On Friday, May 22, 2020, in the closely watched Millennium Health case,1 Judge Gardephe issued a Memorandum Opinion and Order granting the defendants’ motion to dismiss, including the six causes of action in the plaintiff’s petition under the securities laws of California, Colorado, Illinois and Massachusetts, and holding that the leveraged loans at issue were not securities under the blue sky laws of such states on the basis of a Reves2 analysis.
Significantly, Judge Gardephe did so notwithstanding the plaintiff’s argument that the “determination of whether an instrument is a security is fact-intensive” and “not appropriately resolved on a motion to dismiss.”3
Under Reves, “because the Securities Acts define ‘security’ to include ‘any note,’” courts should “begin with a presumption that every note is a security.”4 The court adopted the Second Circuit’s “list of instruments commonly denominated ‘notes’ that nonetheless fall without the ‘security’ category,”5 however. “[T]ypes of notes that are not ‘securities’ include ‘the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a “character” loan to a bank customer, short-term notes secured by an assignment of accounts receivable, a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized)’ [and] ‘notes evidencing loans by commercial banks for current operations’”6 (first quoting Exchange Nat. Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir. 1976), then quoting Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 939 (2d Cir. 1984)). The presumption that a note is a security “may be rebutted only by a showing that the note bears a strong [family] resemblance . . . to one of the enumerated categories of instrument” set forth above.7
The four factors of the family resemblance test are (1) “the motivations that would prompt a reasonable seller and buyer to enter into [the transaction]”; (2) “the plan of distribution of the instrument”; (3) ‘the reasonable expectations of the investing public”; and (4) “the existence of another regulatory scheme [to reduce] the risk of the instrument, thereby rendering application of the Securities Act unnecessary.”8
Crucially, Judge Gardephe found that, while the first factor (motivations of the parties) was “mixed”9 and weighed heavily neither for nor against a finding that the loans were securities, the remaining three factors weighed in favor of a finding that the notes evidencing the loans were not securities.
For the second factor (plan of distribution), Judge Gardephe found that the distribution at issue was “relatively narrow,”10 despite the plaintiff’s arguments that the defendants “solicited hundreds of investment managers across the country” and had an “extremely low” minimum investment amount of $1 million that “did not apply to the investment managers’ clients” and that the notes evidencing the loans at issue “began trading in secondary markets immediately.”
Citing Banco Espanol,11 Judge Gardephe found that the restrictions on the notes “worked to prevent the loan participations from being sold to the general public.” While Judge Gardephe acknowledged that “hundreds of investment managers” were solicited, he found that this constitutes a relatively small number compared to the general public and that, as in Banco Espanol, “only institutional and corporate entities were solicited.” The $1 million minimum investment amount, while small in comparison to the size of the notes, is a high absolute number that would only allow sophisticated investors to participate.
For the third factor (reasonable expectations of the investing public), Judge Gardephe agreed with the defendants that the “governing documents” (including the related confidential information memorandum) would lead a reasonable investor to believe that the loans were just that and were not securities since such documents consistently used the terms “lender,” “loan” and “loan documents” and did not refer to an “investor” or an “investment.”
Again citing Banco Espanol, Judge Gardephe found the use of such terms significant, concluding that buyers “were given ample notice that the instruments were participations in loans and not investments in a business enterprise.”12
For the fourth factor (existence of another regulatory scheme), Judge Gardephe, again relying on Banco Espanol, found that existing bank regulatory policy guidance, even though intended to promote the safety and soundness of banks rather than the protection of note holders, distinguished the entirely unregulated scenario present in Reves from the syndication of loan participations to sophisticated purchasers as in the instant case.
While the US leveraged loan markets will await further developments in this case (including the possibility of appeal) due to its importance to the orderly functioning of this $1.2 trillion market, the decision reaffirms the relevant historical precedent and provides new assurance that such markets are not subject to regulation as “securities” with the draconian consequences that this might have entailed.