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Municipal direct loans: What are the effects of the German Government Investment Act?

The purpose of this paper is to add to the ongoing dialog by discussing the regulative questions that arise when local government funding is arranged as a debt instrument rather than as a government debt instrument, and by providing some considerations on the assessment and management of the risks that a lending operation may later be reclassified as a German Government asset class.

Our conclusion is that as long as a credit 1) is promptly made available to government borrowers, 2) has restricted portability, 3) is for sale only to demanding corporate creditors, 4) is made for a purposes similar to those of conventional credit targets, and 5) has documentary evidence that is more reminiscent of loans than of bonds that loans should not be kept as such.

A large securitised retail lending submarket provides a blueprint for the creation of a resilient local authority lending submarket that could flourish alongside conventional loan finance. In the last 18-month period, public-sector local government bonds have fallen significantly5 , with borrowers resorting to alternate funding techniques, often termed privately-placed.

The rise in direct banking loans is hard to measure as there is no EMMA reporting requirement for loans. The MSRB and the SEC, as well as other interest groups such as credit ratings institutions and investment firms, are committed to this absence of transparent markets. A number of comments suggest that direct lending by the banking sector could have risen by over 400% since 2009.

Irrespective of the real growth, it is undeniable that local authority loans will continue to be an important part of the local authority funding environment for the time being, and the sometimes challenging questions associated with the products in the current legislative environment need to be tackled. Over the past nine month, the MSRB has published three communications highlighting the uncertain ties surrounding the regulation of banking loans and other financial engineering.

Firstly, in August 2011, the MSFB alerted the advisers to'be conscious that the so-called'bank loans' could be local government bond offerings, according to particular conditions'. "In this Communication, the MSFB indicated that it intended to publish a bulletin in support of the distinction between loans and transferable securities stating that "financial advisers should discuss with their lawyers whether the placement in which they are involved is a loan placement or a transferable security placement.

In its second communication, the MSRB noted the increase in the volume of banking loans and the many enquiries about the possible application of the MSRB regime to these instruments. She pointed out that if the so-called'bank loans' were indeed local government bonds, the notifying party'could unintentionally breach the MSRB regulations and other German government bond Acts.

"Sixteen The MSFB admitted that it is hard to differentiate between loans and bonds and referred to the multi-factor test set by the U.S. Supreme Court in Reves v. Ernst & Young, Inc. Essentially, the MSFB alerted the markets in the September 2011 announcement that there is no'one stop shop' for credit/securities issues and stressed that the assessment depends on the facts and conditions of each transaction.

MSRB' s third and most recent Communication took place on 3 April 2012. In this Communication, the MSRB encourages state and locally owned government emitters to publish information on their credit financing on EMMA on a voluntary basis in order to enhance operational visibility and effectiveness. The recharacterisation will have a significant impact on the participants in the operation, should a public -sector credit be called into question and re-designated as collateral, which includes the risk of loss of regulatory and/or legal liabilities.

In the event that a "loan" actually turns out to be a bond, the German Investment Schemes Act and the MSRB provisions shall be applicable. It is likely that if a counsellor becomes an unintended intermediary, the MSRB Rule G-23 (which entered into force on 23 November 2011) will be violated. The MSRB Rule G-23 generally prohibits finance advisers from becoming intermediaries or taking part in issuing book writing activity where they have acted as finance advisers.

Besides G-23 there are many other G-23 regulations that are valid for switching agent, e.g: Regulation A-13 (obligation for broker-dealers to provide underwriting and public sector security valuations and placements); Rule G-3 (obligation for broker-dealers involved in public sector security transactions to meet audits); Rule G-14 (obligation for broker-dealers to provide notification of public sector security purchase and sales); Rule G-17 (obligation for broker-dealers to provide equitable trading in the exercise of public sector security and public sector consulting);

Rules G-32 (submission of formal declarations and related information on new issues); G-34 (requirement for broker-dealers to obtain CUSIP numbers for local authority security issues); and G-37 (prohibition for broker-dealers to conduct two years of local authority dealings in a security after they have made non-minimum policy contribution to certain "issuer representatives"). Those intermediary agency standards, such as an intermediary agent's request to obtain a CUSIP number, are often inconsistent with a creditor's own guidelines on the handling of funding and affect the capacity of an intermediary agency to meet its own regulatorial responsibilities if the intermediary cannot establish that the arrangement is a credit.

Consultants and intermediaries are not the only ones who are confronted with the adverse effects of a recharacterisation of a credit business. Although public-sector security issues are largely exempt from the full stringency of German government security legislation, such as registry and notification obligations, they are still governed by anti-fraud regulations.

In this context, the SEC has recently signalled that it intends to intensify its law enforcing activities in the local government security sector, perhaps targeting local government officers. Likewise, creditors are potentially liable if they plan to enable others, directly or indirectly, their participation in the operation.

If, for example, a creditor obtains a notice from the borrower proving a "loan" and a seller has an interest in the obligation, whether by way of equity interest or sale, then there is a danger that the creditor will act as a broker-dealer with technical responsibility in revaluing the credit.

SO WHEN IS A "LOAN" ACTUALLY A "SECURITY"? 1. any debt, such as a credit facility demonstrated by a bond, is presumed to be a securities; and 2. the simple lack of an instrument referred to as a'bond' does not imply that the instruments are not securities. In credit operations, it is usual to use promissory notes, and loans in the local financial area are no different.

Given the degree to which direct banking loans have substituted local authority offers of shares, it would seem prudent to suggest that some of these new lending operations could be very similar in terms of economics to the offers of shares that they have pushed out. n the following are tests of similarity between families: The " marketing programme " for the tool; The appropriate expectation of the general public; Whether an alternate regulation system or other risk-mitigating element makes the implementation of stock exchange legislation unnecessarily.

"It is also a test that seems particularly unsuitable for the local finance sector. In response to the current flow of regulation, the SEC could establish a policy that considers each of Reves' four tines to be of equal importance in determining whether alternate local government funding is indeed a security.

However, such an approximation, if adopted by NRAs, is unlikely to provide adequate security for operators or actually address important regulation interests. Instead, we believe that a more differentiated and context-based view is best suited to creating a more foreseeable analytic environment that is of great value to all stakeholders.

In spite of the many flaws of the familial similarity test, it is possible to pinpoint those elements of the test that may be more relevant to the issue of when a community credit could be considered as collateral, by carefully considering the core issues of the MSRB and SEC in relation to alternate community financing.

With regard to the local government finance markets, we consider the two most important Reves variables to be (1) the sales programme and (2) whether an alternate regulation system or other mitigating elements render the implementation of stock exchange legislation redundant. Spreading the interest on a direct banking credit beyond highly regulated corporate and other demanding credit institutes is likely to raise the risks of the tool being recharacterised as a transferable asset.

As long as the economy of a local authority credit is limited to well-regulated corporate banking or other demanding institutions33 (and the loans are adequately exposed, as mentioned above), there are fewer reasons to address supplementary regulation such as the German Government Investment Act and the MSRB-Rules. Lastly, while the German Government Act on German Government Treasury Paper does not dominate the substantive issue, the degree to which transactions are more similar to credit documentation than is the case with conventional paper will certainly be taken into account by supervisors.

However, the direct banking credit markets have not yet achieved agreement on credit documentation. Although the term "loan" is not mandatory, the nature of the operation should as far as possible be similar to a real credit and not appear like a hasty " reimbursed " borrowing operation. Consideration should be given in the transactions document to the usual credit conditions such as convenants, escalation provisions and information privileges.

Of course, the notifying party should ensure that the deal is recorded as a credit in its accounts and record. Credit divisions of corporate banking institutions and not groups of leverage market professionals should manage the deal where possible. Although the Reves review is unlikely to be based on a decisive element and the Note is a suspected security, we believe that credit characterization is acceptable if the underlying operations are properly recorded and the main features of Reves are treated as described above.

With the exception of a state in which the Constitution grants authority to municipal administrations for house rules, the communes are governed by the so-called "Dillon's Law" - an established law according to which the communes have only those authority which is explicitly conferred upon them by state legislation or which is necessarily or fairly implicit in the explicit granting of authority.

A State which interprets Dillon's rules rigorously or in which the power of the house rules is restricted may make it hard for a borrowing agent to draw the conclusion that a credit is permissible under national legislation. As a result of this regulation, the nature of the indebtedness and the procedure for approving and issuing it must also comply with state and municipal regulations.

Non-compliance with these rules could lead to a declaration of nullity, an undesirable outcome for any bond creditor or banking institution. William L. Gehrig, Basics of the Local Government Bond Act 11 (2004). For every credit handling operation, the solicitor should check all applicable approval laws, regulations and decisions to feel at ease that the local government issuing body has the statutory power to incur debts by borrowing and, if such power is available, that it has been reasonably exercised in the issuer's decisions.

An emerging direct lending issue challenging Ultra-Vires could lead the borrower between Scylla, which holds an unclaimable credit, and Charybdis to argument that the Ultra-Vires credit is indeed a properly approved debt, even though security legislation and MSFR rules were ignored by the issuers at the inception.

Local authority direct credit is still in its fledgling stages. In order for the markets to be able to grow as well as to deliver cash, creditors and other components should reach agreement on appropriate standardised documents that make it clear that the instrument is a credit and not a security. These documents should restrict portability to banking and other demanding types of institution and should oblige the issuer to make the loans to EMMA public.

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