Second Circuit Finds Syndicated Loan Notes Are Not Securities
Reprinted with permission from the September 7, 2023 issue of The Legal Intelligencer. © 2023 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
Syndicated loans are regularly used to raise large amounts of capital to finance business ventures. Depending upon how the syndication is structured, there is risk that the facility could be viewed as a security offering thereby injecting a significantly greater level of regulatory oversight into the transaction. In an important recent decision, the U.S. Court of Appeals for the Second Circuit reviewed a $1.7 billion syndicated loan and provided a helpful analytical framework for determining whether applicable securities laws were called into play. See Kirschner v. JP Morgan Chase Bank, 2023 U.S. App. LEXIS 22327 (2d Cir. Aug. 24, 2023). In so doing, the court affirmed the U.S. District Court for the Southern District of New York's decision that notes issued from the syndicated loan transaction were not securities under the application of the test set forth in the U.S. Supreme Court's decision in Reves v. Ernst & Young, 494 U.S. 56 (1990).
In March 2014, JP Morgan Chase Bank and certain other institutional lenders (the initial lenders) agreed to provide Millennium Health LLC, Inc., a urine drug testing company, with a $1.775 billion term loan and a $50 million revolving loan. Millennium intended to use the term loan proceeds to retire an outstanding credit facility, make a large shareholder distribution, "redeem outstanding warrants, debentures and stock options," and pay fees related to the transaction. The Initial Lenders and Millennium agreed that the term loan could be syndicated to lenders identified by the "lead arrangers"—JP Morgan Securities and Citigroup Global Markets. The lead arrangers prepared a confidential information memo about Millennium and the syndicated transaction offer. On April 15, 2014, lenders were informed of the amount of their allocations based on their legally binding offers and the lenders became bound to purchase their allocations. The transaction closed on April 16, 2014 in a series of three contemporaneous steps: JP Morgan Chase funded the term loan; JP Morgan Chase assigned, with Millennium's consent, rights and obligations with respect to the Term Loan to the lenders; and the individual lenders purchased their term loan allocations. Ultimately, there were more than 400 institutions that held a part of the syndicated loan.
In the year following the transaction, Millennium faced a series of litigation judgements and settlements, incurring hundreds of millions of dollars in liabilities. On Nov. 10, 2015, Millennium filed Chapter 11. As part of Millennium's plan, the Millennium Lender Claim Trust was created for the benefit of the lenders who purchased syndicated notes, and the plaintiff, Marc Kirschner, was appointed trustee. On Aug. 1, 2017, the trustee filed suit against the Initial Lender defendants for, among other things, violations of state securities laws. The suit was ultimately removed to federal court, where the defendants filed a motion to dismiss the complaint. The U.S. District Court for the Southern District of New York dismissed the securities claims, finding that the "plaintiff failed to plead facts plausibly suggesting that the notes are 'securities' under Reves." The plaintiff appealed the district court decision to the Second Circuit, which considered the question of whether the plaintiff's state-law securities claims were erroneously dismissed because the plaintiff did not plausibly allege that the notes issued as part of the transaction were "securities."
The parties agreed that the relevant framework to analyze whether the notes are securities was the Supreme Court's test set forth in Reves. Pursuant to Reves, courts are to "apply a 'family resemblance' test to determine whether a 'note' is a 'security.'" Initially, courts are to presume that a note is a security and then evaluate four factors related to the notes and underlying transaction. The four factors include: "the motivations that would prompt a reasonable seller and buyer to enter into" the transaction; "the plan of distribution of the instrument"; "the reasonable expectations of the investing public"; and "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 Second Circuit noted that the purpose of the factors is to assist a court with determining whether the note was issued in an investment or commercial context because "only notes issued in an investment context are 'securities.'"
The first Reves factor is an examination of the parties' motivation when purchasing the notes in terms of what "would prompt a reasonable seller and buyer to enter" the transaction. In particular, the court is to evaluate whether the buyer and seller were motivated by investment or commercial interests. The Second Circuit held that the facts plead by the plaintiff plausibly suggest the lenders' expectation was to make a profit (interest earned) from the notes purchased and, thus, their motivation was investment. In contrast, Millennium's motivation was commercial, not investment, because it intended to use the term loan proceeds to pay specific items and not generally for its business enterprise or other investments. Given that the parties' motivations were different, the Second Circuit determined that this factor weighed in favor of the notes being securities.
The second factor requires an examination of the instrument's plan of distribution to evaluate whether the instrument is commonly traded for speculation or investment. If there are restrictions that prevent the general public from purchasing notes, this factor weighs against a determination that the notes are securities. With respect to this factor, the Second Circuit found that the plaintiff failed to plead plausible facts that the notes were "offered and sold to a broad segment of the public." The Second Circuit determined that the notes were only offered to sophisticated institutional entities. While the plaintiff argued that there was a secondary market for the notes, the Second Circuit noted that there were limitations on the assignment of notes that made them unavailable to the general public—namely that the notes could not be assigned to an individual person or without the prior consent of Millennium and the administrative agent and only certain dollar values of the notes could be assigned.
The third factor is an examination of the investing public's reasonable expectations. Here, a court is to consider notes to be securities based on public expectations, even if a purely economic analysis would suggest the notes are not "securities." The Second Circuit found that the plaintiff did not plead facts to plausibly suggest the lenders in this transaction reasonably understood that the notes were securities. Furthermore, the Second Circuit was persuaded that the purchasers of the notes were sophisticated entities that had been given ample notice that the notes were not investments, but rather loans, and that the note purchasers made certifications prior to buying the notes that they were experienced in extending credit and had independently performed their own due diligence into Millennium after which they decided on their own to make the loans.
The plaintiff trustee argued that the loan documents referred to the lenders as "investors" and thus suggested that their reasonable expectation was that the notes were investments and, as a result, securities. The Second Circuit determined, however, that the references to "investors" were isolated and that the loan documents called the buyers "lenders" more than investors. Therefore, such references to "investors" did not plausibly create a reasonable expectation that the notes were securities.
The last of the Reves factors requires an examination of whether some other deal aspect exists that would reduce the instrument's risk and render application of securities laws unnecessary. With respect to this factor, the Second Circuit found that courts consider whether the instrument is secured or insured or whether there are federal policy guidelines that address the specific type of instrument at issue. Here, the notes were secured by a perfected first priority security interest in all of Millennium's assets. Additionally, there are certain bank regulations that address syndicated term loans that, while primarily aim to minimize bank risks, also protect consumers. Between the secured nature of the notes and these regulations, the Second Circuit determined that there were other risk-reducing aspects of the transactions and, as a result, the complaints' pleaded facts did not plausibly suggest that the application of securities laws was necessary.
The Kirschner decision suggests that the exclusive involvement of sophisticated lenders, subject to general banking regulations who purchase notes that are collateralized in a syndicated transaction will be important factors in determining whether the relevant securities laws are applicable. With that said, however, the Kirschner decision applying the Reves test should be reviewed closely by lenders involved in syndicated transactions as there are other conditions which also need to be followed to ensure that they do not get entangled with additional securities law regulations.