Since the Great Depression, U.S. securities regulation has been centered on mandatory disclosure: the various rules requiring issuers of securities to make publicly available certain information that regulators deem material to investors. But do the mandatory disclosure rules actually work? The stakes raised by this question are enormous, yet there is precious little consensus in answering it. After more than eighty years of intensive federal securities regulation, empirical testing of its effectiveness has failed to yield a definitive result.
In a recent paper, Do the Securities Laws Matters? The Rise of the Leveraged Loan Market, I argue that we may finally gain purchase on this question, by redirecting our attention from the corporate equity markets to the corporate debt markets, where recent dramatic changes have created near-perfect conditions for observing the effects of mandatory disclosure. Long viewed as contrasting forms of debt, corporate loans and corporate bonds are rapidly converging into a single asset class. Yet bonds are treated as securities under the federal securities laws, while loans are not. The existence of these two functionally equivalent markets, one subject to mandatory disclosure and the other not, amounts to a near-perfect natural experiment testing the effects of the federal securities laws.
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. 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 to small, opaque companies requiring intensive monitoring. Bonds were thus highly liquid instruments, appropriate for dispersed, unsophisticated retail investors. By contrast, loans were funded nearly exclusively by banks, which had the ability and incentives to monitor their borrowers closely. Because of the steep information costs associated with loans, they were typically held to maturity by the bank that funded them, and thus plainly illiquid. These fundamental differences between bonds and loans as to their creditors and liquidity long justified the regulatory treatment of bonds as securities and of loans as non-securities.
Yet dramatic changes to the corporate loan market have converted it into something closely akin to the bond market, putting significant pressure on the regulatory distinction between the two. 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: leveraged loans and high-yield bonds currently feature strikingly similar pricing, non-price terms, participants, and liquidity.
Unfortunately, the convergence of the loan and bond markets to date strongly suggests that securities regulation is having little effect in the corporate debt markets: mandatory disclosure cannot be a necessary condition to developing a deep and liquid market (as is argued by its proponents), simply because the unregulated leveraged loan market, in which disclosure to investors is limited, non-uniform, and purely voluntary, is now larger than the regulated high-yield bond market. 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.
Admittedly, the conclusion that mandatory disclosure is having no effect in the corporate debt markets 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 be truly impeding investment—the institutional structures to support mandated disclosure are already in place, and some 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 to be terribly harmful—they simply do not seem to matter.
The full paper is available for download here.