(Article from Securities Law Alert, June 2020)
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On May 22, 2020, the Southern District of New York dismissed a state law-based securities fraud action on the grounds that the syndicated term loan notes at issue (the “Notes”) were not “securities” under the “family resemblance” test set forth in Reves v. Ernst & Young, 494 U.S. 56 (1990). Kirschner v. JPMorgan Chase Bank, 2020 WL 2614765 (S.D.N.Y. 2020) (Gardephe, J.). The court rejected plaintiff’s contention that “term loans now commonly contain features that mirror a high-yield bond issuance.” Since no court has yet “held that a syndicated term loan is a ‘security,’” the court found plaintiff’s “claim of a shift in the market” with respect to the character of syndicated term loan notes was “premature at best.”
In Reves, the Supreme Court instructed that courts must “begin with a presumption that every note is a security.” The Court further stated that this presumption “may be rebutted only by a showing that the note bears a strong [family] resemblance” to certain specified categories of notes that are not securities.[1] The family resemblance test turns on four factors: (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) “the existence of another regulatory scheme [to reduce] the risk of the instrument, thereby rendering application of the Securities Act unnecessary.”
The Kirschner court rejected the plaintiff’s argument that “the determination of whether an instrument is a security is a fact intensive question and generally not appropriately resolved on a motion to dismiss.” The court noted that “[c]ourts in this District have, on occasion . . . concluded on a motion to dismiss that a particular instrument is not a security under Reves.”
The court found the first Reves factor “does not weigh heavily in either direction.” The court “conclude[d] that the second Reves factor weighs strongly in favor of finding that the Notes are not securities.” The court noted that in Banco Espanol de Credito v. Sec. Pac. Nat’l Bank, 973 F.2d 51 (2d Cir. 1992), the Second Circuit held that loan participations with a similar type of distribution were not securities. While “hundreds of investment managers were solicited,” the court explained that “this constitutes a relatively small number compared to the general public.” Moreover, “as in Banco Espanol, only institutional and corporate entities were solicited.” The court also found the Notes were restricted to a $1 million minimum investment amount, “a high absolute number that would only allow sophisticated investors to participate.”
With respect to the third Reves factor, the court found that the governing documents “would lead a reasonable investor to believe that the Notes constitute loans, and not securities.” The court observed, for example, that “the Credit Agreement repeatedly refers to the underlying transaction documents as ‘loan documents,’ and the words ‘loan’ and ‘lender’ are used consistently, instead of terms such as ‘investor.’” The court explained that “[i]n Banco Espanol, [the Second Circuit] found the use of such terms significant, concluding that buyers were given ample notice that the instruments were participations in loans and not investments in a business enterprise.”
Finally, the court found “the fourth Reves factor weighs in favor of a finding that the Notes are not securities” because the oversight of federal banking regulators did not reduce the risk of the Notes. The court noted that “[t]he primary focus of Federal banking regulators is presumably the safety and soundness of banks, rather than protection of note holders.”
Based on the Reves analysis, the court found that the Notes were not securities. The court explained 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.”
[1] These include “the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, short-term notes secured by an assignment of accounts receivable, a note which simply formalizes an open-account debt incurred in the ordinary course of business . . . and notes evidencing loans by commercial banks for current operations.” Reves, 494 U.S. 56.