Traditional public municipal bond offerings have steadily declined over the past several years.1 Volume was down by as much as 32% in 2011 compared to 2010.2 At the same time, alternative financing methods, such as direct bank loans to municipalities, appear to have grown dramatically in popularity.3 The reduced availability of bond insurance and the increase in the number of distressed municipalities have drawn both greater scrutiny and enhanced regulation of the municipal bond market from the Securities & Exchange Commission (“SEC”) and the Municipal Securities Rulemaking Board (“MSRB”). At the same time, the rise of the direct loan market is occurring without widely accepted standardized documents and without a clear regulatory framework. Given that the municipal securities market exceeds $3 trillion and has a strong retail component, it should not be surprising that the SEC and the MSRB are increasingly wary of any regulatory gaps in the rapidly growing municipal bank loan space.4

This article seeks to contribute to the current dialogue by addressing the regulatory issues raised when a municipal financing is structured as a loan rather than a public bond offering, and to offer some thoughts on assessing and managing the risk that a loan transaction might at some later time be recharacterized as a security under the federal securities laws. We conclude that as long as a loan 1) is timely disclosed to public investors, 2) has limited transferability, 3) is only sold to sophisticated institutional lenders, 4) is made for a purpose that resembles traditional lending objectives, and 5) has documentation resembling loans more than securities, the loans should not be held to be securities. The large secondary market for commercial loans, which are not considered securities, provides a model for the emergence of a robust market for municipal loans that could thrive alongside traditional bond financing.  


Over the past 18 months, public municipal bond offerings have declined significantly,5 with issuers flocking to alternative financing methods, often referred to as private placements.6 The increase in direct bank loans is difficult to quantify because there is no obligation to report loans on EMMA.7 This lack of market transparency is a key concern of the MSRB and the SEC, as well as other stakeholders such as rating agencies and investors. Some commentators estimate that direct loans from banks may have increased by over 400% since 2009.8 Whatever the actual increase, it is indisputable that municipal loans will remain an important part of the municipal financing landscape for the foreseeable future, and the sometimes difficult issues associated with the product in the present regulatory framework must be addressed.

It is difficult to ascribe the growth in alternative municipal financing, including bank loans, to any one cause. The MSRB has noted that, “[i]n many cases, this shift is attributable to the pending expirations of letters of credit and standby bond purchase agreements providing liquidity for variable rate demand obligations (‘VRDOs’). In other cases, these private placements and bank loans have taken the place of temporary cash flow borrowings previously accomplished with revenue anticipation notes (‘RANs’).”9 Direct placements are also quicker, easier and cheaper to execute than public securities offerings – aside from the fees of financial advisors and placement agents, there are often no underwriting or rating agency expenses – and SEC Rule 15c2-12 includes certain exemptions to the requirement of a comprehensive disclosure document (although bank lenders will almost certainly require extensive initial documentation for due diligence purposes and continuing disclosure through the life of the financing).10 Direct placements are also more attractive to both banks and issuers in an era of bank downgrades (variable rate demand bonds and similar products are often structured with highly rated banks as credit and liquidity support providers).11 Some have also suggested that the trend, in part, has been sparked by health care issuers, who generally have had closer relationships with banks than do other municipal issuers.12

In the last nine months, the MSRB has issued three notices that highlight the regulatory uncertainty concerning the legal characterization of bank loans and other financing techniques. First, in August 2011, the MSRB warned financial advisors “to be aware that what are referred to as ‘bank loans’ may, depending on the specific terms and conditions, be placements of municipal securities.”13 In that notice, the MSRB stated that it planned to issue a notice to assist in distinguishing loans from securities and recommended that “financial advisors should consult with their counsel on whether any placements in which they are engaged are placements of loans or placements of securities.”14 Unfortunately, little guidance has been forthcoming and, as noted in the MSRB’s second notice issued in September 2011, such guidance might in fact be beyond the MSRB’s authority.15 In its second notice, the MSRB noted the growth in bank loans and the many inquiries it had fielded about the potential applicability of MSRB rules to these products. It cautioned that, if so-called “bank loans” are actually municipal securities, the parties thereto “may inadvertently violate MSRB rules, as well as other federal securities laws.”16 The MSRB acknowledged that it is difficult to distinguish between loans and securities and pointed to the multi-factor test established by the U.S. Supreme Court in Reves v. Ernst & Young, Inc., 494 U.S. 56 (1990), which we discuss in more detail below. In essence, the MSRB warned the market in the September 2011 notice that there is no “one size fits all” solution to the questions posed by the loan/security distinction and emphasized that the analysis is dependent on the facts and circumstances of individual transactions. The MSRB issued its third and most recent notice on April 3, 2012.17 In that notice, the MSRB encouraged state and local governmental issuers to voluntarily post information about their bank loan financings on EMMA in order to promote market transparency and efficiency.


In the event that a municipal loan is challenged and recharacterized as a security, the recharacterization will have material consequences for the parties to that transaction, including the potential for regulatory and civil liability. If a “loan” in fact turns out to be a security, then the federal securities laws and MSRB regulations apply.

This issue is particularly important for municipal financial advisors and placement agents. A financial advisor that participates in a municipal security transaction may, depending on the financial advisor’s role in the deal, be required to be registered as a broker-dealer with theSEC under the federal securities laws.18 In essence, there is great risk that financial advisors that solicit or negotiate with investors, or that participate in the structuring or execution of a transaction that the parties believe is a loan at the time of execution, but which later is determined to be a municipal security, will violate Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”) if they are not registered as a broker dealer with the SEC.19 Moreover, such a financial advisor could also unintentionally become a placement agent and be subject to a whole host of MSRB regulations.20

If a financial advisor becomes an inadvertent placement agent, then it is likely that MSRB Rule G-23 (which became effective on November 23, 2011) would be breached. MSRB Rule G-23 generally precludes financial advisors from becoming placement agents or participating in underwriting activities for issuances in which they have been serving as financial advisors.

In addition to MSRB Rule G-23, many other MSRB Rules apply to placement agents, such as: Rule A-13 (requiring broker-dealers to pay assessments on underwritings and placements of municipal securities); Rule G-3 (requiring broker-dealers 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 duty of fair dealing on broker-dealers in the conduct of municipal securities and municipal advisory activities); Rule G-32 (requiring submissions of official statements and related new issue information); Rule G-34 (requiring brokerdealers to obtain CUSIP numbers for municipal securities issues); and Rule G-37 (banning broker-dealers from engaging in municipal securities business for two years following non-de minimis political contributions to certain “issuer officials”).21 These placement agent requirements, such as the requirement of a placement agent to obtain a CUSIP number, often run contrary to a bank lender’s internal policies respecting the treatment of the financing and compromise a placement agent’s ability to discharge its regulatory obligations where the placement agent cannot conclude that the instrument is a loan.

Financial advisors and placement agents are not the only parties that will face negative consequences if a loan transaction is recharacterized. While issuers of municipal securities are largely insulated from the full rigor of the federal securities laws, such as registration and reporting requirements, they are still subject to the antifraud provisions.22 Notably in this regard, the SEC has recently signaled that it plans to step up into its enforcement activity in the municipal securities industry and perhaps target municipal officials.23 Likewise, lenders potentially face liability if they intend to directly or indirectly allow others to participate in the transaction. For example, if a lender receives a note from the issuer evidencing a “loan” and sells an interest in the debt, whether by participation or assignment, then there is a risk that, upon the loan being recharacterized as a security, the lender may be acting as a broker-dealer with underwriting liability. Additionally, a lender that is not a broker-dealer may face liability unexpectedly for not having registered as a broker-dealer with both SEC and a self-regulatory organization.


The question whether a particular instrument is a “security” is a difficult, context-sensitive question. Section 2(a)(1) of the Securities Act of 1933 defines the term “security” to include any “note . . . evidence of indebtedness . . . any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in . . . any of the foregoing.”24 Any instrument which appears on the list set forth in the statutory definition is presumptively a security “unless the context otherwise requires.”

This context-based approach to interpretation affords flexibility to deal with ever-evolving financial markets at the expense of certainty. In addition to the contextsensitive analysis required under the federal securities laws, in deciding “which of the myriad financial transactions in our society come within the coverage of these statutes . . . [the SEC and the courts] are not bound by legal formalisms, but instead take account of the economics of the transaction under investigation.”25

Two things are immediately apparent from the foregoing: (1) any indebtedness, such as a loan, that is evidenced by a note is presumptively a security; and (2) the mere absence of an instrument described as a “note” does not conclusively mean that the instrument is not a security. The answer will depend upon the specific facts and circumstances. It is common for loan transactions to utilize notes, and loans in the municipal financing space are no different. Additionally, given the extent to which direct bank loans have replaced municipal securities offerings, it seems reasonable to speculate that some of these new loan transactions might, in economic substance, be very similar to the securities offerings they have supplanted.


Under the Supreme Court’s decision in Reves, a note is a security unless it (1) falls within a limited category of notes that the courts have decided are not securities, or (2) bears a strong family resemblance to one of the enumerated notes.26 The four factors that constitute the

family resemblance test are as follows:

  • Whether the instrument is motivated by investment or commercial purposes;
  • The “plan of distribution” for the instrument;
  • The reasonable expectations of the public;
  • Whether an alternative regulatory scheme or other risk-reducing factor renders application of the securities laws unnecessary.  

To be sure, the Reves test has met sustained criticism. It has been described variously as “dysfunctional,” “muddy,”27 “unpredictable,” “confusing,” “jumbled,” and “haphazard.”28 It is also a test that seems particularly unsuited to the municipal financing industry. However, the Reves test is still controlling and, despite the widespread criticism it has attracted, it is unlikely to be replaced any time soon.  

The SEC could respond to the present regulatory flux by staking out a position that treats each of Reves’ four prongs as equally important in answering the question whether alternative municipal financings are actually securities. Such an approach, however, if adopted by the regulators, is unlikely to generate sufficient certainty for market participants or effectively serve important regulatory interests. Instead, we believe that a more nuanced and contextual analysis is best tailored to producing a more predictable analytical framework that is of the greatest benefit to all market participants.

Despite the family resemblance test’s many shortcomings, by paying close attention to the key concerns of the MSRB and SEC regarding alternative municipal financings, it is possible to identify those aspects of the test that are arguably more pertinent to the question of when a bank loan made to a municipality might be treated as a security. In the context of the municipal financing market, we believe the two most important Reves factors are (1) the plan of distribution, and (2) whether an alternative regulatory scheme or other risk-reducing factors renders the application of the securities laws unnecessary.

It is clear from the MSRB’s recent notices that the MSRB’s primary concern lies with the lack of transparency for bond investors if obligations, which may be pari passu with public bonds, are characterized as loans and therefore not disclosable on EMMA. In MSRB Notice 2011-52 issued on September 12, 2011, the MSRB reminded market participants that even the direct purchases of municipal securities required a certain level of disclosure to the market: “the reporting of the baseline Rule G-32 information for such transactions alerts investors in other securities of the issuer to the existence of issuer debt that might be on a parity with, or senior to, their own holdings.”29 In other words, the MSRB appears to be concerned that the characterization of municipal financings as “loans” rather than securities will result in even less transparency into municipalities’ financial condition and capital structure. The MSRB’s most recent notice on this topic, MSRB Notice 2012-18 issued on April 3, 2012, reinforces the MSRB’s view that dealers and advisors should err on the side of disclosure, especially where a direct placement, whether conducted by loan or private security placement, involves debt that is senior to, or pari passu with, an issuer’s public debt.30

The MSRB’s concerns on this issue match those of the rating agencies, who have also complained that current disclosure of direct bank placements is both too slow and often not detailed enough. As Fitch has written, “investors and rating agencies may be unaware of an issuer’s use of a [direct bank placement] until the release of audited financial statements. Even then, any information regarding the terms of the [direct bank placement] would be subject to the level of disclosure provided by the auditor.”31 There are, therefore, good arguments that the prompt voluntary disclosure on EMMA of all bank loans that rank at least pari passu with an issuer’s public debt would constitute a risk reducing factor that renders the application of the federal securities laws to municipal bank loans unnecessary. Although, it is outside the MSRB’s authority to impose such a requirement on municipal issuers, lenders could make disclosure a condition of the loan.32

Another important regulatory interest is the protection of relatively unsophisticated retail investors. If interests in a direct bank loan are distributed beyond highlyregulated commercial banks and other sophisticated financial institutions, the risk of the instrument being recharacterized as a security is likely to increase. So long as the economics of a municipal bank loan are restricted to well-regulated commercial banks or other sophisticated institutional investors33 (and the loans are appropriately disclosed as noted above), there is reduced justification for tacking on additional regulatory regimes such as the federal securities laws and MSRB regulations.  

Finally, while form rarely prevails over substance under the federal securities laws, the extent to which transaction documents more closely resemble loan documents than traditional securities will surely be considered by the regulators. The direct bank loan market has not yet reached a consensus on loan documentation. While calling something a “loan” is not dispositive, the form of the transaction should resemble a true loan as much as possible and not appear to be a hastily “rebadged” bond transaction. The transaction documents should include customary loan terms, such as covenants, acceleration clauses and information rights. Parties should, of course, be careful to account for the transaction as a loan on their books and records. Lending departments of commercial banks, rather than debt capital markets teams, should lead the transaction if possible. Lenders should be involved directly in negotiating individual terms, and be careful to not defer entirely to a placement agent.

While no one single factor is likely to be dispositive in the Reves analysis, and bearing in mind that notes are presumptively securities, we believe that loan characterizations are supportable if transactions are carefully documented and the key aspects of Reves are addressed as discussed above.


Except in a state where the constitution provides local government with home rule powers, municipalities are subject to what is known as “Dillon’s Rule” – a wellestablished legal principle that municipalities have only those powers expressly granted to them by state legislatures or that are necessarily or fairly implied in the express grant of power.34 A state that strictly construes Dillon’s Rule, or where home rule powers are limited, may make it difficult for a bond lawyer to conclude that a loan is authorized under state law. A prerequisite for the issuance of any public indebtedness is the grant of statutory or constitutional authority to incur debt. The corollary to this rule requires that the type of debt and the process for approval and issuance must also conform to state and local requirements. The effect of a failure to comply with those requirements could result in a finding of invalidity, an unwelcome result for any bondholder or bank.35 Previous IRS rulings have established that bonds that are invalid under state law because they fail to satisfy substantive or procedural requirements of state law may not be obligations of a political subdivision for purposes of Section 103 of the Internal Revenue Code, a condition to the tax-exempt treatment of bond interest. See William L. Gehrig, Fundamentals of Municipal Bond Law 11 (2004).

In every transaction where loan treatment is sought, counsel should review all relevant authorizing legislation, ordinances, and resolutions to be comfortable that the municipal issuer has the legal authority to raise debt through loans and, if such authority exists, that it has been invoked appropriately in the issuer’s resolutions. A future challenge to a direct loan as ultra vires could put the lender between the Scylla of holding an unenforceable loan and the Charybdis of being forced to argue that the ultra vires loan was really a duly authorized bond, despite the fact that the securities laws and MSRB regulations were ignored by the parties at the time of issuance.


The municipal direct loan market is in its infancy. For the market to grow and provide liquidity, lenders and others constituents should agree on suitable standard documentation that makes clear that the instruments are loans and not securities. That documentation should limit transferability to banks and other sophisticated financial institutions, and the documentation should require issuers to disclose the loans on EMMA.

Rebecca S. Lawerence of Piper Jaffray & Co contributed to this article.