Should the Recent Credit Market Events Affect the Debt-vs.-Equity Characterization of MBS, ABS, CLO, and CDO Notes and, as a Consequence, Their ERISA Eligibility?

Abstract

Since the credit market disruptions that began in 2007, it is not uncommon to see mortgage-backed, asset-backed, and CLO or CDO securities downgraded or purchased at both origination and in the secondary market at higher discounts and/or with higher promised rates of interest than in the past. Should these factors change the traditional approach taken in determining whether securities designated as notes should be considered debt or equity when acquired by pension and profit sharing plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and/or the Internal Revenue Code of 1986, as amended, or entities deemed to hold their assets (collectively, “Plans”)? If such notes must be recharacterized as equity, they cannot be sold to or in some cases held by Plans. Thus, the debt-equity distinction is of great importance to sponsors and underwriters in the initial market, non-Plan sellers in the secondary market, and Plans purchasers in both. This article concludes that while the issue is being debated, on balance the current market conditions should not change the traditional debt-equity ERISA analysis and a note that received debt treatment for ERISA purposes previously would receive the same treatment now. However, even if a note is determined to be debt, whether it should be purchased by a Plan should in the final analysis be based upon its investment suitability as determined by the Plan's fiduciary in accordance with the applicable ERISA prudent investment standards.