August 25, 2023 - PART I. The syndicated loan market can finally breathe a collective sigh of relief.  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.  Maintaining the characterization of Term Loan Bs as non-securities has been a critical focus of the LSTA for years. The LSTA engaged actively on the issue with the Banking Agencies and the SEC in recent months and submitted amicus briefs to both the District Court and the 2nd Circuit. We are gratified that the SEC declined to submit a brief and that the Court adopted our view.

In this article we summarize the Court’s 40-page opinion and briefly review what may come next.  In Part II, which we will publish in the coming days, we will identify and discuss some very important takeaways for moving forward safely in the syndicated loan market. 

The Opinion.  After reviewing the relevant facts, the Court addressed two issues.  First, the Court affirmed that the District Court had federal jurisdiction under the Edge Act.  Kirschner originally brought the case in state court, JPM moved it to Federal Court citing “Edge Act” jurisdiction, and the District Court denied Kirschner’s motion to remand it back.  The Court’s reasoning on the jurisdiction issue is beyond the scope of this article.

The Court then pivoted to the issue of whether the loan is a security. The Court noted that although Kirschner’s claims were brought under state securities laws, the appropriate legal standard for determining whether the loan is a security is the federal law standard which is governed by a 1990 Supreme Court Case, Reves v. Ernst & Young. The Court’s opinion is very straightforward.  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 RevesThe 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. 

The Application of the Reves Factors to Kirschner

Commercial or Investment Motivations.  The Court had to determine “whether the motivations [of the seller and buyer] are investment (suggesting a security) or commercial or consumer (suggesting a non-security) and noted that a buyer’s motivation is investment if it expects to profit from the investment.”  The Court made it clear that earning a fixed or variable rate of return such as interest was enough to be considered earning a profit and ruled that the lender’s motivations were investment.  The Court reasoned that the borrower’s motivations were commercial because Millennium was not using the funds for its core business or to finance other investments.  Instead, it planned to use the funds to pay outstanding debt, make a shareholder distribution and redeem outstanding instruments.  Nevertheless, because the parties’ motivations were mixed, the Court ruled that at this early stage of litigation this Reves factor “tilts in favor of concluding the Kirschner complaint plausibly alleges that the Notes are securities.”

The Plan of Distribution.  The Court explained that the second Reves prong “weighs in favor of determining that a note is a security if it is “offered and sold to a broad segment of the public.” In contrast, this factor weighs against determining that a note is a security if there are limitations in place that “work to prevent the notes from being sold to the general public.”  The Court noted that the notes were offered only to sophisticated institutional entities, and was not a “broad based, unrestricted sale to the general investing public.”  The Court rejected Kirschner’s argument that the presence of a secondary market evidences an offering to a broad segment of the public.  The Court explained that restrictions on any assignment of notes “rendered them unavailable to the general public” and noted that they could not be assigned to a natural person, that assignments needed borrower and agent consent and that the minimum assignment amount was generally $1,000,000.  The Court further noted that the restrictions present in the Millennium loan closely mirrored those present in Banco Espanol de Credito v. Security Pacific National Bank, a 1992 Second Circuit case that addressed whether loan participations were securities.  In Banco Espanol the Court found that the plan of distribution weighed against concluding that the loan participations were securities because “[t]he plan of distribution specifically prohibited resales of the loan participations without the express written permission of the issuer . . . . which worked to prevent the loan participations from being sold to the general public, thus limiting eligible buyers to those with the capacity to acquire information about the debtor.”  In this case, the Court held that the second factor weighs against concluding that the Millennium loans are securities because the “collective impact of the assignment restrictions here likewise works to prevent the Notes from being sold to the general public.” Using these measures, the Court concluded that the “pleaded facts do not plausibly suggest that the Notes were “offered and sold to a broad segment of the public.”

The Public’s Reasonable Perceptions.  The third Reves factor requires the Court to examine the “reasonable expectations of the investing public.”    The Court observed that it is clear that the sophisticated entities that purchased the Notes were given ample notice that the Notes were loans, noting that “before purchasing the Notes, the lenders certified that they were “sophisticated and experienced in extending credit to entities similar to Millennium” and that they had “independently and without reliance upon any Agent or any Lender, and based on such documents and information as they have deemed appropriate, made their own appraisal of and investigation into the business, operations, property, financial and other condition and creditworthiness of Millennium and made their own decision to make their Loans hereunder.”’ The Court again referenced Banco Espanol, recognizing that the certification in Millennium is “substantively identical to the certification made by the purchasers in Banco Espanol, which was central to our determination that the buyers there could not have reasonably perceived the loan participations as securities.”  The Court also rejected Kirschner’s argument that the fact that the loan documents occasionally referred to the buyers as “investors” suggests that they expected that the notes were securities, noting that there were only isolated references to investors and the loan documents more consistently referred to the buyers as lenders. The Court concluded that the pleaded facts do not plausibly suggest that the lenders reasonably perceived the notes to be securities.

Whether Some Other Risk-reducing Factor Renders Application of Securities Laws Unnecessary.  The fourth Reves factor requires the Court to “examine 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.”  Among the factors that reduce the risks are whether the instrument is secured by collateral and whether “specific policy guidelines” issued by federal regulators address the type of instrument at issue.  The Court noted that the Millennium loans were secured by a perfected first-priority security interest in all of Millennium’s tangible and intangible assets.  Second, the OCC, the Fed and the FDIC issued “specific policy guidelines governing syndicated loans, i.e., the Interagency Guidance on Leveraged Lending.  The Court rejected Kirschner’s claim that the guidance does not constitute a regulatory scheme that reduces the risk of the notes because it “merely addresses risk management controls to ensure sound banking practices…and does not address risks to investors.”  Instead, the Court ruled that while the guidance aims to minimize risks to banks, “in doing so it also aims to protect consumers.”  Once again relying on Banco Espanol, the Court noted that it “already considered and rejected the argument raised by plaintiff here in Banco Espanol.” The Court concluded that the pleaded facts do not suggest that the application of the securities laws are necessary here. 

Summary of the Application of the Reves Test.  The first factor—the motivations of the parties—weighs in favor of concluding that the complaint plausibly suggests that the Notes are securities.  But the last three factors — plan of distribution, reasonable expectations of the public, and the existence of other risk-reducing factors—weigh against concluding that the complaint plausibly suggests that the Notes are securities.  Accordingly, like the loan participations in Banco Espanol, 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.”

Conclusion.  “The District Court properly dismissed plaintiff’s state law securities claims because he failed to plead facts plausibly suggesting that the Notes are securities under the “family resemblance” test established by the Supreme Court in Reves v. Ernst & Young.”

Next Steps.  Kirschner has the right to request en banc review from the entire roster of judges on the Second Circuit and to file a petition for certiorari with the United States Supreme Court.  Whether it is prudent for him to do so, and whether either court would grant such review, is beyond the scope of this article.

The Scope of Part II.  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 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 loan could be classified as a security.  In Part II, we will identify and discuss these markers in depth.

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