Last Thursday morning, August 24, the US Court of Appeals for the Second Circuit issued a decision in the closely watched Kirschner v. JPMorgan case, rejecting the plaintiff’s argument that the subject syndicated term loans should be treated as securities.1
The Second Circuit issued its decision just a few weeks after the US Securities and Exchange Commission (“SEC”) declined to weigh in on the case despite having requested three extensions for the filing of a submission.
In advance of the SEC’s decision not to opine on the matter and the Second Circuit’s decision last Thursday, a range of loan market participants were concerned about the prospect that the court could find that syndicated term loans should be treated as securities. There was considerable concern that such a finding would create substantial negative implications for the origination and trading of broadly syndicated institutional term loans, “term loan Bs” (“TLBs”), which are typically syndicated to institutional lenders such as CLOs and hedge funds.
In addition to the TLB market, the CLO markets welcomed the news of the Second Circuit’s Kirschner decision just a day after they welcomed the SEC’s promulgation of pared-back Private Fund Adviser Rules that included a broad carve-out for CLO managers.2
We discuss the Kirschner decision below.
DISTRICT COURT APPLIES REVES TEST TO FIND NO SECURITIES
The “Notes” at issue in the Kirschner case are actually loans in the form of syndicated TLBs. While the loans, like all TLBs, are governed by a credit agreement, that credit agreement (as is typical) permits lenders to request short-form promissory notes issued to further evidence their loans—and it is the underlying loans, not any such promissory note, that were syndicated. As part of the Chapter 11 bankruptcy proceedings for Millennium Health, the plaintiff, Marc Kirschner, was appointed trustee of the Millennium Lender Claim Trust, the ultimate beneficiaries of which are lenders who purchased portions of the loans issued by Millennium Health and have claims in the bankruptcy proceeding.
Kirschner filed suit in 2017 in New York state court against several financial institutions that were involved with the syndication, with claims that included violation of state securities laws. The case was removed to the US District Court for the Southern District of New York.
In May 2020, US District Judge Paul Gardephe granted the defendants’ motion to dismiss.3 With respect to the state securities laws claims, Judge Gardephe applied to the Millennium syndicated loans the four-factor “family resemblance” test outlined by the US Supreme Court in Reves v. Ernst & Young.4 Under the Reves test, courts are to begin with the presumption that every “note” is a security and that presumption may be rebutted by a showing that the subject note bears a strong “family resemblance” to notes in a list of instruments that courts have recognized as not being securities. Judge Gardephe ultimately determined that “the limited number of highly sophisticated purchasers of the [Millennium] Notes would not reasonably consider the Notes ‘securities’ subject to the attendant regulations and protections of Federal and state securities law.”5
Kirschner appealed Judge Gardephe’s decision in October 2021.
SECOND CIRCUIT AFFIRMS: UNDER REVES, NO SECURITIES
For all of the activity surrounding, and attention given to, the Kirschner case for several years, including the Second Circuit’s invitation of SEC input and the breadth of all of the amicus briefs, the Second Circuit’s decision is remarkably short and straightforward.
The four-factor “family resemblance” test
Writing for the panel, longtime Second Circuit Judge Jose Cabranes walked through the four-factor “family resemblance” test, noting that each factor “helps to uncover whether the note was issued in an investment context (and is thus a security) or in a consumer or commercial context (and thus is not a security).” Judge Cabranes identified the four Reves factors as:
- 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 Act unnecessary.
Judge Cabranes noted that, in balancing the four factors, if the “note” at issue does not bear a strong resemblance to an instrument on the “judicially crafted” list of instruments, that is not dispositive. “The test allows courts to expand the list of non-security instruments to include the type of note at issue if, based on the four factors, a court concludes that the note is not a security.”6
The test, applied to Kirschner
1. The Motivations of the Parties
Applying the first of the four factors, the Second Circuit panel determined that the “motivations” factor “tilts in favor of concluding that the complaint plausibly alleges that the Notes are securities.”7 The Second Circuit found, in connection with the motion to dismiss, that the “pleaded facts” indicated that the parties’ motivations were mixed. On the one hand, the Second Circuit determined, the pleaded facts did not plausibly suggest that Millennium’s motivation was investment. The Second Circuit found that it appeared Millennium’s motivations were commercial—to use the subject loans to pay down another facility, for example, as opposed to using the financing for its urine testing business. But “the pleaded facts,” the Second Circuit determined, “plausibly suggest that the lenders’ motivation was investment because the lenders expected to profit from their purchase of the Notes.”8
2. Plan of Distribution
Judge Cabranes wrote that the second factor in the Reves test requires courts to “‘examine the plan of distribution of the investment to determine whether it is an instrument in which there is common trading for speculation and investment.’”9
Judge Cabranes elaborated, “This factor weighs in favor of determining that a note is a security if it is ‘offered and sold to a broad segment of the public.’ This factor weighs against determining that a note is a security if there are limitations in place that ‘work to prevent the [notes] from being sold to the general public.’”10
The Second Circuit was unequivocal that this factor weighed against concluding that the Millennium loans were securities. Judge Cabranes noted that:
- The lead arrangers offered the loans only to sophisticated institutional entities;
- One of the lead arrangers, JP Morgan, proceeded to allocate the loans to “only the sophisticated institutional entities that submitted ‘legally binding offer[s]’”; and
- There were substantial “restrictions on any assignment”—transfer restrictions—with respect to the Millennium loans that “rendered them unavailable to the general public.” Any transfer to a non-affiliate or a fund that was not an “approved fund” required consent from Millennium and from JPMorgan as Administrative Agent and was limited to $1,000,000.
The Second Circuit found that the assignment restrictions were “akin” to those in the longtime Second Circuit precedent Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2d. Cir. 1992), where the Circuit applied Reves and found that the transfer restrictions weighed against finding that the subject loan participations were securities.11
3. The Public’s Reasonable Perception
Judge Cabranes noted that the third Reves factor requires courts to “examine the reasonable expectations of the investing public.” If buyers of loans or notes, Judge Cabranes wrote, were “‘given ample notice that the instruments were…loans and not investments in a business enterprise,’ it suggests that the instrument are not securities.”12
The Second Circuit found that the pleaded facts did not plausibly suggest that the lenders acquiring Millennium loans reasonably perceived any promissory notes associated with the loans as securities.
Judge Cabranes noted that before purchasing the Millennium loans, “lenders certified that they were ‘sophisticated and experienced in extending credit to entities similar to [Millennium].’ They also certified that they had ‘independently and without reliance upon any Agent or any Lender, and based on such documents and information as [they] ha[ve] deemed appropriate, made [their] own appraisal of and investigation into the business, operations, property, financial and other condition and creditworthiness of [Millennium] and made [their] own decision to make [their] Loans hereunder.’”13 Judge Cabranes observed that this certification regarding sophistication and experience was “substantively identical” to the certification made by the purchasers of loan participations in Banco Espanol.14
Significantly, the Second Circuit was not swayed otherwise on this factor by the fact that the documents provided to prospective lenders “at times” referred to the prospective lenders as “investors.” Judge Cabranes reasoned that (1) there were only isolated references to “investors” in the documents, and “these isolated references could not have plausibly created the reasonable expectation that the buyers were investing in securities,” and (2) the loan documents “more consistently” referred to the buyers as “lenders.” Judge Cabranes concluded, “This label aligns with the reasonable expectations of the experienced entities that the Notes were not securities.”15
4. Whether Some Other Risk-reducing Factor Renders Application of Securities Laws Unnecessary
Judge Cabranes noted that the final Reves factor with respect to the instrument is whether some other factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, rendering application of the Securities Act unnecessary.16
The Second Circuit found that this factor also weighed against a finding that the subject Millennium loans were securities.17
First, the Second Circuit cited the fact that the Millennium loans were secured; “[t]hat perfected first priority security interest reduces the risk associated with the Notes.”18
Second, the Second Circuit cited policy guidelines issued by federal agencies addressing syndicated term loans. Judge Cabranes acknowledged Kirschner’s argument that the bank regulators’ guidance simply addresses risk management controls to ensure sound banking practices. Judge Cabranes found that the guidance, in fact, does aim to protect consumers. Moreover, Judge Cabranes noted the panel was following the approach of the Second Circuit with respect to bank regulatory guidance in Banco Espanol.19
Judge Cabranes notably cited Banco Espanol in the Second Circuit’s ultimate conclusion: “Upon our review of the pleaded factors, we conclude that the Notes, like the loan participations in Banco Espanol, ‘bear a strong resemblance’ to one of the enumerated categories of notes that are not securities: ‘[L]oans issued by banks for commercial purposes.’”20
IMPLICATIONS OF KIRSCHNER
The plaintiff in Kirschner has a 14-day window to petition for a rehearing or rehearing en banc and a 90-day window to file a certiorari petition for discretionary review by the US Supreme Court, with both periods running from the entry of judgment. We have not seen any indication from the plaintiff that either will be pursued, but this cannot be ruled out at this stage.
That said, the TLB market (along with debt markets generally) has celebrated the Kirschner decision. The decision has validated and reconfirmed the longstanding overall approach of the TLB market (and debt markets generally) to treat TLBs as loans and not securities.
There are some points to take heed of from the Second Circuit’s decision. For example, if an agent is communicating about TLBs with prospective lenders and wants to avoid securities treatment, it is prudent to:
- Consistently use the term “lender” versus “investor” and “loan” versus “note”;
- Apply customary exacting eligible-lender limitations and requirements and assignment restrictions, including minimum dollar amount assignment rules (including borrower/administrative agent consents); and
- Grant lenders a security interest in the borrower’s assets.
We will be closely monitoring the developments in this space. A Supreme Court test that places emphasis on “motivations” and “reasonable expectations” leaves some room for interpretation. Careful structuring and documentation of TLB transactions is prudent.
2 Release No. IA-6383; File No. S703-22, “Private Fund Advisers: Documentation of Registered Investment Adviser Compliance Reviews,” August 23, 2024 (final Rule); Mayer Brown Legal Update, “SEC Releases Final Private Fund Adviser Rules,” August 24, 2023.
3 Kirschner v. JPMorgan Chase Bank, N.A., 2020 WL 2614765 (2020); J. Paul Forrester, Mayer Brown LLP, “Millennium Health Judge Funds Loans at Issue Not Securities, Dismisses Related Blue Sky Claims; US Leveraged Loan Market Breathes a Sigh of Relief,” 2020.