Although the loan industry has long looked at loans as being obligations that arise in a commercial lending relationship, which are therefore not securities under Federal and state securities laws, the law supporting this view (to be charitable) has been more than just a little unclear…until now.1 On May 22, 2020, the United States District Court for the Southern District of New York in Kirschner v. JPMorgan Chase Bank, N.A., et al (“Kirschner”),2 applying the Reves test,3 determined that a broadly syndicated term loan (referred to as the “Notes” in Kirschner) was not a security and dismissed the plaintiff’s claims under state blue sky laws. In addition, the court rejected plaintiff’s claims that JPMorgan Chase Bank, N.A. (“Chase”), as the “fronting” lender and administrative agent for the lenders, who initially made the term loan and then sold portions of it by assignment to the lenders in the primary loan syndicate, had a “special relationship imposing a duty of care” to provide credit or other information or another “fiduciary duty” to the lenders in the primary loan syndicate, given that those duties were specifically disavowed in the credit agreement and that the lenders were sophisticated entities that had agreed to do their own diligence and make their own credit decisions.
The Kirschner decision has a number of important consequences for the loan industry and for CLOs. Although this case relates to state securities law claims, in applying the Reves test and holding that the Notes are not securities, the court has ruled squarely in favor of the long-held view in the loan industry that loans are not securities.4 The Kirschner holding that the Notes are not securities is important because if loans were deemed to be securities, the ’33 Act and ’34 Act could apply to the lending industry in a number of unexpected—and unhelpful—ways. For example, a plaintiff theoretically could bring a claim under the ’33 Act and/or the ’34 Act (or even state “blue sky” laws that govern securities offerings) based on the allegation that statements made in syndication information or representations in a loan document were false or misleading, creating unanticipated and broad-reaching potential legal liability for loan arrangers, lenders and borrowers. In addition, if loans were held to be securities, loan arrangers would be required to register as broker dealers under the ’34 Act in order to syndicate loans. Moreover, the loan securitization exclusion from covered fund status under the Volcker rule that is relied on by CLOs in order to sell their debt securities to banks would be vitiated since CLOs relying on the loan securitization exclusion are not permitted to hold securities, subject to certain very limited exceptions. If banks were unable to invest in CLO debt securities, this would have a major negative impact on the CLO market that provides a significant portion of the capital used to make loans to U.S. businesses and would also negatively impact the liquidity of existing CLO debt securities.
The loan industry has operated on the general assumption that loans are not securities, and a contrary ruling could destabilize the market for commercial loans. Among other things, the process of syndicating a loan would be far more cumbersome, as every information memorandum would need to contain the same extensive information and risk disclosures as the offering documents for a security. Syndicating a loan would be more costly due to the extra time and attention required, and those increased transaction costs would presumably be passed onto the borrower. The process would also be slower, depriving borrowers of faster access to capital when needed. In addition, if the law required that loans could be based only on publicly-available information, borrowers would lose the ability to obtain financing based on information they may want to keep confidential, and lenders would lose the ability to assess credit risk based on information that borrowers choose not to make public.
Background of the Kirschner Case
The dispute in Kirschner arose out of a US$1.775 billion syndicated term loan transaction that the defendant banks arranged for Millennium Laboratories LLC (“Millennium”), which was used by Millennium to refinance an existing bank credit facility, pay dividends and retire certain debentures. The term loan was syndicated to a number of sophisticated investors (“Investors”), including, among others, banks and funds, and closed in April, 2014. After Millennium filed for bankruptcy in November 2015, the Investors’ claims were contributed to the Millennium Lender Claim Trust (“Trust”). Mr. Kirshner, as trustee of the Trust, filed a complaint in August 2017 against the arranging banks and against Chase in its capacity as administrative agent asserting claims under several states securities laws and common law. The complaint alleged, among other things, that defendants made misstatements and omissions in the offering documents and other communications to the Investors “regarding the legality of [Millennium’s] sales, marketing, and billing practices,”5 as well as “the known risks posed by a pending government investigation into the illegality of such practices” giving rise to claims actionable under state securities laws. The complaint further alleged claims for common law negligent misrepresentation, breach of fiduciary duty, breach of contract, breach of post-closing contractual duties and breach of the implied covenant of good faith and fair dealing.6 On June 28, 2019, defendants moved to dismiss the complaint. On May 22, 2020, the court granted defendants’ motion to dismiss in its entirety.
The Notes Are Not Securities Under The Reves “Family Resemblance” Test
In Kirschner, the court dismissed the plaintiff’s state securities law claims on the ground that “the Notes are not securities.”7 In reaching this conclusion, the court applied the “family resemblance” test set forth by the U.S. Supreme Court in Reves. The court noted that “[i]n Reves, the Supreme Court instructed that “because the Securities Acts define ‘security’ to include ‘any note,’” courts should “begin with a presumption that every note is a security.”8 The court adopted the Second Circuit’s “list of instruments commonly denominated ‘notes’ that nonetheless fall without the ‘security’ category.” The presumption that a note is a security “may be rebutted only by a showing that the note bears a strong [family] resemblance . . . to one of the enumerated categories.”9
The four factors of the “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.”10 The Kirschner court attached little weight to the first factor of the test and more weight to the other three factors when reaching its conclusion that the Notes are not securities.
Motivations of the Seller and Buyer. The court found that this factor did not weigh heavily in deciding whether or not the Notes were securities, because the seller’s and buyer’s motivations differed. Where “the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments . . . the instrument is likely to be a ‘security,’” but where “the note is exchanged 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 note is less sensibly described as a ‘security.’”11 From Millennium’s perspective, the purpose of the Notes was to advance “some other commercial purpose,” i.e., repayment of other outstanding loans and debentures and payment of a dividend.12 From the buyers’ perspective, however, the purpose of acquiring the Notes was investment as many of the ultimate purchasers were pension and retirement funds who purchased the Millennium Notes for their investment portfolios.13
Plan of Distribution. The court found that the “plan of distribution” factor weighed strongly in favor of the Notes not being securities, relying on the Second Circuit’s holding in Banco Español de Crédito v. Security Pacific Nat’l Bank that a loan participation was not a security where the “plan of distribution . . . worked to prevent the loan participations from being sold to the general public.”14 Here, the plan of distribution was targeted to sophisticated financial institutions and funds, and the credit agreement had restrictions on transferability of the Notes, including, among other things, a limitation that they could not be transferred to individuals.
Reasonable Expectations of the Investing Public. The court similarly found that this factor weighed in favor of the Notes not being securities because the syndication information and credit agreement made available to potential Investors made clear that the Notes constituted loans, and not securities. Relying on Banco Espanol,15 the court noted that the credit agreement repeatedly used the terms “loan,” “lender” and “loan documents,” as opposed to terms relating to securities investment activities.
Existence of Another Regulatory Scheme. Again relying on Banco Espanol and notwithstanding the fact that not all of the Investors were banks, the court agreed with the defendants that the interagency guidance and other measures taken by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board were sufficient to constitute another regulatory scheme precluding the need for the securities law to apply to the transaction.16
Conclusion. In weighing these factors, the court concluded that “the limited number of highly sophisticated purchasers of the Notes would not reasonably consider the Notes ‘securities’ subject to the attendant regulations and protections of Federal and state securities law.”17 Instead, the court stated “it would have been reasonable for these sophisticated institutional buyers to believe that they were lending money, with all of the risks that may entail, and without the disclosure and other protections associated with the issuance of securities.”18 Accordingly, the court held that the presumption that the Notes evidencing the loan were securities was overcome and granted defendants’ motion to dismiss the state securities law claims.
It is worth noting that the Kirschner court granted the plaintiff leave to amend, meaning that the plaintiff has another “bite at the apple” to argue that the loans at issue qualify as securities. However, in light of the court’s analysis, it appears unlikely that any amendment could change the bases on which the court concluded that the syndicated loan at issue was not a security. Nonetheless, it is likely that this issue will be appealed and ultimately decided by an appellate court. Moreover, while the courts in the Southern District of New York are highly-respected nationwide, the Kirschner ruling does not bind other courts outside of the jurisdiction (or even companion courts within the Southern District). Thus, while the reasoning of the Kirschner decision is compelling, it likely is not the last word on this topic.
Kirschner Likely Will Not Alter the Treatment of Broadly Syndicated Loans under the 1940 Act and Advisers Act
Although the plaintiff’s securities law claims arose under state securities laws (and not under the federal securities laws), the court looked to the Reves family resemblance test in analyzing whether the broadly syndicated loans in questions were securities, and Reves, itself, addressed the definition of “security” for purposes of the ’33 Act and the ’34 Act and not under the ’40 Act or the Advisers Act. Although the definitions of “security” in each of the four acts is substantially similar, they are not identical and the SEC Staff has historically taken the position that the definitions should not always be applied in an equivalent manner as between the ’33 Act and ’34 Act, on one hand, and the ’40 Act and the Advisers Act, on the other, based on the differences in the policies and purposes of the various acts.19 Under this “non-equivalence position”, the SEC, the Staff or a court could find that a note or other financial instrument, such as a broadly syndicated loan, that courts have determined not to be a security for purposes of the ’33 Act and the ’34 Act (e.g., under the Reves family resemblance test) should still be viewed as a security under the ’40 Act and the Advisers Act. As the court in Kirschner was not in a position to address the status of broadly syndicated loans under either the ’40 Act or the Advisers Act, its decision therefore does not represent precedent that would compel a change in the view of the SEC or its Staff as to the treatment of broadly syndicated loans under the ’40 Act or the Advisers Act nor does it impact the fiduciary duties owed by investment advisers who provide investment advice to clients regarding broadly syndicated loans.
The court’s decision not to classify syndicated loans as securities in Kirschner is especially important in the context of the current COVID-19 crisis, as a decision subjecting syndicated loans to securities regulation could have chilled this market at a time when many borrowers have a heightened demand for liquidity.
1.) See Cori. R. Haper, Sometimes Promising is Not So Promising: The Breakdown of the Family Resemblance Test, 29 U. DAYTON L. REV. 71, 71 (2003) (“Unpredictable,” “confusing,” “jumbled,” “haphazard.” Unfortunately, this is still the state of the family resemblance test more than twelve years after the Supreme Court’s articulation of the test in Reves v. Ernst & Young. Despite the Supreme Court’s attempt to clarify the issue of when a “note” is a “security” under the Securities Acts of 1933 and 1934 with its formulation of the family resemblance test, the Court’s articulation of the test in Reves left securities law in a state of uncertainty.”)
2.) Kirschner v. J.P. Morgan Chase N.A., et al., 17-cv-06334 (PGG) (S.D.N.Y. May 23, 2020).
3.) Reves v. Ernst & Young, 494 U.S. 56, 66-67 (1990). In Reves, the Supreme Court considered whether or not a note was a security within the meaning of the Securities Act of 1933, as amended (“’33 Act”) and the Securities Exchange Act of 1934, as amended (“’34 Act”).
4.) As discussed below, this decision did not address (nor should it be seen to necessarily alter) the status of broadly syndicated loans for purposes of the Investment Company Act of 1940 (“’40 Act”) or the Investment Advisers Act of 1940 (“Advisers Act”).
5.) Kirschner, slip op. at 2.
6.) Id. at 2, 9.
7.) Id. at 22.
8.) Id. at 13.
10.) Id. at 14.
11.) Id. at 16 (quoting Reves, 494 U.S. at 66).
14.) Id. at 18 (citing Banco Espanol, 973 F.2d 51, 55 (2d Cir. 1992))
15.) In Banco Espanol, the court found the use of such terms significant, concluding that buyers “were given ample notice that the instruments were participations in loans and not investments in a business enterprise.” Banco Espanol, 973 F.2d at 55.
16.) Kirschner, slip op. at 21 (citing Banco Español, 973 F.2d at 55-56).
17.) Id. at 22.
19.) For example, in the context of analyzing the status of a non-US bank (pr ior to the adoption of Rule 3a-6 under the 40 Act) as an investment company, the Staff stated that: a determination that a note evidencing a commercial transaction is not a security under the 1933 Act and the 1934 Act is, in our view, not applicable in determining whether a person engaged in the business of investing in such notes is investing in "securities" in the context of a determination of whether the person is an investment company under the 1940 Act.
Bank of America Canada (pub. avail. Jul 25, 1983).