Syndicated term loans are not considered “securities”—for now

Market participants are relieved after the Second Circuit recently affirmed the lower court’s decision in Kirschner v. JP Morgan Chase Bank, N.A.¹ applying the Reves four-part test to conclude syndicated term loans do not constitute “securities”. But the industry should remain cautious.

What you need to know

• Relief for institutional lenders. The Second Circuit’s holding in Kirschner closely follows established precedent, reassuring institutional lenders concerned that loans and market participants would be subjected to additional regulations.
• Residual uncertainty in the courts. Given that the Reves four-factor “family resemblance” analysis—which assesses parties’ “motivations” and “reasonableness”—is inherently open to judicial interpretation through fact-specific analysis, it is advisable to carefully structure and draft syndicated term loan transactions.
• Takeaways for agents. To insulate against potential treatment of notes as securities, under Kirschner and Reves, agents should consider replacing any reference in marketing materials to “investor” and “security” with “lender” and “note,” respectively.
• Using another test could potentially yield a different outcome. The parties’ stipulation to application of the Reves test leaves open whether the Court might have reached a different conclusion under another test.

Background

Millennium Health LLC, Inc. (Millennium) entered into a credit facility with a group of arranging banks, including JP Morgan, providing Millennium with a $1.775B term loan and $50M of revolving loan commitments. As is common in the U.S. syndicated loan market, the lead arrangers intended to syndicate the loans to non-bank institutional investors (many of whom also invest in securities such as bonds).

At the time of the syndication, Millennium was involved in anti-trust litigation with a competitor over an alleged kickback scheme and subject to a DOJ investigation regarding possible health care law violations. The lead arrangers prepared a Confidential Information Memorandum to disclose information regarding Millennium and the loan terms to potential lenders. As is customary, the disclosure in the Confidential Information Memorandum was far less detailed than what would be required under applicable regulations for a registered offering of securities.  The Confidential Information Memorandum included disclaimers concerning the lead arrangers’ due diligence and sophistication and experience with similar transactions. The Confidential Information Memorandum disclosed that the lead arrangers intended to syndicate loans to investors of their choosing.

Lenders, including JP Morgan, ultimately assigned loans to approximately 400 entities, of which nearly half were foreign. The credit agreement also allowed for a secondary market for the notes through post-closing assignments, subject to restrictions, which included prohibiting assignment to a natural person and assignment of an amount less than $1M, with some exceptions. Consent from Millennium and JP Morgan for any assignment was also required, in some circumstances.

Millennium bankruptcy

After a nearly $15M verdict was entered against Millennium in the anti-trust litigation, and Millennium reached a settlement with the DOJ relating to its earlier investigation, Millennium voluntarily filed for Chapter 11 bankruptcy relief.

The litigation

Plaintiff Marc Kirschner was appointed trustee of the Millennium Trust for the benefit of the note holders. The plaintiff commenced this action in state court in 2017, alleging violations of state securities laws, among other claims. The lenders removed the action to federal court relying on the Edge Act², and the District Court rejected the plaintiff’s attempt to send the case back to the state court.

Lenders then moved to dismiss the state securities law claims, because the plaintiff failed to plead the notes were “securities”. The District Court—applying the four-part test enunciated in the 1990 U.S. Supreme Court decision Reves v. Ernst & Young³—dismissed the securities claims. The plaintiff appealed to the Second Circuit.

Decision on appeal

The Second Circuit affirmed the District Court’s decision on two grounds: 1) the Edge Act conferred subject matter jurisdiction; and 2) the notes were not “securities” under Reves. The SEC was invited to opine on the notes’ status, but declined after receiving several extensions.

The Edge Act

The Edge Act was enacted to permit certain financial institutions to engage in offshore banking without the threat of enforcement from state regulators. The Court explained that JP Morgan satisfied the three-part test to maintain jurisdiction. Specifically, the suit is civil, JP Morgan was identified as an Edge Act bank, and JP Morgan itself engaged in “international or foreign banking” because it had directly assigned its interest in the term loan to foreign lenders.

Reves test

The parties had agreed the Court could limit its analysis of the securities law issue to the four-part “family resemblance” test in Reves v. Ernst & Young⁴. And the analysis weighed in favor of finding the “notes” were not “securities” for purposes of state and federal securities laws.

Under Reves, the analysis begins with the assumption that a note is a “security” and continues with consideration of the following:

1. motivations that would prompt a seller to enter the transaction;
2. the plan of distribution of the instrument;
3. the reasonable expectations of the investing public; and
4. “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”⁵.

First, the Court held that since the facts alleged in the complaint indicated that the parties’ motivations were mixed, the first Reves factor tilted in favor of concluding that the complaint plausibly alleged that the Notes are securities⁶. However, the Court then held that because the notes were only offered to sophisticated institutional entities and contained assignment restrictions prohibiting their sale to a “natural person”, the second Reves factor weighed against concluding the complaint alleged the notes were securities⁷.

The Court reached the same result on the third factor, which required the Court to “examine the reasonable expectations of the investing public”⁸. Since the buyers were sophisticated entities that received ample notice the notes were loans and not investments, and because the buyers certified they conducted their own diligence before entering into the transaction, the Court found the buyers could not have reasonably perceived the loan participations as securities⁹. The Court likewise held the fourth Reves factor counseled against a finding the notes were “securities”, since application of securities laws would be unnecessary given the notes were secured by Millennium’s collateral, reducing any risk associated therewith, and bank regulators had issued “specific policy guidelines” addressing syndicated term loans¹⁰.