Notes are securities and loans are not securities. Simple enough. Except, our financial system doesn’t operate in such a black and white manner. Syndicated loans kind of fall in the middle.
Your traditional loan is a single lender who holds and controls the debt. Notes and bonds get issued into a more fungible format to more than one investor, with control centralized with a trustee or loan administrator. There are lots of different structures on the notes and bond side of the spectrum.
Syndicated loans involve a group of lenders. Typically it’s a smaller group of lenders and they have some amount of control, collectively, over the administration of the loan.
There a fight in the Second Circuit in Kirschner v. JP Morgan Chase Bank on whether a particular syndicated loan issuance was a security. There is enough uncertainty that the court asked the Securities and Exchange Commission to offer its opinion. A few days ago, the SEC declined to do so.
While we are used to a discussion of the Howey test when talking about securities, it’s important to note that it is focused on the definition of an “investment contract.” There is a whole other line of cases on the “loan” versus “note” definition lead by the Reves v. Ernst & Young case which established the “family resemblance test.”
The analysis is whether the note in question is like any of these notes that are not securities:
- the note delivered in consumer financing,
- the note secured by a mortgage on a home,
- the short term note secured by a lien on a small business or some of its assets,
- the note evidencing a ‘character’ loan to a bank customer,
- short-term notes secured by an assignment of accounts receivable, or
- a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
- notes evidencing loans by commercial banks for current operations.
In determining whether the note in question has a family resemblance to one of the seven, there are four factors to consider:
- The motivation of seller and buyer – If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security. Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, then its more likely to be a security.
- The plan of distribution of the note – If the note instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.
- The reasonable expectations of the investing public – If the investors think that the securities laws and their anti-fraud provisions apply to the note, then it’s more likely to be a security.
- Alternative regulatory regime – Is there another regulatory scheme, like banking regulation, that applies to the note, then its less likely to be a security.
The case as hand involves a $1.775 billion syndicated loan to Millennium Laboratories. As you might expect, Millennium defaulted. The loan participants are suing the loan syndicator to try get some additional recovery. The district court ruled that the syndicated loan interests were not securities and the loan participants appealed to the Second Circuit.
As mentioned above, the Second Circuit is mulling over the appeal and asked the SEC to opine on the treatment of this loan syndication. The SEC’s failure to say that the syndicated loan interests are not securities has created a bit of a panic in the syndicate loan markets.
We’ll keep an eye out for this decision.
Sources:
- SEC punts on whether syndicated loans are securities, in closely watched appeal by Alison Frankel
- Kirschner v. JP Morgan Chase Bank (S.D.N.Y. Sep. 30, 2021)
- SEC Declination letter July 18, 2023
- Reves v. Ernst & Young 110 S.Ct. 945 919900
- To Be or Note to Be a Security: Reve v. Ernst & Young by Scott Museles
- Is a Note a Security?
