March 20, 2023 - On March 9th, a three-judge panel of the United States Court of Appeals for the Second Circuit (2nd Circuit) held oral arguments in Kirschner v. JPM, a case that could decide the critical issue of whether broadly syndicated Term Loan Bs are subject to state and federal securities laws.  Last week, in a critically important and somewhat surprising development, the court asked the SEC to weigh in with “any views it wishes to share” on whether the loans in the Kirschner case are securities under Reves v. Ernst & Young, the seminal US Supreme Court case on that issue.

Following, we briefly summarize the oral argument, discuss the implications of the invitation to the SEC, review, once again, why a finding that loans are subject to the securities laws would pose an existential threat to the loan market as we know it, and conclude with a discussion of next steps.

Background.  The appeal seeks to overturn a May 2020 decision by Judge Paul Gardephe of the US District Court for the Southern District of New York (SDNY) granting a motion to dismiss the securities law claims on the ground that the underlying Term Loan B was not a security. In May 2020, the LSTA submitted an amicus brief to the 2nd Circuit supporting the SDNY’s decision.

The Oral Argument.   The 2nd Circuit panel included Judges Cabranes, Bianco and Perez.  Argument was scheduled to last only 20 minutes but the panel was very engaged and questioned the lawyers for over 45 minutes.  The appeal hinges on whether the SDNY properly granted the banks’ motion to dismiss or, rather, should have required discovery to determine more facts before ruling on the question of whether the Term Loan Bs were securities. That determination is governed by a four-pronged test enumerated in two precedential cases, Reves v. Ernst & Young, a 1990 Supreme Court case and Banco Español v. Security Pacific, a 1991 2nd Circuit interpretation of Reves.  The SDNY, applying those precedents, determined, based on the undisputed facts before it, that the Term B loans were not securities.

The judges questioned both attorneys about the application of the four Reves factors to Term Loan Bs.  In addition, they homed in on the fact that the market has been in existence for over 30 years and neither Congress, the SEC, nor the banking regulators have intervened to suggest that such loans are subject to the securities laws. The judges also asked whether more discovery was needed and one judge noted that a previous 2nd Circuit case involving the question of whether loans should be considered securities was resolved on a motion to dismiss, contrary to the position taken by the appellant.  Late in the argument, Judge Cabranes wondered why the SEC had not weighed in on this case and asked whether the court should solicit the SEC’s, or the US Solicitor General’s views.  Counsel for the banks explained that the SEC is aware of the case and could have weighed in but apparently chose not to.  He also argued that reaching out to the SEC was not necessary because the record in the case is sufficient to conclude that the loans are not subject to the securities.  While there was no further discussion on that point, the court ultimately decided to solicit the SEC’s views.

What can we expect from the SEC and what will it mean?  While it is unwise to speculate as to how the SEC will respond, as we noted in our amicus brief, for the past 30 years, Congress, the SEC and the bank regulators have consistently recognized the differences between, and different treatment of, broadly syndicated loans and securities.  For example, in the 2010 Dodd-Frank Act, while Congress significantly expanded the definition of “securities” (broadening it to cover, for example, security-based swaps), they did not see fit to expand the definition to cover loans.  On the contrary, Congress and the regulators specifically exempted “Loan Securitizations”, including CLOs, from the Volcker Rule. As recently as 2020, in their reformulation of the Volcker Rule, the banking regulators and the SEC once again affirmed the different treatment of loans by permitting “Loan Securitizations” to include “a limited amount of debt securities” in addition to loans.  It is also unwise to speculate exactly how the court will react to the advice it receives from the SEC but, by requesting their input, one can expect the court to take their views quite seriously.

Treating Term Loan Bs as Securities Would Jeopardize a Trillion-dollar Market That is Vital to the Economy.  Holding that loans are securities would have a devastating effect on the $1.4 trillion market for leveraged syndicated term loans. Subjecting syndicated term loans to the securities laws would introduce enormous practical complications and impose very significant compliance costs on loan market participants. Loan market participants would be obligated to comply with securities laws at the state and federal level as well as the rules of securities industry self-regulatory organizations, such as FINRA, subjecting them to a patchwork of rules that may have different requirements. In addition, if syndicated term loans were deemed to be securities, loan syndication and trading activity would have to be conducted through registered broker-dealers, and any market participant that receives compensation tied to loan transactions would have to determine if it needs to register as a broker-dealer. Broker-dealers are subject to extensive SEC and FINRA regulations that could cause significant disruptions to loan transactions. For example, unlike securities transactions, which generally are settled within two days, secondary trades in loans often take ten or more days to settle.  If syndicated term loans were securities, their extended settlement cycle would implicate margin, net capital, and other rules that apply to the settlement of securities transactions; imposition of these rules would complicate loan transactions and burden market participants with additional costs. Treating syndicated term loans as securities would also profoundly disrupt customary arrangements between borrowers and other loan market participants that have developed over many years and deprive both borrowers and lenders of the significant benefits that flow from the ability to choose between different instruments with different characteristics and regulatory regimes. Moreover, the syndicated term loan market currently allows borrowers to share with lenders important financial and corporate information that may be MNPI. As discussed above, lenders can choose whether to receive such information (“private side” lenders) or not to receive it, so that the lender can continue trading in the borrower’s securities (“public side” lenders). When a private-side lender trades with a public-side lender, the public-side lender acknowledges that there may be an informational asymmetry due to the other party’s possession of MNPI, but that it is choosing to rely on its own due diligence and enter into the transaction regardless. Such provisions are generally disfavored by securities regulators because they are seen as a way of contracting around the protections provided by the securities laws.  As a result, if syndicated term loans were deemed to be securities, the loan market would likely become a “public-only” market, where no lender receives access to confidential information, and borrowers who want to provide potential MNPI to lenders on a confidential basis would be unable to do so—eliminating one of the key features of syndicated term loans that make them desirable to borrowers and lenders.

What’s Next? The court has asked for the SEC’s views by April 13th and has directed the parties to the litigation to comment within seven days of the submission of the SEC of its views.  The LSTA is considering whether to submit its own comments as well.  We will continue to closely monitor and report on these proceedings.

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The Kirschner Case: This is the End

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