Second Circuit Affirms District Court’s Decision Determining That Term Loan Notes Were Not “Securities” Subject To Securities Laws And Regulations
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  • Second Circuit Affirms District Court’s Decision Determining That Term Loan Notes Were Not “Securities” Subject To Securities Laws And Regulations

    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.

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