Are Syndicated Loans Securities?12 October 2023

Second Circuit Decision

Summary
On August 24, 2023, the Second Circuit issued the highly anticipated ruling in Kirschner v. JP Morgan Chase Bank, N.A. et al., No 21-2726, (2d. Cir. Aug. 24, 2023), affirming that syndicated loans should not be considered securities under federal law.

The Second Circuit relied on the framework previously established in Reves v. Ernst & Young, 494 U.S. 56 (1990), in which the United States Supreme Court relied on a four-pronged “family resemblance” test to determine whether a debt obligation is a security. The relevant test initially presumes that every note is a security, but then applies the following four factors of a “family resemblance” test to determine if a particular note should not be a security:

• whether the motivation of the parties involved indicate a commercial or investment purpose for the transaction;
• whether the instrument is to be widely or narrowly distributed;
• what the investing public would reasonably expect; and
• whether the existence of another regulatory scheme, such as interagency guidance and other measures taken by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, or the Federal Reserve Board, that would render application of securities laws unnecessary.

Facts of the Case
In Kirschner, a trustee for the Millenium Lender Claim Trust (the “Trust”) alleged, on behalf of the Trust’s beneficiaries, that, in 2014, JP Morgan Chase and other financial institutions provided misleading information and omitting crucial facts as the arranger banks in the offering materials related to the syndication of US$1.825bn in syndicated loans represented by promissory notes (the “Notes”), violating requirements enforced by federal securities and blue sky laws. The borrower’s 2015 bankruptcy, prompted by a related civil lawsuit and government inquiry, triggered this claim brought by Mark Kirschner in his capacity as bankruptcy trustee. Therein, the banks countered Kirschner’s claims, stating the loans are valid because securities laws are inapplicable to the transaction, since “a syndicated bank loan is not a ‘security’ and a loan syndication is not a ‘securities distribution’.” In May 2020, the district court dismissed Kirschner’s claims, concluding that the Notes did not meet the definition of a security based on the Supreme Court’s four-factor ‘family resemblance’ test outlined in Reves v. Ernst & Young and Kirschner appealed.

Court Analysis
Though the Second Circuit requested the SEC’s opinion on whether the term loans should be classified as securities earlier this year, the SEC declined to weigh in. Limiting its securities law analysis to the Reves framework, the Second Circuit found that three out of the four factors—the plan of distribution, the reasonable expectations of the public, and the presence of other risk-mitigating factors—supported the conclusion that the term loan and the Notes should not be classified as a security.

The first factor, scrutinizing the motivations of the parties involved, leaned toward classifying the Notes as securities; while the borrower’s intent appeared predominantly “commercial,” the lenders’ expectation for profit from their purchase of the note indicated an “investment” motive. The second factor, examining the plan of distribution, opposed classifying the Notes as securities as, particularly due to a number of restrictions on assignments, the Notes were not broadly accessible to the general public. Because the lenders were sophisticated institutional entities with an outward understanding that the Notes were not securities by having agreements repeatedly use terms such as “loan documents,” “lenders and potential lenders” (despite occasional references to “investors” in loan documents), the third factor—assessing the reasonable expectations of the public— likewise contradicted the notion that the Notes are securities. The fourth factor, considering the existence of other risk-reducing regulations, was supported by the collateral securing the Notes and the issuance of “specific policy guidelines” by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve, and the Federal Deposit Insurance Corporation concerning syndicated loans, collectively diminishing investment risks to both banks and consumers.

In consideration of the above, the Second Circuit affirmed the district court’s decision that loan syndications do not fall under the heavily regulated category of securities.

Implications of Kirschner

The ruling underscores the importance of structuring and documenting term loans to prevent their misclassification as securities. To ensure loans continue to be recognized as non-securities, market participants should:

• use loan-related terminology and avoid terms associated with securities, such as “investor,” “investment,” “notes” or “securities,” which are terms used for bonds;
• maintain well-defined syndication and distribution plans targeting a limited group of lenders;
• use appropriately tailored precautionary language in marketing materials; and
• require consent for assignments to unaffiliated parties and set minimum assignment amounts, to avoid the appearance of a public offering.

The Second Circuit’s decision reinforces the industry consensus that loan syndications do not fall under the heavily regulated category of securities federal laws. As such, it preserves the current regulatory framework for syndicated term loans and averts the significant disruptions that might have occurred in the syndicated loan market had the district court’s decision been overturned or if the Second Circuit had indicated that term loans should be treated as securities.

This article was written by Partner Steven Hollander and Associate Krisly Zamor. If you have any questions, please contact one of the authors or your regular Watson Farley & Williams contact.