On August 24, 2023, the United States Court of Appeals for the Second Circuit (the "Court") upheld the District Court's ruling in Kirschner v. JPMorgan Chase Bank, N.A. that notes issued as part of a refinancing transaction involving Millennium Health LLC, Inc f/k/a Millennium Laboratories, or Millennium, are not "securities" under the Securities Acts of 1933 or the Securities Exchange Act of 1934 (collectively, the "Securities Acts") or for purposes of state securities laws.
The Court applied the "family resemblance" four-factor test the Supreme Court enunciated in Reves v. Ernst & Young to reach its conclusion that the notes at issue were not "securities." The Court's application of the "family resemblance" test in this case makes it clear that the method of syndication, and the language used in all documents relating to a debt issuance, are crucial in ensuring that debt instruments are not categorized as "securities" subject to the Securities Acts and state securities laws.
Parties to financing transactions should become familiar with the application of the "family resemblance" test in Kirschner v. JPMorgan Chase Bank, N.A. to ensure that debt instruments are classified as intended by the parties, given that both borrowers and lenders could be subject to liability for breaches of the Securities Acts or state securities laws.
What was at issue in Kirschner v. JPMorgan Chase Bank, N.A.?
Millennium was a California-based urine drug testing company that had entered into a credit agreement in March 2012 with JPMorgan Chase Bank, N.A., or JPM, and other lenders, pursuant to which the lenders made multi-million-dollar term loans and revolving loans to Millennium. Millennium was under investigation by the U.S. Department of Justice for potential breaches of federal healthcare law and was also being sued by a competitor for alleged violations of federal anti-kickback statutes.
In light of Millennium's legal issues, Millennium engaged JPM and Citigroup Global Markets in March 2014 as lead arrangers for the syndication of a large refinancing facility consisting largely of a $1.775 billion term loan and a $50 million revolving loan (the "Millennium Transaction"). The engagement letter relating to the Millennium Transaction allowed the lead arrangers to syndicate the term loan to other lenders. The Millennium Transaction closed on April 16, 2014. On November 10, 2015, Millennium filed a voluntary insolvency proceeding under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware.
As part of Millennium's Chapter 11 proceeding, the plaintiff, Marc S. Kirschner, was appointed as trustee of a trust established for the ultimate benefit of lenders who participated in the Millennium Transaction as purchasers of a portion of the term loan, which was evidenced by a note. The plaintiff sued both lead arrangers and other initial lenders on the closing date of the Millennium Transaction, alleging, among other things, that the defendants had breached securities laws because the notes sold to the trust beneficiaries as part of the Millennium Transaction were "securities" for purposes of securities laws. On May 22, 2020, the District Court for the Southern District of New York ruled that the plaintiff failed to present facts plausibly suggesting that the notes are "securities" under the Reves ruling. On August 24, 2023, the Court upheld the District Court's ruling.
How did the Court determine whether the notes were "securities"?
To determine whether the notes at issue were "securities" for securities law purposes, the Court applied the four-factor "family resemblance test" promulgated by the Supreme Court in the Reves case. The Supreme Court in Reves stated that, although the Securities Acts define "security" to include "any note," such phrase should not be interpreted to mean literally "any note." Instead, the Supreme Court pointed out that the purpose of the Securities Acts is to regulate the investment market. Therefore, only notes issued for investment purposes are "securities." Notes issued in a commercial or consumer context are not "securities."
A closer look at the Reves four-factor "family resemblance test"
The Reves test begins with a presumption that every note is a security and then directs courts to examine and weigh four factors to determine whether a particular instrument was issued in an investment context (and is therefore a "security") or in a consumer or commercial context (and therefore is not a "security"). The four factors are:
1) The motivations that would prompt a reasonable seller and buyer to enter into the transaction at hand
If a buyer expects to profit from its purchase of the instrument, including through earning interest, it is presumed that the buyer was motivated to purchase the instrument as an investment. If the seller of the debt instrument is raising money for general use of a business enterprise or to finance a substantial investment, it will be presumed that the seller also had an investment motivation in issuing the debt instrument. By contrast, if the seller is issuing the debt to correct for seller's cash-flow difficulties or to advance some other commercial or consumer purpose, the seller's motivation is commercial, and not investment.
2) The plan of distribution of the instrument
The purpose of analyzing the debt instrument's plan of distribution is to determine whether there is a common trading speculation with respect to such debt instrument. If the instrument is offered and sold to a broad segment of the public, a court will lean toward classifying the instrument at hand as a "security." If there are limitations in the plan of distribution that prevent the instrument from being sold to the general public, a court will lean toward determining that the instrument is not a "security."
3) The reasonable expectation of the investing public
If buyers are given ample notice that the instruments are loans and not investments in a business enterprise, there is a strong likelihood that the instruments will not be classified as "securities."
4) Whether some other factor significantly reduces the risk of the instrument and therefore renders the application of the Securities Acts unnecessary
Factors that can reduce the risk associated with the purchase of the instrument and would render the application of the Securities Acts unnecessary include whether the instrument is secured by collateral or insured, whether the instrument is guaranteed, and whether there are other laws, rules, or regulations that govern the instrument in question.
What were the seller's and buyer's motivations in the Millennium Transaction?
The Court of Appeals held that the motivation of the parties in the Millennium Transaction were mixed. The purchasers' motivations seem to have been investment, since they were entitled to receive quarterly interest payments under the notes, and thereby expected to receive a valuable return on the notes. However, Millennium's motivation seems to have been commercial, since it planned to use the term loan to pay outstanding amounts due under the March 2012 credit agreement; make a shareholder distribution; redeem outstanding warrants, debentures, and stock options; and pay fees and expenses related to the Millennium Transaction.
The Court's analysis highlights not only the importance of the economic terms of a particular financing transaction (e.g., whether the parties will be receiving interest payments or any other returns on the loans or notes at issue), but also how the use of proceeds is spelled out in the loan documents. If the debtor's use of proceeds from the debt issuance is not for the general use of a business enterprise or to finance substantial investments, the court will not necessarily rule that the parties' motivations in entering into a transaction are for investment purposes, even if the interest and other returns are payable to the holders of such debt instrument. Parties should beware of broad use of proceeds language and should focus on narrowly tailoring the use of proceeds language to ensure that there is no ambiguity as to the motivation of the debtor in issuing a debt instrument.
What was the plan of distribution for the notes issued as part of the Millennium Transaction?
As is common in syndicated financings, the lead arrangers offered allocations of the term loan made as part of the Millennium Transaction to various institutional investors. While the lead arrangers prepared a confidential information memorandum to market the loans to such institutional investors, and such confidential information memorandum could be viewed as an offering document, the Court highlighted that the confidential information memorandum included various disclaimers, including a statement that the memorandum was "prepared to assist potential purchasers in making their own evaluation of Millennium and the term loan" and language indicating that a prospective purchaser's receipt of the confidential information memorandum constituted a representation by such potential purchaser that it was sophisticated and experienced in extending credit to entities similar to Millennium. The Court also focused on the fact that the lead arrangers only offered the allocations of the term loan and only provided the confidential information memorandum to sophisticated investors.
Furthermore, while there was a secondary market for the loans because such loans could be assigned or participated, the assignment provisions in the loan documents included restrictions, such as requiring the prior written consent of both Millennium and JPM (unless the assignment was to another Lender or affiliate of a Lender or approved fund) and no assignments could be made to natural persons. The Court held that such assignment restrictions worked to prevent the sale of the loans to the general public.
The Court's analysis of the facts when evaluating this prong of the Reves test highlights the importance of the language included in offering documents and loan documents relating to a debt offering. Counsel should be engaged from the outset of the transaction and should review and comment on any offering documents relating to the sale of debt instruments to ensure that they include appropriate disclaimers so that the offering of the debt instrument is not construed as an offer to the general public. Similarly, it is important to have counsel closely review the assignment and participation provisions in the financing documents to ensure that there are restrictions in place that adequately prevent non-sophisticated investors and natural persons from purchasing the debt instruments evidenced by such financing documents.
What were the reasonable expectations of the investment public in the Millennium Transaction?
The Court pointed again to the disclaimers in, and language of, the confidential information memorandum when evaluating this prong of the test. The representations from the prospective purchasers in the confidential information memorandum that they were "sophisticated and experienced in extending credit to entities similar to Millennium" and had "independently and without reliance upon any agent or any lender, and based on such documents and information as they have deemed appropriate, made their own appraisal of and investigation into the business, operations, property, financial and other condition and creditworthiness of Millennium and made their own decisions regarding whether to purchase the loans" were, according to the Court, strong indicators that the purchasers could not have reasonably viewed the purchase of the notes evidencing the loans as "securities."
The Court also indicated that the limited references to the purchasers being "investors" rather than "lenders" in the confidential information memorandum and other loan documents did not create a reasonable expectation that the purchasers were investing in securities. The Court focused on the isolated use of the word "investors" in the documents and determined that, except for such isolated mentions, all documents used the word "lender" more consistently to describe the purchasers.
This analysis points again to the crucial role of counsel in ensuring that all documents relating to a debt issuance, from the engagement letter stage to the offering documents and the final loan documents, are drafted in such a way that it is clear to purchasers of such debt instrument that they are lenders (rather than investors), and the debt instrument is a loan, not a security.
Was there some other risk-reducing factor rendering the application of securities laws to the Millennium Transaction unnecessary?
According to the Court, Millennium's grant to JPM, as administrative agent for the benefit of the lenders, of an all-assets first-priority perfected security interest to secure the loans, reduced the risk associated with purchasing the notes, since the purchasers would be secured creditors of Millennium. Additionally, the Court pointed to the fact that syndicated term loans are subject to policies and guidelines promulgated by bank regulators, such as the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, as further support that these regulatory schemes govern the notes, reduce the risks associated with purchasing the same, and render the application of the Securities Acts unnecessary.
It is imperative for parties to work closely with counsel when structuring a debt issuance, particularly for transactions that involve unsecured or uninsured debt instruments and/or involve non-bank lenders, to ensure that the structure includes mitigation of risks associated with the debt instruments being offered and to determine what, if any, regulatory schemes apply to the debt instruments being offered, to reduce the likelihood that a court will determine that the application of the Securities Acts to such debt instruments is necessary.
What's next?
The ruling in Kirschner v. JP Morgan Chase Bank, N.A. highlights the importance of engaging counsel as early as possible when contemplating a debt issuance. Counsel will be critical in drafting offering and loan documents that include appropriate disclaimers and restrictions on transferability of debt instruments that prevent the applicability of the Securities Acts to such debt instruments. Counsel should also be consulted with respect to prospective participants in a financing. This is particularly important in the current market, in which non-bank lenders are more frequently assignees of or participants in loans or offer direct lending products. Given that non-bank lenders are usually not subject to banking regulations, it will be critical to discuss with counsel early in the process what regulations, if any, apply to non-bank lenders and the debt instruments they are offering or purchasing, so that they are not classified as securities. Ensuring that all offerees and purchasers of a debt instrument are sophisticated investors as defined under applicable law is also crucial to avoid any inadvertent breaches of the Securities Acts.
The Securities Acts impose liability on both the issuers of securities and underwriters of the same. Therefore, both lenders and borrowers should be aligned as to whether a particular debt instrument is intended to be a "security" and should work closely with their respective counsel to ensure that the structure of the debt issuance and the documents relating to the same are prepared in a manner that minimizes the likelihood that a court would classify such debt instrument as a "security" under the Reves test.
Loan arrangers and borrowers should also consider foregoing the requirement that a note be issued to evidence loans made under a credit agreement. If appropriately drafted, the credit agreement is sufficient to create an enforceable obligation of the Borrower to repay the loan and to pay interest and other amounts. Some credit agreements still require, or give the lenders the option to request, that the Borrower execute a separate note evidencing the loans made under the credit agreement. Foregoing the receipt of a separate note minimizes the risk that a loan will be classified as a "security" since the Securities Acts do not refer to loans when defining what is a "security." Promissory notes offer only a minor procedural advantage for enforcement and thus are included only on an as-requested basis now in most market transactions. The next step would be to omit them altogether.
If you have any questions about this alert, or are considering participating in a debt issuance, whether as a borrower, arranger or lender, please contact one of our authors or any member of Venable's Corporate Group.