MSRB Issues Guidance on IOUs

WASHINGTON - The Municipal Securities Rulemaking Board issued guidance on Friday warning broker-dealers of the muni rules that they need to comply with when selling or trading California IOUs.

The MSRB's notice followed guidance the Securities and Exchange Commission released late Thursday asserting that the IOUs - formally known as registered warrants - are municipal securities subject to federal securities laws and muni rules.

Both notices come as large banks in the state said last week that they would not accept IOUs from their customers as deposits after Friday. Market participants said the move could lead to sales of the IOUs in a secondary market in which, barring federal intervention, holders of IOUs could be lured into liquidating their warrants at steep discounts. The SEC is particularly concerned that the IOUs will be sold online at sites such as Craigslist, where there are no restrictions on the sales of securities.

In its notice, the MSRB warned that all dealers who sell or trade munis, like the IOUs, must be registered with the board and comply with its rules on professionalism and fair practice. "The buying, selling, and trading of California's warrants by intermediaries are subject to all MSRB rules of conduct and fair practice," general counsel Ernesto Lanza said in a press release.

The board stressed that dealers must comply with its Rule G-30 on prices and commissions, which requires dealers to buy and sell securities at fair and reasonable prices based on best judgment of their fair market value.

"Dealers must deal fairly with customers and must not take advantage of a customer’s need for cash by offering to purchase registered warrants at deeply discounted prices that are below what could reasonably be viewed as their fair market value," the notice said.

The board also noted that its Rule G-17 on fair dealing requires dealers to disclose to their customers, at or prior to a transaction, material information, possibly including statements from the Web sites of California Treasurer Bill Lockyer and Controller John Chiang.

"In particular, dealers selling registered warrants to customers must ensure that purchasing customers are aware of the terms on which the registered warrants are expected to become payable (including information about the contingent nature of the stated maturity date, the potential for early redemption, and any contingencies concerning tax exemption of interest on the warrants)," the MSRB notice said.

The notice's reference to "contingencies" concerning the tax status of the IOUs comes as market participants have warned that the instruments - which state that they are redeemable on or after Oct. 2 - will become taxable if they are not redeemed within 12 months after issuance, according to guidance the Internal Revenue Service released in 1992, the last time the state issued warrants.

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.

The MSRB also said that if the warrants do not have Cusip numbers, trades of them do not need to be reported to the board under its Rule G-14. Still, the board warned that dealers must maintain records of their transactions with customers under Rule G-8, and must provide customers with confirmations of their transactions under Rule G-15 on confirmations. In addition, individuals who engage in sales and trading of the warrants must pass examinations.

It is unclear just how many dealers are interested in creating a market for the warrants. Some firms, like SecondMarket, which finds buyers and sellers for illiquid securities, are considering getting involved with IOUs.

But Bill Mullally , president of the Walnut Creek, Calif.-based municipal broker-dealer Alamo Capital, said the hassle factor is too high and too distracting from the core mission of the firm. He said some customers have asked if the firm plans to deal in the warrants.

"We don't really want to get involved," Mullally said. "I just don't want to deal with it."

Generally, the banks with the largest branch networks in California - including Wells Fargo & Co., Citi, Bank of America, and JPMorgan Chase - agreed to accept registered warrants for deposits from customers at face value through Friday.

Going forward, many smaller banks and credit unions have said they plan to continue accepting the IOUs from customers.

The state controller's office began issuing the warrants July 2, 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, such as bondholders, or under court rulings.

The IOUs are earning a 3.75% annualized interest return, and are, for the time being at least, tax-exempt. Under the IRS guidance from 1992, securities are exempted from having to be registered, or issued 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 the 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.

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