SEC: California IOUs Are 'Securities’ Subject to Federal Law

WASHINGTON — The Securities and Exchange Commission late Thursday announced that the IOUs being issued by California are “securities” that are subject to the federal securities laws, a position that effectively overrules state officials' claims that the "registered warrants" are not securities but rather "negotiable instruments similar to checks."

The SEC guidance means the IOUs or registered warrants are subject to federal antifraud regulations and that they are municipal securities because they are issued by a state government. As a result, the SEC’s guidance is expected to be followed Friday morning by a related notice from the Municipal Securities Rulemaking Board on the muni rules that broker-dealers need to be aware of when trading them.

“Persons acting as intermediaries between buyers and sellers of the IOUs may need to register as brokers, dealers, or municipal securities dealers, or as alternative trading systems or national securities exchanges,” the SEC warned.

That statement appears to refer to the fact that some individuals were trying to trade the IOUs over Craigslist and eBay, which has a policy stating that “the sale of stock or other securities is not permitted on eBay.”

Securities law experts said that if securities were traded over a Web site, the regulators could determine that it is acting as a securities exchange. The SEC is particularly concerned about Craigslist because it does not restrict sales of securities.

In a new wrinkle concerning the tax status of the California IOUs, some market participants warned that the IOUs — which state that they are redeemable on or after Oct. 2 — would become taxable if they were not redeemed within 12 months after issuance, according to guidance the Internal Revenue Service released in 1992, the last time the state issued warrants. This is something that broker-dealers would have to disclose to investors, the market participants said.

“It seems to us that if the tax status is contingent on them being redeemed within 12 months — and there’s no requirement that they be redeemed within 12 months — then that combination is something that would seem to be material,” said Margaret “Peg” Henry, associate general counsel at the MSRB.

The guidance the IRS issued in 1992 stated that under Section 149(a) of the federal tax code, interest on any registration-required bond or other obligation is not exempt from federal income tax unless the bond is in registered form. In this case, registered form means book-entry or electronic rather than bearer-bond form. Bearer bonds, which typically are in paper form, permit the holder — as opposed to the person that initially owned the bond — to receive payment.

Securities are exempted from having to be registered, or in book-entry form, if they have maturities of less than a year. But while the California IOUs have nominal maturity dates of several months, under state law, if the state cannot pay them within a year, their maturities continue beyond a year and the bonds continue to accrue interest.

As a result, the state cannot assure that the IOUs will be paid within a year and that they will remain exempt from registration requirements.  If they are required to be registered and are not, then they lose their tax-exempt status and the interest earned from them becomes taxable.

The MSRB notice to be issued early Friday is expected to warn that dealers selling the warrants will need to adhere to essentially all of the MSRB’s rules, including G-17 on fair dealing, which requires the dealer to pay fair-market value for the security.

“There’s concern that some people who get these warrants and really need the cash might be taken advantage of,” Henry said Thursday. Though the IOUs do not have the same priority repayment as the state’s general obligation debt, and might not be worth as much as the GOs, dealers would have to determine a fair-market price for the warrants by comparing their value to other securities, she said.

Another rule dealers would have to follow is G-19 on suitability, to ensure that the securities are suitable for the investor they are sold to, as well as the board’s professional qualifications rules, which require that employees selling them to pass qualifying exams.

One of the only rules that would not apply is G-14 on trade reporting, because IOUs do not have Cusips, and could therefore not be reported through the MSRB’s electronic trade reporting system, Henry said.

The state controller’s office began issuing the IOUs last Thursday, after lawmakers and Gov. Arnold Schwarzenegger deadlocked over how to solve the massive budget deficit and a related looming liquidity crisis.

The state plans to issue as much as $3.2 billion of the warrants this month to state vendors, county governments, and taxpayers owed refunds to preserve cash for creditors who have standing under the state’s constitution or under court rulings.

The IOUs are earning a 3.75% annualized interest return, which is exempt from federal and state income tax.

Guidance from the SEC is in part designed to prevent fraud against holders of the IOUs, who might try to sell them at steep discounts, particularly on online sites such as Craigslist and eBay.

An eBay spokesman said that the online auction site prohibits the sale of stocks and other securities. But a search for IOUs on Craigslist turned up several “wanted” ads, with buyers offering to purchase them for as little as 70 cents on the dollar. A Craigslist spokeswoman did not return an e-mail seeking comment.

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