Second Circuit Rules Syndicated Term Loan in Kirschner Is Not a Security

On August 24, 2023, the U.S. Court of Appeals for the Second Circuit affirmed the decision of the United States District Court for the Southern District of New York in Kirschner v. JP Morgan Chase Bank, N.A.¹, which held that the syndicated term loans underlying the dispute in the case were not securities subject to state law securities claims.

Our previous Alert summarized some of the background and stakes of the Kirschner appeal.

By stipulation of the parties, the Second Circuit limited its securities law analysis to the four-factor test under the Supreme Court’s decision in Reves v. Ernst & Young.² Under Reves, courts apply a “family resemblance” test to determine whether a promissory note is a security under the federal securities laws. The test presumes that every note is a security. Courts must then examine four factors, each of which helps to discern 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).

The Second Circuit affirmed the dismissal of Kirschner’s case on the grounds that “plaintiff failed to plausibly suggest that the Notes are securities under Reves.” Writing for the court, Circuit Judge Cabranes summarized the critical four-factor Reves analysis:

The first factor—the motivations of the parties—weighs in favor of concluding that the complaint plausibly suggests that the Notes are securities because, although [the borrower]’s motivation appears to be “commercial,” the lenders’ motivations were “investment.”

The second factor—the plan of distribution—weighs against concluding that the complaint plausibly suggests that the Notes are securities because they were unavailable to the general public by virtue of restrictions on assignments of the Notes.

The third factor—the reasonable expectations of the public— weighs against concluding that the complaint plausibly suggests that the Notes are securities because the lenders were sophisticated and experienced institutional entities with ample notice that the Notes were not securities.

The fourth factor—the existence of other risk-reducing factors—weighs against concluding that the complaint plausibly suggests that the Notes are securities because they were secured by collateral and federal regulators have issued specific policy guidance addressing syndicated loans.

On balance, the court therefore concluded that the syndicated loan interests here were most analogous to loans issued by banks for commercial purposes, and thus not securities.

While industry breathes a collective sigh of relief, a few words of caution are in order. First, the court did not release a blanket opinion that no syndicated loan is ever a security. Instead, it simply applied the Reves factors to this particular loan structure and found that no security existed. It stands to reason that under a different fact pattern the court could have reached a different conclusion.

Second, as noted above the court by stipulation of the parties only analyzed the loan interests under Reves. But Reves is not the only path to finding that a financial instrument is a security. The Second Circuit did not consider, for example, whether the loan interests were investment contracts under the Supreme Court’s separate Howey test, which looks to whether there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.³ The securities laws claims in Kirschner were predicated under state law, not federal law; many states also apply the Howey test. Further, many states employ an even broader test than Howey.

In light of the Second Circuit’s opinion, at this time we do not believe an immediate change to market practice in marketing and documenting most syndicated loans is necessary. But the case serves as a reminder that lenders should take care in loan documents to avoid securities-like terminology such as “investor”, “investment” or “broker” lest the expectations of the parties be uncertain. The use of robust cautionary language in marketing materials also seemed important to the Second Circuit in finding against investment intent. Nevertheless, although the Second Circuit did not seem particularly troubled that the loan at issue was syndicated to approximately 400 beneficial owners, the practice of syndicating loans to that many participants (rather than a small group of banks and other institutional lenders) is also one that may be subject to future attack.

¹ Kirschner v. JPMorgan Chase Bank, 2023 WL 5437811 (2d Cir., Aug. 24, 2023).

² 494 U.S. 56 (1990).

³ See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).