Kirschner v. JPMorgan Chase: What It Means for Syndicated Loans and Its Implications for the Secondary Trading Market

On May 22, Judge Paul Gardephe of the U.S. District Court for the Southern District of New York granted a motion to dismiss in Kirschner v. JPMorgan Chase Bank, N.A., a case that, among other things, considered whether the origination and distribution of a syndicated bank loan is subject to state securities laws. In dismissing the securities law claims against JPMorgan and several other banks that had arranged and distributed the loan, the court upheld the common market understanding that syndicated loans are generally not considered securities. A decision to the contrary could have had major adverse implications for secondary trading, as a loan characterized as a security would be subject to federal and state securities laws, as well as liability for underwriting, syndication and trading. Because of this, the generally accepted practices, guidance and industry-standard documentation governing the trading of syndicated loans would be discarded. Regulating syndicated loans as securities would also significantly affect both borrowers and lenders, as borrowers would likely bear the increased costs and time burdens of syndicating a loan and would also be faced with difficult decisions relating to disclosure of syndicate information. Furthermore, holding syndicated loans to be securities would deprive both borrowers and lenders from choosing the market “that best suits their needs,” profoundly disrupting the direct lending market at large.

Case Background^[1]

The case arose out of a $1.775 billion syndicated loan to Millennium Laboratories LLC. The lending syndicate included nearly 70 lenders consisting of approximately 400 funds and other institutional investors. In June 2014, two months after the closing of the syndicated loan transaction, a jury in the Ameritox litigation returned a verdict finding that Millennium had violated both the Stark Law and the anti-kickback statute. In May 2015, Millennium reached a settlement with the U.S. Department of Justice with respect to violations of the False Claims Act. In November 2015, following both the Ameritox litigation and the DOJ settlement, Millennium filed for bankruptcy. In August 2017, the trustee of the Millennium Lender Claim Trust filed a lawsuit against the arranging banks and broker-dealers of the syndicated loan, alleging, among other things, violations of various state “Blue Sky” securities laws.

Reves and the ‘Family Resemblance’ Test

In deciding whether the syndicated loan at issue in Kirschner constituted a security, Judge Gardephe applied the “family resemblance” test first established by the U.S. Supreme Court in Reves v. Ernst & Young. See Reves v. Ernst & Young, 494 U.S. 56 (1990). In Reves, the Court held that “because the Securities Acts define ‘security’ to include ‘any note,’” courts should “begin with a presumption that every note is a security,” which presumption may be overcome if the note bears a strong “family resemblance” to one of several judicially created categories of instruments excluded from the definition of a security. In Reves, the Court set forth the four factors of the family resemblance test for courts to consider.

1. Motivations of Seller and Buyer. In considering the “motivations that would prompt a reasonable seller and buyer to enter into a particular transaction,” the Court in Reves held that if the seller’s purpose is to “raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit of the note, the instrument is likely to be a security”; however, where “the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to address the seller’s cash-flow difficulties or to advance some other commercial or consumer purpose,” the note is not likely to be a security. In essence, the first Reves factor asks whether the motivations are investment (suggesting a security) or commercial or consumer (suggesting a non-security). In Kirschner, from the buyers’ perspective, the purpose of acquiring the notes appears to have been an investment, while from the defendants’ perspective, the seller’s motivation was to “pay dividends and satisfy or refinance existing debt.” In applying the “motivations” test, Judge Gardephe found the borrower’s and lenders’ motivations to be mixed, holding that the first Reves factor did “not weigh strongly in either direction.”
   
   
2. Plan of Distribution of the Instrument. Next, the court turned to the second Reves factor, which considers “the plan of distribution” for the instrument, including whether it is subject to “common trading for speculation or investment.” In Kirschner, the court cited to Banco Espanol de Credito v. Security Pac. Nat’l Bank, where the Second Circuit held that the restrictions on the notes at issue in that case “worked to prevent the loan participations from being sold to the general public.” See Banco Espanol de Credito v. Security Pac. Nat’l Bank, 973 F.2d 51 (2d Cir. 1992). Relying on Banco Espanol, Judge Gardephe found the plan of distribution in Millennium to be “relatively narrow,” citing to the facts that “only institutional and corporate entities were solicited,” that the $1 million minimum investment amount would allow only sophisticated investors to participate, and that transfers required the consent of a lender, lender affiliate or approved fund. While the district court recognized that “hundreds of investment managers were solicited” to participate in the loan, this “constitute[d] a relatively small number compared to the general public.” Based on the foregoing, Judge Gardephe concluded that the second Reves factor weighed “strongly in favor of finding” that the loans did not constitute securities.
   
   
3. Reasonable Expectations of the Investing Public. With respect to the third Reves factor, the court will consider instruments to be securities based on “such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not securities as used in that transaction.” In Kirschner, the arranging banks argued that the governing loan documents, such as the Confidential Information Memorandum and Credit Agreement, distributed to potential investors “made clear to the parties that they were participating in a lending transaction, not investing in securities.” The district court focused on the terminology used in Millennium’s marketing materials for the syndicated loan, which referred to “loans” and “lenders” rather than to “investor.” Relying on Banco Espanol, where the Second Circuit found the use of such terminology as providing the buyers with “ample notice that the instruments were participations in loans and not investments in a business enterprise,” Judge Gardephe held that the Millennium marketing materials distributed to potential lenders would “lead a reasonable investor to believe the notes constituted loans, and not securities.”
   
   
4. Existence of Another Regulatory Scheme. Lastly, in determining “the existence of another regulatory scheme [to reduce] the risk of the instrument, thereby rendering application of the Securities Act unnecessary,” Judge Gardephe stated that the “primary focus” of the bank regulatory regime is to ensure the “safety and soundness of banks,” not the protection of note holders. Citing to Banco Espanol, where the Second Circuit distinguished “the entirely unregulated scenario” at issue in Reves (which involved “uncollateralized and uninsured” instruments and “no risk-reducing factor”) from the market for the sale of loan participations to “sophisticated purchasers” (which “is subject to policy guidelines from the Comptroller”), Judge Gardephe concluded that the fourth and final Reves factor “weighs in favor of finding that the notes were not securities.”

Based on the facts set forth in Kirschner, the district court found the first Reves factor to be inconclusive but found that the other three factors weighed in favor of finding the loans “analogous to the enumerated category of loans by banks for commercial purposes.” Therefore, the court in Kirschner held that the presumption that the loans were securities was overcome and dismissed the securities law claims. With respect to the various other allegations of  common law negligent misrepresentation, breach of fiduciary duty, breach of contract, breach of post-closing contractual duties, and breach of the implied covenant of good faith and fair dealing, the district court dismissed these claims as well.

The LSTA’s Response

In July 2019, the LSTA, joined by the Bank Policy Institute, filed an amicus brief in the Kirschner case. In its brief, the LSTA articulated its “long-held view” and the “common market understanding” that the loan participations at issue are widely recognized as lending transactions, not securities, and that market participants are sophisticated institutions that “fully appreciate the need to conduct appropriate diligence in order to assess the risk associated with the extension of credit,” and are “more than capable” of conducting the required diligence and enforcing their legal rights. According to the LSTA, a decision to the contrary would “overturn the reasonable, settled expectations of market participants” and “profoundly disrupt the origination and trading of loans, which have become a critical source of capital for modern commerce.” For these reasons, the LSTA concluded that the Kirschner court should hold that syndicated term loans are not securities. Although Judge Gardephe denied the LSTA’s motion for leave to file its brief, the LSTA, in response to the granting of the motion to dismiss, declared the court’s ruling a “victory for the flow of capital to American businesses,” as a ruling to the contrary would have “upended the expectations of borrowers and lenders and wreaked havoc in the large market for these loans.”

What Happens Now and What Kirschner Means Going Forward

The plaintiff in Kirschner will apparently be seeking to re-plead the causes of action and has until June 12 to file an amended complaint. While the district court has already ruled on the securities law claims based on the existing facts of the Millennium loan syndication, the ruling in Kirschner does not mean the issue is conclusively settled. First, it is important to note that the Reves test and the court’s decision in Kirschner are both highly fact specific and therefore a different set of facts and circumstances could yield a different conclusion under the four-factor analysis. Because of this, it is unclear how other similarly situated plaintiffs may fare. Additionally, as Kirschner reflects the view of one district court judge and is not binding precedent, it is very possible that future courts could apply the Reves test to syndicated loans and hold differently, which could result in enormous adverse implications for both the participants and the syndicated loan market at large. Nearly $1.2 trillion in syndicated term loans are currently outstanding, and such loans play a critical role in the American economy.

^[1] To read our colleagues’ analysis of the Kirschner case, please see: https://www.kramerlevin.com/en/perspectives-search/Kirschner-v-JPMorgan-Chase-Holds-that-Syndicated-Bank-Loans-Are-Not-Securities.html.