On May 22, the U.S. District Court for the Southern District of New York issued an important decision for the syndicated loan market, holding, in Kirschner v. JP Morgan Chase Bank N.A., that the syndicated loan in that case was not a “security.”
The decision also serves as a reminder of the nuanced analysis to determine whether a debt product constitutes a “security” and key factors driving that analysis.
Kirschner Seeks to Upend the Status Quo
Kirschner arose from a $1.775 billion syndicated loan to Millennium Laboratories LLC. The plaintiff, Millennium’s bankruptcy trustee, alleged that the syndicated loan at issue was a “security” under several states’ securities (or Blue Sky) laws and that the defendant banks and brokers had committed fraud by including misstatements and/or omissions in the information memorandum distributed to the lenders.
A syndicated loan is a debt instrument that typically is arranged and administered by a bank, which “syndicates” the loan to qualified institutions who act as lenders to a corporate borrower.
Lenders, borrowers, and other participants in the syndicated loan market do not treat syndicated loans as securities and doing so would have substantial consequences, as discussed further below. For this reason, Kirschner was closely watched by the syndicated loan industry.
In a decision issued by Judge Paul G. Gardephe, the court in Kirschner held that the syndicated loan at issue is not a security. The court reached this decision by applying the “family resemblance” test adopted by the U.S. Supreme Court in Reves v. Ernst & Young.
Because the securities laws define the term “security” to include “any note” other than one with a maturity “not exceeding nine months,” the Reves test “begins with a presumption that any note with a term of more than nine months is a ‘security.’”
This presumption, however, may be rebutted by showing, through application of a four-factor test, that the note resembles one of the “instruments commonly denominated ‘notes’ that nonetheless fall without [i.e., outside] the ‘security’ category.”
The first factor considers the buyer’s and seller’s motivations, with an investment purpose such as raising capital for general business purposes indicative of a security and a commercial or consumer purpose less so. Reflecting the elusiveness of this distinction, the Kirschner court found this factor to be indeterminate because Millennium’s purpose, which included repaying a prior loan and issuing a dividend, was commercial, while the buyers’ purpose was to acquire the notes for their investment portfolios.
The second factor considers the “plan of distribution.” This factor weighed strongly against the Millennium notes being securities because, as the court found, the “hundreds” of investors who were solicited “constitutes a relatively small number compared to the general public.”
The court also noted that “only institutional and corporate entities were solicited” and that the “$1 million minimum investment amount … is a high absolute number that would only allow sophisticated investors to participate.”
The third factor, which considers the reasonable expectations of the investing public, also weighed against deeming the notes securities. As the court explained, the language of the credit agreement and the information memorandum—including its use of words such as “loan” and “lender” rather than “investor”—“would lead a reasonable investor to believe that the Notes constitute loans, and not securities.”
Finally, the fourth Reves factor considers whether another regulatory scheme exists to reduce the risk of the instrument. Kirschner held that interagency guidance and other measures taken by federal banking regulators satisfied this factor.
In applying the Reves test, the court arguably took a lenient approach, particularly regarding the second and fourth factors. While not referenced in the decision, the court’s analysis may have been influenced by the potentially disruptive impact of a contrary decision on the syndicated loan market.
Significance of Kirschner
Kirschner marks the first time that a court has squarely addressed the question of whether a syndicated loan is a security. Its holding that the syndicated loan at issue is not a security is an important win for the syndicated loan market. It is also significant that the court dismissed the claims at the outset of the action instead of requiring the parties to first engage in discovery.
A ruling that syndicated loans are securities would have had immediate and far-reaching consequences to the syndicated loan market, whose practices and expectations are premised on these instruments not being securities.
For example, disclosures provided in connection with a syndication are typically less comprehensive than those required in a securities offering. Instead, lenders rely on their own due diligence and on representations made by the borrower in the credit agreement. Requiring banks to comply with the heightened disclosure obligations required by securities laws would increase the borrowers’ costs and delay the transaction, jeopardizing businesses’ access to affordable capital in a timely manner.
While favorable, the Kirschner decision is in many respects fact-specific. It is also non-binding as a district court opinion. Debt instruments should therefore be carefully reviewed with counsel to determine whether they constitute a security under the Reves test.
Arranging banks and brokers should be mindful of the borrower’s and lenders’ purposes in entering the syndicated loan transaction, the number and type of investors to whom the loan is marketed, and the disclosures and terminology used in the loan documentation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Tarnetta Jones is senior counsel in Thompson Hine’s Business Litigation practice in New York. Mendy represents businesses in complex commercial disputes, with a focus on lender liability and securities litigation.
Mendy Piekarski is senior counsel in Thompson Hine’s Business Litigation practice group in New York. His experience includes federal and state court litigation and arbitration in areas of law including complex breach of contract, shareholder and securities litigation, class action defense, business torts, fraud, internal investigations, copyright and trademark, and SEC and FINRA investigations.
Renee Zaytsev is senior counsel in Thompson Hine’s Business Litigation practice in New York. Renee represents businesses and fiduciaries in complex commercial disputes, with a focus on securities and shareholder litigation.
Anna Stark is an associate in the New York office of Thompson Hine and has a wide spectrum of litigation experience that encompasses handling complex civil cases and white-collar defense.