Firms may soon resume slicing and dicing bonds to create secondary market derivatives out of debt sold by local California issuers.
The state Senate's banking committee will hold a hearing today on a measure to exempt most deals from a law passed last October that was intended to prevent abusive leaserelated transactions but also managed to complicate derivatives transactions.
The law, Section 25403 of the state's corporations code, requires that firms get written permission from issuers before creating secondary market derivatives.
The law also created headaches for institutions holding secondary market derivatives created before the law was passed. Many firms felt they had to get permission from the underlying issuer even for those derivatives that predated the October law.
"The law was meant to stop abusive vendor lease transactions," said Stun Ladnet, a partner at Mudge Rose Guthrie Alexander & Ferdon. "But the effect has been on secondary market derivatives too. The language of the original statute was so broad it scooped up bonds."
While market participants welcomed the expected change, they noted that-the volume of secondary market derivatives has slowed considerably this year.
"It was an unforeseen consequence, and it's good that they're now rectifying it," said Robert Scott, a director at Merrill Lynch & Co. "But it won't have a large effect on the market at this time."
Scott also pointed out that the. current law does not apply to state issues, such as California's general obligation bonds.
The proposed modification, Assembly Bill 3073, would tailor the law to exempt most secondary market derivatives transactions and would grant a blanket exemption for transactions done before Oct. 2, 1993.
The state Assembly unanimously passed the bill, and the Senate is expected to approve the change, attorneys familiar with the law said,
Typically, a firm creates secondary market derivatives by purchasing fixed-rate bonds and plaCing them in a trust or partnership. The new entity then issues derivatives which pass on the interest of the underlying bonds. The issuer the bonds is not directly affected and is not involved:
But last year, California changed its laws governing the resale of interest firm debt obligations and Isles of issuers in the state.
"It is unlawful for any person to offer in this state any security constituting a fractional interest in a lease, installment sale, or other obligation, of a city, county, city and county, school district, special district, or other local agency of this state without obtaining the prior written consent of that" entity, the law states.
The original law was prompted by an unauthorized sale of certificates of participation in a Los Angeles County lease in 1991.
Localities frequently enter leases with vendors for buildings or equipment. The vendor then might sell the lease obligation to a third party, which then issues certificates of par,ticipation backed-by the lease payments.
The locality often has no knowledge of the transaction between the third party and investors holding the certificates.
In some cases, the localities had the right not to renew the leases, but this right was not always disclosed to the certificate holders.
Los Angeles County already prohibited the resale of its vendor leases, but that didn't stop the 1991 transaction, prompting a call for statewide legislation.
Forcing firms to get permission delayed deals and raised expenses. In several cases, issuers demanded compensation in return for giving their permission, derivatives professionals said.
The market's solution was to avoid using bonds covered by the law in secondary market derivatives deals.
"It makes you just not want to do things there," one derivatives professional said.
The bill to modify the law contains several exemptions.
Fractions of interest sold as part of a registered unit investment trust or management company would be exempt. Any fraction contained, in a security that is registered under the Securities Act of 1933 would be exempt.
But many secondary market derivatives are sold as private placements and are not registered. So the bill would also exempt fractions of interestsold among "one or more persons who are reasonably believed to be qualified institutional buyers or accredited investors."
One aim of the original law .was to ensure that issuers would not be held liable if a secondary market offering went into default, one attorney said.
So the modification bill contains more explicit language stating that issuers will not be required to review offering units, whether or not they had to give their permission for a transaction.
Further, the modification bill would require that offering documents for any transaction "shall include a prominent statement ... to the effect that the consenting local agency (specified by name) has not reviewed any of the proceedings."
