The $1.4-trillion leveraged loan market1 yet again breathed an immense sigh of relief on August 24, 2023, with the United States Court of Appeals for the Second Circuit’s unanimous affirmation2 of the Southern District of New York’s 2020 Kirschner v. JPMorgan Chase Bank, N.A.3(“Kirschner”) decision.  The latest decision affirmed the prevailing market view that notes representing syndicated loans do not constitute “securities.”4 The leveraged loan market had operated for decades under the assumption that syndicated loans are not securities, but without firm judicial or regulatory certainty as to such assumption.  Although the Second Circuit’s latest decision is not necessarily the final word (or binding law throughout the country), it provides strong legal guidance to the industry that loans are not securities. The historical lack of certainty stemmed in part from the fact that “notes” and “evidences of indebtedness” are enumerated types of securities in the federal securities laws’ “security” definition, leading to a plausible assumption that such instruments are, in fact, securities. Furthermore, under the seminal Howey test,5an instrument is deemed to be a security if it involves an investment of money in a common enterprise with an expectation of profits from others’ efforts. The Howey test could certainly be interpreted to consider a note or syndicated loan to be an investment contract, with the act of syndication itself causing the noteholders to be reliant on the efforts of others and thus an SEC-regulated “security”. Many loan-related products (e.g., letters of credit) exist that are known not to be securities. In recognition of this, in the seminal Reves6case, the U.S. Supreme Court first acknowledged that notes are not necessarily securities,  even though they are specifically included in the Securities Act’s “security” definition. In 1992, in Banco Espanol de Credito v. Security Pacific National Bank7, the Second Circuit Court of Appeals expanded Reves’ ruling in holding that loan participations are not securities. The U.S. Supreme Court refused to address the Banco Espanol ruling on appeal, allowing it to become the law (at least in the Second Circuit) for the past three decades. While Banco Espanol and Reves led to the accepted market practice that syndicated loans are not securities, uncertainty has remained. Some of this uncertainty relates to the fact that in the intervening decades, the syndicated loan market has grown exponentially (particularly in volume of secondary market transactions), leading some to question whether Banco Espanol would still be upheld in light of the resemblance in some ways of the current syndicated loan market to a securities marketplace. Further, Banco Espanol did not expressly address more current types of loan transactions, which are syndicated and involve a purchase and immediate resale to investors. The Case As discussed in our July 2020 advisory8,Kirschner involved a $1.775 billion syndicated loan transaction in which Millennium Laboratories LLC syndicated a term loan to investors. The Kirschner defendants9 had served as arrangers and underwriters in the transaction. Two months after the loan facility closed, Millennium was found liable for violating the Physician Self-Referral (Stark) law and anti-kickback statutes. Millennium also was the target of other proceedings, including a Department of Justice investigation in connection with False Claims Act violations, all of which impacted Millennium’s valuation. In light of such actions and other issues, Millennium filed for bankruptcy protection in New York. After Millennium’s bankruptcy filing, Marc Kirshner, the bankruptcy trustee of the Millennium Lender Claim Trust, filed suit in the United States District Court for the Southern District of New York, alleging securities and other violations. The case considered whether the origination and distribution of a syndicated bank loan were subject to state securities (“blue sky”) laws in California, Colorado, Illinois and Massachusetts. The District Court granted the defendants’ motion to dismiss on the ground that a syndicated bank loan is not a “security.” Sidestepping the Howey test completely, the District Court applied the “family resemblance” test outlined in Reves to determine whether the Millennium notes were securities. Under Reves and its progeny, a note is presumed to be a security unless it bears a strong family resemblance to instruments that are denominated as notes but nonetheless not legally categorized as securities. Mortgage loans, consumer financing loans, accounts receivable factoring agreements, notes evidencing debt incurred in the ordinary course of business (particularly if collateralized) and notes evidencing loans by commercial banks for current operations fall within such category. The four factors of the Reves “family resemblance” test are: motivations that would prompt a reasonable seller and buyer to enter into the transaction; the instrument’s plan of distribution; the investing public’s reasonable expectations; and whether some factors, including the existence of another regulatory scheme, significantly reduce the instrument’s risk, thereby rendering Securities Act application unnecessary10. Ultimately, the District Court concluded (and the Second Circuit court ultimately agreed) that the second, third and fourth Reves test factors weighed in favor of finding that the notes were “analogous to the enumerated category of loans issued by banks for commercial purposes” and, as such, not securities11. Given the determination that the notes at issue in the Kirschner case satisfied three out of the four Reves test prongs, the District Court dismissed the action in May 2020, granting summary judgment to the defendants. For more details as to how the District Court analyzed these factors, please see our 2020 advisory. The Kirschner plaintiff appealed to New York’s Second Circuit, arguing (among other things) that the District Court should disregard the Reves test’s presumption that the loan was a security. Prior to making its decision, the Second Circuit issued an order to “solicit any views that the [SEC] may wish to share” regarding the status of the syndicated term loan notes as securities under Reves. Interestingly, even given the current SEC’s activism, and despite the court’s prodding, the SEC declined to weigh in with its own arguments in the case after indicating a prior intention to file an amicus brief (and procuring extensions on the filing deadline12), leading to speculation that the SEC was unable to muster internal policy consensus to submit an amicus brief that the loans were (or were not) securities (especially given the gravity of a possible policy change).  This is in contrast with the Banco Espanol case, in which the SEC filed a short amicus brief asking the court to rule that the notes were purchased in investment transactions and, therefore, were securities13. Notwithstanding (or maybe due to) the SEC’s lack of amicus guidance in the case, the Second Circuit affirmed the Kirschner’s lower court ruling that the notes at issue were not securities. In particular, the Second Circuit observed that the third prong had been satisfied since the lenders purchasing the notes had to certify that they (a) were sophisticated and experienced in extending credit to entities similar to Millennium, (b) had independently (and without reliance upon any agent or lender, and based on documents and information that they deemed appropriate) made their own appraisal of (and investigation into) Millennium’s business, operations, property, financial and other condition and creditworthiness and (c) made their own decisions to make loans thereunder. The Second Circuit again noted a parallel with Banco Espanol, under which a substantively identical certification was central to the court’s determination that the buyers could not have reasonably perceived the loan participations to be securities. Takeaways From The August 2023 Ruling It is hard to overestimate the profound effect that would come about should syndicated loans be re-classified as securities. Indeed, the market as we know it would cease to exist. The transaction at issue involved a loan facility that was similar to other syndicated loan facilities. If the Second Circuit had deemed such loan a security, it would have been difficult to differentiate it from most other syndicated loans – which could have brought the entire loan market’s operations under SEC scrutiny (thus disrupting the loan markets and likely changing their economics). It also is likely that the structure of the collateralized loan obligation (CLO) market (which currently purchases about 70% of all U.S. syndicated loans issued14) would not transition well to a regulatory environment where loans are deemed securities. Another unintended consequence of classifying notes as securities is the possibility that more borrowers would seek financing from less desirable sources, such as entirely unregulated private lenders. The Kirschner opinions (together with the prior case law) suggest that a transaction’s facts and circumstances will largely determine whether a note will be deemed a “security,” with the application of the Reves family resemblance test to a transaction being analyzed on a case-by-case basis. To minimize the risk of a particular loan becoming considered a security, leveraged loan products should be structured in a manner that is consistent with general principles in the Loan Syndications and Trading Association (LSTA) Code of Conduct and the Reves family resemblance test15. One reason why the leveraged loan market has been able to thrive thus far without being regulated as a security is that loan syndications have steered clear of the retail market and have done a good job of policing themselves. While the Second Circuit’s Kirschner decision was favorable to the loan market, it does not constitute binding precedent for other districts 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 the recent decision. That said, the Court’s application of the Reves test rather than the Howey test solidifies the legal consensus that debt instruments should be analyzed using the Reves test. Other industries (in particular “network” or “utility” digital assets) have looked at syndicated loans and the Kirschner ruling with a bit of envy, wondering if digital assets could be structured to similarly avoid SEC scrutiny16. The loan market could be seen as evidencing a historical anomaly, partly based on its resemblance to instruments that are not securities and cannot be compared with other financial instruments. It would be prudent for any industry or asset class that wants to avoid SEC scrutiny to follow the lead of syndicated loans - with a relatively strict code of conduct, few failed transactions and possibly limited retail involvement. The Kirschner reassurance that syndicated loans do not constitute securities could erode as other courts weigh in on this issue and/or other and new financial instruments are tested in court.  For instance, advancement to create efficiencies in the loan market (such as continued automation of the loan trading process, potentially through the use of a blockchain) may require further analysis. It also will need to be clarified whether an instrument with identical characteristics to a syndicated loan would be considered a security simply because the debt is tokenized rather than represented by a note. [1] As of June 30, 2023, according to the Loan Syndications and Trading Association.  See, e.g., https://www.lsta.org/news-resources/2q23-the-dog-days-of-summer/#:~:text=In%20light%20of%20this%2C%20it,2023%20and%202022%20highs%2C%20respectively. [2]Kirschner v. JP Morgan Chase Bank, N.A., No. 21-2726, 2023 WL 5437811 (2d Cir. Aug. 24, 2023). [3]Kirschner v. JP Morgan Chase Bank, N.A., 2020 U.S. Dist. LEXIS 90797 (S.D.N.Y., May 22, 2020). [4] The Second Circuit first analyzed and agreed with the District Court with respect to the lower Court’s jurisdiction over the case pursuant to the Edge Act (§12 U.S.C. 632) based on the engagement by JPMorgan Chase Bank, N.A., in international or foreign banking in connection with the transaction. [5] SEC v. W.J. Howey Co., 328 U.S. 293 (1946). [6] Reves v. Ernst & Young, 110 S. Ct. 945 (1990) (“Reves”). [7] Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2nd Cir. 1992). [8] Court Provides Additional Guidance On When Notes Are Not Securities- The Kirschner Case (July 13, 2020.  https://www.polsinelli.com/publications/court-provides-additional-guidance-on-when-notes-are-not-securities-the-kirschner-case. [9] The defendants were JPMorgan Chase Bank, N.A., JPMorgan Securities LLC, Citigroup Global Markets Inc., Citibank, N.A. and BMO Capital Markets Corp. [10] Reves, 494 U.S. at 67. [11] Banco Espanol, 973 F. 2d 51, 56 (1992). [12] See, e.g., https://www.lsta.org/app/uploads/2023/08/AFR-letter-re-SEC-Punt.pdf. [13] See https://casetext.com/case/banco-espanol-de-credito-v-sec-pac-nat-bank.  The Banco Espanol dissent noted that the SEC had submitted a brief amicus curiae advocating the use of the Howey test rather than the Reves test. [14] As of March 2023, according to Pitchbook. [15] Factors in the Kirschner transaction that could help weigh against classification of the transaction as a “loan” and not a “security,” including the following: (1) the transaction documents language should use the explicit language of loan transactions; e.g., references to “loan” and “lender” throughout the governing documents weighed against classification as a security in Kirschner; (2) the composition of purchasers and potential purchasers that are solicited should be sophisticated, and ideally qualified institutional buyers; (3) parties should consider the minimum hold requirements that preclude retail investors; (4) transfer/assignment restrictions should be at least as stringent as were found in the Kirschner and Banco Espanol loans; and (5) the administrative agent and/or the borrower should have control of who becomes a lender. [16] Certain tokenized loan products have been drafted so as to comply with Reves and its progeny.

The application of the Corporate Transparency Act to decentralized autonomous organizations raises novel legal issues. DAOs are a relatively new type of business association that lack statutory governance and liability protections for participants because they have not been formed as traditional legal entities. As a result of legislative enactments seeking to fit DAOs into traditional entity structures to promote protections for them, DAOs operated through business entities will need to comply with the CTA's disclosure obligations. What the CTA Requires: Beginning Jan. 1, 2024, reporting companies operating in the U.S. must file Beneficial Ownership Secure System, or BOSS, reports with the U.S. Department of the Treasury's Financial Crimes Enforcement Network, including owners' names, birthdates, addresses and copies of government-issued photo identification. A reporting company is an entity like a corporation, limited liability company, limited partnership or business trust that is created or registered to do business in the U.S. through a secretary of state filing. Heavily regulated businesses — such as public companies and their regulated advisors, financial institutions, insurance providers and Section 501(c)(3) nonprofits — are exempt. Also exempt are large operating companies — i.e., those with a U.S. physical street address, 21 or more full-time employees, and more than $5 million in annual gross receipts or sales as reported in a prior-year tax filing. Wholly owned subsidiaries of an otherwise exempt entity are also excluded. Companies formed by Dec. 31 must initially file BOSS reports by Dec. 31, 2024, with companies formed starting Jan. 1, 2024, having 30 days to file — with changes due within 30 days. BOSS reports may be accessed by federal, state, local and tribal law enforcement, and by financial institutions with customer consent — but will not be publicly accessible, including by Freedom of Information Act request. Beneficial owners include persons with substantial control over — and those who directly or indirectly own 25% or more of — the company's equity. Every reporting company must report at least one person, and an owner's refusal to disclose may signal their noncompliance to the Financial Crimes Enforcement Network. Fines and penalties for nonreporting or false reporting can be steep. DAO Framework: A DAO is an association of persons represented in part by rules encoded as a transparent computer program, usually controlled by the association and not influenced by a central governance body, and blockchain technology managing the DAO by decentralized autonomous means — often including a proprietary digital asset. A DAO is set up by programing the organizational structure onto blockchain technology by smart contract, with preprogrammed code setting forth the decision-making structure and governance — and a smart contract often serving as de facto governing document. DAOs typically fundraise by issuing tokens allowing for voting rights to make rule changes and take action. DAO members may view transactions on the blockchain — including a timeline of contributions and use of funds — with tokens usually purchased on decentralized platforms or directly through peer-to-peer transactions. As of June, there were reportedly approximately 2.5 million active voting DAO members and almost 7 million DAO governance token holders worldwide. As of spring 2023, only Tennessee, Utah, Vermont and Wyoming recognized DAOs, with various other states considering legislation. Many DAOs form as Delaware LLCs, and state cooperative law statutes, e.g., in Colorado or New York, or alternative DAO structures, such as benefit LLCs, also may provide a framework. As of 2022, the Republic of the Marshall Islands approved legislation recognizing DAOs as LLCs. Other popular countries for DAOs include the Bahamas, British Virgin Islands, Cayman Islands, Gibraltar, Liechtenstein, Panama, Singapore and Switzerland. DAOs' challenges, constraints and risks include those relating to: Governance; Intellectual property ownership; Contract enforceability; Infrastructure and scaling; Proper taxation and procuring insurance; Application of bankruptcy, insolvency and securities rules and antitrust; Fraud and error; Cryptocurrency risks; and Dealing with know-your-customer and anti-money laundering rules. How the CTA May Apply To and Affect DAOs: The CTA assumes that a reporting company is a legal entity with a system of beneficial ownership and governance that a DAO may not possess. Traditional partnership-based DAOs will not fall within CTA purview, but those DAOs subject to traditional state formations are considered legal entities in DAO legislation states and will need to consider CTA compliance. CTA reporting requirements will be particularly burdensome for DAOs given their structure and framework — i.e., DAOs lack managers, directors or officers — so each member, and not the DAO as an organization, may need to determine whether they have substantial control or own 25% of the DAO. A DAO that is a state-law, member-managed LLC would require each member to file a BOSS report. The CTA prohibits blank stock and anonymous reporting company ownership, in direct opposition to DAOs' compelling feature of anonymity. The Financial Crimes Enforcement Network has provided nontraditional entities with advice that substantial control includes control exercised in novel and less conventional ways, advising that control could apply to varying and flexible governance structures such as DAOs — for which different control indicators may be more relevant. While the Financial Crimes Enforcement Network is unsure of how the CTA applies, the CTA applies to state-formed DAOs nonetheless. The CTA does not address certain DAO-specific matters such as whether membership by token ownership is beneficial ownership for CTA purposes. Realistically, without directors and officers, DAOs will have trouble naming compliance personnel. Wrapping DAOs into traditional structures has exposed DAOs to reporting requirements and compliance protocols, now expanding to include CTA compliance. Using traditional DAO parameters to regulate nontraditional businesses may be incompatible with DAOs' innovative and changing nature and autonomy. DAOs required to be CTA compliant will need to monitor CTA guidance as the rollout continues. A state-registered DAO may have easier CTA compliance or may lack personnel to track CTA requirements, but be expected to track them nonetheless. Wrapped-entity DAOs should set up CTA compliance protocols — including point persons — and track ongoing compliance. Since DAOs operate through the blockchain and smart contracts, structuring a DAO to adopt CTA-disclosure procedures may be unrealistic. Traditional DAOs operated as common law partnerships do not face CTA exposure, whereas DAOs operated as or through entities established through state law filings must be CTA-compliant. The inherent characteristics of DAOs and blockchain technology will make CTA compliance challenging. Takeaways: As the CTA rollout ramps up in late 2023 and in 2024, many questions likely will arise as to how DAOs that are wrapped or state-registered should properly comply with the CTA. We would expect the Financial Crimes Enforcement Network to issue more guidance as to the application of the CTA to DAOs as the CTA rollout continues. In the meantime, the CTA rollout could lead states to slow their efforts to pass DAO-related legislation pending a better understanding of the interplay between the CTA and state-registered DAOs. Because DAOs are traditionally self-governed and self-regulated by their participants, burdensome CTA compliance requirements and rigid state regulation may further incentivize self-regulation in the DAO industry. DAOs also may be driven away from registering — or staying registered — in U.S. states if their status imposes reporting obligations with which they cannot legally comply. The CTA's compliance requirements may further the perception of the U.S. as an unfavorable environment for blockchain and DAOs, pushing DAOs toward registering or focusing operations in countries with laws that are perceived as more welcoming. In upcoming months, in anticipation of the CTA's effectiveness, proper DAO formation will require sophisticated formation and operational advice that is mindful of CTA compliance and potential pitfalls. *This article first appeared on Law360.