February 24, 2021

US District Court for Southern District of NY Confirms Leveraged Loans Are Not Securities






Federal and state securities laws generally apply only to instruments that fall under the definition of “security” within the meaning of Federal securities laws (and states’ “blue-sky” laws which generally refer to the definitions in the Federal securities laws). Whether a particular instrument is a “security” therefore generally determines whether that instrument may be, among other things, subject to disclosure requirements in connection with the issuance thereof and whether issuers and underwriters may be subject to liability under securities laws based on inadequate disclosure[1]. Consequently, the classification has important consequences for the way in which an instrument may be issued and traded.

In the syndicated term loan market, the general consensus is that syndicated term loans are not securities. However, despite the significant growth of the syndicated term loan market in the U.S. over the last decades, courts have rarely had to weigh in on whether syndicated term loans qualify as “securities.” In the 1990 case Reves v. Ernst & Young[2], which concerned the question whether certain promissory notes issued by a farmers’ cooperative qualified as “securities,” the Supreme Court devised a four-factor test (the so called “family resemblance test” or the “Reves test”) for determining whether loan notes qualify as securities. Two years later, in 1992, the Court of Appeals for the Second Circuit applied the Reves test in the case Banco Espanol de Credito v. Security Pacific National Bank[3] and found that certain syndicated loan participations were not securities. Notably, however, there is no appellate court case that has directly ruled on the question whether widely syndicated term loans of the type often seen in standard leveraged finance transactions are “securities.”

On May 22, 2020, in the closely followed Millennium Health case[4], the question was considered by the United States District Court for the Southern District of New York, which held that the syndicated term loans in question were not “securities.” The decision provided important clarity, and was met with a sigh of relief, from market participants.

This article summarizes the Millennium Health court’s decision and the guidance it offers for negotiating and documenting future syndicated term loan transactions.

Federal Statutory Definitions of ‘Security’

Federal securities laws define the term “security” broadly. Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”), defines “security” as follows: “The term ‘security’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, any put, call, straddle, option or privilege on any security, certificate of deposit or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a security or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of or warrant or right to subscribe to or purchase, any of the foregoing.”[5]

Section 3(a)(10) of the Securities Exchange Act of 1934 (the “Exchange Act”) contains an almost identical definition, except that the Exchange Act definition includes a proviso at the end thereof which expressly excludes notes with a maturity shorter than nine months.[6] This exception was intended to capture commercial paper. The scope of the Exchange Act is, however, not intended to be different than the Securities Act; the Securities Act exempts notes with a maturity of less than nine months under a separate exemption, see Section 3(a)(3) of the Securities Act.[7]

Although the main focus of this article is to examine whether the disclosure requirements of the Securities Act and the Exchange Act are applicable to syndicated term loans in light of the Millennium Health case, it should be noted that the Investment Company Act of 1940 (the “Investment Company Act”) and the Investment Advisers Act of 1940 (the “Investment Advisers Act”) contain definitions of “security,” which are relevant for determining such laws’ applicability. The definitions of “security” in the Investment Company Act is found in Section 2(a)(36) and in the Investment Advisers Act, the corresponding definition is found in Section 202(a)(18). On their faces, both definitions are virtually identical to those found in the Securities Act and the Exchange Act.[8] However, the lead-ins to the definitions in the Investment Company Act and Investment Advisers Act contain the caveat “unless the context otherwise requires.” In reliance on those lead-ins, the SEC has generally adopted the position that the term “security” under the Investment Company Act and Investment Advisers Act has a different meaning than in the Securities Act and the Exchange Act, and in several instances deemed certain financial assets to constitute “securities” even though they would not be considered “securities” under the Securities Act and the Exchange Act.[9] Therefore, the Millennium Health case is not immediately relevant in connection with a determination of whether a syndicated term loan is a “security” under the Investment Company Act.

Tests Developed in Prior Case Law

As seen above, the statutory definitions of “security” in the Securities Act and the Exchange Act do not provide a bright line test as to what is or is not a security. The U.S. Supreme Court and other courts have in various contexts created four different tests to determine whether a “security” is involved in a transaction: (1) the “investment contract” test from SEC v. W.J. Howey[10] and United Housing Foundation, Inc. v. Forman[11], (2) the “stock” test from Landreth Timber Co. v. Landreth[12], (3) the “family resemblance” test from Reves and (4) the “risk capital” test, which has been interpreted differently by various courts. The four tests are as follows:

  • The Howey-Forman, or “Investment Contract” Test: Under the test developed in Howey and Forman, a court considers the “economic realities underlying a transaction, and not the name appended thereto”[13] to determine whether an instrument is an “investment contract.” An “investment contract” is defined as “an investment of money in a common enterprise with profits to come solely from the efforts of others.”[14] Under the four-part Howey-Forman test, a court considers whether: (1) there was an investment of money or other value[15]; (2) such investment was made in a “common enterprise”[16]; (3) the goal of the investment was to recognize a profit, gain or other financial return[17]; and (4) the success of the investment depended upon the managerial and entrepreneurial efforts of others.[18]
  • The Landreth, or “Stock,” Test: Under the Landreth test, a court considers whether an instrument which is called “stock” has the characteristics normally associated with stock: (1) the right to receive dividends contingent upon an apportionment of profits, (2) negotiability, (3) the ability to be pledged or hypothecated, (4) the conferring of voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value.”[19]
  • The Reves, or “Family Resemblance,” Test: Under Reves, a court presumes that an instrument called a “note” is a security, which presumption is rebuttable by showing that either the instrument is in a category found by the Supreme Court not to be a security or that it bears a “family resemblance”[20] to such category.
  • The “Risk Capital” Test: Under the “Risk Capital” test, which was developed on the lower court level, a court inquires as to whether an investor has contributed risk capital to a venture subject to the entrepreneurial or managerial efforts of others. This test does not require a horizontal common enterprise, the receipt of nonpecuniary benefits is sufficient for “profits,” and the “efforts of others” prong of Howey-Forman is relaxed.

These tests were developed in cases which concerned different types of financial assets. The Howey-Forman case concerned an offering of land contracts relating to units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor. The Landreth case concerned common stock in a lumber business. The Reves case arose in the context of promissory notes, payable on demand, which were sold to members of an agricultural cooperative. In determining which of the various tests developed that is relevant in the context of a particular type of financial asset, one has to look at which test is appropriate of the type of asset in question. In the Reves case, the Supreme Court stated that “[t]he application of the [Howey-Forman] test to notes is rejected, since to hold that a “note” is not a “security” unless it meets a test designed for an entirely different variety of instrument would make the 1933 Securities Act’s and the 1934 Act’s enumeration of many types of instruments superfluous and would be inconsistent with Congress’ intent in enacting the laws.” The Supreme Court went on to develop the Reves test (discussed further below) as the most relevant test to apply in the context of loan notes.

The Millennium Health Case

The Millennium Health case arose out of a $1.775 billion syndicated term loan B transaction arranged by four banks and in which several banks and other financial institutions acted as lenders to Millennium Laboratories LLC (“Millennium”), a California-based urine drug testing company. The transaction closed in April 2014. Shortly thereafter, Millennium lost a significant litigation involving alleged kickbacks and entered into a settlement with the U.S. Department of Justice to resolve alleged violations of the False Claims Act. Nineteen months after the transaction closed, Millennium filed for bankruptcy, in which the bankruptcy trustee filed a lawsuit against the arrangers claiming that they had, among other things, violated state blue-sky laws by making misrepresentations to the lenders, including allegedly falsely assuring the lenders that Millennium had no exposure to material litigation.

The defendants moved to dismiss the complaint for failure to state a claim, arguing that syndicated bank loan notes are not “securities” and syndications of such notes are not “securities distributions.”

In determining whether the loans were “securities,” the Millennium Health court applied the analytical steps set out in the Reves case, which begin with the presumption that every loan note is a security, since the Federal securities laws define the term “security” to include, among other things, “any note.” A plain reading of the definition of “security” could render the interpretation that literally every loan note instrument is a “security.” However, in the Reves case, the Supreme Court instructed that that is not the case. The Supreme Court noted that Congress’ fundamental purpose of enacting securities laws was “to eliminate serious abuses in a largely unregulated securities market,”[21] and that there is a virtually limitless scope of human ingenuity, especially in the creation of “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”[22] The Supreme Court continued to note that, on the other hand, Congress had not “intend[ed] to provide a broad Federal remedy for all fraud.”[23] Therefore, Congress painted with a broad brush when defining the term “security” to include any type of investment in whatever form they are made and by whatever name they are called, but left it up to the Securities and Exchange Commission (the “SEC”) and the courts to ultimately define the finer boundaries of the area regulated by securities laws. The Reves court went on to explain that even though, on the face of the definition of the term “security,” it would seem that any instrument called a “note” would be a “security,” there are certain notes which the parties thereto would not expect to be covered by securities laws. Therefore, the words “any note” in the definition of “security” should not be interpreted as meaning literally any instrument called a note.

The Reves court went on to go through a body of case law which had deemed certain types of notes to have such characteristics that they should in no event be considered “securities.” These include notes delivered in consumer financing, notes secured by a mortgage on a home, short-term notes secured by a lien on a small business or some of its assets, notes evidencing a “character” loan to a bank customer, short term notes secured by an assignment of accounts receivable, notes 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.[24]

However, the Reves court continued, it is not sufficient to simply design a list of enumerated exceptions from the presumption that every note is a security. Instead, the Reves court stated that one must look at the specific characteristics of a particular note to determine whether it is sufficiently similar to one of the enumerated types of notes to warrant being excepted from the “security” definition and, if the note is not similar to one of the enumerated types of notes, whether the characteristics of the note in question warrants a new category of exempted notes. These four factors of the family resemblance test are the following:

Motivations of the Parties

The first factor is “the motivations that would prompt a reasonable seller and buyer to enter into [the transaction].” The Reves court expressed the relevant dichotomy here as follows: “If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security.’ If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a ‘security.’”[25]

Applying the first factor to Millennium’ loan, the court noted that the proceeds of the loans were used by Millennium to (i) refinance $304 million of existing bank debt, (ii) refinance $196 million of existing debt owed under certain debentures and (iii) pay an extraordinary dividend and bonuses to Millennium’s directors, officers and controlling shareholders in the aggregate amount of $1.27 billion. On one hand, the court characterized Millennium’s motivation behind these uses not as investments, but rather as “some other commercial purpose”—namely to repay existing debt and paying a dividend, which, based on the Supreme Court’s guidance in Reves, would indicate that the loans are not securities. On the other hand, the lenders’ purpose with making the loans was investment, which would indicate that the loans are securities. In light of these mixed motivations, the court found the first factor not to weigh heavily in any direction.

The Plan of Distribution

Under this factor, the court considered the “plan of distribution,” including whether the instruments are subject to “common trading for speculation or investment.”[26] The court noted that the Second Circuit had instructed in the Banco Espanol case that the determinative query in this factor is whether the restrictions on distribution of the note “worked to prevent the loan participations from being sold to the general public.”

Millennium’s loans had been sold to a few hundred investors with a minimum initial allotment of $1 million. No assignments were permitted to natural persons or any other person (except affiliates and related funds) without the consent of Millennium.

The court agreed with the defendants that the group of investors in the transaction was a relatively small number compared to the general public and that only institutional and corporate entities were solicited. The court also stated that the fact that secondary trading of the loans began immediately did not significantly broaden the total investor group. Therefore, the court concluded that the second factor weighed strongly in favor of finding that the loans were not securities.

The Reasonable Expectations of the Investing Public

Under this factor, the court found it significant that in the marketing materials for the loans, as well as the credit agreement itself, the loan notes were consistently referred to as “loans” and the documents referred to as “loan documents,” and the investors consistently referred to as “lenders.” The court rejected as unpersuasive the argument that the inclusion of provisions in the marketing materials and credit agreement relating to “non-public information” demonstrated that the loans were securities, as well as market commentary that syndicated term loans have increasingly included terms that were historically found in high-yield bonds. Rather, the court pointed to the absence of precedent for the holding that a syndicated term loan is a “security” and concluded that the reasonable expectations of the investing public weighed in favor of the finding that the loan notes were not securities.

The Existence of Another Regulatory Scheme to Reduce the Risk of the Loan Notes

Under this factor, the court considered whether loans are subject to some circumstance which reduces the risk of the notes, such as the existence of a separate regulatory scheme, that would render the application of securities laws unnecessary. The court found that although the primary focus of Federal banking regulators (namely, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board) is “presumably the safety and soundness of banks, rather than the protection of note holders,” the policy guidelines of the Comptroller of the Currency for the sale of loan participations to sophisticated purchasers distinguishes the syndicated loan market from one that is unregulated, and concluded that this factor weights in favor of loans not being treated as securities.

Although not mentioned in the Millennium Health case, it should be noted that the Reves decision included a prong in this factor to look for other risk-reducing circumstances, such as whether the notes are insured or collateralized, that may weigh in favor of finding that the notes are not securities.[27]

 In conclusion, the Millennium Health court found that the first factor did not weigh heavily in either direction, and the second, third and fourth Reves factors weighed in favor of finding the loan notes analogous to notes evidencing “loans issued by banks for commercial purposes.” Accordingly, the court held that the presumption that the loan notes were securities was overcome.

The complaint was dismissed but the plaintiff was granted leave to seek to amend certain of its claims. The plaintiff has since submitted a motion to file a proposed amended complaint asserting common law fraud claims, as well as aiding and abetting fraud, conspiracy to commit fraud and negligent misrepresentation. The motion was referred to the magistrate judge who issued a report and recommendation in December 2020 recommending that the motion be denied. As of the date of publication of this article, no decision has been issued regarding the plaintiff’s motion.

Practical Lessons From the Millennium Health Case

Although the ruling in the Millennium Health case was based on a fact sensitive analysis (and is subject to appeal and, as a trial court opinion, is not controlling precedent in other courts), it provided certain guidance for marketing, negotiating and documenting a syndicated term loan deal:

  • Avoid Solicitation of the General Public: As part of the analysis of the second Reves factor (plan of distribution), the court cited the Banco Espanol opinion, which noted that restrictions on the distribution of the notes there in question “worked to prevent the loan participations from being sold to the general public.”[28] In the Millennium Health case, a few hundred investment managers had been solicited, but the court noted that this number constituted a relatively small number compared to the general public.
  • Assignment and Participation Restrictions and Consent Rights of the Borrower: As part of the analysis of the second Reves factor (plan of distribution), the court noted as significant the various assignment restrictions in the credit agreement. The Second Circuit reasoned similarly in the Banco Espanol case, noting that the loan participations there in question could not be resold without the consent of the agent, which weighed in favor deeming the participations not to be securities. Therefore, provisions in future credit agreements helpful to the loan vs. security analysis include consent rights of the borrower and/or the agent and prohibitions against assignments and participations to natural persons. Generally, the more restrictive the transfer restrictions, the more helpful to the second Reves factor analysis (though this factor alone would in no way be dispositive of a finding that a note is a security). Notably, the Millennium Health court deemed it acceptable to include exemptions to the borrower’s consent right for assignments and participations to affiliates and related funds.
  • Minimum Assignment and Participation Amounts: As part of its analysis of the second Reves factor (plan of distribution), the court noted that the minimum assignment and participation amount, which in the Millennium Health case was $1 million, while small in comparison to the size of the deal, was a high absolute number that would only allow sophisticated investors to participate. In this context, the court noted this did not change because certain affiliates of the lenders received sub-allocations in smaller amounts (in the order of hundreds of thousands of dollars). Therefore, in future syndicated loan transactions, it may be helpful to the second Reves factor analysis to include high minimum assignment and participation amounts.
  • Loan Documentation Terminology: Under the third Reves factor (the reasonable expectations of the investing public), the Millennium Health court noted that a factor weighing in favor of finding the loans not to be “securities” was that both in the loan documentation and the marketing materials the terminology used consistently referred to “loans,” “lenders,” “loan documents,” etc. In doing so, the Millennium Health court cited the Banco Espanol case in which the Court of Appeals for the Second Circuit noted that by signing the participation agreement which referred to the instruments as loan participations, those “institutions were given ample notice that the instruments were participations in loans and not investments in a business enterprise.”[29] Therefore, when drafting loan documentation and marketing materials, it is helpful for the third Reves factor analysis to consistently (and indeed correctly) use terms that refer to the parties as borrowers and lenders, and the instruments as loans (as opposed to for example calling the lenders “investors” and the instruments “investments”), in order to put both parties on notice that the intention is for the instruments to be loans and not securities.
  • High-Yield Type Provisions: It is also worth noting items mentioned in the Millennium Health case that were not in themselves determinative for the classification of the loans. The Millennium Health court rejected the plaintiff’s argument that the fact that the loan documentation included certain terms that have traditionally been seen in high-yield bond deals was to weigh in favor of finding that the loans were securities. This means that when drafting syndicated loan agreements, concepts from high-yield bond indentures may generally be included without increasing the risk of the loans being deemed to be “securities.” However, it is likely advisable to exercise caution in marketing materials by refraining from comparing returns on loan participations to those of traditional securities such as bonds.
  • Use of Non-Public Information: The court also noted that the plaintiff had argued that the notes should be deemed to be “securities” because the marketing materials distributed to lenders (primarily in the form of a confidential information memorandum (a “CIM”)) contained certain non-public information. The court rejected this argument. On the contrary, the court noted that one characteristic which differentiates the loan marketing process from marketing of instruments that are traditionally viewed as securities, is the use of non-public information to evaluate the creditworthiness of the borrower.
  • Information Covenants and Lender Due Diligence: A point of guidance related to the item immediately above regarding non-public information is that the marketing process and loan documentation should include undertakings of the borrower to provide financial information to enable lenders to perform due diligence and monitor the borrower’s creditworthiness. The loan documentation should also include representations by the lenders to the effect that they have had sufficient access to information to make its own credit decision and that they have done so, and that the lenders have not relied on the arrangers to evaluate the loans.

To conclude, the syndicated term loan market has grown and evolved significantly during the last decades and is continuing to do so. It may be that we have not heard the final word on the question of whether securities laws will or should apply to syndicated term loans. Further developments in the Millennium Health case on a possible appeal, and otherwise on the topic, should be followed closely.


[1]A reclassification of syndicated loans as securities could also have other effects. As an example, collateralized loan obligations (CLOs) – investment vehicles which own approximately 60% of all syndicated loans – supply much of the funding for the syndicated loan market.Banks are one of the largest groups of buyers of the highest-rated debt issued by CLOs, accounting for 25% of CLOsʼ AAA-rated notes, making banks a critical funding source for the CLO market.Banks are subject to the Volcker Ruleʼs prohibition on investments in “covered funds.” Many CLOs rely on the “loan securitization exemption” to avoid “covered fund” status.However, this exemption would not be available if the loans held by a possible covered fund constituted securities.For purposes of the Volcker Rule, the term “security” references the definition contained in the Exchange Act.[2]Reves v. Ernst & Young, 494 U.S. 56 (1990).
[3]Banco Espanol de Credito v. Sec. Pac. Nat’l Bank, 973 F.2d 51 (2d Cir. 1992).
[4]Kirschner v. JPMorgan Chase Bank, No. 17 Civ. 6334 (S.D.N.Y.) (the “Millennium Health” case).
[5]15 U.S.C. § 77b(a)(1).
[6]15 U.S.C. § 78c(a)(10).
[7]15 U.S.C. § 77c(a)(3).
[8]15 U.S.C. § 80a-2(a)(36).
[9]In various no-action letters, the SEC has the following financial assets are securities even though they would not necessarily be securities under the Securities Act and the Exchange Act:

  • Certificates of deposit (Merrill Lynch, Pierce, Fenner & Smith Inc., SEC No-Action Letter, 1982 WL 30517 (Oct. 28, 1982)).
  • Inter-company loans (CCBP Int’l, Inc., SEC No-Action Letter, 1987 WL 108783 (Dec. 1, 1987)).
  • Promissory notes evidencing commercial or consumer transactions (Bank of America Canada, SEC No-Action Letter, 1983 WL 29858 (July 25, 1983), Harrell Int’l, Inc., SEC No-Action Letter, 1989 WL 246259 (May 24, 1989), and World Evangelical Dev., Ltd., SEC No-Action Letter, 1979 WL 13621 (Apr. 5, 1979)).
  • In certain limited circumstances, general partnership interests in a limited partnership that give the general partner the management rights (typically, such general partnership interests will in most cases not be treated as securities for purposes of the Investment Company Act, consistent with their treatment under the Securities Act and Exchange Act, but “if a person designated as a ‘general partner’ is really a passive investor who depends substantially upon the managerial efforts of others” then such interests might be considered to be securities (Great Am. Mgmt. & Inv., Inc., SEC No-Action Letter, 1982 WL 29802 (Sept. 27, 1982)).

[10] SEC v. W.J. Howey Co., 28 U.S. 293 (1946) (sale of interests in orange groves, coupled with service contract, held to be security).
[11] United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (investment in cooperative housing motivated by finding housing, not profit, held not security).
[12] Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).
[13] Forman, 421 U.S. at 849.
[14] W.J. Howey Co., 328 U.S. at 301.
[15] The investor must give up “some tangible and definable consideration in return for an interest that [has] substantially the characteristics of a security.” Int’l Brotherhood of Teamsters, Chauffeurs, Warehousemen & Helpers of Am., 439 U.S. 551, 560 (1979).
[16] The Supreme Court has not clarified this element, however lower courts have approached it as applying to both “horizontal” (e.g., a pooling of investments or participation of other investors) or “vertical” (dependent upon the actions of the promoter) common enterprises. The key element is that the success or failure of the investment must require a joint effort by all of the investors or the successful efforts of the promoter (i.e., the investor depends on a third party or parties).
[17] The Supreme Court has defined “profit” under the Howey test to mean “either ‘capital appreciation’ or ‘a participation in earnings.’” Reves, 494 U.S. at 68 n.4.
[18] The lower courts have developed various interpretations of “efforts of others.” A key factor in courts’ analyses has been the level of involvement permitted to investors in the management of the investment venture.
[19] Landreth, 471 U.S. at 687.
[20] Reves, 494 U.S. at 64-67.
[21] Forman, 421 U.S. at 849.
[22] W.J. Howey Co., 328 U.S. at 299.
[23] Marine Bank v. Weaver, 455 U.S. 551, 556 (1982).
[24] Reves, 494 U.S. at 65.
[25] Id. at 66.
[26] Id.
[27] Id. at 67.
[28] Banco Espanol, 973 F.2d at 55.
[29] Banco Espanol, 973 F.2d at 55.


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