With less than one month left before the Volcker Rule goes into effect, questions abound as to what it will look like and how it will affect the municipal market.

While regulators remain silent in the face of the looming July 21 effective date and the muni market awaits further clarification regarding the definition of “governmental obligations,” the banks are busy preparing contingency plans.

One particular concern in the industry — but not perhaps widely publicized — is that the Volcker Rule appears to be on a collision course with “direct lending,” the ever-growing practice of banks purchasing entire bond issues from issuers in transactions that bear a substantial resemblance to commercial bank lending.

While this concern turns on the same issue facing the rest of the municipal industry, namely the definition of governmental obligations, it also turns on whether or not the direct-lending transaction is characterized as a security or a loan.

As most of us are aware, the Volcker Rule prohibits “proprietary trading” by banks. It was put into place in order to prevent banks from taking risks with the purported funding advantage that federal deposit insurance gives them, which many believe helped lead to the 2008 financial crisis. On its face, this ban would send the municipal market into disarray as most public finance transactions are publicly offered and underwritten by the banks.

Several commentators have identified this issue, focusing on the rule’s exemption for “governmental obligations.” However, as noted in a Municipal Securities Rulemaking Board comment letter dated Jan. 31, the term governmental obligations in the Volcker Rule currently includes an exemption only for bonds issued directly by states and their political subdivisions and not obligations of public agencies or authorities.

As further pointed out in the MSRB comment letter, this definition differs from the terms and definitions used in Section 3(a)(2) of the Securities Act of 1933 and in Section 3(a)(29) of the Exchange Act of 1934, both of which include exemptions for public agencies and authorities.

If the definition of governmental obligations found in the Volcker Rule is not broadened — as many industry experts are hoping it will be — a number of relatively common types of muni bonds, such as enterprise revenue bonds and conduit private-activity bonds, will in many cases be swept up by the rule, resulting in the bifurcation of the municipal marketplace. This would mean that public finance transactions would no longer be possible for certain revenue bonds issued by state and local authorities and agencies.

Taking this one step further, if direct lending is proprietary trading, and if there is no applicable exemption for the municipal market or otherwise, then direct lending would appear to be dead in its tracks for a large part of the market.

We observe, however, that in the case of direct lending there is a threshold question to be answered before analyzing possible exemptions from or exceptions to the rule. Are the governmental issuer’s obligations really securities (bonds), or is the transaction substantively a commercial loan? The Volcker Rule only applies to proprietary trading in securities. It does not attempt to prohibit banks from making commercial loans, which would be an absurd and almost unimaginable result.

So, the question comes down to whether the governmental obligation is a loan or a security. If the former, then the Volcker Rule is irrelevant. If the latter, then the definition of exempt governmental obligation becomes very important. While there is no authority directly on point as to what constitutes a loan or a security in the municipal space, a 1990 Supreme Court case relating to promissory notes provides some helpful guidance.

In Reves v. Ernst & Young (1990), the court stated that promissory notes are presumed to be securities unless they bear a “strong family resemblance” to one of the following types of instruments that are specifically excluded from the definition of securities: “the note delivered in a consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a 'character’ loan to a bank customer, a short-term note secured by accounts receivable, a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized) … [and] notes evidencing loans by commercial banks for current operations.”

The court went on to identify four factors that can be considered in determining whether such a family resemblance exists: “(i) the motivations that would prompt a reasonable seller and buyer to enter into [the transaction],” (ii) the “plan of distribution of the instrument to determine whether the note is an instrument in which there is common trading for speculation or investment,” (iii) the “reasonable expectations of the investing public,” and (iv) “whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary.”

Working through the types of excluded instruments and then through the four factors above, we are left with a number of unanswered questions. It appears that the determination of whether or not a transaction involves a security is very fact-driven but with no guidance on the relative weighting of the four factors.

In addition, many in the industry disagree with the application of Reves v. Ernst & Young to the direct lending market and believe that it leads to an analysis that is based on form and not substance.

Notwithstanding this fact, it seems, however, that an argument for loan treatment can be made where there is a limited intent to distribute (where the bank intends to hold until maturity), where the business terms look like those commonly seen in commercial lending (e.g. pricing based on a spread to the London Interbank Offered Rate, loan-like prepayment features or loan-like covenants), and where the bank treats the instrument as a commercial loan for internal purposes and attempts to document the transaction as such.

This last point may be particularly significant, as it appears that a number of banks that engage in direct lending are currently accounting for those transactions as loans rather than investments in securities.

Nevertheless, until there is further guidance with respect to the definition of a security, there remains the possibility that the Securities and Exchange Commission or a court might find that even though the bank may treat an instrument as a loan internally, it may still be a security subject to all the rules and regulations under the federal securities laws, as well as the rules of MSRB.

As the July 21 effective date approaches and the silence continues, it is imperative that the banks be prepared for the possibility that there will be no change in the definition “governmental obligations” under the Volcker Rule. In addition, for those banks that are involved in direct-lending programs, it is important to develop policies, procedures and analyses to support their conclusions as to whether their direct-purchase programs are either loans or securities.

In either case, the banks must be in compliance with applicable banking laws if they determine that they have a loan, or the rules and regulations under the federal securities laws, as well as the rules of Municipal Securities Rulemaking Board, if they determine that they have a security.