Executive Summary
November 7, 2022 - Term loan Bs or TLBs are term loans made to corporate entities and syndicated through a bank agent to a group of institutional lenders. The U.S. Court of Appeals for the Second Circuit is considering whether these loans are “securities” subject to state and federal securities laws under the decision of the U.S. Supreme Court in Reves v. Ernst & Young. The outcome could have a profound effect on all market participants in the syndicated loan market, including private fund managers that employ strategies in the credit space and borrowers seeking continued liquidity during the current bear market.
Background
In April 2014, approximately 70 institutional investor groups purchased $1.775 billion in then- outstanding debt obligations of Millennium Laboratories LLC (“Millennium”) from a group of lenders, including JPMorgan Chase Bank. In November 2015, Millennium filed for bankruptcy. The investors' claims against the lenders were assigned to the Millennium Lender Claim Trust (the “Trust”). In August 2017, Marc S. Kirschner, as trustee of the Trust, sued the lenders in the U.S. District Court for the Southern District of New York, claiming, among other things, that the debt obligations constituted securities, and thus were subject to stringent disclosure rules under “blue sky” state securities laws. The lender defendants moved to dismiss the securities law claims on the grounds that a syndicated bank loan is not a security, and a loan syndication is not a securities distribution. In May 2020, the U.S. District Court held that the debt obligations did not constitute securities and granted the defendants' motion to dismiss all claims.1 In October 2021, the trustee filed an appeal to the Second Circuit to have the decision overturned.2
In holding that the debt obligations were not securities, the lower court applied the “family resemblance” test first articulated by the Supreme Court in Reves.3 Under Reves, a note (other than certain enumerated categories of notes)4 is presumed to be a security. That presumption may only be rebutted by a showing that the note bears a strong family resemblance to one of the enumerated categories of notes that were adopted in Reves not to be securities. The family resemblance test consists of four factors: (1) the motivations of the parties to enter into the transaction, (2) the plan of distribution of the instrument, (3) the reasonable expectations of the investing public with respect to the instrument, and (4) the existence of another regulatory scheme to reduce the risk of the investment, thus making the Securities Act of 1933, as amended (the “Securities Act”) protections unnecessary. The lower court found that three of the four factors weighed in favor of overcoming the presumption that the debt obligations were securities. First, the plan of distribution for the notes was relatively narrow such that it was not subject to common trading for speculation or investment. Second, the confidentiality language in the governing loan documents would lead a reasonable investor to conclude that the notes constituted loans and not securities. Third, the sale of loan participations to “sophisticated purchasers” is subject to certain policy guidelines from the Office of the Comptroller of the Currency such that the notes were subject to an existing regulatory scheme. The court also found that the remaining Reves factor (i.e., whether the transactional motivations were akin to a securities transaction) did not weigh heavily in either direction.
Potential Implications
Market Disruption
If the Second Circuit holds that syndicated term loan Bs are securities under Reves, the resulting practical complications and compliance costs for loan and collateralized loan obligation (“CLO”) market participants could make it significantly more difficult for certain businesses to access loans and for those businesses to engage in liability management transactions. As emphasized by the amicus brief submitted by the Loan Syndications and Trading Association (the “LSTA”), such a holding would jeopardize a trillion-dollar-plus market that is vital to the U.S. economy.
Securities Act Registration
A holding that syndicated term loan Bs are securities would require a borrower to register such loans under the Securities Act, unless the loans qualify for an exemption. Such a requirement could disrupt loan origination and sales in the secondary market. Even if an exemption is available (such as the private placement exemption), the costs resulting from complying with the exemption could be significant as such exemptions may involve additional work and expenses related to, among other things, perfecting investor qualifications, avoiding general solicitation, creating and circulating tailored disclosures on an ongoing basis and obtaining additional auditors' comfort letters and opinions from counsel.
Broker-Dealers
If the decision of the U.S. District Court is reversed, loan syndication and trading may be required to be conducted through registered broker-dealers, and any market participant who receives compensation tied to loan transactions may have to register as a broker-dealer. Broker-dealers are subject to extensive SEC and FINRA regulations that could cause significant disruptions to loan transactions, including the difference in settlement periods (secondary trades in loans often take ten days or more to close, a timeline much longer than two days for most securities transactions).
Insider Trading Implications
If syndicated term loan Bs were deemed to be securities, borrowers would lose the ability to share with lenders important financial and corporate information that may be material non-public information (“MNPI”). Currently, lenders can choose whether to (a) receive such information (“private-side” lenders) or (b) not receive it and thus preserve the ability to continue trading in the borrower's securities (“public-side” lenders). In a secondary loan market trade involving a public-side lender and a private-side lender, the former acknowledges such informational asymmetry and that it is relying on its own due diligence in entering into the transaction. These transactions are premised on the assumption, and, before this Kirschner case, well-established market convention that syndicated term loan Bs are not securities. If the Second Circuit reverses the lower court's decision, market participants with access to private-side information could face an increased risk of insider trading liability. As a result, lenders might choose not to receive MNPI from borrowers, and borrowers would not be able to provide lenders with MNPI, making the loan market “public only”. Due diligence would become more difficult for lenders and access to loans would become more limited for borrowers.
Tender Offers
A ruling that syndicated term loan Bs are securities could subject certain transactions to the federal tender offer rules. Borrowers and third parties would need to consider whether a proposed offer to purchase the loans for cash or to exchange them for other consideration constitutes a “tender offer” under applicable case law. Under the “new security” doctrine, the tender offer rules could be triggered by proposed amendments to basic financial terms, such as a proposed change to the applicable interest rate or an extension of maturity. In the event a transaction constitutes a tender offer, the borrower or other offeror would need to comply with certain rules under the Securities Exchange Act of 1934, as amended, including the requirements that the offer be held open for 20 business days and that the offer remain open for at least 10 business days after any change in consideration or the percentage of the tranche being sought. Application of tender offer rules would greatly reduce loan market participants' flexibility to propose liability management transactions and efficiently negotiate changes to terms.
CLO Restrictions
The decision could also have an impact on the CLO market. CLOs are single securities backed by a pool of debt. Most CLOs permit only a small dollar amount of securities to be included in their pools as eligible assets. As a result, many CLOs hold mostly syndicated loans based on the premise that syndicated loans are loans and not securities. If these loans are considered securities, CLOs would reach their limits earlier, and banks would need to hold more loans on their books as opposed to syndicating them out to CLOs and other buyers of such loans. This would result in reduced loan funding to eligible borrowers and a negative impact on the economy.
Takeaways
Court decisions do not always confirm the expectations of market participants and observers, and market participants should pay close attention to the outcome of the Kirschner appeal. The analysis under Reves and Kirschner is fact-based, and a case with different facts could produce a different result. Individual loans may still be classed as a security under the Reves test. Nonetheless, it will be important for all market participants to closely follow this case (oral argument is scheduled for late 2022 in the Second Circuit). This will be particularly important in the context of the looming recession and current bear market, which threatens to increase loan defaults and limit access to the capital markets. A decision subjecting term loan Bs to securities regulation likely would further chill the current market at a time when private fund managers in the credit space are having difficulty with deployment and when many potential borrowers have a heightened need for continued liquidity following the COVID-19 crisis.
Footnotes
1 Kirschner v. JPMorgan Chase Bank, N.A., 2020 WL 2614765 (S.D.N.Y. 2020). For purposes of resolving the defendants' motion to dismiss, the District Court accepted the plaintiff's assertion that Reves applies to the plaintiff's claims under state securities laws.
2 The docket number is 21-2726.
3 494 U.S. 56 (1990).
4 These notes include (a) a note delivered in consumer financing, (b) a note secured by a mortgage on a home, (c) a short-term note secured by a lien on a small business or some of its assets, (d) a note evidencing a character loan to a bank customer, (e) short-term notes secured by an assignment of accounts receivable, (f) a note that simply formalizes an open-account debt incurred in the ordinary course of business (particularly if it is collateralized as in the case of the customer of a broker), and (g) notes evidencing loans by commercial banks for current operations. Id. at 65.
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