Article courtesy of Margaret G. Parker-Yavuz (Akin Gump)
Kirschner v. J.P. Morgan Chase Bank, N.A., et al., 2020 WL 2614765 (S.D.N.Y. May 22, 2020)
Applying the so-called “family resemblance” test from Reves v. Ernst & Young, the U.S. District Court for the Southern District of New York found that notes issued to institutional investors in a syndicated term loan financing do not constitute “securities”.
The case concerns term notes issued by Millennium Laboratories LLC, a California-based drug testing company. In 2014, Millennium entered into a $1.775 billion syndicated term loan financing pursuant to which institutional investors were issued notes under a credit agreement. The transaction was structured with J.P. Morgan Chase Bank, N.A. (“Chase”) making an initial term loan to Millennium which was immediately assigned to a number of institutional investors according to pre-agreed commitments to purchase allocations in the loan. Chase was the administrative agent under the facility. The facility refinanced a 2012 credit facility between Millennium and several banks including Chase. J.P. Morgan Securities LLC and affiliates of other lenders in the 2012 facility were the arrangers for the new facility, and there was evidence that certain of the banks wished to have the 2012 facility refinanced due to their concerns regarding legal allegations against Millennium. Although Chase was to make the initial loan under the new facility, the banks agreed among themselves that if any investor in the facility failed to purchase its agreed allocation of the initial loan, the investor’s allocation would be divided among the banks. The vast majority of the investors in the new facility were U.S. entities consisting of mutual funds, hedge funds, pension and retirement funds, and other institutional investors. Almost all of the proceeds of the loan were used to refinance the 2012 facility and to pay dividends.
Within two years after the new term loan facility closed, Millennium defaulted on the loan and filed for bankruptcy following a series of legal disputes with federal regulators and competitors alleging, among other things, federal healthcare law violations. The bankruptcy plan established a trust for the lenders’ claims against Millennium. The trustee of the trust filed suit in the Supreme Court of the State of New York against Chase, J.P. Morgan Securities LLC and the other banks that were arrangers under the facility alleging, among other things, violations of state securities laws under the “blue sky laws” of California, Massachusetts, Colorado and Illinois. The trustee argued that the Millennium notes are securities and are therefore subject to state securities laws and that, among other things, the defendants created offering materials containing material misstatements and omissions that were designed to and did induce investors to purchase the Millennium notes. The defendants removed the case to the U.S. District Court for the Southern District of New York, and moved to dismiss for failure to state a claim. The defendants argued that the trustee’s state securities law claims should be dismissed on the ground that a syndicated loan is not a “security” and a loan syndication is not a “securities distribution”. The court held in favor of the defendants, concluding that the Millennium notes do not constitute securities.
In arriving at its decision that the Millennium notes are not securities, the court applied the so-called “family resemblance” test set forth by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990). In Reves, the Supreme Court stated that, because the securities acts define “security” to include “any note”, courts should begin their analysis with the presumption that every note is a security. However, in Reves, the Supreme Court also adopted Second Circuit decisions identifying certain types of notes that nevertheless do not constitute securities, and found that the presumption that a note is a security may be rebutted by showing that the note bears a strong resemblance to one of the enumerated categories of instruments set forth in the Second Circuit decisions. The so-called family resemblance test arising from Reves looks at four factors: (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. Applying the Reves family resemblance test to the Millennium notes, the court concluded that the first factor does not weigh strongly in either direction, and that the second, third and fourth factors weigh in favor of finding the Notes analogous to loans rather than securities.
With respect to the first factor under the Reves family resemblance test, the court cited language in Reves stating that where “the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments … the instrument is likely to be a ‘security,’ ” but where “the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, … the note is less sensibly described as a ‘security,’ ”. The court concluded that, since the motivations of the sellers and the buyers under the Millennium facility were mixed (the sellers’ aim was to refinance debt and pay dividends, whereas the buyers’ purpose was to make an investment), this prong of the test is inconclusive in Millennium’s case.
Under the test’s second factor, the Reves analysis considers whether the plan of distribution for the instrument is subject to common trading for speculation or investment. The court concluded that the plan of distribution for the Millennium notes was relatively narrow because only institutional and corporate entities were solicited, not the general public.
Under the test’s third factor, the court noted that instruments can be considered “securities” on the basis of public expectations even where the economic analysis would suggest otherwise. However, the transaction documents for the Millennium facility (including the information memorandum and the credit agreement) used language that made it clear that the notes were loans and not securities, repeatedly using terms such as “loan documents”, “loan” and “lender” (rather than using terms such as “investor”), leading the court to conclude that this prong of the test weighed in favor of finding that the notes are not securities.
Finally, under the test’s fourth factor, the court concluded that there is a separate regulatory scheme for loans under the regulations of the Office of the Comptroller of the Currency, the FDIC and the Federal Reserve Board, and that this factor therefore weighs in favor of finding that the Millennium notes are not securities.
The court’s finding in Kirschner that the Millennium notes are not securities is consistent with prior law and confirms a widely-held understanding of the distinction between loans and securities, but it is noteworthy because Reves and the main Second Circuit precedent case (Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2d Cir. 1992)) date back nearly thirty years and the case-by-case analysis required under the family resemblance test does not provide clear assurances as to how the courts will view a given transaction. The finding in Kirschner underscores the importance of the way in which debt financings are documented and whether the transaction documents describe an instrument as a loan or a security.