CLIENT ALERT 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 banks 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 credit 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 bond 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 CLIENT ALERT 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 security 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 Uniform Commercial Code 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 loan 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 pledge 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, perfection 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 collateral because a creditor 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” lien 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 security agreement. (In the case downside risk to taking this step. of a secured loan, the bill of sale is executed in advance and transfer of ownership of the warrants is deemed to occur upon an event of default justifying foreclosure on the pledged warrants.) If one of the exempt institutions ends up taking CLIENT ALERT 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.