June 5, 2020 - On Wednesday, June 4th, the LSTA hosted a webinar that delved into the recent decision in the critical Kirschner v. JP Morgan Chase litigation. In Kirschner, Judge Paul Gardephe dismissed claims against JP Morgan and a number of banks, ruling that securities law claims against the defendants could not stand because the syndicated institutional loan to Millennium Labs was not a security. Moderated by LSTA General Counsel Elliot Ganz, the panel included Yoon-Young Lee of WilmerHale and Greg Laufer and Richard Tarlowe of Paul Weiss. The webinar focused on three principal questions: First, why is the Kirschner litigation so important, second, what did Judge Gardephe’s opinion actually say, and third, what are the implications of the decision going forward?
Why does Kirschner matter? The Kirschner case is critical because the syndicated loan to Millennium Labs was a typical term loan B, with no clear characteristics to distinguish it from most other term loan Bs. Thus, a determination that it is a security would suggest that most, if not all, institutional term loans would be so characterized. Why does that matter? A loan recharacterized as a security would be immediately subject to federal and state securities laws and liability for underwriting, syndication, and trading. Standard practices and the code of conduct developed by the industry for syndicated loans would have to be discarded and the current public/private nature of loan markets would be untenable. Moreover, all syndication, distribution and trading activity would likely have to be conducted through broker-dealers. The syndication process itself would have to change, likely resembling that of a Rule 144A offering. This would require more extensive disclosures and due diligence and a slower and more expensive process. Secondary trading would also have to change and settlement would be subject to trade reporting, margin, net capital, trade clearance, recordkeeping and other rules applicable to bonds. Some borrowers would not be able to access this market (as they cannot access the high yield bond market). They would also lose control over the composition of the lender group and have less flexibility with waivers, consents and amendments. From a lender’s perspective, there would be less flexibility re bespoke terms and, perhaps most crucially, it would not be clear what happens to CLOs which own more than half the term loan Bs but are not structured to purchase securities.
What did Judge Gardephe Hold? The court’s decision was based on a straight application of a 1990 U.S. Supreme Court case, Reves v. Ernst & Young, in which the Court held that a note is presumed to be a security but that the 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. The Supreme Court identified four factors that courts should consider: First, the motivations that would prompt a reasonable seller and buyer to enter into the transaction (i.e., the borrower’s purpose in securing capital, and the nature of the return expectations of the lender); Second, the breadth of the plan of distribution of the instrument; Third, the reasonable expectations of the investing public; and Fourth, the existence of risk-reducing elements, such as another regulatory scheme to govern the transaction at issue. The court found that three of the four factors weighed against finding that the syndicated loan was a security. In applying the “motivations’ test, the court determined that the borrower’s and lenders’ motivations were mixed and concluded that this factor does not weigh heavily in either direction. Next, the court applied the plan of distribution test, holding that the plan of distribution in Millennium, which excluded private individuals, was limited to sophisticated institutions, had a minimum loan size of $1MM, and required consent, was “relatively narrow” and not the type that was typical of a security. Notably, the court held that even though hundreds of investment managers were solicited to participate in the loan, “this constitutes a relatively small number compared to the general public.” Applying the “reasonable expectations” test, the court found that the Credit Agreement and the Confidential Information Memorandum distributed to potential lenders would “lead a reasonable investor to believe that the notes were loans, and not securities.” Finally, in determining whether there exists another regulatory regime that reduces the risk of the instrument, the court stated that the purpose of the bank regulatory regime is to ensure the safety and soundness of the banks, rather than the protection of note holders. Nevertheless, it observed that in Banco Espanol, the 2nd Circuit case that interpreted Reves and is binding precedent in the Southern District of New York, the court distinguished the entirely unregulated scenario in Reves from the market for loan participations which was subject to the policy guidelines of the OCC. In light of Banco Espanol, the court found that the fourth Reves factor weighs in favor of a finding that the loans are not securities.
What’s next? The plaintiff will apparently be seeking to re-plead the causes of action in the coming weeks. Given that Judge Gardephe has already ruled on the securities law claims based on the exiting facts of the Millennium loan syndication, it is hard to imagine a different result when the defendants move for a motion to dismiss the repleaded securities claims. But, as our panelists pointed out, it is important to remember that the Kirschner decision, while well-reasoned, is the view of one district court judge and is not binding precedent. And, since the Reves analysis is based on the facts and circumstances of each situation, other aggrieved plaintiffs might still seek to litigate this issue, particularly if the plan of distribution in a particular loan is not as limited as that described in Kirschner. While Kirschner is an important case, it is not necessarily the end of the story. A replay of the webinar and the associated presentation are available here.
