Summary
The United States Court of Appeals for the Second Circuit upheld on August 24, 2023, a decision from the District Court to dismiss a securities fraud case brought by a Chapter 11 bankruptcy trustee, on the grounds that a $1.8 billion syndicated loan was not a security. The decision addresses a long-standing question of whether syndicated loan notes are subject to the anti-fraud sections of the federal securities laws and by implication, all of the rules and regulations that come with underwriting securities. A contrary outcome would have been a major event for the syndicated loan market, as such loans would otherwise then need to comply with extensive disclosure obligations and failures to disclose would cause strict liability for underwriters. The decision affirms the established understanding in the market that loan participations are not securities.
The Upshot
- The question of whether a note is a security under federal securities laws is not a new one. Federal securities laws include a definition of “security” sufficiently broad to encompass virtually any instrument that might be sold as an investment, but do not provide much by way of description of the characteristics of such instruments.
- In Exchange Nat. Bank of Chicago v. Touche Ross & Co., the Second Circuit crafted a list (the List) of instruments that are commonly identified as “notes”, which are not “securities” under federal securities laws. The List included notes evidencing loans by commercial banks for current operations.
- In Reves v. Ernst & Young, the Supreme Court concluded that courts are to apply a four-factor “family resemblance” test in determining whether a “note” is a “security”, by comparing the instrument in question to the List, and the United States Court of Appeals applied this test in determining that the $1.8 million syndicated loan was not a security.
- The Second Circuit concluded that the syndicated loan notes in Kirschner fail to resemble a security under three of the four factors and bear a strong resemblance to one of the notes on the List that are not securities: “[L]oans issued by banks for commercial purposes.”
The Bottom Line
The analysis of the Kirschner opinion is helpful to syndicated loan structurers and lawyers who want to characterize their transactions as loans and avoid potential liability under federal securities laws for nondisclosure of material information. The Securities and Exchange Commission (the SEC) declined the Second Circuit’s request to weigh in on whether syndicated loan notes are securities under Reves, so future loan vs. security analyses will remain based on case law. Failing to consider the List and the four factors set forth in the Reves Test could result in unexpected regulation and liability under federal securities laws.
On August 24, 2023, in Kirschner v. JPMorgan Chase Bank the United States Court of Appeals for the Second Circuit upheld a decision from the District Court to dismiss a case brought by a Chapter 11 bankruptcy trustee, on the grounds that a $1.8 billion syndicated loan was not a security. The decision addresses a long-standing question of whether syndicated loan notes are subject to the Securities and Exchange Act of 1934, as amended (the 1934 Act), and the Securities Act of 1933, as amended (the 1933 Act and, together with the 1934 Act, the Federal Securities Laws), and all of the rules and regulations that come with them. A contrary outcome would have been a major event for the syndicated loan market, as such loans would otherwise then need to comply with extensive disclosure obligations and failures to disclose would cause strict liability for underwriters. The decision affirms the established understanding in the market that loan participations are not securities.
Background: The Millennium Term Loan
In March 2012, a group of banks including JP Morgan Bank, N.A. (JP Morgan Chase) and JP Morgan Securities, LLC (JP Morgan Securities) (together referred to herein as JP Morgan), executed a credit agreement (the 2012 Credit Agreement) providing California-based urine drug testing company Millennium Health LLC, Inc. (Millennium) with a $310 million term loan and a $20 million revolving loan. By the time the 2012 Credit Agreement closed, Millennium was subject to a subpoena from the United States Department of Justice in connection with alleged violations of federal health care laws, and was in litigation related to alleged violations of federal anti-kickback statutes.
In light of the ongoing litigation, JP Morgan and other institutional lenders (collectively, the Initial Lenders) agreed to provide Millennium a $1.775 billion term loan (the Term Loan) and a $50 million revolving loan pursuant to a Credit Agreement dated April 16, 2014 (the Credit Agreement), to (i) pay the outstanding amount due under the 2012 Credit Agreement ($304 million); (ii) pay a shareholder distribution ($1.27 billion); (iii) redeem outstanding warrants, debentures and stock options ($196 million); and (4) pay fees and expenses related to the transaction ($45 million). The Initial Lenders and Millennium agreed to syndicate the Term Loan to various lenders, as arranged by JP Morgan Securities and Citigroup Global Markets as “Lead Arrangers”, with JP Morgan acting as “Administrative Agent.”
In connection with the syndication, the Lead Arrangers furnished a Confidential Information Memorandum (the CIM) on behalf of Millennium, describing Millennium and the Term Loan for potential lenders. While the CIM and other relevant documents widely referred to “lenders”, the CIM, and an “Investor Presentation” prepared in connection therewith, also made a handful of references to “investors.”
The CIM contained a number of disclaimers warning that the CIM did “not purport to be all-inclusive”, was “prepared to assist potential lenders in making their own evaluation of [Millennium] and the [Term Loan]”, and advised each potential lender to “perform its own independent investigation and analysis of the [Term Loan] or the transactions contemplated thereby and the creditworthiness of [Millennium].” And further by receiving the CIM, potential lenders “represent[ed] that [they were] sophisticated and experienced in extending credit to entities similar to [Millennium].”
Potential lenders were given a deadline for making offers to purchase an allocation of the Term Loan. Following the passing of the deadline, JP Morgan Securities notified the potential lenders with outstanding legally binding offers of the amount of their allocation of the Term Loan, at which point the potential lenders became actual lenders (Lenders) obligated to purchase their allocation. The syndicate included a total of 61 Lenders, who were permitted to sub-allocate their allocation to investors in their respective funds.
On April 16, 2014, JP Morgan agreed to fully fund the Term Loan, Millennium agreed to JP Morgan Chase assigning its rights and obligations with respect to the Term Loan to the Lenders, “each individual [Lender] […] became irrevocably committed to [JP Morgan Chase] [...] to purchase” its allocated amount of the Term Loan, and the transaction closed.
Each Lender executed an “Assignment and Assumption Agreement” with JP Morgan Chase, by which the Lenders assumed all rights and obligations of JP Morgan Chase in its capacity as a lender under the Credit Agreement, which established the conditions of the Term Loan. Each Lender entering the Credit Agreement by way of an Assignment and Assumption Agreement, represented that it had “independently and without reliance upon any Agent or any other Lender, and based on such documents and information as it has deemed appropriate, made its own appraisal of and investigation into the business, operations, property, financial and other condition and creditworthiness of [Millennium] and made its own decision to make its Loans hereunder and enter into [the Credit] Agreement.” The Credit Agreement defines “Loans” as “any loan made by any Lender pursuant to the[e] [Credit] Agreement.” The Credit Agreement “create[d] in favor of the Administrative Agent (JP Morgan Chase), for the benefit of the Lenders, a legal, valid and enforceable security interest” in Millennium’s collateral and each Lender was issued a note in the amount of its allocation of the Term Loan as evidence of Millennium’s repayment obligations (the Notes).
The Credit Agreement also allowed for the creation of a secondary market for the Notes subject to certain assignment restrictions, including: (i) a prohibition on assignment to “a natural person”; (ii) a requirement that Millennium and JP Morgan Chase, acting in its capacity as Administrative Agent, provide written consent to any assignment (subject to certain exceptions); and (iii) a requirement that any assignment be for more than $1,000,000, unless, among other things, the assignment was to a “Lender, an affiliate of a Lender, or an Approved Fund or an assignment of the entire remaining amount of the assigning Lender’s” allocation. The Notes began trading in the secondary market as early as April 15, 2014.
Just over a year and half after the closing date of the Term Loan, Millennium filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware and the plaintiff trustee, Marc S. Kirschner (the Plaintiff Trustee), was appointed trustee of the Millennium Lender Claim Trust (the Trust), the ultimate beneficiaries of which are the Lenders who purchased Notes and have claims in the bankruptcy proceedings. Almost two years later, the Plaintiff Trustee filed suit in the Supreme Court of the State of New York, New York County on August 1, 2017, in which he brought various claims on behalf of the Bankruptcy Estate, including for violations of state securities laws. The case was removed to the United States District Court for the Southern District of New York on August 21, 2017.
The defendants (including JP Morgan) moved to dismiss Plaintiff Trustee’s complaint on June 28, 2019, and the District Court granted the motion on May 22, 2020, dismissing the state-law securities claims on the grounds that the Plaintiff Trustee failed to plead facts plausibly suggesting that the Notes are “securities” based on the four-factor “family resemblance” test (the Reves Test) set forth in Reves v. Ernst & Young, 494 U.S. 56 (1990). The Reves Test is used to determine whether notes are “securities” under Federal Securities Laws, and while the Plaintiff Trustee’s claims were brought under state securities laws, the District Court (and subsequently the Second Circuit) accepted the Plaintiff Trustee’s assertion that Reves applied to the state securities law claims and examined the Notes thereunder. Plaintiff Trustee appealed on October 28, 2021, and the Second Circuit Court of Appeals affirmed the District Court’s finding that the syndicated Term Loan Notes are not “securities.”
It should be noted that the Plaintiff Trustee’s stipulation that the Reves Test applied to state securities law claims may not be binding in future cases brought under state securities laws. Future plaintiffs may argue that a particular state’s laws are different from Reves, thus rendering its application inapplicable.
When Is a Note a Security?
The question of whether a “note” is a “security” under Federal Securities Laws is not a new one. The Federal Securities Laws included a definition of “security” sufficiently broad to encompass virtually any instrument that might be sold as an investment, but does not provide much by way of description of the characteristics of such instruments. The 1934 Act defines “security” in full as:
any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profitsharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.
In Reves, the U.S. Supreme Court recognized the handful of approaches the appeals courts had adopted up to that point to determine whether a note was a “security” under Federal Securities Laws. The majority of those approaches focused on an “investment versus commercial” approach, which distinguishes, “on the basis of all of the circumstances surrounding the transactions, notes issued in an investment context (which are ‘securities’) from notes issued in a commercial or consumer context (which are not).”
The Reves Test
In Reves, the Supreme Court concluded that courts are to apply the following “family resemblance” test in determining whether a “note” is a “security”: A note is presumed to be a “security” until, upon examining the note under the four factors set forth below, the note is determined to bear a strong resemblance to any of the instruments on the list of commonly identified “notes”, that are not “securities” under Federal Securities Laws (the List), which was crafted by the Second Circuit Court of Appeals in Exchange Nat. Bank of Chicago v. Touche Ross & Co. Nevertheless, if the note does not resemble an instrument on the List, and the court concludes during its examination of the instrument under the four factors that the note is not a security, the court may add the instrument to the List.
The List: Notes That Are Not Securities:
The Second Circuit’s “judicially crafted list” of notes that are not “securities” (the List) is made up of the following:
- the note delivered in consumer financing,
- the note secured by a mortgage on a home,
- the short-term note secured by a lien on a small business or some of its assets,
- the note evidencing a ‘character’ loan to a bank customer,
- short-term notes secured by an assignment of accounts receivable,
- a note which simply formalizes an open-account debt incurred in the ordinary course of business, and
- -notes evidencing loans by commercial banks for current operations.
The Four Factors. Reves enumerates the four factors under which an instrument should be examined for resemblance to the instruments on the “not a security” List as follows:
- the motivations that would prompt a reasonable seller and buyer to enter into the instrument;
- the “plan of distribution” of the instrument;
- the reasonable expectations of the investing public with respect to the instrument; and
- the existence of some other risk-reducing factor, such as another regulatory scheme, thereby rendering application of the Federal Securities Laws unnecessary.
As in Reves, Kirschner examined the Notes under the four-factor Reves Test. The Second Circuit concluded that the Notes in Kirschner fail to resemble a security under three of the four factors and bear a strong resemblance to one of the notes on the List that are not securities: “[L]oans issued by banks for commercial purposes.”
Kirschner found the first factor, the motivations of the parties, to weigh in favor of concluding that the Notes are securities because, although Millennium’s motivation appeared to be “commercial,” the lenders expected to profit from their purchase of the Notes in the form of interest and the Lenders were “investment” motivated. According to Reves, if a seller’s purpose is to raise money for general business use or to finance substantial investments and the buyer’s primary interest is the profit that is expected to be generated therefrom, the instrument is likely to be a “security.” Whereas if a note 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 more likely to be a loan.
The Second Circuit found factors two through four to weigh in favor of the Notes being loans.
Second factor – plan of distribution: Because Notes were initially offered and allocated to sophisticated institutional entities only, and were subject to subsequent assignment restrictions (described under “Background: The Millennium Term Loan” above), the Second Circuit concluded that the plan of distribution in Kirschner was unavailable to the general public and thus weighed against concluding that the Notes were securities.
Third factor – reasonable expectation of investing public: Kirschner found the examination of the third factor to suggest that the Notes were not securities because the lenders were sophisticated and experienced institutional entities with ample notice that the Notes were not securities.
Fourth factor – existence of risk-reducing factors: The Second Circuit in Kirschner concluded that application of securities laws were unnecessary because the Notes were secured by collateral and federal regulators have issued specific policy guidance addressing syndicated loans.
The Supreme Court in Reves tells us it is acceptable to trust the characterization of the instrument – if the notes are characterized as investments and no facts exist to the contrary that would lead a reasonable person to question such characterization, it is a security. The following table breaks out a non-exclusive list of loan vs. security characteristics and considerations from Reves and Kirschner.
Where Does This Leave Us?
The decision in Kirschner affirms the loan market’s view that syndicated loan notes are not securities. Based on the Kirschner decision, underwriters of syndicated loans can avoid costly and burdensome disclosures and can avoid securities law based liability for failure to disclose material information.
The Reves Supreme Court reflected that the “fundamental purpose undergirding the Federal Securities Laws is ‘to eliminate serious abuses in a largely unregulated securities market’”, but Congress did not, however, “intend to provide a broad federal remedy for all fraud.” Importantly, the Securities and Exchange Commission (the SEC) declined the Second Circuit’s request in Kirschner that the SEC weigh in on whether the syndicated Term Loan Notes are securities under Reves, so future loan vs. security analyses will remain based on case law.
The Kirschner opinion is a helpful reminder of the considerations to be taken when structuring, underwriting, and performing due diligence a new transaction: the motivations of all parties involved (investment or commercial); how the offering will be made; how interested parties will be solicited; and what other regulatory guidance and schemes will apply to the note. Failing to consider the List and the four factors set forth in the Reves Test could result in unexpected regulation and liability under Federal Securities Laws.
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