Kirschner v. JPMorgan Chase Bank: Syndicated Loans Are Not Securities | Practical Law

Kirschner v. JPMorgan Chase Bank: Syndicated Loans Are Not Securities | Practical Law

The US District Court for the Southern District of New York in Kirschner v. JPMorgan Chase Bank held in a motion to dismiss that syndicated loans were not securities subject to the securities laws. This decision endorses the view among many loan market practitioners and participants that the securities laws ought not to apply to syndicated loans – and, subject to the plaintiff's right to appeal, should go some way to alleviating concerns that the evolution of the syndicated loan market in recent years has opened the door to the loan asset class constituting securities to which the securities laws apply.

Kirschner v. JPMorgan Chase Bank: Syndicated Loans Are Not Securities

Practical Law Legal Update w-025-7740 (Approx. 5 pages)

Kirschner v. JPMorgan Chase Bank: Syndicated Loans Are Not Securities

by Practical Law Finance
Published on 28 May 2020 • USA (National/Federal)
The US District Court for the Southern District of New York in Kirschner v. JPMorgan Chase Bank held in a motion to dismiss that syndicated loans were not securities subject to the securities laws. This decision endorses the view among many loan market practitioners and participants that the securities laws ought not to apply to syndicated loans – and, subject to the plaintiff's right to appeal, should go some way to alleviating concerns that the evolution of the syndicated loan market in recent years has opened the door to the loan asset class constituting securities to which the securities laws apply.
UPDATE:
On March 16, 2023, an appeal was filed with the US Court of Appeals for the Second Circuit. Practitioners are closely watching this case to see if the decision upends the long-held assumption that loans are not securities to which the securities laws apply.
On May 22, 2020 the United States District Court for the Southern District of New York in Kirschner v. JPMorgan Chase Bank (S.D.N.Y. 2020) held in a motion to dismiss that syndicated loans were not securities subject to the securities laws. This decision endorses the view among many loan market practitioners and participants that the securities laws do not apply to syndicated loans – and, subject to the plaintiff's right to appeal, should go some way to alleviating concerns that the evolution of the syndicated loan market in recent years has opened the door to the loan asset class constituting securities to which the securities laws apply.
UPDATE:
On March 16, 2023, an appeal was filed with the US Court of Appeals for the Second Circuit. Practitioners are closely watching this case to see if the decision upends the long-held assumption that loans are not securities to which the securities laws apply.

Background

The case concerned a $1.775 billion syndicated loan that was held by a broad and diverse group of some 400 institutional investors to Millennium Laboratories, LLC, a California-based private company (Millennium) that offered urine testing services to medical practitioners. Following a Department of Justice (DOJ) investigation into Millenium's sales, marketing and billing practices, and litigation from a major competitor that these practices constituted unfair competition, Millenium entered into the huge institutional financing in April 2014. The $1.775 billion of loan proceeds were used to refinance Millenium's approximately $300 million of existing debt and provide funds to pay an extraordinary dividend to its investors, as well as bonuses to its directors and officers. Nineteen months later Millenium filed for bankruptcy.
The plaintiff, Marc S. Kirschner was the trustee of a trust that was set up as part of the bankruptcy plan. The trust was provided with the investors' claims against the defendants JP Morgan Chase Bank, N.A., Citibank, N.A., Bank of Montreal, SunTrust Bank and each of their broker-dealer affiliates, who acted as the arrangers and initial lenders of the loan, which was immediately sold to institutional investors in the amounts of their respective subscriptions. The 11 causes of action in the case alleged generally that the defendants failed to provide the investors with information relating to the DOJ investigation and unfair competition litigation and the potential impact of both on Millenium's business.
The first six causes of action in the case arose under the so-called "blue sky" securities laws of California, Colorado, Illinois and Massachusetts and alleged that the defendants made actionable misstatements and omissions in communications to the investors. The defendants moved to dismiss the securities laws violation claims for failure to state a claim on the grounds that a syndicated bank loan is not a security and a loan syndication is not a securities distribution.
The remaining five causes of action in the case alleged negligent misrepresentation by all the defendants and certain breach of contract claims against JPMorgan Chase Bank as administrative agent, which are not relevant to the question of whether the loans constituted securities and are not discussed further here.

Outcome

In analyzing the question of whether debt obligations such as Millenium's notes were securities, the Court applied the "family resemblance" test from the Supreme Court decision in Reves v. Ernst & Young. 494 U.S. 56 (1990). Under the Reves decision, every note is a security apart from enumerated categories of notes and notes bearing a strong family resemblance to one of those categories. The enumerated categories of notes that are not securities adopted by the Supreme Court in Reves comes from Second Circuit decisions, and includes:
  • Consumer financing notes.
  • Home mortgage loan notes.
  • "Character" loans to bank customers.
  • Short-term notes secured by liens on a small business or some of its assets
  • Short-term notes secured by an assignment of accounts receivable.
  • Notes formalizing open account debts incurred in the ordinary course of business.
  • Notes evidencing loans by commercial banks for current operations.
The "family resemblance" test, to determine whether a note bears a strong family resemblance to one of the above types of notes and is therefore not a security, involves an analysis of the following four factors:
  • The motivations that would prompt a reasonable seller and buyer to enter into the transaction.
  • The "plan of distribution" of the notes.
  • The "reasonable expectations of the investing public."
  • The existence of another regulatory scheme to reduce the risk of the notes, which renders the application of the Securities Act unnecessary.

Reves Factors

In addressing the first Reves factor, the Court considered the motivations of Millenium, which issued the notes for the commercial purposes of repaying existing debt and paying a dividend, against the motivations of the investors which acquired the notes for their investment portfolios. While commercial purposes would suggest that the notes were not securities and investment motives would suggest that they were, the Court determined that the first Reves factor did not weigh heavily in either direction.
The Court concluded that the second Reves factor regarding the plan of distribution of the notes, weighed strongly in favor of the notes not constituting securities. Even though the defendants solicited hundreds of investment managers across the country and the minimum investment amount of $1,000,000 was very low (and could be reduced still further through sub-allocations by investment managers to their affiliates), the Court concluded that the plan of distribution was nevertheless relatively narrow compared to the general public. Transfer restrictions in the notes also meant that they could not be assigned to natural persons and could only be held by sophisticated institutional investors. Also, while $1,000,000 was a low number compared to the size of the loan, the Court concluded that it was still a high absolute number which ensured only sophisticated investors could participate.
For the third Reves factor concerning the reasonable expectations of the investing public, the Court highlighted that the nomenclature used in the loan agreement and the information memorandum, including repeated use of the terms "loan," "loan documents," and references to purchasers of the notes as "lenders" rather than "investors," would lead a reasonable investor to believe that the notes constituted loans and not securities. Nor was the Court persuaded by the plaintiff's argument that lender confidentiality undertakings regarding the borrower's non-public information, which are common in loan agreements, signaled that the notes were securities.
The Court noted that the plaintiff had cited no case in which a syndicated term loan was held to be a security and found no case to that effect in its own review. The plaintiff cited, among other market commentary, the Practical Law Finance Article, Term Loans and High-Yield Bonds: Tracking the Convergence in support of its argument that the notes were securities, and the Court correctly concluded that that article does not stand for this proposition but instead describes certain bond-like features that have been imported into loan documents as the syndicated term loan B market has evolved. Rather, the Court held that the plaintiff's claim of a shift in the market that would lead to syndicated term loans constituting securities was "premature at best," and that this factor weighed in favor of finding that the notes were not securities.
For the final Reves factor regarding an alternative regulatory scheme rendering the securities laws unnecessary, the Court noted that the parties did not agree on whether the interagency guidance issued by the Federal banking agencies (the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board) constituted a regulatory scheme. While the Court expressed the view that the primary focus of these agencies is the safety and soundness of banks rather than the protection of noteholders, it noted the Second Circuit's distinction (in Banco Espanol de Credito v. Security Pac. Nat'l Bank, 973 F.2d 51 (2d Cir, 1992)) between a market that is subject to policy guidelines versus an entirely unregulated market, and concluded that this factor weighed in favor of the notes not constituting securities.
Ultimately, the plaintiff was granted leave to amend. However, the plaintiff had filed a motion seeking leave to amend with a proposed amended complaint attached, but this motion was dismissed because it included claims that the Court had dismissed, including all the causes of action under the securities laws.

Practical Implications

The syndicated loan market has grown considerably in size in recent years with record years exceeding $2 trillion of activity, and it plays an important role in the US economy. A lurking concern among many market participants and practitioners was that this growth in the market and the evolution in loan terms might lead to syndicated loans being regarded as securities, with the result that the attendant compliance issues and other regulations applicable to high-yield bonds would be required of syndicated loans. Subject to the plaintiff's right to appeal to the Second Circuit, this decision goes some way to alleviating this concern that syndicated loans as an asset class might be held to be securities because of changes in the nature of the loan market.
On the question of whether an individual loan may be classed as a security, the decision confirms that the Reves factors remain the criteria by which the matter will be judged. However, in a transaction that is consistent with established syndicated loan market conventions, loans that are evidenced by a carefully drafted loan agreement that makes it clear on its face that the loans are loans and not investments ought not to be held to be securities.