The MSRB has published Notice 2011-52 (the “Notice”) to alert municipal securities market participants of the MSRB’s view that, under existing legal principles, certain financings that are called bank loans may, in fact, be municipal securities. The MSRB cautions that parties that play a role in such financings without determining whether the bank loans are municipal securities may violate MSRB rules, as well as other federal securities laws.
In publishing the Notice, the MSRB noted that it is aware that many state and local governments have turned to private placements of their municipal securities with banks (sometimes referred to as “direct purchases”) and bank loans as an alternative to public offerings of municipal securities, either due to pending expirations of letters of credit and standby bond purchase agreements providing liquidity for variable rate demand obligations (“VRDOs”) or to take the place of temporary cash flow borrowings previously accomplished with revenue anticipation notes (“RANs”). As discussed further below, if a loan transaction involving a state or local government does involve a security, then the whole panoply of MSRB rules may apply to the transaction and its participants. The Notice is intended to provide guidance regarding the potential applicability of MSRB rules or other federal securities laws in these contexts.
The MSRB encourages dealers and municipal advisors that play a role in bank financings evidenced by notes to consult with counsel about whether the financings are securities or loans. The fact that a bank financing is called a “loan” is not necessarily dispositive of whether the financing is a loan or a security.
Analysis of “Bank Loans” Under Reves
The Notice explains that when banks make “loans” to state and local governments, even if only to provide a source of funds for governments to purchase their own securities, whether such “loans” will be considered securities can be a difficult question.
The applicable standard for determining whether a “note” is a security is the test set forth in Reves v. Ernst & Young, Inc., 494 U.S. 56 (1990). As set forth in Reves, the question of whether a “note” is a security is determined under a four-part test of whether the note bears a “family resemblance” to loans which the court identified as non-securities in Reves, which include notes delivered in a consumer financing, notes secured by a mortgage on a home, short-term notes secured by a lien on a small business or its assets, notes formalizing open account debts incurred in the ordinary course of business, and notes evidencing loans from commercial banks for ordinary operations.
The Reves test is comprised of the following factors.
Application of the Reves Factors to Bank Loans
The MSRB apparently believes that, based on application of the Reves test, many bank financings may involve securities, although the MSRB acknowledges that the result for different bank financings may be different depending on the facts and circumstances in each case. The MSRB also observes that, while Reves is the leading case on whether a note is a loan or a security, other court decisions and SEC guidance have also addressed the question.
In light of the MSRB’s identification of loans as an area of concern, the MSRB recommends that parties involved in bank loan transactions involving a state or local government seek advice from counsel in determining whether the loan should be considered a municipal security.
If a broker-dealer serves as a placement agent for a “direct purchase” by a bank of municipal securities or as a placement agent for a “bank loan” that is, in fact, a municipal security, then the broker-dealer is subject to all MSRB rules, as well as other federal securities laws. Such a primary offering must be reported to the MSRB under Rule G-32 even though the rule does not require that copies of private placement memoranda be delivered to the MSRB.
The Notice also identifies other MSRB rules that might apply to a broker-dealer placing a bank financing that is a municipal security. These are: Rule A-13 (requiring broker-dealers to pay assessments on underwriting and placements of municipal securities); Rule G-3 (requiring persons engaged in municipal securities activities to pass qualifying examinations); Rule G-14 (requiring broker-dealers to report purchases and sales of municipal securities); Rule G-17 (imposing a duty of fair dealing on broker-dealers and municipal advisors in the conduct of their municipal securities and municipal advisory activities); Rule G-34 (requiring broker-dealers to obtain CUSIP numbers for municipal securities); and Rule G-37 (banning broker-dealers from engaging in municipal securities businesses for two years following non-de minimis political contributions to certain “issuer officials.”) If a municipal advisor that advises a state or local government issuer on whether to enter into a “bank loan” that is, in fact, a municipal security, then the municipal advisor would be subject to the MSRB’s rules concerning municipal advisors, including a fiduciary duty to act in the issuer’s best interests.
When Are Bank Loans Securities?
Despite the words of caution from the MSRB in the Notice, we believe few bank loans to state and local governments should be considered securities under the Reves test. Rather, we think the majority of bank loans to municipalities bear a family resemblance to loans which the Reves court identifies as non-securities. Our view is based on the following factors. Most significantly, both state-chartered and national banks are subject to supervision by federal bank regulators. Consequently, (in contrast to the unregulated notes at issue in Reves) the banks that make loans to state and local governments are fully subject to an adequate alternative regulatory scheme, so bank loans to these governments will not escape regulation. Second, although the MSRB cautions that titling a transaction as a “loan” is not determinative, surely the fact that parties intend the transaction to be treated as a loan argues against any kind of reasonable public expectation that the notes issued to the governments in those transactions are securities. Third, while some bank loans to state and local governments may be syndicated with other banks, they are not typically offered and sold in a way that creates “common trading for speculation or investment.” We believe that only the first of the four Reves factors will sometimes point in the direction of the note being a security, and even in that instance, many loans to state and local government do involve covering cash-flow difficulties or other purposes fully consistent with treatment as non-securities.
For the above reasons, it seems likely that many bank loans to state and local governments should not be deemed securities subject to MSRB regulation. That being said, clients involved in loan transactions with state and local governments would be well-advised to consult with counsel and to obtain legal opinions as suggested by the MSRB that those transactions do not involve securities.
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This article was originally published by Bingham McCutchen LLP.