On September 12, 2011, the Municipal Securities Rulemaking Board (MSRB) released an advisory notice (MSRB Notice 2011-52) to municipal market participants concerning the potential applicability of federal securities laws to bank loans to state and local governments.
The MSRB has received a growing number of inquiries relating to the increasingly common direct purchase by banks of municipal securities and direct lending by banks to state and local governments, and the distinction between bank loans and municipal securities. This is the second MSRB notice addressing this sector of the municipal market in the past two months. MSRB Notice 2011-37 was issued on August 3, 2011.
In its most recent notice, the MSRB attempts to address the market uncertainty as to the applicability and ramifications of federal securities laws to transactions in which a bank loan, typically evidenced by a promissory note, may involve a municipal security.
The MSRB reminds banks and governments to consider legal precedent established by the U.S. Supreme Court in 1990 in Reves v. Ernst & Young, Inc. In Reves, the Supreme Court reiterated that the purpose of the federal securities laws is to regulate investments and held that a note is presumed to be a security, and that the presumption may be rebutted only by a showing that (i) the note falls within one of a short list of specific exceptions (notes evidencing consumer loans, mortgage loans, certain short-term, secured small business loans, short-term accounts receivable loans, and so-called “character” loans to bank customers, and notes which formalize an open-account debt incurred in the ordinary course of business) or (ii) the note bears a strong “family resemblance” to one of the specified exceptions. The four factors the Court considered in making a “family resemblance” analysis include:
- the motivations of the parties, including when the seller’s purpose is to raise capital and the buyer’s purpose is to earn a return on its investment
- the plan of distribution, if any, of the note to ascertain whether there is a common trading for speculation of the investing public
- the reasonable expectation of the investing public, even when an economic analysis of the transaction might suggest that the note is not a security in that circumstance
- whether there is an alternative regulatory regime that significantly reduces the risk of the note, thereby rendering application of the federal securities laws unnecessary
If a note issued by a state or local government to a bank is considered a municipal security, a number of important federal securities laws and MSRB regulations may be implicated, especially when a broker-dealer or municipal adviser is involved in a placement agency relationship with the issuer. Those regulations can include (i) an obligation to report primary offerings to the MSRB, (ii) potential obligations to undertake secondary market disclosures, and (iii) a host of potential broker-dealer regulatory requirements including qualifying examinations, payment of assessments, trade reporting, imposition of fair dealing standards, and prohibitions on non-de minimis political contributions to certain issuer officials.
The MSRB advises that application of the Reves standard may result in certain bank loans evidenced by notes being treated as securities, depending on the facts and circumstances of the transaction.