When Might Loans Be Deemed Securities?

From time to time, we are asked by clients to advise them on the status of various entities they manage and/or control for purposes of the Investment Company Act of 1940 (Investment Company Act). To the extent these entities acquire or issue loans, the question invariably arises whether loans are securities for purposes of the federal securities laws. We find that the notion that loans can be considered securities often catches clients by surprise. Such a reaction is understandable — many associate securities with public offerings and with private equity interests. However, fund managers who acquire or issue private debt instruments should be aware that loans can indeed be deemed securities under certain circumstances.

In Reves v. Ernst & Young, one of the seminal cases on this issue, the U.S. Supreme Court stated that there is a general presumption that loans evidenced by notes are in fact securities. However, the Supreme Court explained that the following types of notes are not securities under the federal securities laws:

• A note delivered in a consumer financing
• A note secured by a mortgage on a home
• A short-term note secured by a lien on a small business or some of its assets
• A note evidencing a “character” loan to a bank customer
• A short-term note secured by an assignment of accounts receivable
• A note that simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized)
• A note evidencing a loan by a commercial bank for current operations

The Supreme Court went on to explain that even if a particular loan does not squarely fall into one of the above-listed categories, a note still will not be deemed a security if it bears a “family resemblance” to one of the above-listed note types. To figure out whether such a “family resemblance” might be present, the Supreme Court stated that the motivation for the transaction, the plan of distribution of the instrument, the reasonable expectations of the investors and certain additional factors must be analyzed.

In another leading case, Banco Espanol de Credito v. Security Pacific National Bank, the U.S. Court of Appeals for the Second Circuit considered the “family resemblance” factors to determine that the loan participations at issue were not securities. The Second Circuit reasoned that the overall motivation of the parties in selling and purchasing the loan participations was the promotion of “commercial purposes,” such as the seller’s desire to diversify its risk and the purchaser’s desire to obtain a short-term return on excess cash, rather than an investment in a business enterprise. Furthermore, the participations were offered exclusively to institutional and corporate entities, the investors were on notice through contractual provisions that the instruments were participations in loans and not investments in a business enterprise, and the Office of the Comptroller of the Currency already provided regulatory oversight over the purchase and sale of the loan participations.

More recently, in Kirschner v. J.P. Morgan Chase, the plaintiffs brought state securities laws claims against the defendant banks in connection with a syndicated loan. However, the U.S. District Court for the Southern District of New York granted the defendants’ motion to dismiss these claims. The court applied the Reves “family resemblance” test and concluded that a majority of the factors weighed in favor of the syndicated loan not being a security. While these claims were brought under state rather than federal laws, the court applied the same framework as was applied in the above seminal cases with claims under the federal securities laws.

Oftentimes, when one analyzes loans under the guidelines provided in these cases, a loan will not meet all of the requirements to be deemed a security or a non-security loan. Instead, it may meet a mixture of both. As a result, it is important to analyze the characteristics of the loans in question with counsel to make an appropriate determination. It should also be noted that the Reves case examined the status of loans under the Securities Exchange Act of 1934 (Exchange Act), the Banco case did so under the Securities Act of 1933 (1933 Act) and, again, the Kirschner case did so under state securities laws. Accordingly, these cases do not provide explicit guidance for how such loans should be treated under the Investment Advisers Act of 1940 (Advisers Act) and the Investment Company Act. However, given the similarities in the definition of “security” across the federal statutes, the general approach is that if something is a security under the 1933 Act and the Exchange Act, it is also a security under the Advisers Act and the Investment Company Act.

In summary, while loans are often not deemed securities, fund managers should consider whether there are any factors that might qualify their private debt transactions as securities under the federal securities laws. This analysis can be rather complex, and this is an area of law that may still be developing.