WASHINGTON – The Municipal Securities Rulemaking Board and Financial Industry Regulatory Authority warned firms on Monday that they need to conduct adequate due diligence to determine if bank loans and private placements involve municipal securities.
"The MSRB and FINRA are aware of the increasing practice of privately placing municipal securities directly with a single purchaser and of the use of bank loans as alternatives to traditional public offerings in the municipal securities market," the self-regulators said in a joint notice to dealers and municipal advisors. "Although it can be beneficial for potential issuers of municipal securities to consider such alternatives and the means of financing used is the issuer's choice, this development raises a number of concerns with respect to firms' conduct in connection with such alternative financings."
"The consequences of failing to analyze such financings properly may be significant," the self-regulators said.
The MSRB and FINRA said they are concerned that municipal advisors may be engaging in private placements without fully understanding whether they are acting as municipal advisors or broker-dealers. They also warned that some firms may not have fully considered the applicability of the securities laws and rules underlying the transactions.
The notice is similar to an MSRB notice released in September 2011 that warned market participants that some loans could actually be considered securities. Muni market groups, and the Municipal Securities Rulemaking Board, have been seeking guidance from the Securities and Exchange Commission on when private placements and bank loans involve securities. But the SEC has refrained from doing so.
Leslie Norwood, managing director and co-head of munis for the Securities Industry and Financial Markets Association, said on Monday that while SIFMA appreciates the MSRB and FINRA's concern about regulating alternate forms of financing, bank loan regulation is not in either of their purviews and it is "inappropriate for MSRB rules to be applied to bank loans."
She added that the SEC "should draw clearer lines between loans and securities for market participants to have the certainty they need regarding which rules apply to a particular product."
Jessica Giroux, general counsel and managing director of federal regulatory policy for Bond Dealers of America, said BDA appreciates the notice and hopes that FINRA and the MSRB continue to educate market participants about applicable rules.
"For years, BDA has pointed out the confusion in the market is caused by non-dealer advisory firms acting as placement agents on direct placement transactions that qualify as municipal securities," she said. "This activity violates securities law and denies the marketplace of the protections of the broker-dealer regulatory regime."
FINRA and the MSRB, as has the SEC, pointed to the U.S. Supreme Court case Reves v Ernst & Young, Inc. as the "principal legal authority" on determining whether "a note" is a security. . They noted many bank financings involve notes.
That case held that a note is presumed to be a security unless it is specifically identified otherwise. Examples of non-securities under the case are: 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; and notes evidencing loans from commercial banks for ordinary operations.
If a note is not explicitly deemed a non-security, it may qualify as a non-security if it bears a "strong family resemblance" to the non-security notes identified in the case. The "family resemblance test" from the case has four factors to consider: the motivations of the buyer and seller; the plan of distribution; the reasonable expectations of the investing public; and the existence of an alternate regulatory regime.
The MSRB and FINRA said firms need to carefully review their transaction documentation with an eye toward the Reves test. FINRA has found instances where firms have concluded some financing arrangements are loans even though the test factors would indicate they are securities and the issuers and banks involved in the transaction considered the instruments munis, according to the notice.
They also recommended firms consult with counsel on the difference between a muni and a loan.
