MSRB: Watch out for 'loans' that are really municipal securities

By Angela McDaniels

Tacoma, Wash., Sept. 12 - The Municipal Securities Rulemaking Board issued a notice Monday to remind market participants that private placements or direct purchases of municipal securities are subject to MSRB rules and to alert them that some financings that are called "bank loans" may in fact be municipal securities.

MSRB said that "when banks make 'loans' to state and local governments, even if only to provide a source of funds for those governments to purchase their own securities, whether such 'loans' will be considered municipal securities can be a difficult question."

Many loans are evidenced by notes. MSRB said the U.S. Supreme Court case of Reves v. Ernst & Young, Inc. is the principal legal authority on the distinction between a note that is a security from one that is not. A note is presumed to be a security unless it is of a type specifically identified as a non-security.

Types of non-security notes 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, short-term notes evidenced by accounts receivable, notes evidencing "character" loans to bank customers, notes formalizing open account debts incurred in the ordinary course of business and notes evidencing loans from commercial banks for ordinary operations.

Four-part test

Reves established a four-part test to determine whether a note is a security. If a note fails the test, it is deemed a security. MSRB said the four factors of the test are:

• The motivations of the buyer and seller. The Supreme Court said the instrument is likely to be a "security" if the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate.

On the other hand, the note is less sensibly described as a "security" if it is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller's cash-flow difficulties or to advance some other commercial or consumer purpose;

• The plan of distribution. The Supreme Court said the question is whether the note is an instrument in which there is "common trading for speculation or investment";

• The reasonable expectations of the investing public. The Supreme Court said that it might consider instruments to be "securities" on the basis of public expectations; and

• The existence of an alternate regulatory regime that significantly reduces the risk of the instrument, thereby rendering application of the securities laws unnecessary.

MSRB said dealers and municipal advisers that play a role in bank financings evidenced by notes should consult with their counsel on whether the financings are securities or loans. "The consequences of failing to analyze such financings properly may be significant."

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