On May 22, 2020, Judge Paul G. Gardephe of the Southern District of New York, in Kirschner v. JPMorgan Chase, reaffirmed that syndicated bank loans are not securities. In Kirschner, the plaintiff alleged that a $1.77 billion syndicated bank loan made to Millennium Laboratories LLC (Millennium), a California-based urine testing company and subsequently sold to 70 institutional investors was, in fact, a security — affording it additional protections under the certain state “blue sky” securities laws. The plaintiff alleged that defendants J.P. Morgan Chase Bank, N.A., J.P. Morgan Securities LLC, Citibank, N.A., Citigroup Global Markets, Inc., Bank of Montreal, BMO Capital Markets Corp., SunTrust Bank and SunTrust Robinson Humphrey, Inc., sold debt obligations to the investors but “misrepresented or omitted…material facts in the offering materials they provided and communications they made to Investors regarding the legality of [Millennium’s] sales, marketing, and billing practices” and “the known risks posed by a pending government investigation into the illegality of such practices.” Shortly after the closing of the loan transaction, Millennium lost an important litigation matter that resulted in a $500 million decrease to its valuation and, in addition, entered into a $256 million settlement with the Department of Justice (DOJ) over claims related to alleged healthcare law violations. Within a month of finalizing the DOJ settlement, Millennium defaulted on the loan and filed for bankruptcy.
Analysis of the Decision
In upholding the defendants’ motion to dismiss and finding that the syndicated bank loan was not a security, the court referenced Banco Espanol de Credito v. Security Pacific National Bank, the leading case regarding loan participations, which held that loan participations were not securities in 1992. The court also applied the four factor “family resemblance” test first adopted in Reves v. Ernst & Young 494 U.S. 56 (1990). The court analyzed (i) the motivations that would prompt a reasonable seller and buyer to enter into the transaction; (ii) the plan of distribution of the instrument; (iii) the reasonable expectations of the investing public; and (iv) the existence of another regulatory scheme to reduce the risk of the instrument, thereby rendering application of the Securities Act unnecessary.
Motivations of the Buyer and Seller. In Reves, the court held that if the seller was raising money for working capital or to finance investments, the note was likely to be a security. But, if the note was issued to facilitate the purchase of an asset or consumer good, to manage cash-flow challenges or to advance some other commercial purpose, it was less likely to be a security. Under the present circumstances, the proceeds of loan were used for loan repayment and payment of dividends which the court determined to be “some other commercial purpose.” However, the court concluded that the buyers appear to have purchased the notes for investment purposes. Since the motivations were mixed, the court concluded that this factor was neutral.
Plan of Distribution. The court determined that the plan of distribution was “relatively narrow.” The defendants only solicited a small number of institutional and sophisticated investors and the restrictions on the notes prohibited the loan participations from being sold to the general public. Based upon these factors, the court determined that the second factor weighed in favor of the notes not being determined to be securities.
Reasonable Expectations of the Investing Public. The court concluded that the governing documents for the loan transaction made it clear that the investors were participating in a loan transaction, and not purchasing a security.
Existence of Another Regulatory Scheme. While the plaintiff alleged that the federal banking regulators only “ensure sound banking practices and minimize risks to bank, not risks to non-bank investors,” the court noted that “in Banco Espanol the Second Circuit affirmed the district court’s finding ‘that the Office of the Comptroller of the Currency has issued specific policy guidelines addressing the sale of loan participations,’ and relied in part on ‘the existence of another regulatory scheme’ in concluding that ‘application of the securities laws was unnecessary’.” The court agreed with Banco Espanol and found that the fourth factor also weighed in favor of the notes not being deemed to be securities.
Since three of the four factors in the Reves “family resemblance” test weighed against the notes being deemed securities and one was neutral, the Kirschner Court determined that the notes were not securities and granted the motion to dismiss.
Implications of the Decision
While the Court affirmed the prior case law over the past thirty years and the prevailing industry view, the decision in Kirschner is noteworthy. If the Court had held that syndicated bank loans were indeed securities, it would have created chaos in an already fragile market dealing with the COVID-19 pandemic and the related economic fallout. Instead, the court’s decision in Kirschner provides additional certainty that syndicated bank loans are not securities and that the status quo will be preserved for the foreseeable future.
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