In a closely watched decision, on May 22, 2020, Judge Gardephe of the federal district court for the Southern District of New York held that certain syndicated bank loans were not “securities” and therefore dismissed the state-law securities fraud claims the plaintiffs had asserted. The decision in the case, captioned Kirschner v. JPMorgan Chase Bank, N.A. et al.1, reaffirms a critical underpinning of the $2.4 trillion syndicated loan market: that syndicated loans are not securities subject to SEC registration, disclosure and antifraud regulations. This principle provides additional flexibility to borrowers and sophisticated investors to structure their transactions without a mandatory minimum level of disclosure and without compliance with various SEC reporting, disclosure and liability provisions2. A contrary outcome—applying the full regulatory rigor of the SEC’s disclosure and liability regime to the syndicated loan markets—could have further restricted access to capital for some borrowers in what is already a challenging credit environment for many industries.
In 2014, the plaintiffs, consisting of various institutional investors, purchased debt obligations of Millennium Laboratories LLC (“Millennium”), a California-based drug testing company, from the arranging banks. The transaction was structured as a $1.775 billion syndicated loan by way of an assignment of the loans from the arranging banks to the institutional investors shortly after the initial closing. Nineteen months after the loan closed, Millennium filed for bankruptcy. The plaintiffs claimed that the arranging banks violated state securities laws in connection with the 2014 sale of the loan notes because, among other things, they failed to perform due diligence concerning the legality of Millennium’s sales, marketing and billing practices and the known risks posed by a pending government investigation regarding such practices. Plaintiffs further claimed that the offering materials contained material misstatements or omissions.
The Court dismissed the securities fraud claims, holding that the Millennium loan notes were not securities. Though Kirschner was decided based on the characteristics of the syndicated loans in the case, their defining characteristics—such as the direct contractual relationship between investors and borrowers, the assignment restrictions contained in the loan documents, the limited solicitation of sophisticated institutional investors by the arranging banks and various other terms of the loan documentation—are common among syndicated loans. The holding in Kirschner therefore reaffirms the broader principle that syndicated loans are not securities.
Although the plaintiffs asserted only state-law securities claims, the parties and the Court agreed that the applicable test was the four-factor “family resemblance” test found in the 1990 U.S. Supreme Court case Reves. v. Ernst & Young, a case involving federal securities claims.3 The Court’s holding in Kirschner is consistent with the application of Reves to loan participations set forth in the 1992 Second Circuit case, Banco Español de Crédito v. Security Pacific National Bank.4
In Reves, the Supreme Court noted that, because the Securities Exchange Act of 1934 defines “security” to include “any note,” courts should presume any note is a security. However, this presumption may be rebutted if the notes bear a strong “family resemblance” to one of the enumerated categories of notes that are not securities, including “notes evidencing loans by commercial banks for current operations.”5
The four factors of the Reves family resemblance test are: (1) the motivations that would prompt a reasonable seller and buyer to enter into the transaction; (2) the plan of distribution of the instrument; (3) the reasonable expectations of the investing public; and (4) the existence of another regulatory scheme to reduce the risk of the instrument, thereby rendering application of the Securities Act unnecessary.6
In applying the Reves test to the Millennium loan notes, the Court relied heavily on the Second Circuit’s decision in Banco Español.
(1) Motivations of Seller and Buyer
The Court concluded that this factor did not weigh heavily in either direction. While the Supreme Court in Reves had stated that an instrument is likely to be a security if “the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments,” the Supreme Court also concluded that an instrument is not likely to be a security if the seller’s purpose is to “facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose.”
The Court found that Millennium’s motivations for the loan—to pay dividends and to satisfy or refinance existing debt—were better characterized as “some other commercial purpose.” However, many of the ultimate purchasers were pension and retirement funds that purchased the notes for their investment portfolios. Given that the seller’s and buyers’ motivations were mixed, the Court concluded that this factor was not persuasive one way or another.7
(2) Plan of Distribution
The Court examined the plan of distribution for the Millennium loan notes, concluding that this factor weighed strongly in favor of the notes not being securities. The notes had transfer restrictions, including a prohibition on transfers to natural persons. Furthermore, only a relatively small number of institutional investment managers were solicited, and the loan notes were not offered to the general public.
In response to the plaintiffs’ argument that the $1 million minimum investment threshold with respect to the Millennium loan notes was extremely low, the Court asserted that, though the $1 million minimum investment amount was small in comparison to the size of the loan, it was still a high absolute number that would only allow sophisticated investors to participate. The Court also found unpersuasive the plaintiffs’ arguments that certain affiliates of parent investors received sub-allocations in the hundreds of thousands of dollars and that the notes were traded in an immediate secondary market that saw daily price fluctuations. The Court noted that the sub-allocations merely reflected that sophisticated investors have complex corporate structures, and the trading in the secondary market was consistent with the transfer restrictions mentioned above. Additionally, the plaintiffs had not alleged that the trading in the secondary market significantly broadened the distribution of the loan notes. As such, the Court concluded that the plan of distribution strongly weighed in favor of the conclusion that the notes were not securities.8
(3) Reasonable Expectations of the Investing Public
The Court analyzed the reasonable expectations of the investing public and concluded that this factor also weighed in favor of the loan notes not being securities. Citing Banco Español, the Court found the consistent use of certain terms in the transaction documents, such as “loan documents,” “loan,” and “lender,” and the absence of terms, such as “investor,” to be significant and concluded that buyers “were given ample notice that the instruments were participations in loans and not investments in a business enterprise.”9
(4) Existence of Another Regulatory Scheme
Finally, the Court considered whether another regulatory scheme existed that would reduce the risk of the instrument, thereby rendering application of the Securities Act unnecessary, and concluded that this factor weighed in favor of the Millennium loan notes not being securities. Acknowledging the plaintiffs’ argument that the primary focus of federal banking regulators is presumably the safety and soundness of banks, rather than the protection of note holders, the Court, again citing Banco Español, distinguished the entirely unregulated scenario at issue in Reves from the market for the sale of loan participations to sophisticated purchasers, which is subject to policy guidelines from Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board.10 As such, the Court concluded that the existence of another applicable regulatory scheme weighed in favor of a conclusion that the loan notes were not securities.
Given that an application of the Reves factors ultimately weighed in favor of finding the Millennium loan notes “analogous to the enumerated category of loans issued by banks for commercial purposes,” the Court held that the Millennium loan notes were not securities. The Court further concluded that the limited number of highly sophisticated purchasers of the loan notes would not reasonably consider them to be securities. Instead, it would have been reasonable for the sophisticated institutional buyers to believe that they were lending money, with all the risk that may entail and without the disclosure and other protections provided by securities laws. Therefore, consistent with the long-standing assumption underlying the syndicated loan market, the Court concluded that the presumption that the notes were securities was overcome under the facts of the case.
1Kirschner v. J.P. Morgan Chase, et al., 17-cv-06334 (PGG) (S.D.N.Y. May 23, 2020)
2Although certain securities offerings involving sophisticated investors can also be accomplished with a minimal amount of disclosure, the additional regulation associated with securities and their sale or transfer generally renders many aspects of administration of a debt securities financing more onerous than syndicated loan transactions.
3Id. at 13.
4973 F.2d 51 (2d Cir. 1992).
5Reves v. Ernst & Young, 494 U.S. 56, 67 (1990)
6Id. at 66–67.
7Kirschner at 16.
8Id. at 17–18.
9Kirschner at 19–20.
10Id. at 21 (citing Banco Español, 973 F.2d at 55-56).
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