On August 24, 2023, the United States Court of Appeals for the
Second Circuit affirmed a decision by the United States District
Court for the Southern District of New York dismissing claims
brought under state securities laws against a group of banks which
acted as arrangers ("Defendants" or the
"Arrangers") for a term loan on behalf of a
California-based medical testing company (the "Company"),
holding that term loan "notes" issued as part of a
syndicated loan were not "securities" subject to
securities laws and regulations. Kirschner v. JP Morgan Chase
Bank, N.A., et al., 21-2726-cv (2d Cir. Aug. 24, 2023). The
Second Circuit also affirmed that the district court had
jurisdiction pursuant to the Edge Act.
Plaintiff is the trustee of a trust for which the beneficiaries
were lenders and alleged purchasers in the Company's $1.775
billion syndicated term loan transaction. 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. We previously covered the district
court decision as well as the appellate arguments before the Second Circuit. The
Second Circuit had also requested that the Securities and Exchange
Commission ("SEC") provide its views, but the SEC
declined to do so.
In affirming the district court's holding regarding
jurisdiction under the Edge Act, the Second Circuit noted that
Congress enacted the Edge Act "to provide for the
establishment of international banking and financial corporations
operating under Federal supervision with powers sufficiently broad
to enable them to compete effectively with similar foreign-owned
institutions in the United States and abroad." The Court
further noted that Congress "authorized the creation of
banking corporations chartered by the Federal Reserve Bank,
so-called 'Edge Act banks,'" which could engage in
offshore banking operations "freed from regulatory barriers
imposed by state banking commissioners." The Second Circuit
explained that jurisdiction under the Edge Act requires "(1)
the suit must be 'of a civil nature at common law or in
equity,' (2) at least one party to the suit must be an Edge Act
bank or corporation, and (3) the suit must 'aris[e] out of
transactions involving' (a) 'international or foreign
banking,' (b) 'banking in a dependency or insular
possession of the United States,' or (c) 'out of other
international or foreign financial operations.'" The
parties did not dispute that the first two elements were met, and
the Second Circuit held that the third element was satisfied
because one of the defendant-banks itself engaged in international
or foreign banking to effectuate the syndicate loan transaction by
assigning a portion of its interest to foreign lenders.
The Court then addressed whether the term loan notes were
"securities" under the test applied in Reves v. Ernst
& Young, 494 U.S. 56 (1990). Under Reves, courts
must apply a "family resemblance" test to determine
whether a "note" is a "security." As the Court
explained, the test starts "with a presumption that every note
is a security" but then "directs courts to examine four
factors, each of which helps to uncover whether the note was issued
in an investment context (and is thus a security) or in a consumer
or commercial context (and is thus not a security)." Under the
Reves test, the four factors for determining whether a
"note" is a "security" involve assessing: (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) "whether
some factor such as the existence of another regulatory scheme
significantly reduces the risk of the instrument, thereby rendering
application of the Securities Acts unnecessary."
With respect to the motivation of the parties, the Second Circuit
reasoned that, while the lenders may have participated in the
transaction because they were motivated by profit—which
weighed in favor of concluding the notes were securities—the
Company itself entered the transaction to pay outstanding amounts
in respect of other obligations. The Court held this was a
"commercial" rather than "investment" motive
that weighed against finding the notes were securities.
Addressing the plan of distribution, the Second Circuit emphasized
that the notes were offered only to sophisticated entities, as
opposed to a broad segment of the public, which tended to indicate
that the notes were not securities. The Court acknowledged
plaintiff's argument that a broad secondary market existed for
the notes, but the Court reasoned this was not determinative as the
notes could not be sold to natural persons; sales required consent
from the Company and the administrative agent, and there were
limits on the amounts that could be transferred.
Turning to the reasonable expectations of the public, the Second
Circuit held that the loan was presented to lenders as notes,
including through provisions in the credit agreement such as the
non-reliance provision, which referenced the lenders'
obligation to conduct their own credit analysis. The Second Circuit
held that occasional references to the lenders as
"investors" in the loan documents were insufficient to
change the conclusion that this factor weighed against finding that
the notes should be deemed securities.
Finally, addressing the existence of other risk-reducing factors,
which considers whether there are other risk-reducing factors that
render resort to the securities laws unnecessary, the Second
Circuit held that resort to the securities laws was not necessary
in this case because (i) the notes were secured by perfected first
priority security interests, and (ii) the Office of Comptroller,
the Board of Governors of the Federal Reserve, and the FDIC have
all issued guidelines for syndicated loans. As such, the Second
Circuit affirmed the district court decision dismissing the state
Blue Sky securities law claims.
In a summary order issued concurrently with its opinion, the Second
Circuit also affirmed the district court's dismissal of the
negligent misrepresentation and breach of contract claims for
substantially the same reasons as those articulated by the district
court. The district court had held that plaintiff failed to allege
that defendants owed to plaintiff the duties necessary to plead
claims for negligent misrepresentation and could not overcome the
clear disclaimers in the governing contracts, and had also
concluded that the breach of contract claim was not adequately
pleaded because plaintiff based it on alleged duties which either
did not exist in the contract or were not triggered in this
case.
Summary Order: Kirschner v. JP Morgan Chase Bank, N.A., et al.
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