Second Circuit considering whether syndicated term loans are securities | Akin Gump Strauss Hauer & Feld LLP

Important points

• The 2nd Circuit considers whether syndicated loans — that is, loans to companies made by a group of lenders rather than a single lender — are “securities” under a US Supreme Court decision rev.
• The LSTA recently submitted one amicus curiae short argument that syndicated term loans are Not Securities and warning of the devastating impact on the $1.4 trillion market that would entail any other conclusion.
• When the 2nd Circuit holds these syndicated term loans are securities under rev, the resulting practical complications and compliance costs for credit and CLO market participants could make it significantly more difficult for certain companies to access debt financing and for those companies to engage in liability management transactions. Such a ruling could even create an increased risk of insider trading claims under federal securities laws.

background

The trustee of the Millennium Lender Claim Trust filed suit against numerous financial institutions alleging that a $1.8 billion syndicated loan transaction violated state securities laws.

On May 22, 2020, Judge Paul G. Gardephe of the U.S. District Court for the Southern District of New York granted the defendants’ motion to dismiss, finding that the syndicated notes in question (the “Notes”) are not securities under the “Family Resemblance Test.” as articulated in Reves vs. Ernst & Young494 US56 (1990).¹

in the reves, The Supreme Court recognized that there is a presumption that bonds are securities and that many types of bonds are in fact securities. However, rev also enumerated several categories of notes, which are Not Securities governed by federal securities laws, including, for example, debt securities secured by home mortgages, consumer finance debt securities and debt securities supporting commercial bank loans for ongoing operations. Recognizing that many types of debt securities would not fall directly into these enumerated categories, the Supreme Court ruled that if a particular debt security bears a “family resemblance” to debt securities commonly understood to be non-securities, the presumption that a bond is a security can be refuted.²

Judge Gardephe argued that the debentures were comparable to bank loans – not securities – because:

• (1) The distribution schedule for the Notes was relatively narrow, so that they were not subject to common trade for speculation or investment.
• (2) Confidentiality language in the relevant loan documents would lead a reasonable investor to conclude that the Notes are loans and not securities.
• (3) The sale of loan participations to “skilled buyers” is subject to certain Office of the Comptroller of the Currency guidelines such that the Notes are subject to an existing regulatory regime.

Judge Gardephe noted that the remainder rev Factor (i.e. whether the transaction motivation resembled a securities transaction) did not have a large influence in either direction.

On October 28, 2021, plaintiff appealed to the U.S. Court of Appeals for the 2nd Circuit, contending that the district court found the rev Assumption that debt securities are securities and that the “family resemblance” test has been misapplied.

The LSTA amicus letter

On May 23, 2022, the Loan Syndications and Trading Association (LSTA) filed amicus curiae Brief to the 2nd Circuit arguing that syndicated term loans are not securities subject to state and federal securities laws. In support of the District Court’s view, LSTA emphasizes that treating syndicated loans as securities would jeopardize a multi-trillion dollar market critical to the US economy.

The LSTA argues that the additional practical and compliance issues that would result from treating syndicated loans as securities would impose enormous costs and restrictions on borrowers. Market participants would be required to conform to a patchwork of state and federal laws, which would only drive up borrowing costs. In addition, loan syndication and trading activities would likely need to be conducted through broker-dealers registered with the US Securities and Exchange Commission (SEC), and each market participant receiving compensation linked to credit transactions would need to determine whether to register as a broker-dealer. In addition, the LSTA emphasizes that treating syndicated loans as securities would fundamentally disrupt normal arrangements between borrowers and credit market participants.

Possible additional wide-ranging impacts

A 2nd Circuit decision that syndicated term loans are securities could potentially have far-reaching implications beyond the concerns outlined in the LSTA amicus curiae meager.

• Effects of insider trading: Market participants trading term loans often elect to access private data rooms which may contain confidential material arguably material non-public information (MNPI). Other participants may choose to trade term loans without accessing such private information, fully aware that their counterparties may be in possession of these potential MNPIs.³ These transactions are based on the assumption – and by then well-established market convention – that term loans are not securities. If the 2nd Circuit reverses the decision below, market participants with access to private information could face increased risk of insider trading liability, particularly from regulators such as the SEC.
• Problems with takeover bids: A determination that term loans are securities could subject certain transactions in the term loan market to federal takeover bid rules. Borrowers and third parties would need to determine whether a proposed offer to purchase term loans for cash or to exchange term loans for other consideration constitutes a “takeover bid” under applicable law. Tender bid rules could also potentially be impacted (under the “new certainty” doctrine) by proposed changes in fundamental financial conditions, such as: B. a proposed change in the applicable interest rate or an extension of the term. In the event that a transaction constitutes a takeover bid, the borrower or other offeror would have to comply with Regulation 14E of the Securities Exchange Act of 1934, including the requirements that the bid be kept open for 20 business days and that the bid be kept open for at least 10 business days after each change in the consideration or the percentage of the target tranche. The application of bid rules would significantly limit the flexibility of credit market participants to propose liability management transactions and efficiently negotiate changes in terms.
• Collateralized Loan Obligation (CLO) Restrictions: As the largest group of investors in broadly syndicated leveraged bank loans, CLOs would be particularly hurt if such loans were treated as securities. Most CLOs only allow a small number of securities to be included in their pools as eligible assets. A determination that certain types of syndicated loans are securities would narrow the universe of eligible assets for CLO investments. If banks are required to hold more loans on their books rather than syndicate to CLOs and other traditional buyers of such loans, banks can be expected to fund fewer loans to eligible borrowers in response to such reduced liquidity. As a result, it will be much more difficult for businesses to get quick access to financing on flexible, tailored terms, and for lenders to pool funds quickly and easily to offer credit to borrowers who may not qualify for other types of financing that will be far-reaching have a negative impact on the US economy.
• Possible impact on other markets: A sweeping 2nd Circuit judgment could impact the emerging areas of decentralized finance (DeFi) and cryptocurrency. The SEC highlighted rev in a recent administrative order that determined that certain digital tokens were securities.⁴ The SEC’s position on the application of rev DeFi has yet to be tested in court and a full decision made Kirschner could impact future decision-making by this agency in this entirely separate and rapidly evolving market.

Participants in the syndicated lending market – including private fund managers who employ strategies in lending – should pay close attention Kirschner litigation continues. No other at this point amicus Briefs have been filed and the notice of appeal will conclude in mid-June with the filing of plaintiff’s response. The hearing will likely take place sometime in the fall and it is expected that the 2nd Circuit will deliver its opinion thereafter.

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¹ While the plaintiff contended that the defendants violated state securities laws rather than state securities laws, the court accepted the plaintiff’s contention that the rev “Family resemblance test” performed.

² The four factors of the “Family Resemblance Test” are: (1) “the motivations that would induce a reasonable seller and buyer to enter into a relationship [the transaction]”; (2) “the distribution plan of the Instrument”; (3) “the reasonable expectations of the investing public”; and (4) “the existence of a different regulatory regime [to reduce] the risk of the instrument, making the application of the Securities Act unnecessary.” ID. at 66-67.

³ The trade confirmations typically used to process syndicated loan transactions contain standardized “big boy” provisions that require parties to be willing to proceed with the transaction even if they have chosen not to access private information , which may have been verified by the other party. While these types of representations afford parties protection from private litigation in the syndicated loan market, the SEC has indicated that they would not constitute a defense against a regulatory enforcement action alleging insider trading. See SEC litigation release no. 20132, Barclays Bank Pays $10.9 Million to Settle Insider Trading Charges Based on Information from Bankruptcy Creditors’ Committee (30 May 2007), http://www.sec.gov/litigation/litreleases/2007/lr20132.htm.

⁴ See In the matter of Blockchain Credit Partners d/b/a DeFi Money Market, Gregory Keough and Derek Acree (SEC August 6, 2021), available at https://www.sec.gov/litigation/admin/2021/33-10961.pdf.