As we previously covered, on May 22, 2020, Judge Paul G. Gardephe of the United States District Court for the Southern District of New York dismissed a complaint asserting claims under state blue-sky laws as well as common-law claims against financial institutions that acted as arrangers on a syndicated term loan, holding that the term loan at issue was not a “security.” 2020 WL 2614765 (S.D.N.Y. May 22, 2020). In October 2021, plaintiff filed an appeal to the Second Circuit challenging the issue of whether the syndicated loan in question was a security and therefore subject to securities laws and regulations. No. 0:21-cv-02726 (2d Cir., Oct. 28, 2021).
Plaintiff brought the action as trustee of a trust for which the beneficiaries were lenders and alleged purchasers in a $1.775 billion syndicated term loan transaction which defendants allegedly arranged for a California-based medical testing company (the “Company”). After the Company defaulted on the term loan and filed for bankruptcy protection, plaintiff filed suit against the arrangers, asserting claims under various state securities laws (“Blue Sky” laws), as well as numerous common-law claims. Plaintiff alleged generally that defendants misrepresented or omitted material facts in the alleged “offering materials” provided and other communications allegedly made regarding the legality of the Company’s sales, marketing, and billing practices, as well as the known risks posed by a pending government investigation into the illegality of such practices.
In connection with plaintiff’s state securities law claims, the district court first addressed whether the term loan was a security. The district court applied the Reves test (named after the Supreme Court case Reves v. Ernst & Young, 494 U.S. 56 (1990)), which was the standard plaintiff argued should apply. As noted by the Supreme Court in Reves, Congress “enacted a definition of ‘security’ sufficiently broad to encompass virtually any instrument that might be sold as an investment.” Id. at 61. In particular, the definition of “security” refers to “notes,” and the Supreme Court has accordingly stated that every note is initially presumed to be a security. Id. at 65. This presumption may be rebutted, however, if the note strongly resembles one of the families of instruments previously determined by the courts to be non-securities—including, for example, notes delivered in consumer financing, notes secured by a mortgage on a home, or notes evidencing loans by commercial banks for current operations. Id. at 65, 67. The determination of whether a note at issue bears a “family resemblance” to any of these categories of non-security notes requires a consideration of four factors: the motivations of the seller and buyer; the plan of distribution of the instrument; the reasonable expectations of the investing public; and the existence of another regulatory scheme to reduce the instrument’s risk. Id. at 66–67. After analyzing the Reves factors in connection with the term loan at issue, the Court concluded that “the limited number of highly sophisticated purchasers of the Notes would not reasonably consider the Notes ‘securities’ subject to the attendant regulations and protections of Federal and state securities law,” but rather that “it would have been reasonable for these sophisticated institutional buyers to believe that they were lending money, with all of the risks that may entail, and without the disclosure and other protections associated with the issuance of securities.” 2020 WL 2614765, at *10.
On appeal, plaintiff contends (among other things) that the district court “disregarded” the alleged presumption under Reves that the “notes” at issue are securities and, according to plaintiff, erroneously held that they evidence loans by commercial banks for the borrower’s current operations, “largely by discrediting the Trustee’s allegations and assuming a fact-finding role at the pleading stage.” Defendants argue (among other points) that the district court appropriately assumed the truth of the Complaint’s factual allegations and applied Reves to determine whether those allegations supported the existence of a security. Defendants point out that plaintiff’s argument that the term loan falls within the “note” category of securities under the Supreme Court’s four-factor test in Reves “runs headlong” into the Second Circuit’s decision in Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2d Cir. 1992), which concluded that a similar type of loan was not a security under the Reves test, and no court has held otherwise.
Notably, after oral argument, the Second Circuit issued an order “solicit[ing] any views that the United States Securities and Exchange Commission may wish to share” regarding “whether the syndicated term loan notes at issue in this appeal are securities under Reves.” In that order, the Second Circuit stated that “[w]e have not previously considered whether this type of note is a security” and that it is asking for the SEC’s views “given the importance of the issue, the parties’ diverging positions, and the policy implications that would result from our resolution of this case.” The SEC’s response is currently due on June 27, 2023. Defendants submitted a request to solicit views of other relevant agencies besides the SEC—including the OCC, Treasury Department, FDIC, and Federal Reserve—but the Second Circuit denied that request on May 31, 2023.
If the Second Circuit were to overturn the district court’s clear rejection of plaintiff’s attempt to recharacterize the TLB transaction structure as a sale of securities subject to the securities laws, this could have significant market and legal repercussions.