There's a blacklist that rules $800 billion U.S. loan market

What do Highland Capital Management, Fortress Investment Group LLC and Cerberus Capital Management have in common? The firms, which manage some $110 billion among them, are on a list that says they can never invest in a $155 million loan that's trading in U.S. markets.

RBS Holding Co., the owner of direct marketer Quadriga Art, banned the three firms and seven others last year from buying parts of the loan, according to two people with knowledge of the matter who asked not to be named because the decision was private. They were deemed, the people said, to be too demanding in debt restructurings, a fate that executives at RBS -- which has no relationship to the Scottish bank -- considered as Quadriga's business faltered.

Unlike any other market in the U.S., the blacklist rules in leveraged loans. No regulator polices trading in the $800 billion market. Here, borrowers -- and the investors who control them -- choose who gets into the club. It would be as if Apple Inc. got to decide who could buy its stock.

"I really can't think of a good example of another market where you really are selling to a lot of people but you still retain the right to keep some people out," said Elisabeth de Fontenay, a professor at Duke University School of Law in Durham, North Carolina, and a former corporate lawyer.

While banks managing stock and bond deals can pick which investors are allotted securities in public offerings, anyone with enough money can buy the assets once they start trading in the market. Not so with loans. The lists prohibiting investors can last until the debt matures.

Booming Market

The practice poses risks to a market whose size has quadrupled from about $200 billion over the last decade as plunging interest rates fueled investor demand for securities that offer extra yield. Blacklisting reduces the number of potential buyers, which in turn makes the loans difficult to trade, and can exclude the savvier investors who are better able to fight for creditor rights in a default.

"These types of limitations are tremendously detrimental" to the market's quantity and quality of buyers and sellers, said Greg Margolies, a senior partner at Los Angeles-based Ares Management LP, which manages about $80 billion in assets including speculative-grade debt and real estate. "Ares will not invest in a name where secondary liquidity can dry up immediately because an issuer has decided to blacklist a number of market participants."

Blacklist Defined

The Merriam-Webster Dictionary defines blacklist as "a list of persons who are disapproved of or are to be punished or boycotted." In the loan market, there are three things that can warrant punishment: having a reputation for being a tough negotiator in debt restructurings, like Highland and the other firms in the RBS deal; having an affiliation with a borrower's competitor; or simply being disliked.

"We protect the rights of our investors," Jim Dondero, president of Highland, said in an e-mailed statement. "Sometimes we must pursue the 'bad acts' of management teams or sponsors. It stuns us that some managers are passive and never protect their investors."

Mark Schulhof, chief executive officer of RBS, declined to comment. Gordon Runte, a spokesman for Fortress, and Peter Duda, a spokesman for Cerberus at Weber Shandwick, declined to comment.

Illiquid Assets

The lack of liquidity in speculative-grade debt has drawn warnings from regulators, including the Financial Stability Board and the U.S. Securities and Exchange Commission, as individual investors poured money into mutual funds and exchange-traded funds. The concern is that it's become too easy to get into a market for people who don't understand how tough it may be to cash out when sentiment sours.

Trading is slow even in a bull market.

It took 20 days on average to complete a loan trade in the three months ending in June, according to data compiled by the New York-based Loan Syndications & Trading Association. That's almost seven times as long as the three-day average in the corporate bond market.

Yet for all of the concern expressed by U.S. policy makers, none of them oversee the loan market. Its unregulated status traces back to securities laws that were drafted in the 1930s, when company loans were mainly private transactions between one bank and one borrower. These days, though, the debt is mostly sliced into pieces worth several million dollars and distributed to investors.

The SEC's authority in this market is limited to loans that meet the legal definition of a security, which "depends on the facts, circumstances and economic terms of the loan or loan tranche," according to spokesman John Nester. "The SEC is focused on the oversight of liquidity management in mutual funds and ETFs, and will continue to vigorously pursue violations of the securities laws within its jurisdiction," Nester said in an e-mailed statement.

Bad Blood

Blacklisting is rampant. And growing.

Data gathered by Xtract Research show that 77 percent of all loan deals in the third quarter included provisions giving borrowers the ability to block individual lenders, up from 51 percent at the end of last year. The lists can often be updated to add new investors whenever a borrower wants.

The most common explanation given for excluding potential buyers is that they have an affiliation with rivals of the borrower. There's private information that lenders get access to -- things like financial projections -- that the borrower doesn't want them to see.

Robert Blank, head of leveraged-loan research at Xtract in Westport, Connecticut, calls those circumstances the most "reasonable" for justifying the blacklist.

Apollo-Highland

Jonathan Kitei, head of U.S. loan sales and collateralized- loan obligation origination at Barclays Plc, said, though, that he's seen personal animosity shape lists.

"Often times you see a sponsor put an investor on a blacklist because one partner at the firm doesn't like the investor," said Kitei, who is based in New York. "There are great inconsistencies in the use of blacklists."

Leon Black's Apollo Global Management LLC has blocked Highland from buying several loans of its takeover targets, according to a person with direct knowledge of the matter. There's a history of feuding between the two firms: Highland sought in 2006 to stop a merger between Apollo-backed SkyTerra Communications and Motient Corp., triggering a series of court battles.

Highland, a Dallas-based money manager, was banned from deals including loans taken out by Caesars Entertainment Corp., the casino operator partly owned by Apollo, according to the person, who asked not to be identified because the matter is private.

Charles Zehren, a spokesman for New York-based Apollo at Rubenstein Associates Inc., declined to comment.

'Shindler's List'

Blacklisting dates back to at least the late 1990s, when Nextel Communications Inc.'s then chief financial officer Steve Shindler penalized lenders who didn't participate in the company's new credit facility by banning them from buying the debt in the secondary market, according to industry newsletter Bank Letter.

It became known as "Shindler's List," reflecting Wall Street's penchant for tasteless puns that twist history. The phrase is a reference to German businessman Oskar Schindler's list of Jews to be saved from transportation to concentration camp Auschwitz during World War II, the subject of the Oscar- winning film of that name in 1993.

To this day, traders still use the name when talking about blacklists. Shindler, who is now chief executive officer of NII Holdings Inc., the bankrupt mobile-phone company that uses the Nextel brand in Latin America, declined to comment.

'Disqualified Institutions'

"It's anti-American," Lee Shaiman, a senior portfolio manager with Blackstone Group LP's credit unit GSO Capital Partners in New York, told the LSTA's annual conference Oct. 23 when asked about the practice. "It's anti-competitive."

Some investors find out that they have been barred when they try to complete a trade and are turned away by broker- dealers. Others never know. Most lists are kept privately by the banks that arrange the deals.

Occasionally, they're included in public credit agreements, like the blacklist orchestrated this year by a Goldman Sachs Group Inc.-controlled company named Interline Brands Inc. An addendum to a March 19 regulatory filing for the deal listed two names as "Disqualified Institutions" that couldn't buy the loans: hedge funds Bulldog Investors and QVT Financial.

Andrea Raphael, a spokeswoman for Goldman Sachs, said the bank didn't select the names on the list. Lev Cela, a spokesman for Interline, didn't respond to e-mails and telephone calls seeking comment. A QVT representative declined to comment.

Phil Goldstein, the co-founder of Bulldog in Saddle Brook, New Jersey, was unaware for months that he had been banned. "It kind of irks you that there's somebody saying you're not good enough to do this or we don't want you for that," he said.

The whole thing is perplexing to Goldstein.

His fund, he said, doesn't even invest in loans.