August 28, 2023 - COMING WEBINAR. On Wednesday, September 6th at 4 p.m., we will be hosting a webinar on the Kirschner case: What Does it Say and What Are the Takeaways? with Jason Kyrwood and James Florack of Davis Polk, moderated by the LSTA’s Elliot Ganz. You can register by clicking here.
On August 24th, in a unanimous decision, the United States Circuit Court of Appeals for the Second Circuit (the “Court”) affirmed the ruling by the District Court for the Southern District of New York (SDNY) in Kirschner v. JPM that a syndicated term loan to Millennium Labs is not a security. Because the loan to Millennium was structured and distributed similarly to most existing Term Loan Bs, the Court’s decision has broad implications for the entire syndicated loan market. We recently published an analysis of the Court’s opinion. In addition to affirming the District Court’s ruling that the Millennium Labs loan is not a security, the Court laid out a road map for maintaining the status of syndicated term loans as non-securities going forward. The main text of the opinion and many footnotes lay out very clear ground rules for the documentation and distribution of syndicated loans that, if followed, would protect against the risk that a syndicated term loan could be characterized as a security. In this article we identify those important takeaways for the market.
Background: As we discussed in Part I, the Court concluded that the Millennium Labs loan was not a security by applying a four pronged “family resemblance” test originally articulated in a 1990 Supreme Court case, Reves v. Ernst & Young. Under Reves, the Court begins with a presumption that every note is a security unless it resembles a note that falls into a category that is not considered a security. It then applies Reves’ four-factor “family resemblance” test to determine “whether the note was issued in an investment context (and is thus a security) or in a consumer or commercial context (and is thus not a security).”
The Four Factors of Reves. The four Reves factors are (i) the motivations that would prompt a reasonable seller and buyer to enter into the transaction; (ii) the plan of distribution of the instrument; (iii) the reasonable expectations of the investing public; and (iv) whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.
Summary of the Application of the Reves Test. The Court concluded that three of the four Reves factors weighed in favor of concluding that the Millennium loans were not securities. Accordingly, it held that the Millennium loans “bear a strong resemblance to one of the enumerated categories of notes that are not securities: “[L]oans issued by banks for commercial purposes.”
Takeaways. We will break down the major takeaways by how certain characteristics of loans were treated by the Court under each of the four prongs and what we can learn from such treatment.
The motivations that would prompt a reasonable seller and buyer to enter into the transaction.
The Court held that the motivation of the lenders was to profit from an investment (albeit just floating rate interest) and the motivation of the borrower was commercial in nature. The Court said that “Millennium was not using the Term Loan to raise funds for its urine testing business or to finance other investments. Instead, it planned to use the Term Loan to pay the outstanding amount due under the 2012 Credit Agreement, make a shareholder distribution, “redeem outstanding warrants, debentures and stock options,” and pay fees and expenses related to the Transaction. These uses suggest that Millennium’s motivation was commercial.” We are generally confused by this prong of the Reves test in the current age of finance and, frankly, we are specifically confused by the Court’s quoted reasoning with respect to the borrower. While parties can agree to include self-serving language in credit agreements that state that the motivations of the borrower and lender are commercial, it is not clear that a Court would be persuaded. Other than supplementing loan document language, we do not see a useful path forward in addressing this prong.
The plan of distribution of the instrument. The Court held that the plan of distribution for the Millennium loan was not “offered and sold to a broad segment of the public” and therefore this prong weighed against characterization as a security. The clear takeaways from this prong include: (i) Loans can only be offered to sophisticated institutional entities; (ii) The plan of distribution cannot permit sales to natural persons; (iii) requiring the consent of the borrower and the agent to assignments is critical; (iv) deemed consent for borrowers does not weaken a limited plan of distribution; (v) the $1,000,000 minimum assignment amount is a helpful fact. In a footnote, the Court stated that “[a]lthough the number of purchasers may be probative of whether the note is broadly available to the general public, in the circumstances presented here, the Notes’ distribution to more than 400 lenders did not render them available “to a broad segment of the public.’” It is important to note that in its description of the facts, the Court broke down the lenders into “Parent Lenders” who received the initial allocation from the agent bank in the primary distribution of the loan and “Child Lenders” to whom the loans were sub-allocated and noted that there were only sixty-one Parent Lenders. So, while we know it is safe to have 400 Lenders, it is not clear what number might raise a court’s eyebrows. Importantly, while restrictions on distribution are important for the Reves analysis, it is extremely important that loans be as liquid as possible and settle as quickly as possible. The loan asset class is already under great pressure from the SEC and others to reduce settlement times (for example under the proposed Liquidity Risk Management Rule) so, while including the factors the court found to be dispositive is important, adding provisions in credit agreements that go beyond the minimum needed to address a Reves test would be counterproductive and harmful.
The Public’s Reasonable Perceptions. The Court found that the entities that purchased the Millennium loans were given ample notice that they were loans and not securities. The clear takeaways from this prong include (i) requiring certifications from lenders in the loan documents that they have “independently and without reliance on any Agent or any Lender” made their own appraisal and investigation into the business, operations, property, financial and other condition and creditworthiness of the borrower; (ii) referring to lenders as such and not as “investors” in the loan documents, marketing and offering materials; and (iii) including an acknowledgement in credit agreements that the loans are not securities and the securities laws do not apply to them.
Whether some other risk-reducing factor renders application of the Securities Acts unnecessary. The Court held that other factors existed that reduced the risk of the Millennium loans, thereby rendering the application of the securities laws unnecessary. These included the fact the Millennium loans were secured by the assets of the company and that “specific policy guidelines” issued by federal regulators address the loans. The clear takeaways from this prong include: (i) loans must be secured by a companies’ collateral. Unsecured loans could be at greater risk under application of the Reves test; and (ii) syndicated loans that are covered by the Leveraged Lending Guidance and are part of the Shared National Credit Program are safer than those that are not. A corollary takeaway might well be that loans that are nominally collateralized but are subject to aggressive liability management schemes might be more susceptible to Reves challenges than more traditional collateral structures.
Conclusion. The Court’s well-reasoned opinion in Kirschner provides a very clear road map to loan market stakeholders to stay on the right side of the non-security border.