July 13, 2020
The loan market breathed an immense sigh of relief this spring with the ruling in Kirschner v. JPMorgan Chase Bank, N.A.  (“Kirschner”) affirming the prevailing market view that notes representing syndicated loans are not “securities.” The leveraged loan market has been operating for decades under the assumption that syndicated loans are not securities, perhaps shockingly without firm judicial or regulatory certainty to that effect. This uncertainty stems from the fact that “notes” and “evidences of indebtedness” are enumerated types of security in the definition of “security” under federal securities laws. Further, under a test known as the “Howey Test,” a contract is deemed to be a security if it involves an investment of money in a common enterprise with an expectation of profits from the efforts of others. This could have also resulted in the note being an investment contract if the act of syndication itself caused the holders of the notes to be reliant on the effort of others. 

In 1990, in the case Reves v. Ernst & Young (“Reves”) the U.S. Supreme Court first acknowledged that notes might not be securities despite the fact that they are specifically included in the definition of “security” in the Securities Act of 1933.  In 1992, the Second Circuit Court of Appeals held that loan participations are not securities in Banco Espanol de Credito v. Security Pacific National Bank (“Banco Espanol”).  However, in the intervening 30 years the syndicated loan market has grown considerably, particularly in the number of secondary market transactions. This may have led some to question whether the ruling in Banco Espanol would still apply to loans today. Further, Banco Espanol did not expressly address promissory notes that were syndicated via a purchase and immediate resale to investors.  

While the Court’s decision in Kirschner to grant dismissal of the case was favorable to the loan industry, it does not constitute precedent for other courts and therefore does not create certainty.  Accordingly, the characteristics of syndicated loans will continue be analyzed on a case-by-case basis even in light of this decision. That said, the Court’s application of Reves rather than the Howey test solidifies the thinking that debt instruments should be analyzed using the Reves test, described in more detail below.

Even a small risk of the classification of loans as “securities” needs to be taken seriously, as such classification would dramatically alter the structure and regulation of leveraged loans, and likely diminish, if not, destroy the asset class. The recent economic downturn caused by the global pandemic is likely to increase loan defaults and result in legal actions to recover losses. This new paradigm raises the possibility of another plaintiff obtaining a different result. Importantly, there are several similarities between the structure of syndicated loans (which historically have not been treated as securities) and bonds (which clearly are securities) that could lead a court to utilize the Howey Test rather than following the Reves test. Finally, as the loan market considers automating the loan trading process, potentially through the use of a blockchain, it is important to consider how these technologies might affect the security law analysis of loans. Click here to view the full update.