As we previously covered, on May 22, 2020,
Judge Paul G. Gardephe of the United States District Court for the
Southern District of New York dismissed a complaint asserting
claims under state blue-sky laws as well as common-law claims
against financial institutions that acted as arrangers on a
syndicated term loan, holding that the term loan at issue was not a
"security." 2020 WL 2614765 (S.D.N.Y. May 22, 2020). In
October 2021, plaintiff filed an appeal to the Second Circuit
challenging the issue of whether the syndicated loan in question
was a security and therefore subject to securities laws and
regulations. No. 0:21-cv-02726 (2d Cir., Oct. 28, 2021).
Plaintiff brought the action as trustee of a trust for which the
beneficiaries were lenders and alleged purchasers in a $1.775
billion syndicated term loan transaction which defendants allegedly
arranged for a California-based medical testing company (the
"Company"). After the Company defaulted on the term loan
and filed for bankruptcy protection, plaintiff filed suit against
the arrangers, asserting claims under various state securities laws
("Blue Sky" laws), as well as numerous common-law claims.
Plaintiff alleged generally that defendants misrepresented or
omitted material facts in the alleged "offering
materials" provided and other communications allegedly made
regarding the legality of the Company's sales, marketing, and
billing practices, as well as the known risks posed by a pending
government investigation into the illegality of such
practices.
In connection with plaintiff's state securities law claims, the
district court first addressed whether the term loan was a
security. The district court applied the Reves test (named
after the Supreme Court case Reves v. Ernst & Young,
494 U.S. 56 (1990)), which was the standard plaintiff argued should
apply. As noted by the Supreme Court in Reves, Congress
"enacted a definition of 'security' sufficiently broad
to encompass virtually any instrument that might be sold as an
investment." Id. at 61. In particular, the definition
of "security" refers to "notes," and the
Supreme Court has accordingly stated that every note is initially
presumed to be a security. Id. at 65. This presumption may
be rebutted, however, if the note strongly resembles one of the
families of instruments previously determined by the courts to be
non-securities—including, for example, notes delivered in
consumer financing, notes secured by a mortgage on a home, or notes
evidencing loans by commercial banks for current operations.
Id. at 65, 67. The determination of whether a note at
issue bears a "family resemblance" to any of these
categories of non-security notes requires a consideration of four
factors: the motivations of the seller and buyer; the plan of
distribution of the instrument; the reasonable expectations of the
investing public; and the existence of another regulatory scheme to
reduce the instrument's risk. Id. at 66–67.
After analyzing the Reves factors in connection with the
term loan at issue, the Court concluded that "the limited
number of highly sophisticated purchasers of the Notes would not
reasonably consider the Notes 'securities' subject to the
attendant regulations and protections of Federal and state
securities law," but rather that "it would have been
reasonable for these sophisticated institutional buyers to believe
that they were lending money, with all of the risks that may
entail, and without the disclosure and other protections associated
with the issuance of securities." 2020 WL 2614765, at
*10.
On appeal, plaintiff contends (among other things) that the
district court "disregarded" the alleged presumption
under Reves that the "notes" at issue are
securities and, according to plaintiff, erroneously held that they
evidence loans by commercial banks for the borrower's current
operations, "largely by discrediting the Trustee's
allegations and assuming a fact-finding role at the pleading
stage." Defendants argue (among other points) that the
district court appropriately assumed the truth of the
Complaint's factual allegations and applied Reves to
determine whether those allegations supported the existence of a
security. Defendants point out that plaintiff's argument that
the term loan falls within the "note" category of
securities under the Supreme Court's four-factor test in
Reves "runs headlong" into the Second
Circuit's decision in Banco Espanol de Credito v. Security
Pacific National Bank, 973 F.2d 51 (2d Cir. 1992), which
concluded that a similar type of loan was not a security under the
Reves test, and no court has held otherwise.
Notably, after oral argument, the Second Circuit issued an order
"solicit[ing] any views that the United States Securities and
Exchange Commission may wish to share" regarding "whether
the syndicated term loan notes at issue in this appeal are
securities under Reves." In that order, the Second
Circuit stated that "[w]e have not previously considered
whether this type of note is a security" and that it is asking
for the SEC's views "given the importance of the issue,
the parties' diverging positions, and the policy implications
that would result from our resolution of this case." The
SEC's response is currently due on June 27, 2023. Defendants
submitted a request to solicit views of other relevant agencies
besides the SEC—including the OCC, Treasury Department, FDIC,
and Federal Reserve—but the Second Circuit denied that
request on May 31, 2023.
If the Second Circuit were to overturn the district court's
clear rejection of plaintiff's attempt to recharacterize the
TLB transaction structure as a sale of securities subject to the
securities laws, this could have significant market and legal
repercussions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
