Bank Direct Lending to Municipalities - Avoiding State Law Landmines

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Bank Direct Lending to Municipalities - Avoiding State Law Landmines

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Over the past few years, direct lending by banks to local governments has increased dramatically. As discussed below, most of the attention both in legal commentary and regulatory announcements has been focused on the characterization of these transactions for securities law purposes. However, as direct lending grows to encompass more complex transactions which may include variable rate obligations with puts, tenders and changes on interest rate modes, governmental entities need to assure that there is clear authority to enter into these types of arrangements.

Direct lending has certain advantages, including the avoidance of certain costs of issuance associated with a public offering. Typical costs of public debt issuance include rating agency fees, costs of preparing an offering document, and, in some cases, costs of credit enhancement or liquidity facilities, such as letters of credit or standby bond purchase agreements. In addition, direct lending transactions can often move from inception to closing faster.

For a variety of regulatory reasons, banks desire to characterize these municipal borrowings as loans as opposed to securities. There has been significant legal commentary in the past few years discussing the characterization of direct lending transactions as “loans” versus “securities.” The Municipal Securities Rulemaking Board has also weighed in to address the Loan vs. security distinction in general, but also in the context of how the characterization of a direct loan impacts the regulatory obligations of municipal bond underwriters (broker-dealers under its regulatory framework) and more-recently regulated financial advisors.

This securities law analysis often takes center stage, as banks and issuers endeavor to execute transactions quickly. In many cases bank counsel will prepare a set of somewhat standardized documents, adapted for the particular transactions. This documentation may go so far as to include a form of city authorizing resolution for the issuer’s governing body to adopt, and a form of issuer’s counsel opinion. Local governments are cautioned to check with bond counsel before going too far towards closing this sort of transaction.

Direct bank lending is now available for general obligation bonds, revenue bonds and special taxing district debt. But often, the direct lending involves ancillary agreements prepared by banks, most often appearing for variable rate obligations or obligations which can change interest rate mode or offer prepayment flexibility to an issuer. These ancillary agreements often contain ongoing operational and reporting covenants and may also contain choice of law and venue provisions. More importantly, these agreements contain contingent financial obligations such as indemnification of the bank, an agreement to pay increased costs due to bank regulatory changes, “clawback” of interest in the event amounts due the bank exceed a statutory maximum interest rate and an obligation to pay bank counsel fees upon occurrence of certain events.

But does an issuer have clear legal authority to undertake these additional obligations? Moreover an issuer should assure itself that it is fully empowered to enter into a “loan” transaction (see the discussion above) as opposed to the typical bond or note offerings which are the traditional mechanisms for local governmental borrowings and which are expressly authorized by statutes. Is special authorizing legislation in the form of an approving ordinance or even special State legislation required?

Schiff Hardin has municipal bond counsel expertise and can assist local governments in addressing these “authorization” issues. Schiff attorneys also act as issuer’s counsel on a regular basis and can advise appropriately in these increasingly prevalent and increasingly complex bank lending transactions. Our banking attorneys also bring this analysis to bear on behalf of our banking clients on the transactions which are being undertaken by an increasing number of banks and other financial institutions.

Schiff Hardin’s Public Law Group is actively engaged in legal developments affecting the municipal market. We regularly advise municipal debt issuers, underwriters, and placement agents and credit providers.