Had the court found that loans are securities, such a ruling would have had profound consequences on the leveraged loan market.

On May 22, 2020, the U.S. District Court for the Southern District of New York ruled in Kirschner v. J.P. Morgan. The court held that a syndicated term loan is not a “security” under state securities laws. Had the court found that loans are securities, such a ruling would have had profound consequences on the leveraged loan market. This Alert provides a brief overview of the court’s holding and details the implications on the banking and financial services industry.

Background

The case arose out of a $1.8 billion loan provided in April 2014 by J.P. Morgan Chase Bank, N.A. and a syndicate of other lenders to Millennium Laboratories LLC. Shortly after closing, the lenders sold respective portions of their interest in the term loan to several institutional investors.

On October 16, 2015, Millennium paid $256 million as part of a settlement reached in connection with a federal investigation involving allegedly fraudulent billing practices. Because of the financial burden of the settlement, in November 2015, Millennium failed to pay its debt service on the loan and immediately filed a bankruptcy petition.

The bankruptcy trustee brought suit on behalf of the investors against the lenders claiming violations of state securities laws, also known as blue sky laws. The investors alleged that the lenders misrepresented or omitted material facts in the loan offering materials provided to the investors. The trustee specifically argued that the lenders failed to disclose the pending federal investigation into Millennium’s billing practices and such failure to disclose was a blatant violation of blue sky laws. The lenders moved to dismiss the claims arguing that a loan is not a “security” and therefore not subject to the purview of blue sky laws.

Issue

At issue in this case is whether loans that are syndicated through a bank agent to a group of institutional lenders or investors are “securities.”

Rule

The court applied the Reves test, named after the 1990 Supreme Court case Reves v. Ernst & Young. There, the Supreme Court noted that there is a presumption that every note is a security. There is an exception to this presumption if the note strongly resembles one of the families of instruments previously determined by the courts to be nonsecurities. A note bears a “family resemblance” to any of these categories of nonsecurity notes based on four factors: (i) the motivations of the seller and buyer, (ii) the plan of distribution of the instrument, (iii) the reasonable expectations of the investing public and (iv) the existence of another regulatory scheme to reduce the instrument’s risk.

Holding and Analysis

The district court found that the facts here overcame the presumption that notes are securities because “it would have been reasonable for these sophisticated institutional buyers to believe that they were lending money, with all of the risks that may entail, and without the disclosure and other protections associated with the issuance of securities.” The court’s holding was based on the fact that three of the four Reves factors weighed strongly in favor of finding that the notes here were not securities.

The Motivations of the Seller and Buyer

The court found this factor inconclusive. On the one hand, the lenders were motivated by loan repayment and not Millennium’s business enterprise, per se, which suggests that the notes were not securities. On the other hand, because many of the investors were pension and retirement funds, the investors’ motivation was, in large part, investing, which favors the finding that the note here was a security.

The Plan of Distribution of the Instrument

This factor concluded the notes were not securities because the notes were restricted from being sold to the general public and only institutional and corporate entities were solicited to purchase interests in the loans.

The Reasonable Expectations of the Investing Public

The court found that the notes were not securities with respect to this factor because the primary documents (i.e., the credit agreement and confidential information memorandum) used the words “loan” and “lender” instead of words such as “investor.” As such, the court concluded that a reasonable participant would believe they were participating in a lending transaction and not an investment in a company’s business.

The Existence of Another Regulatory Scheme to Reduce the Instrument’s Risk

Because the sale of loan participations to sophisticated purchasers is subject to federal banking regulators (including the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board), the court held that this factor weighed in favor of finding that the notes were not securities.

In light of the foregoing, the court concluded that “the limited number of highly sophisticated purchasers of the Notes would not reasonably consider the Notes ‘securities’ subject to the attendant regulations and protections of Federal and state securities law.”

Implications for Lenders and Borrowers

Had the court ruled in favor of the trustee and found that loans were securities, the way in which lenders put leveraged loans into place would have significantly changed, thereby altering how American businesses raise capital through debt markets. Such a ruling would have caused leveraged loans and lenders to be subject to the same offering and disclosure standards currently applied to the debt securities markets, in addition to the regulatory oversight and enforcement mechanisms that accompany securities offerings.

These requirements would add significant time and transaction costs to the loan marketing process, which lenders would likely pass along to borrowers: Lenders would have to offer higher interest rates and fees and borrowers would not have quick access to capital. Moreover, many borrowers choose to raise capital through private debt markets because they want certain information regarding the business to remain confidential; classifying term loans as securities would force borrowers to make this information public to access that capital. This in turn could cause businesses to publicly disclose information that may negatively impact their competitive advantage in the marketplace.

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