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July 2009 FACTORING OR LENDING ON CALIFORNIA IOUS By Daniel Wheeler, Esq. and Brandon Guzmán, Esq.

Parties who conduct significant business with California (b) a statement that the warrant was not paid for want of urgently need to monetize the IOUs they are receiving. But, funds, and many lenders and factors are refusing to factor or lend on these IOUs. In 1992 when last accepted California’s IOUs, (c) that the warrant bears interest at the rate fixed pursuant the banking industry knew that their accommodation was short to law from the date of the registration to the maturity date term. This time, California’s budget situation is far worse and or, if the warrant does not have a maturity date, the date on lenders have a corresponding lack of confidence in California’s which the state treasurer advertises that the warrant is ability to honor its obligations. Any lender or factor should payable upon presentation. The registered warrants that understand the opportunity and risks involved in dealing with California is currently issuing pay an annual interest rate of these IOUs. 3.75% until the warrant is redeemed.

What Is an IOU? IOU maturity date IOU is shorthand or popular parlance for what the State of The maturity of a registered warrant is subject to California formally refers to as “registered warrants.” A postponement or acceleration. The state can effectively registered warrant is a promise to pay that is issued by extend the maturity date if there are no funds available in the California when there is not enough money in the state’s state’s general fund on the maturity date. Whether or not the general fund to pay all of the state’s obligations. California warrant has a maturity date, if the warrant is not paid due to began issuing these registered warrants on July 2, 2009. unavailability of funds on the maturity/due date, the state controller, with the approval of the Pooled Money Investments Features of IOUs Board (the “Board”), determines another time to pay the California registered warrants have the following features: warrant. The law does not require the controller to determine a new due date/maturity date by any particular deadline or (1) The California State Attorney General has opined that the limit the number of times that warrant debt can be extended. warrants are valid and binding obligations of the state. Because The state can also redeem registered warrants prior to the they share the same expected source of repayment, the maturity date if the Board so chooses. It is therefore impossible warrants generally have the same quality characteristics to know exactly when a holder might receive payment on these as the state’s other general obligations. As of July 6, 2009, one registered warrants. There is also no certainty as to whether ratings agency rated California’s long‐term general obligation the warrants will ever be paid or as to the remedies available if as BBB, which is the very bottom of the "investment the state defaults, given the inherent political nature of these grade" rating ladder and just one notch above the junk debt obligations. category. Payment of IOUs and accrued interest (2) The state treasurer may redeem non‐registered warrants at Immediately after the Board approves payment of registered any time, including immediately after issuance. Registered warrants, the state treasurer must publish a redemption notice warrants are not immediately redeemable and pay interest. in the legal notice section of newspapers in Sacramento, San Francisco, and Los Angeles. The notice will also be published on (3) Registered warrants may or may not have a maturity date. the websites for the state treasurer’s office and the state The registered warrants that California is currently issuing have controller’s office. Once the registered warrants are eligible for a maturity date of October 2, 2009. redemption, they can be presented in person or by mail to the State Treasurer’s Office, as specified on the registered warrant. (4) A registered warrant must, by law, have an endorsement Accrued interest is paid to the holder of the warrant on the on the back containing the following information: date of redemption. Interest stops accruing on the first of (a) the maturity date, if any, if the state then has sufficient funds (a) the date of presentation or endorsement by the state or (b) the redemption date, which must be at least three days controller or treasurer, after the published redemption notice. If warrant is not

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redeemed within one year from the date it becomes Ensure holder in due course status redeemable, the California controller is required to cancel the Normally, a holder in due course takes a negotiable instrument warrant, making it worthless. free of most claims and defenses and has priority over an earlier perfected interest. But, a purchaser or holder of Registered warrants are negotiable instruments a negotiable interest does not take free of an earlier secured Under the usual analysis, registered warrants likely do not interest in the instrument if the purchaser or holder knows satisfy the test under the to qualify about the prior security interest or otherwise does not take the as negotiable instruments. However, the California negotiable interest in good faith. Comment 5 to UCC §9331 Government Code provides that “[n]otwithstanding any states that “[a]lthough ‘good faith’ does not impose a general provision of the Uniform Commercial Code, all registered duty of inquiry, e.g., a search of the records in filing offices, warrants are negotiable instruments.” Since the California UCC there may be circumstances in which ‘reasonable commercial does not expressly say that the legislature may not characterize standards of fair dealing’ would require such a search.” This a particular document as a negotiable instrument, it seems means that if factors and lenders become holders or pledgees likely that the courts will respect the intent of the legislature of the registered warrants pursuant to a factoring agreement and construe registered warrants to be negotiable instruments or a secured agreement and they either know about a for purposes of security interest analysis under the UCC. prior security interest or do not first run a UCC search of any prior filings, they may not be considered to have taken in good Registered warrants are municipal securities faith and thus may not be holders in due course of the The SEC has expressed its view that registered warrants are registered warrants. Thus, even though a factor or lender may municipal securities under federal securities laws. have taken possession of the registered warrants, if they knew about the prior interest or did not conduct a UCC search prior How to Lend on IOUs to taking possession, a secured party with a senior security There are several important considerations in extending credit interest in the registered warrant may still have a priority claim secured by a of registered warrants, including ensuring on the registered warrant. that the lender has a perfected first priority security interest in the warrants. Obtain a bill of sale The California treasurer’s office states that it will not redeem Perfect by possession registered warrants that have been purchased by third parties Because registered warrants are deemed to be negotiable unless the third party purchaser presents the registered instruments under California law, of a security warrant along with a notarized bill of sale signed by the payee interest in the registered warrant is accomplished the same as whose name appears on the registered warrant. The by any other negotiable instrument, i.e. by acquiring and requirement to present a notarized bill of sale to redeem a maintaining possession. It is not enough to simply file a UCC‐1 registered warrant does not apply to banks, credit unions, financing statement on the because a who investment banks, other financial institutions, brokerage firms, merely files a UCC‐1 financing statement will not have a priority or broker‐dealers. This requirement by the California claim against a holder in due course. For this reason, even treasurer’s office appears to conflict with the statute lenders with an “all assets” on a borrower that is holding construing registered warrants as negotiable instruments. registered warrants must ensure that they take physical Under California law, a holder of negotiable instrument is possession of the warrants. Failure to do so risks loss of the entitled to payment by the maker upon presentment and no lender’s security interest to another lender that does take bill of sale is required when presenting a negotiable instrument possession. Lenders with an “all assets” lien on borrowers due for payment. There is an argument therefore that a holder in to receive California registered warrants should send a notice due course of a registered warrant should be able to receive of assignment pursuant to UCC §9406 to the state to ensure payment from California on the registered warrant even that warrants, when they issue, are titled in the name of the without a notarized bill of sale. lender and to ensure that any interim interest payments are sent to the lender. It is not clear whether the state will Even exempt lenders should consider obtaining a notarized bill recognize and honor such notices, but there appears to be no of sale in addition to the usual . (In the case downside risk to taking this step. of a , the bill of sale is executed in advance and transfer of ownership of the warrants is deemed to occur upon an event of justifying on the pledged warrants.) If one of the exempt institutions ends up taking

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ownership of registered warrants pledged as collateral, the Because registered warrants are securities (see below), the institution may need to sell the warrants to a party that is not purchase of warrants is subject to the anti‐fraud provisions of exempt from the bill of sale requirement. Having a notarized securities law. bill of sale to transfer along with the warrant may be necessary or helpful from the transferee’s point of view. Also, some credit Regulatory Issues Related to Factoring or Lending on providers may not fit neatly into one of the listed categories IOUs exempt institutions and having a bill of sale removes any doubt as to such a lender’s right to the pledged warrants. Securities laws The SEC has expressed its view that registered warrants are Other loan documentation provisions municipal securities under federal securities laws. State Lenders should ensure that their loan and security agreements securities law regulators will likely take the same position. This adequately document the security interest in the warrants and means that anyone who purchases, sells, or offers to sell the interest payable on the warrants, require the execution of a registered warrants is within the scope of the anti‐fraud conditional bill of sale for each warrant, require interim interest provisions of federal and state securities law, among other payments to be sent to the lender and allow UCC §9406 provisions. If a or factor wants to re‐sell registered assignment notices to be sent to the state (to ensure that new warrants it comes to own, that sale must be scrutinized to warrants do not fall into the possession of anyone other than ensure the sale documents comply with applicable disclosure the lender). Lenders are not subject to the pricing restrictions law and regulation and the rules of the Municipal Securities and disclosure requirements to which securities dealers are Rulemaking Board. Anyone acting as intermediary between subject and thus lenders may deeply discount the value of buyers and sellers of warrants may need to register as a broker, warrants in calculating borrowing bases or otherwise assigning dealer or an exchange. These compliance costs may restrict any collateral value to the warrants. Finally, warrants are not an secondary market in registered warrants and make it necessary obligation of the federal government, so the Federal as a practical matter for lenders and factors to hold warrants Assignment of Claims Act does not apply and there is no until they are redeemed. California state equivalent. Under guidance published by the Municipal Securities How to Factor IOUs Rulemaking Board, persons acting as intermediaries between Factors (parties who purchase receivables as opposed to buyers and sellers of California registered warrants must effect extending credit secured by a pledge of receivables) should be purchases and sales at fair and reasonable prices based on the aware that registered warrants are negotiable instruments dealer’s best judgment of the warrants’ fair market value. when dealing with clients who also have a secured facility with Under that guidance, dealers must charge fair and reasonable a lender. If the factor’s client has granted an "all assets" lien to commissions in connection with brokered transactions. Among a lender, the factor must obtain physical possession of the other restrictions, dealers must deal fairly with customers and registered warrant as a condition to purchasing the warrant must not take advantage of a customer’s need for by and take the steps outlined above to be a holder in due course. offering to purchase registered warrants at deeply discounted In addition, factors must obtain a notarized bill of sale for each prices that are below what could reasonably be viewed as their purchased warrant, since factors are not generally considered a fair market value. These and other restrictions only apply to financial institution of the type exempt from the bill of sale registered brokers, dealers and municipal securities dealers, requirements. There is a possibility that factors who do not not to factors or lenders who are not registered dealers or have a bill of sale but who are holders in due course of a acting as intermediaries between buyers and sellers of warrant may nonetheless be able to enforce payment against warrants. California. But, this possibility (which arises out of the apparent conflict between the bill of sale requirement and the nature of Risk weighting a warrant as a negotiable instrument) has not yet been tested The federal regulators, including the NCUA and the OTS, in court. published an interagency statement on July 8, 2009 related to California registered warrants. That statement applies to all Factors are not subject to the pricing restrictions and disclosure state and federal‐chartered banks, state and federal credit requirements to which securities dealers are subject and thus unions and thrifts. The statement says that, for risk‐based factors may offer and pay a deeply discounted purchase price. capital purposes, California’s registered warrants would receive the same 20% risk weighting as other general obligation claims on a state. However, under a Basel II approach that looks at

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credit ratings, including inferred ratings for unrated exposures, a 20% risk weighting would generally apply only if the obligation is rated AA or better. Given that California’s general obligations are currently rated "BBB," a “BBB” rating may well be the most appropriate inferred rating for California’s registered warrants, which are also considered a general obligation of the state.

In the interagency guidance, the agencies said that financial institutions should carefully manage risks related to these warrants, including evaluating the credit quality of the warrants, establishing appropriate concentration limits and ensuring appropriate liquidity risk management. If California’s general obligation bonds are downgraded from their current near‐junk bond status to junk bond (below investment grade) status, the federal agencies may well require holders of registered warrants to make further risk weighting and other capital adjustments. Even if there is no additional downgrade of the general obligation bonds, lenders subject to risk weighting rules should carefully consider factoring in either a 50% or 100% risk weighting in considering the capital impact of making secured by registered warrants.

Conclusion Given the risks involved in lending on California’s IOUs, there is little competition for any lender wishing to proceed. If a lender has the capital to absorb the potentially larger than expected risk weighting adjustments, and the lender can obtain adequate pricing and additional credit support, such loans may be a viable opportunity. Factors do not have to deal with capital reporting obligations, but they also must ensure they follow the additional procedures required to document a purchase of IOUs.

Daniel Wheeler is Senior Counsel in our San Francisco office. He can be reached at 415.227.3530 or at [email protected].

Brandon Guzmán is an Associate in our San Francisco Office. He can be reached at 415.227.3557 or at [email protected].

Buchalter Nemer is a full‐service business law firm representing national and global clients in eight primary areas of practice: Bank and Finance, Business Practices, Insolvency & Financial Solutions, Litigation, Labor and Employment, Intellectual , and and Estate Planning. The firm has offices in Los Angeles, Orange County, San Francisco and Scottsdale. For more information, visit www.buchalter.com

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