everybody into inaction."
Six Flags' Dannhauser concurs. "We mark everything private because we'd be stupid not to," he says.
Street questions, too
Investors aren't the only market participants under fire. "To the extent that a bank participates in the CDS market and is an underwriter or lender to that same name, it presents a natural conflict and a potential regulatory concern," says Pimco's Dialynas.
"We are not aware of any specific situations of abuse, but it is certainly a question that people ask," Gibson says. And, says a hedge fund manager: "Many investors have lingering questions with regard to banks' behavior."
In October 2003, a consortium of industry associations led by the BMA put out a statement of principles and recommendations regarding the handling of material nonpublic information for the U.S. market. Among others, those best practices include establishing written and formalized policies and procedures, an independent compliance function, the physical and functional separation of departments, procedures for communications across Chinese Walls and for restricted lists, watch lists and trading reviews.
In part due to those best practices, investors say they have more confidence now that broker/dealers have adequate safeguards to prohibit the transfer of material nonpublic information from their lending business units to the desks that trade bank debt, bonds and credit derivatives. By and large, banks are also perceived to have walled off from lending their credit portfolio management activities, or those operations undertaken to offset risk in their loan portfolios.
But no single model is evolving. When the BMA guidelines came out, Gross says, "firms were debating whether their loan traders and credit portfolio managers should be on the public side or the private side of the wall."
Earlier this year, JPMorgan Chase moved its bank-debt trading operations to the public side of the house, an effort that could avoid the perception of wrongdoing. But the fact that Citigroup, an archrival in both loan origination and debt underwriting, has chosen to keep trading bank debt on the private side simply underscores how fluid best practices may be.
Gross says a universal bank "can be in compliance either way, but it needs policies and procedures for making sure it is not misusing material nonpublic information, as outlined in the 2003 paper."
That said, a proprietary trader working for a broker/dealer could very easily find himself in rough seas. For example, says one market participant, that trader might consistently work with a certain hedge fund, and might have a strong suspicion-from seeing the fund's participations in lending syndicates and subsequent trades-that the fund is acting on material nonpublic information. "The second the fund puts on a series of trades-say, buying a small piece of a loan and then buying protection on it-it has transferred that information" to the trader, says one market participant. The trader who then puts on the same trades as the hedge fund could be viewed as having violated antifraud provisions of the securities laws, lawyers say.
Warnings in Europe
The potential for mishandling private, price-sensitive information is also getting attention in Europe. In late April, European banking groups warned members dealing in credit derivatives to maintain strong Chinese walls between their lending and trading departments or potentially face insider dealing charges. In May, those banking groups-including the International Swaps and Derivatives Association, the Loan Market Association and the BMA-published a manual of best practices similar to those introduced in the U.S. 20 months ago.
As in the U.S., there haven't been any public cases of insider dealing in credit derivatives brought against European banks thus far, but the measure may not be totally pre-emptive. A report published earlier this month by two researchers at the London Business School concluded that over the past four years, price movements in the CDS market indicate that some banks could be misusing private information to take trading positions.
Richard Metcalfe, senior policy director and co-head of ISDA's European office, says the paper's particular emphasis is on credit portfolio management, "because that is where the nub of the issue is. Questions are being raised about whether banks in the lending business could gain some advantage that would ultimately aid their credit portfolio management activities."
The guidelines were triggered in part by the European Union's Market Abuse Directive, which goes into effect on July 1. The paper tightens the definition of insider trading in many European countries and explicitly brings credit derivatives into the regulatory regime. As it stands, insider trading laws in some EU member states do not extend to securities not traded on public exchanges, such as credit derivatives, Metcalfe says.
Ahead of the curve'
In 2004, the Securities and Exchange Commission is said to have conducted a sweep of the major universal banks, including Citigroup, JPMorgan Chase, UBS and Credit Suisse First Boston, with the aim of examining the way leveraged loans are traded. The questions raised in that sweep have subsequently shown up in routine examinations of other broker/dealers, sources say. The agency's continuing interest in this topic has spurred the loan industry to be very proactive in formulating appropriate internal policies and procedures to prevent misuse of private, price-sensitive information.
A spokesman for the SEC, following its customary practice, declined to confirm or deny any investigative actions.
The BMA guidelines, aimed at the broker/dealer community, are seen by some as a good start. Those recommendations suggest that Chinese walls should exist between the people who are privvy to inside information through the bank loan market and those who are trading the securities and credit derivatives, and that those policies should be very rigid. Gross, the BMA's regulatory counsel, notes that the October 2003 forum paper-formally released by the Joint Market Practices Forum-"had nothing to do with pressure from regulators and everything to do with staying ahead of the curve with regard to all the legal and reputational issues that arise when a bank hedges its credit exposure to a company that gives it nonpublic credit information, by trading securities and security-based derivatives of the same company."
Pimco's Dialynas is impressed with parts of the proposal. But he and others have criticized the BMA guidelines because they don't include a mechanism to ensure that the recommendations are being implemented. "That begs the question whether there was anything significant to come out of [the guidelines] in a real sense. The recommendation was quite good, but again, if there is no policing mechanism, and penalties are not well stipulated, then there is always the temptation to cheat."
As a trade association, the BMA does not see itself as having a regulatory role. "The law provides penalties for misuse of material nonpublic information," says Gross. "We don't need to."
Meanwhile, the Loan Syndications and Trading Association is in the midst of a confidential process to "determine what guidelines, if any, should be developed in the broader loan capital markets," according to spokesman Jon Teall. Because the association takes in all participants in the loan market, it has a tough, and possibly long, road ahead to build consensus among players with a disparity of interests.
Materials handed out in an April LSTA seminar on the subject outlined an ambitious goal: "to establish general standards of trading conduct that are applicable to all market participants in connection with all loan market activities."
Are loans securities?
Heightened regulatory oversight of hedge funds could put the brakes on some dodgy trading practices. In February 2006, the investment advisers to most hedge funds must register with the SEC. As such, at least in theory, the funds will be subject to a physical walkthrough once a year by an agency examiner. Among other things, says Baum, "that means the SEC will look through a fund's records to figure out whether the fund has given the best execution to its accounts. And it will look at basic documentation, to make sure they're trading properly."
And then there's the possibility that loans traded in the secondary market will be deemed securities, which would cut off the flow of private information to lenders. It's a possibility former SEC Chairman Harvey Pitt believes is sufficiently real-and told LSTA members as much at its annual conference in late October.
The Supreme Court has ruled that traditional commercial loans are not securities. But that decision was premised on a number of assumptions, one of which was that there was an alternative regulatory apparatus-the Fed and the OCC-to oversee commercial banks, which at that time held the loans, securities lawyers said.
Today, "the real question is, Are these loans really loans, or are they securities?'" says one securities lawyer. The types of loans that hedge funds and mutual funds buy-called B-term loans-are structured more like a bond than a loan, with a bullet maturity and minimal amortization schedule, of, say, 1% a year.
"When you look at a term loan B, you don't have the alternative regulatory scheme that you have with commercial bank loans, because you don't have commercial lenders, you have hedge funds, which are all lightly regulated," the lawyer explains. "So now you have a whole bunch of people who are basically high-yield bond buyers who are buying loans and high-yield bonds and effectively viewing them as fungible. Clearly, the question arises as to whether they really may be securities."
And that's an outcome, however unlikely, that the leveraged loan market will fight at any cost.
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# posted by Tom @ 2:44 PM 
