In a closely watched case that has the potential to upend the estimated $2.5 trillion syndicated loan market, the Securities and Exchange Commission has declined to submit an amicus brief—following a request from the United States Court of Appeals for the Second Circuit soliciting the SEC’s views—as to whether or not a “syndicated term loan note” is a “security” and, thus, subject to the disclosure and other requirements of the federal securities laws and state blue-sky laws. After three extensions of time to provide the Commission’s position, the Commission’s Staff informed the Second Circuit in Kirschner v. JP Morgan Chase Bank, N.A., No. 21-2726 (2d Cir. Oct. 28, 2021), that it was “unfortunately not in a position to file a brief on behalf of the Commission in this matter.” Regardless of whether the Second Circuit affirms the district court’s holding that the notes at issue are not securities (or reverses or remands the case for further findings), its decision is expected to provide further guidance on how to apply the legal framework first articulated by the United States Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990) for making this determination.
While the timing of any decision is uncertain, we expect a ruling later this year or during the early part of 2024. The Second Circuit could affirm the District Court’s ruling, reverse the District Court’s determination that the term loan notes at issue are not securities, or remand the case for discovery and further proceedings to evaluate whether the Millenium notes are or are not securities. We will continue to monitor the case closely for further developments.
A reversal by the Second Circuit could have far-reaching and potentially disruptive impacts on the syndicated loan market, including that such commercial lending transactions might have to comply with state and federal securities laws for underwriting, syndication, and trading. Among other things:
- Syndicated term loans could have to be registered under the securities laws unless the loans qualify for an exemption from registration, such as a private placement exemption;
- Loan syndication and trading activity might have to be conducted through registered broker-dealers, who are also subject to SEC and FINRA regulations;
- Customary arrangements between borrowers and lenders could be altered, affecting otherwise standard loan market practices that have developed over time, including (as one example) borrower and agent consent rights to transfers of syndicated loans that are not typically found in high yield bond indentures; and
- Borrowers may no longer be able to share material non-public information with certain of its lenders.
All of this could raise questions about how, and in what form, market participants will access capital going forward.
The District Court Decision
The case arose out of the completion of a $1.775 billion syndicated loan transaction by the defendant banking institutions, who sold debt obligations of Millennium Laboratories LLC (Millenium), a California-based urine drug testing company, to a trust whose beneficiaries were composed of numerous institutional investor groups. Such debt obligations were in the form of term loans evidenced by a New York law governed credit agreement. Nineteen months after the transaction closed, Millennium filed a bankruptcy petition, and the trust that purchased the debt obligations filed a complaint in New York State court on August 1, 2017, alleging, inter alia, violations of state securities laws. The case was removed to the United States District Court for the Southern District of New York, and the defendants moved to dismiss the complaint on the basis that the syndicated term loan notes are not securities.
On May 22, 2020, the District Court granted the motion to dismiss. Kirschner as Tr. of Millennium Lender Claim Tr. v. JPMorgan Chase Bank, N.A., No. 17 CIV. 6334 (PGG), 2020 WL 2614765 (S.D.N.Y. May 22, 2020). In doing so, the court applied the legal framework articulated by the United States Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990), in which it determined whether certain demand notes constituted securities. The Reves framework incorporates a presumption that every “note” qualifies as a security under the applicable definitions provided in the Securities Act of 1933 and the Securities and Exchange Act of 1934. Under Reves, the presumption can be rebutted if the note in question: (i) bears a “family resemblance” to one of several judicially created exceptions, including notes delivered in consumer financing and notes secured by a mortgage on a home; or (ii) satisfies a four-factor test that looks at whether the characteristics of the note and the motivation of the parties suggest that the note should or should not be governed by the securities laws. In particular, that four-factor test considers: (1) the motivations of the parties to the transaction; (2) the plan of distribution applicable to the note; (3) the reasonable expectations of the investing public; and (4) “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.” Reves, 494 U.S. at 66-67.
Applying the Reves framework, the District Court granted the motion to dismiss, concluding that the first Reves factor could cut either way, but that the other factors weighed heavily in favor of dismissal. In particular, the District Court reasoned:
- From the seller’s perspective, these were not securities, but for the buyers, the purpose appears to have been investment. Given that the buyers’ and sellers’ motivations were mixed, the first factor did not weigh heavily in either direction.
- The plan of distribution was relatively narrow, and defendants only sold to a small group of sophisticated institutions; members of the general public were not solicited and did not participate in the loan syndication.
- The terms and agreements repeatedly referred to the underlying transaction documents as “loan documents” and the words “loan” and “lender” were used consistently, instead of “investor.” The District Court further noted that it failed to find any case in which a court has held that a syndicated term loan (unlike the demand notes at issue in Reves) was a security.
- The amount of regulation by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve Board was enough to distinguish Kirschner’s syndicated term loans from the unregulated scenario in Reves.
Appeal to the Second Circuit and Existing Second Circuit Precedent
Plaintiff appealed the dismissal to the United States Court of Appeals for the Second Circuit, arguing both that the dismissal was premature because discovery is necessary to evaluate the Reves factors and that the District Court misapplied the factors. Amicus briefs were filed by: (i) the Loan Syndication and Trading Association, the Bank Policy Institute, the Chamber of Commerce of the United States of America, and the Security Industry and Financial Markets Association; and (ii) Americans for Financial Reform. On March 9, 2023, the Second Circuit heard oral argument, and on March 16, 2023, the court solicited the Commission’s opinion regarding whether a syndicated term loan note is a security. The Commission sought three extensions of time to file its amicus brief before finally informing the Second Circuit last week (on July 18) that it “is unfortunately not in a position to file a brief on behalf of the Commission in this matter.” Kirschner v. JP Morgan Chase Bank, N.A., No. 21-02726 (2d Cir. Oct 28, 2021), ECF No. 137.
Without the Commission’s views, the market is left only with the appellate briefing, the transcript of the oral argument, and prior Second Circuit decisions from which to try and intuit how the appeal will be resolved. Two prior Second Circuit cases are particularly instructive, and we summarize them briefly here.
In Banco Espanol de Credito v. Sec. Pac. Nat’l Bank, 973 F.2d 51 (2d Cir. 1992), the defendant sold loan participations of Integrated Resources, Inc. to institutional investors at differing interest rates. Analyzing the four Reves factors, the Second Circuit affirmed the district court’s dismissal of the claims, finding:
- On the first factor, the parties’ motivation for “promotion of commercial purposes” rather than “investment in a business enterprise” meant the first factor favored defendants;
- On the second factor, the prohibited resales of loan participations without express written permission of defendant Security Pacific limited eligible buyers and demonstrated that the plan of distribution weighed in favor of defendants;
- On the third factor, the purchasers were given ample notice that the instruments were participations in loans and not investments in a business enterprise; and
- On the fourth factor, the Office of the Comptroller of the Currency issued specific policy guidelines addressing the sale of loan participations suggesting securities laws were unnecessary with the existence of another regulatory scheme here.
In Pollack v. Laidlaw Holdings, 27 F.3d 808 (2d Cir. 1994), by contrast, the Second Circuit held that uncollateralized, speculative participation in mortgages bought by investment professionals on behalf of passive individual investors, were securities. The Second Circuit was swayed in particular by the facts that: (i) buyers and sellers of the mortgage participations were focused on investments and were looking for “secure, conservative instruments”; (ii) the “broad-based, unrestricted sales to the general investing public alleged in the complaint support[ed] a finding that these instruments are within the scope of the federal securities laws”; (iii) the fixed interest rate and presence of personal guarantees supported the appellants’ motivations as investment-based, and appellants believed they were pursuing a conservative investment strategy through registered professionals; and (iv) New York states regulations regarding mortgages, the Investment Advisers Act of 1940, and ERISA would not afford enough protection.
While the syndicated term loan notes at issue in Kirschner are not directly analogous to the notes at issue in either Banco Espanol or Pollack, we can expect a similar analysis by the Second Circuit regarding the Kirschner notes.
 “The term ‘security’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ‘security’; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance, which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.” 15 U.S.C.S. § 78c ; 15 U.S.C.S. § 77b; Reves, 494 U.S. at 61 n.1 (1990) (“We have consistently held that ‘the definition of a security in § 3(a) (10) of the 1934 Act . . . is virtually identical [to the definition in the Securities Act of 1933] and, for present purposes, the coverage of the two Acts may be considered the same.’”)