Leveraged Loan Update: Millennium Court Decision Confirms Syndicated Loans Are (Still) Not Securities

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White & Case LLPThe Bottom Line: On May 22, 2020, the United States District Court for the Southern District of New York concluded that broadly syndicated term loans are not "securities". This decision is highly significant to the US syndicated loan market. If syndicated term loans were deemed to be securities, they would be subject to federal and state securities laws, including disclosure requirements and potential liability for issuers and arrangers based on inadequate disclosure. This would require a fundamental shift in the way the $1.2 trillion syndicated loan market currently operates. However, based on the court’s decision, participants in the US syndicated term loan market may continue to operate "as is," noting that plaintiffs have the right to appeal the decision.

The Case: The case was brought by Marc S. Kirschner, the trustee for the litigation trust established in the Chapter 11 proceedings initiated by Millennium Laboratories LLC (Millennium), a California-based urine drug testing company. The defendants in the case were the arrangers of a $1.775 billion term loan B that closed in April 2014, 19 months before Millennium filed its bankruptcy petition. Among other things, the complaint alleged that in the marketing materials provided to would-be investors, the arranger defendants misrepresented or omitted material facts regarding the legality of Millennium’s sales, marketing and billing practices and a related pending government investigation. They argued that these actions violated various state-based "Blue Sky" securities laws that should be applied to the Millennium loan notes.

The Decision: Judge Paul Gardephe of the United States District Court for the Southern District of New York dismissed the securities-related causes of action on the grounds that the Millennium loan notes were not securities. He stated that "it would have been reasonable for these sophisticated institutional buyers to believe that they were lending money, with all the risks that may entail, and without the benefit of the disclosure and other protections associated with the issuance of securities."

The Rationale: In reaching his decision that the Millennium loan notes were not securities, Judge Gardephe applied the four-factor "family resemblance" test proposed by the Supreme Court in the 1990 decision of Reves v. Ernest & Young. In Reves, the Supreme Court stated that courts should begin with the presumption that every "note" is a security, however that presumption may be rebutted if the notes bear a strong "family resemblance" to one of the categories of non-securities instruments enumerated by the court, which included "notes evidencing loans made by commercial banks for current operations". In applying the Reves test, Judge Gardephe leaned heavily on the decision previously regarded as the most directly relevant to the question of whether syndicated loans are securities—the 1992 decision of Banco Espanol de Credito v. Security Pacific National Bank. In Banco, the Second Circuit applied the Reves test to loan participations and concluded that they were not securities.

The four Reves factors used to determine whether such resemblance exists are as follows:

(1) The motivations of a reasonable buyer and seller to enter into the loan transaction

Under this factor, the court scrutinized the motivations of both Millennium and the term loan investors and ultimately concluded that this factor did not weigh heavily in either direction. On the one hand, Millennium’s motivation in raising the term loans was not for an investment or its general use (rather, it was for another commercial purpose—to refinance existing debt and to make a dividend) which, based on the Supreme Court’s guidance in Reves, would indicate that the loan notes were not securities. But on the other hand, the court concluded that the primary motivation of the term loan investors was investment, which would indicate that the notes are securities. In light of the mixed motivations of the buyers and seller of the loan notes, the court did not find this factor to be persuasive one way or another.1

(2) The plan of distribution of the loan notes

Under this factor, the court examined the "plan of distribution" of the loans, including whether they are subject to "common trading for speculation or investment". The court agreed with the arranger defendants that the loans were syndicated to a relatively small group of sophisticated institutional and corporate investors and not offered to the public at large. In reaching its conclusion, the court noted that the minimum size of the loan that was permitted to be assigned to a new lender was $1 million, as well as the fact that the loans were not permitted to be assigned to natural persons, or to any persons (other than affiliates or related funds), without the consent of Millennium.

(3) The reasonable expectations of the investing public

Under this factor, the court found it significant that in the marketing materials for the term loans, as well as the credit documentation itself, the loan notes were consistently referred to as "loans" and "loan documents", etc., and the investors were consistently referred to as "lenders". The court rejected as unpersuasive the argument that the inclusion of provisions in the marketing materials and credit agreement relating to "non-public information" demonstrated that the loans were securities, as well as market commentary that syndicated term loans have increasingly included terms that were historically found in high-yield bonds. Rather, the court pointed to the absence of precedent for the holding that a syndicated term loan is a "security" and concluded that the reasonable expectations of the investing public weighed in favor of the findings that the loan notes were not securities.

(4) The existence of another regulatory scheme to reduce the risk of the loan notes

Under this factor, the court considered whether loans are subject to a separate regulatory scheme that would render the application of securities laws unnecessary. The court found that although the primary focus of Federal banking regulators (namely, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board) is "presumably the safety and soundness of banks, rather than the protection of note holders", the policy guidelines of the Comptroller for the sale of loan participations to sophisticated purchasers distinguishes the syndicated loan market from one that is unregulated, and concluded that this factor weighs in favor of loans not being treated as securities.

In conclusion, the court found that the first factor did not weigh heavily in either direction, and the second, third and fourth Reves factors weighed in favor of finding the loan notes analogous to notes evidencing "loans issued by banks for commercial purposes". Accordingly, the court held that the presumption that the loan notes were securities was overcome.

Reactions: In reaction, Elliot Ganz, general counsel and chief of staff for the Loan Syndications & Trading Association (LSTA), said in a statement on May 26, 2020, "The ruling is a victory for the flow of capital to American businesses. Declaring syndicated term loans to be securities would have upended the expectations of borrowers and lenders and wreaked havoc in the large, and vitally important, market for those loans. We are pleased that Judge Gardephe declined to go down this path." Client Alert White & Case 3

On May 27, 2020, Bloomberg’s Davide Scigliuzzo noted that the "$1.2 trillion leveraged loan market’s biggest players can breathe a collective sigh of relief – at least for now."

White & Case LLP will continue to monitor the case closely in the event of an appeal.

1 While not applicable in the Millennium case, in many cases syndicated term loans are used to finance acquisitions and other investments. In such circumstances a court may therefore conclude that this factor weighs in favor of the loan being treated as a security; however such an argument would still need to overcome the remaining three Reves factors.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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