Direct lending by banks has proliferated in the $3.7 trillion municipal bond market as states, local governments and non-profits find that they can borrow, in the form of direct loans, at interest rates comparable to those on bonds, with lower fees than public-debt offerings.

According to a recent joint regulatory notice from the Municipal Securities Rulemaking Board (MSRB) and the Financial Industry Regulatory Authority (FINRA), the proliferation of direct loans with banks raises two concerns: First, banks may not be conducting sufficient investigation and analysis of direct loans offered to state and local governments to determine whether an instrument is a loan or a security, and thus may not be "fully considering the applicability of the federal securities laws and the rules and regulations thereunder," to the transactions. As a result, the MSRB and FINRA joint notice warns, "a private placement of municipal debt with a single purchaser, including a bank, could be a security even if described as a bank loan."1

The second issue raised by the joint notice provides that "firms may be engaging in placements of these instruments without fully understanding the nature of their roles in the transactions, such as whether the firm is engaging in conduct that makes it a broker-dealer or municipal advisor."

Bank Loan or Security

According to the MSRB, the determination of whether an instrument is a bank loan or a security should be analyzed based on the principles set forth in the U.S. Supreme Court case Reves v. Ernst & Young, 494 U.S. 56, 73 (1990), which held that an instrument is presumptively a security unless it's specifically identified otherwise. In instances where the transaction is not explicitly deemed a loan, it may still be a loan if it bears a "strong family resemblance" to the non-security loans identified in the case.

In its determination of whether an instrument is a loan or a security, the Reves case set out a four-part test, which examines: (i) the motivations of the seller: if the seller's purpose is to raise money for the general use of the borrower or to finance substantial investments, than the instrument is likely to be a security; (ii) whether the instrument will be used for "common trading for speculation or investment"; (iii) the "reasonable expectations of the investing public": if the investing public considers the instrument a security, it will bear on the nature of the instrument; and (iv) whether some factor such as the "existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary." Therefore, as expressed in the joint notice, simply "labeling an alternative financing for a municipal entity a "loan," which is often evidenced as a loan, does not obviate the need to fully assess the particular facts and circumstances of the financing transaction."

In the joint notice, FINRA cited instances of financing arrangements that firms concluded are loans even though the Reves factors indicated otherwise. The joint notice cites as examples of this where, "the transaction documentation described the instruments as "bonds," or contained language consistent with bond offerings, such as: (i) references to "purchasers" or "sellers"; (ii) the debt instruments were to be sold in separate denominations; (iii) the purchasers made representations regarding their knowledge and experience in investments and willingness to take on risk; and (iv) the debt instruments could have been resold."