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 syndicated Term Loan B notes (“TLBs”), holding that the notes at issue are not “securities.” See Kirschner v. JPMorgan Chase Bank, N.A.
, No. 17-cv-6334 (PGG) (May 22, 2020). This is an important decision in that it is the first case of which we are aware to address whether TLBs are securities. Plaintiff was granted leave to amend, although the basis for an amendment is not apparent.
Plaintiff brought the action as trustee of a trust for which the beneficiaries were lenders and alleged purchasers of TLB notes as part of a $1.775 billion syndicated term loan transaction (the “Notes”) which defendants allegedly arranged for a California-based medical testing company (the “Company”). After the Company defaulted on the Notes and filed for bankruptcy protection, plaintiff filed suit against the arrangers of the Notes, asserting claims under the state securities laws (“Blue Sky” laws) of California, Massachusetts, Colorado, and Illinois, as well as common-law claims for negligent misrepresentation, breach of fiduciary duty, breach of contract, and breach of the implied covenant of good faith and fair dealing. 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 Court first addressed whether the Notes are securities. The 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.
In addressing these factors, defendants argued that the Notes were not
securities because: (i) the proceeds of the loan were used to refinance an existing loan; (ii) the lenders were a small set of institutions that were repeat players in the market, not the general public; (iii) the “reasonable perception of the instrument” precludes classification of the Notes as securities because they were part of an industry-standard transaction in a $2 trillion per year market accessible only to sophisticated institutional lenders, and the governing documents made clear to the parties that they were participating in a lending transaction, not investing in securities; and (iv) the presence of a separate regulatory regime for the notes (including regulatory guidance by the OCC, Federal Reserve, and FDIC) militated against finding the Notes to be securities. Plaintiff argued that the Notes at issue were securities because (among other things): (i) they were purchased by alleged investors for investment purposes, not commercial lending purposes; (ii) they were allegedly sold to institutional investors with a provision for secondary trading; (iii) they were reviewed by a rating agency; and (iv) both at the time of the transaction and after, there was a trackable trading price for the Notes.
After analyzing the Reves
factors in connection with the Notes 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.” In particular, as to each factor, the Court found that:
- the motivations of the seller were focused on advancing a specific commercial purpose, namely loan repayment and the paying of a dividend, rather than for the Company’s general business purpose or investments, which suggested that the Notes were not securities, but on the other hand, from the buyers’ perspective, the purpose of acquiring the Notes appears to have been investment, so this factor was “mixed”;
- the plan of distribution here was relatively narrow, including to the extent the restrictions on the Notes worked to prevent them from being sold to the general public, which strongly weighed in favor of finding that the Notes are not securities;
- the loan documents and marketing materials for the Notes used terms like “loan” and “lender” instead of terms like “investor,” leading a reasonable participant to believe they were participating in a lending transaction and not an investment, such that the “reasonable expectations of the investing public” factor weighed in favor of finding that the Notes are not securities; and
- the sale of syndicated loan participations was subject to interagency guidance and others measures taken by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve Board, such that the fourth factor also weighed in favor of finding that the Notes are not securities.
As for plaintiff’s common-law claims, the Court held that plaintiff failed to allege that defendants owed to plaintiff the duties necessary to plead claims for negligent misrepresentation and breach of fiduciary duty, including in light of the clear disclaimers in the governing contracts. In particular, the Court noted that under New York law, a claim for negligent misrepresentation requires, among other elements, that the parties stood in some “special relationship” imposing a duty of care on the defendant to render accurate information to theplaintiff. Plaintiff argued that a “special relationship” existed here because the alleged “investors were [purportedly] in privity with the [i]nitial [l]ender [d]efendants as assignees,” and defendants “were uniquely situated and possessed special knowledge” about the Company. Among other things, plaintiff claimed that defendants had knowledge superior to that of the buyers regarding the facts surrounding the DOJ investigation because of their alleged “unique access,” including to the Company’s general counsel. The Court noted that the complaint, however, did not contain factual allegations demonstrating that defendants used this “unique access” to induce purchase of the Notes. Further, the Court went on to find that plaintiff could not overcome disclaimers in the underlying agreements that were “fatal to its negligent misrepresentation claim” insofar as they provided that the administrative agent had no “duty or responsibility to provide any [l]ender with any credit or other information” and that each lender represented that it would not rely upon the administrative agent and would make its own credit analysis. The Court also concluded that the breach of contract claim was not adequately pleaded because plaintiff based it on alleged duties which either did not exist in the contract or were not triggered in this case. The Court also held that plaintiff’s good faith and fair dealing claim was unmoored from a specific provision in the contract and duplicative of its breach of contract claims and therefore must be dismissed.
In sum, in a closely watched case, the Court squarely rejected plaintiff’s attempt to recharacterize the TLB transaction structure as a sale of securities subject to the securities laws and reaffirmed the arm’s-length nature of the arranger’s role in rejecting plaintiff’s negligent misrepresentation claim.