Millennium Health Trustee Says Syndicated Loans Are ‘Securities’; Defendants, LSTA Warn Case Could Throw Loan Market ‘Into Disarray’

Relevant Documents:
Complaint
Motion to Dismiss Memorandum
Trustee Response
Defendants Reply
LSTA/BPI Amicus Brief

The parties in the Millennium Health lender claim trustee’s action against the arrangers and agents of the debtors’ prepetition $1.775 billion syndicated loan have asked Judge Paul Gardephe of the U.S. District Court for the Southern District of New York to decide whether interests in a syndicated loan qualify as “securities” under state Blue Sky laws, which would require heightened information disclosures to loan syndicate participants. According to defendants JPMorgan and Citi, a final decision in favor of the trustee “could throw a multi-trillion dollar sector of the credit markets into disarray and rewrite decades of commercial law.”

The case presents a rare public airing of such claims since the trustee is suing as assignee - via the bankruptcy process - for the benefit of “consenting lenders” under the term loan, many of whom might individually oppose increased regulation of this market. A list of “participating lenders” and their managers and advisors is attached to the RSA including in the confirmation order. According to the trust agreement filed in December 2015, the trustee, Marc Kirschner, was originally overseen by a three-member trust advisory board. The trust’s latest quarterly report lists $11.6 million in assets after a $9 million distribution in March.

In agreeing with the defendants, the Loan Syndications and Trading Association, or LSTA, and the Bank Policy Institute assert in a joint amicus brief that “[d]eclaring syndicated term loans to be securities would upend the expectations of borrowers and lenders and wreak havoc” in the “vitally important” $1.2 trillion syndicated loan market, endangering “the flow of capital to American businesses.”

The trustee calls these “breathless policy arguments” both “fanciful” and “plainly overblown,” asserting that “market participants (including Defendants’ law firms) have openly acknowledged that the status of syndicated debt is less a settled expectation than an uneasy ‘assumption’ that ‘is not universally held’ and ‘not free from doubt.’”

Defendants assert that the matter was placed beyond doubt by the U.S. Court of Appeals for the Second Circuit in its 1992 Banco Espanol decision. In that case, the court of appeals held that a syndicated loan was not a security because only institutional and corporate entities were solicited and investors “were given ample notice that the instruments were participations in loans and not investments in a business enterprise.”

According to the trustee, “major shifts in the syndicated loan market” and “convergence with the high-yield bond market” since Banco Espanol justify revisiting the issue: “[W]hatever similarities early generations of syndicated bank loans once shared with traditional commercial lending, the Note offering [at issue in this case] mirrored a high yield bond issuance.” The trustee submits that the courts must act rather than wait for Congress due to “[t]he daunting politics in passing new securities legislation or regulation aimed at protecting investors in the rapidly growing and changing leveraged loan marketplace.”

The LSTA and BPI counter that “[w]hile the loan market has changed significantly since 1992, the Second Circuit’s reasoning in Banco Espanol applies equally to syndicated term loans like the one in this case, and should by itself resolve the question whether such loans are securities.”

The trustee also argues that from a procedural standpoint, the issue is not yet ripe and should be postponed until after discovery (as in Banco Espanol).

Both sides have requested that Judge Gardephe hear oral argument on the defendants’ motion to dismiss the trustee’s claims on these and other grounds, but the date for any such oral argument has yet to be scheduled.

Trustee’s Position

On Aug. 1, 2017, the trustee filed his complaint against two JPMorgan entities, two Citi entities, BMO Capital Markets, the Bank of Montreal, and two SunTrust entities asserting claims for, among other things, violations of California, Colorado, Illinois and Massachusetts securities laws. According to the complaint, during and after syndication of a $1.775 billion loan to laboratory services provider Millennium Health in 2014, defendants “misrepresented or omitted to state material facts in the offering materials they provided and communications they made to Investors concerning the legality of the Company's sales, marketing and billing practices and the known risks posed by a pending government investigation into the illegality of such practices.”

The trustee sues as assignee of “roughly 400 mutual funds, hedge funds, and other institutional investors” that acquired interests in the loan, which was used, the trustee alleges, to pay an “extraordinary dividend,” “pay off JP Morgan and lenders for past financing” and “provide them huge fees.” The trustee alleges that “[t]he sheer size of the $1.775 billion term loan amount (almost six times that in the 2012 Credit Agreement), the extraordinary dividend of $1.2 billion to the Insiders, and the fact that the Company itself would have no access to the funds advanced … all demanded heightened and lengthy scrutiny,” which defendants never intended to undertake.

According to the trustee, investors “did not discover Defendants' misconduct until a year after their investment, in May 2015, when Millennium informed them of a settlement in principle with the federal government and state Medicaid programs for $256 million.” Less than a month after finalizing that settlement, the trustee alleges, Millennium filed its prepackaged bankruptcy. In December 2015 the bankruptcy court confirmed the debtors’ prepackaged plan, which, among other things, established the lender claims trust.

In support of his securities law claims, the trustee asserts that the lenders’ “debt obligations” were “styled as ‘leveraged loans’” but in fact “have all the attributes of and, in fact, constituted credit agency-rated and tradeable debt ‘securities’ within the meaning of the Blue Sky laws of the offering State of California and the purchasing Investors' States.”

In a response to the defendants’ motions to dismiss, the trustee contends that “there is no doubt that the Defendants-sellers did not intend to engage in commercial lending since they eliminated their exposure under the prior credit facility, held none of the new financing, arranged for the credit ratings and sale of the Notes with investors, and supported a secondary market that emulated an over-the-counter securities market.”

The trustee’s argument follows the four factors courts generally apply in determining whether debt obligations are securities:
 

• The motivations of buyer and seller;
   
• The plan of distribution;
   
• The reasonable expectations of the investing public; and
   
• The absence of an alternative regulatory regime to protect investors.

According to the trustee, all four factors weigh in favor of characterizing interests in the Millennium term loan as securities. With respect to motivation, the trustee argues that “there is no doubt that the Defendants-sellers did not intend to engage in commercial lending since they eliminated their exposure under the prior credit facility, held none of the new financing, arranged for the credit ratings and sale of the Notes with investors, and supported a secondary market that emulated an over-the-counter securities market.” In support, the trustee cites emails between defendants and Millennium executives “about how the Notes were performing in secondary trading and what that trading indicated as to whether Millennium could have raised even more money” and notes that JPMorgan “assigned to Millennium an analyst who normally covered high-yield debt securities.”

With respect to distribution, the trustee focuses on the secondary market for syndicated loan interests. “The initial investors could engage in secondary trading either by outright sale of the Notes (‘assignment’) or by retaining title, but allowing the third party to share in interest and principal payments (‘participation’).” The trustee points out that “[n]o consent was required from Millennium, or JPMNA as agent, for a trade of a participation and only a limited, ‘negative’ consent was required for certain assignments.” Further, the trustee asserts that “[d]istribution was also dependent on obtaining ratings from rating agencies, just as in high-yield security issuances,” and cites the “extremely low” $1 million minimum investment, which “promoted a wider distribution.”

With respect to investor expectations, the trustee submits language regarding the handling of material nonpublic information in accordance with “Federal and state securities laws” as evidence that the parties reasonably expected the loan interests to qualify as securities. “Unless the parties anticipated that the Notes could be deemed ‘securities,’” the trustee says, “there was no need to define MNPI in a way that captured information material to trading in the Millennium Notes under the state and Federal securities laws.”

Finally, according to the trustee, there is no alternative “regulatory scheme” that “significantly reduces the risk of the instrument, thereby rendering application of the securities laws unnecessary.” The trustee argues that joint interagency guidance on leveraged lending, policy guidelines and the Shared National Credits Program “all address risk management controls to ensure sound banking practices and minimize risks to banks, not risks to non-bank investors in debt instruments due to conduct by the banks and others in the offering of such instruments.”

The trustee notes that “[r]ecently, legislators have called for more regulation especially in the investor-protection area,” quoting Sen. Elizabeth Warren: “[T]he large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market. ... Many of the loans are securitized and sold to investors ... allowing the loan originators to pass the risk of poor underwriting on to investors.”

The trustee calls Banco Espanol a “nearly 30-year old decision” that “predates the major shifts in the syndicated loan market and its convergence with the high-yield bond market,” “addressed materially different instruments, terms, and distribution from the Millennium Notes,” and “anticipated that in future cases ‘even if an underlying instrument is not a security, the manner in which participations in that instrument are used, pooled or marketed might establish that such participations are securities.’”

As a procedural point, the trustee contends that the loans/securities issue need not be decided on a motion to dismiss but should be pushed until after discovery, calling the issue a “fact-intensive” matter not appropriately resolved at the dismissal stage. The trustee points out that the decision in Banco Espanol “affirmed a post-discovery grant of summary judgment” rather than a dismissal order.

Defendants’ Position

JPM and Citi have filed a motion to dismiss, among others, the trustee’s securities law claims (which other defendants joined), arguing that the Millennium syndicated loan interests were not “securities” under state law. JPM and Citi call the premise of the trustee’s complaint “as simple as it is flawed: in the wake of Millennium’s bankruptcy, the sophisticated entities that lent Millennium money now try to classify the loan as a ‘security’ and the loan syndication as a ‘securities distribution’ in an attempt to manufacture a securities fraud claim where none is viable.”

The defendants agree with the trustee on the four factors the court should consider but disagree on their application to this case. According to defendants, the loan interests do not qualify as securities because the “Lenders sought a return on their capital through contractually-specified interest payments secured by collateral,” “members of the general public were not solicited and did not participate in the loan syndication,” and the “Term Loan was an industry-standard transaction in a multi-trillion dollar per year market accessible only to sophisticated institutional lenders.”

Further, defendants contend that the “governing documents made clear to the parties that they were participating in a lending transaction, not investing in securities,” and that the presence of a “robust regulatory framework” (including OCC, FDIC and Federal Reserve guidance and the Shared National Credits Program) “militates against duplicative regulation under the securities laws.”

The defendants suggest that “[a]ccepting plaintiff’s theory not only would ignore the terms of the parties’ agreements, upend the parties’ and the market’s settled expectations, and be contrary to well-established law, it also could throw a multi-trillion dollar sector of the credit markets into disarray and rewrite decades of commercial law.”

“That two prominent industry organizations - the LSTA and BPI - agree that the Term Loan is not a security and took the time to submit a brief on the issue only underscores the point,” defendants assert.

LSTA/BPI Amicus Brief

According to the LSTA and BPI, “While the loan market has changed significantly since 1992, the Second Circuit’s reasoning in Banco Espanol applies equally to syndicated term loans like the one in this case, and should by itself resolve the question whether such loans are securities.” The amici point out several distinctions between syndicated loan interests and securities:
 

• “[T]he members of a loan syndicate are lenders: Each member has its own direct contractual lending relationship with the borrower”;
   
• “[S]yndicated term loans are not marketed to the public. Rather, the participants in a loan syndicate are sophisticated institutions that are charged with conducting their own due diligence and agree by contract to do so”;
   
• “[I]n contrast to investors in securities, participants in a syndicate may rely on confidential information - which sometimes includes material non-public information under the securities laws - in deciding whether to lend”;
   
• “Syndicated term loans are typically secured by a senior lien on the borrower’s assets; bonds are much less likely to be secured”; and
   
• “Because syndicated term loans involve a smaller group of lenders (and any particular lender can be vetoed by the borrower), their terms and conditions are more easily amended than the terms of a bond indenture.”

The LSTA and BPI point out another major distinction: “[T]he most important lenders in the syndicated term loan market - collateralized loan obligations (‘CLOs’), which provide about 60% of the capital for such loans - cannot as a practical matter buy securities, due to regulations that have been interpreted to bar banks from owning interests in CLOs for investment purposes where the CLO holds securities.”

“The heightened disclosure regime applicable to securities, intended to correct [an] informational disadvantage, is unnecessary,” the amici summarize, “in a market where the ‘investors’ are sophisticated institutions that decide based on their own due diligence, and often based on confidential information, to lend large sums of money to a particular borrower.”