In Kirschner, the Court of Appeals for the Second Circuit unanimously affirmed a district court order that held that notes evidencing term loans were not securities but rather “[l]oans issued by banks for commercial purposes.” [1] In the underlying matter, the District Court for the Southern District of New York dismissed a plaintiff-trustee’s state-law securities claims for failing to plead facts to plausibly suggest that notes issued in connection with a syndicated loan facility were securities under the “family resemblance” test established by the Supreme Court.

Background

In 2012, Millennium Health LLC, Inc. (f/k/a Millennium Laboratories) was a urine drug testing company that faced dual challenges from litigation with a competitor and a DOJ investigation. By February 2014, Millennium decided to pursue a “huge institutional financing” consisting of a term loan in excess of $1.7 billion, intending to use the proceeds to (a) pay the outstanding amount due on its then-existing credit facility; (b) pay a shareholder distribution; (c) redeem outstanding warrants, debentures, and stock options; and (d) pay fees and expenses related to this transaction. The company and the initial term loan lenders agreed to syndicate the term loan, and to facilitate the syndication the initial lenders prepared a “Confidential Information Memorandum” that contained disclaimers including, among others, that prospective lenders should conduct their own due diligence regarding the company.[2]

After issuance, the notes began trading on secondary market. The notes were subject to certain assignment restrictions, including a prohibition on assignment to a “natural person” and the requirement that Millennium and the administrative agent consent to the transfer.[3]

In November 2015, Millennium filed for chapter 11 bankruptcy protection, and, as a part of the proceedings, the Kirschner plaintiff was appointed trustee of the Millennium Lender Claim Trust. In August 2017, the trustee filed suit in the Supreme Court of the State of New York, bringing claims for, among other things, violating state securities laws. The action was ultimately removed to the District Court, which granted the defendants’ motion to dismiss these claims.[4] The trustee appealed the decision to the Second Circuit.

The Second Circuit’s Decision

In the Second Circuit’s review of whether the notes could be considered securities, the Court reiterated that while notes issued in an “investment context” are securities, notes issued in a “commercial or consumer context” are not securities.[5]

In making this determination, courts apply a “family resemblance” test, which begins with the presumption that every note is a security before directing courts to consider the following four factors:

• The motivations that would prompt a reasonable seller and buyer to enter in the transaction;
• The plan of distribution of the instrument;
• The reasonable expectations of the investing public; and
• Whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary.[6]

In this case, the Second Circuit ultimately concluded that while the first factor weighed in favor of the notes plausibly being considered securities, the remaining three factors weighed against plausibly concluding the notes to be securities.[7] With respect to the first factor (motivation), the Court held that the facts suggested that the lenders’ motivation was investment, not commercial, “because the lenders expected to profit from their purchase of the Notes.”[8]

For the second factor (plan of distribution), the Court held that the notes were most likely not “offered and sold to a broad segment of the public,”[9] because the lead arrangers of the syndication provided the Confidential Information Memorandum only to sophisticated institutional entities. The Court also found that assignment restrictions made the notes unavailable to the general public, weighing in favor of the notes not being considered securities.[10]

For the third factor (public’s reasonable expectations), the Court held that the facts did not suggest that the lenders reasonably viewed the notes as securities, as each lender had to certify that it was “sophisticated and experienced” with respect to extending credit to entities like Millennium, and that it had made its own determination regarding the creditworthiness of Millennium in connection with making the decision to purchase the notes. The Court also rejected the trustee’s argument that buyers reasonably expected the notes to be securities because the underlying documents occasionally used the term “investors” since, among other reasons, the loan documents most consistently referred to the buyers as “lenders.”[11]

Finally, with respect to the fourth factor (other regulatory scheme), the Court found that the application of securities laws was unnecessary because the notes were secured by perfected first priority security interests in collateral, which reduced the risk associated with the notes, and because certain bank regulators had already issued “specific policy guidelines” addressing syndicated term loans.[12]

Conclusion

Kirschner is a substantial victory for syndicated term loan lenders. Had the Second Circuit reversed the District Court and found that leveraged loans are securities, it would have sent shockwaves through this over $1 trillion market. That said, the Second Circuit did caution that “[i]t is possible that a court faced with a different transaction could find that the reasonable investing public perceived an instrument labelled a ‘syndicated term loan’ to be a ‘security.’”[13] Accordingly, lenders should be mindful in syndicated finance deals to (a) understand and limit as appropriate the pool of investors being solicited; (b) provide for reasonable assignment restrictions; (c) require buyers to make certifications similar to the ones the Millennium noteholders made with respect to their sophistication and independent investigation of the borrower; and (d) avoid drafting loan documentation that makes reference to potential “investors” rather than “lenders.”[14]

[1] No. 21-2726, 2023 WL 5437811, at *13. (2d Cir. Aug. 24, 2023) (citation omitted).

[2] See Kirschner, 2023 WL 5437811, at *2 -*3.

[3] See id. at *4.

[4] See Kirschner as Tr. of Millennium Lender Claim Tr., No. 17 CIV. 6334 (PGG), 2020 WL 2614765 (S.D.N.Y. May 22, 2020).

[5] See Kirschner, 2023 WL 5437811, at *7.

[6] See id. at *8 (quotation marks and citations omitted).

[7] See id. at *13.

[8] See id. at *9.

[9] See id. (citation omitted).

[10] See id. at *9.

[11] See id. at *11.

[12] See id. at *12-*13.

[13] See id. at *11, n. 104.

[14] The Second Circuit’s analysis of the fourth factor also suggests that secured lenders have a bit more protection under Kirschner than unsecured noteholders. That having been said, Kirschner stands as a strong signal to the market that courts do not view these instruments as securities, and plaintiffs will likely be wary to bring these types of claims moving forward, absent more unique facts.

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