Kirchner v. J.P. Morgan: Syndicated Term Loans Are Not Securities, But What About Digital Assets?

In a highly anticipated ruling, the US Court of Appeals for the Second Circuit recently ruled Kirchner v. JPMorgan Chase Bank, NAthat B-wide syndicated term loans are not securities and that securities laws may not serve as a basis for claims against parties such as those responsible for marketing such loans to potential lenders.

The case was watched closely by secondary loan market participants, private credit lenders, syndicate members, banks and borrowers, because the opposite outcome that these loans were securities could lead to: 1) requiring all debt trading activities in the secondary market to include a registered broker-dealer subject to securities regulations; 2) The limited ability of borrowers to issue syndicated term loans except through a public offering or qualified private placement. 3) the limited ability of US banks to hold syndicated loans consistent with the Volcker rule’s restrictions on banks’ investments in securities; and 4) it has led to higher expenses for both private fund managers who use credit strategies and borrowers – since transactions will need to comply with federal and state securities laws.

The outcome was largely expected, following a similar ruling by the lower court in September 2021. However, the 2nd Circuit ruling nonetheless came as a relief to many market participants in the trillion-dollar syndicated loan market.

JPMorgan Chase & Co. and certain other banks (the primary lenders) have agreed to provide a term loan of $1.775 billion, and a revolving loan of $50 million, to Millennium Health LLC, Inc. f/k/a Millennium Laboratories (Millennium) in 2014. Coinciding with the closing of the loan, the initial lenders marketed the loan to syndication, eventually syndicating the loan to a group of approximately 61 institutional investors who sub-allocated or syndicated their loans to approximately 400 entities.

Whether in the lead up to or after the loan closing in April 2014, Millennium has been subject to all of the following: an ongoing investigation by the US Department of Justice (DOJ), litigation with a competitor, and legal action alleging improper billing practices. Millennium eventually reached a $256 million settlement with the Department of Justice. In November 2015, Millennium filed for partial bankruptcy to address the financial difficulties caused by paying this settlement.

As part of Millennium’s bankruptcy, a litigation fund was set up with Mark Kirchner as trustee, which was empowered to pursue, among other things, securities fraud claims against the primary lenders based on their bundling of the loan in question. In August of 2017, Kirchner filed a lawsuit in New York state court against the initial lenders.

The initial lenders moved to dismiss the case, arguing that the loans in question were not “securities” and therefore could not be subject to securities liability under state law. The Federal District Court agreed and dismissed the case. Kirchner appealed to the Second Circuit.

Second Circuit decision

The second circuit affirmed the lower court’s finding that the loans in question were not “securities,” and thus Kirchner’s claims had to be dismissed under the Government Securities Act.

In this regard, the Second Circuit agreed with the District Court that the appropriate test to be applied was the “family similarity” test announced by the Supreme Court in Reeves v. Ernst & Young It is also applied by the same second circuit in Banco Espanol de Credito v. Security Pacific National Bank, two cases from the 1990s. This test begins with the assumption that every banknote is a security. However, this assumption can be overcome if the securities in question bear a strong ‘family resemblance’, based on four factors, to one of the mentioned classes of instruments excluded from the definition of a security.

These four factors are: 1) the parties’ motivation for entering into the transaction (that is, if the transaction is for “investment” purposes it is likely to be a security; if the transaction is for “commercial” purposes, it is unlikely to be a security); 2) The extent of the tool’s distribution plan. 3) Reasonable expectations of the investing public. 4) The existence of another regulatory system to reduce the risk of the instrument, which makes the application of securities laws unnecessary.

By applying these four factors to the disputed facts of the Millennium Loan, the Second Circuit agreed that the securities associated with that loan, after the syndicated loan, are not securities.

• Regarding the first factor, the second circuit found that the parties’ motives were mixed, with the lenders’ motives focused on investment (i.e. benefiting from their purchase of securities) and Millennium’s motives were commercial (i.e. raising money for its business). The Court found that these mixed rules supported the finding that the securities associated with these loans are securities.
• With respect to the second factor, the Second Circuit found that the Bonds were not available on an unrestricted basis to the general public because of the assignment restrictions applied to transferees and loan participants contained in the Loan Documents, and therefore preferred the conclusion that these were bonds and not “securities”.
• Regarding the third factor, the second circuit found that the assigns of the Bonds were all sophisticated entities who were given sufficient notice that the Bonds were loans and “not investments in a commercial enterprise”. Hence this factor would also have preferred to conclude that banknotes are not securities.
• Regarding the fourth and final factor, the Second Circuit found that several aspects of the transaction reduced its risk, including that the bonds were collateralized and that the Office of Foreign Transactions Coordination (OCC), the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC) all issued specific policy guidelines General addresses syndicated term loans. Avoiding the need to also be protected by securities laws. This last factor has also favored the conclusion that banknotes are not securities.

Based on the foregoing, the Second Circuit considered that the bonds related to loans bear a “strong resemblance” to one of the aforementioned categories of securities that are not securities, which is “loans issued by banks for commercial purposes.” Since there was no basis for Kirchner’s claims under state law, the Second Circuit affirmed its denial.

Fast food; Impact on digital asset regulation?

Key takeaways from Kirchner is that the common debt market does not need to be completely reformulated to include registered broker-dealers or public offerings or to take the Volcker rule into effect. While such an impact was unlikely in light of the lower court’s 2021 decision, the negative impact that the counter-decision would have had was enough to keep the industry on edge. Now that cloud has lifted, the industry can breathe a sigh of relief.

the Kirchner The decision may offer some hope to the digital asset community still in limbo with no relief in sight. By confirming the test used in RevisThe second circle recognized that banknotes are used in a variety of settings, and for different purposes, and not all uses involve investment. Although some debt instruments are securities under the Securities Act, the Court has developed the “investment versus trading” test to recognize that there are many types of instruments that are securities, but not all instruments are investments and therefore do not need to be regulated as securities.

overlap between Kirchner The issue and digital asset space was made clear by the SEC’s refusal, during the appeals process, to provide its own view of whether the loans in question should be considered securities – the 2nd Circuit explicitly asked for the SEC’s view, but the SEC declined provide it. Commentators have speculated that the SEC was interested in providing a position on one type of financial instrument that has not traditionally been seen as a security while, at the same time, trying to regulate digital assets that might bear some resemblance to a loan in some respects.

We still have to see if it does Kirchner The decision will affect the SEC’s attempts to regulate digital assets as securities. The SEC has been active and vocal in its attempt to regulate cryptocurrency, taking the position that all cryptocurrency tokens are essentially securities — regardless of commercial application; Dependence on semen SEC v. WJ Howey Company. A case for determining whether digital assets are “investment contracts” subject to federal securities laws. Howey defines an “investment contract” as a contract, transaction or scheme whereby a person: 1) invests his money; 2) in a joint enterprise; and 3) with a reasonable expectation of earnings based on the administrative efforts of the Promoter or a third party. Kirchner It shows that the Court has the power to discriminate even when Congress paints with a broad brush. It seems unlikely amateur It will be replaced as the dominant standard by which digital assets and protocols will be analyzed by regulators and courts – but the situation is nonetheless worth watching.

For more information, please contact your Barnes & Thornburg attorney or Gregory Plotko at 646-746-2406 or gplotko@btlaw.comMushfiqur Shams Billah at 646-746-2037 or msbillah@btlaw.comAaron Gavant at 312-214-4583 or agavant@btlaw.comOr Lorian Cristea at 646-746-2033 or laurian.cristea@btlaw.com

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