Company A wants to borrow $1 billion and approaches Bank X. Bank X says sure, we’ll lend you $300 million ourselves and get the rest from other institutions. Bank X then approaches banks, insurance companies, and other lenders, raising the full $1 billion. Each lender holds a piece of the $1 billion loan, as if holding a separate promissory note. The pieces they hold are called “loan participation interests.”
The market for loan participation interests is gigantic and received a gigantic boost in 2023 when the Second Circuit Court of Appeals, in a case called Kirschner v. JP Morgan Chase Bank, N.A., decided that loan participation interests generally are not “securities” for purposes of the U.S. securities laws.
To illustrate why that matters, imagine that when Company A approached Bank X, Bank X formed a limited partnership, naming itself as general partner and offering limited partnership interests to the other banks, insurance companies, and other lenders. Those limited partnership interests (probably) are securities. And that means the other banks, insurance companies, and other lenders can sue Bank X for securities law violations, including violations of Rule 10b-5 (material misstatements or omissions).
The gigantic market for loan participation interests breathed a gigantic sigh of relief at the decision in Kirschner v. JP Morgan Chase Bank, N.A. Today, some entrepreneurs are taking the decision one step farther. Reading law firm blogs captioned “Loan Participation Interests Are Not Securities,” these entrepreneurs are offering loan participation interests to the public in Crowdfunding-like offerings, without bothering with securities laws. Unfortunately, this one step farther might be a step too far.
If we ignore the blog captions and look at the case itself, we see there is no bright-line rule. To determine whether the loan participation interests were securities, the court in Kirschner v. JP Morgan Chase Bank, N.A. relied on a case called Reves v. Ernst & Young, where the Supreme Court created a four-part test to determine whether a given loan participation interest (or promissory note generally) is a security. The decision balanced on the second test: the “plan of distribution,” meaning how and to whom the interests were sold. The court stated, “This factor weighs against determining that a [loan participation interests] is a security if there are limitations in place that ‘work to prevent the [loan participation interests] from being sold to the general public.’”
In the case before it, the court found that the loan participation interests were offered only to “sophisticated institutional entities.” Hence, the court concluded that “This allocation process was not a ‘broad-based, unrestricted sale to the general investing public.’” No sale to the general investing public, no security.
In the Crowdfunding-like offerings I’ve seen, loan participation interests are offered to “sophisticated investors.” No doubt they hope to fall within the “sophisticated” language of the Kirschner v. JP Morgan Chase Bank, N.A. decision. But the decision doesn’t say just “sophisticated.” It says, “sophisticated institutional entities.” In the jargon of Regulation D offerings, a doctor with two real estate investments is often referred to as “sophisticated,” but under Rule 506(b)(2)(ii), that just means she “has such knowledge and experience in financial and business matters that she is capable of evaluating the merits and risks of the prospective investment.” The doctor is a far cry from a “sophisticated institutional entity.”
For that matter, selling loan participation interests on a website accessible to everyone seems very close to a “sale to the general public,” exactly what the court in Kirschner v. JP Morgan Chase Bank, N.A. was watching out for.
The blog caption “Loan Participation Interests Are Not Securities” would have been more accurate saying “Loan Participation Interests Are Not Securities If Sold to Sophisticated Institutions” or even “Loan Participation Interests Are Securities Unless Sold to Sophisticated Institutions” or even “Alert: Loan Participation Interests Sold Through Crowdfunding Are Securities.”
Websites selling loan participation interests to the public – even to the “sophisticated” public – are taking great risks. By selling unregistered, non-exempt securities, they risk lawsuits from unhappy investors, both as a company and as individuals. They also risk enforcement actions by the SEC, actions that could leave the company and the individuals branded as “bad actors” for the next 10 years.
Questions? Let me know.
