A financial regulatory reform law that would require ABS issuers to retain at least 5% of the debt they issue is so broad that some market participants are warning the retention requirements could apply to certain municipal bond transactions.

Richard Sigal of Hawkins Delafield & Wood alerted treasurers meeting here this weekend to the provision and warned that applying it to municipalities would “not be consistent” with the way municipal issuers function.

The provision was added to regulatory reform legislation to ensure that there would be no replay of the events leading to the subprime loan-triggered financial crisis, when the originators of such loans had no “skin in the game” and therefore no incentive to make sure they performed well.

But it was written so broadly it could cover munis, some lawyers said. While debt sold “in the public interest” or debt sold by states or localities are among the types of ABS eligible for possible full or partial exemptions from the 5% provision, the Securities and Exchange Commission (SEC) has wide latitude in writing carve-outs, and must do so jointly with federal banking regulators.

In addition, while certain high-quality ABS backed by residential mortgages would be exempt from the 5% provision, other types of ABS may be subject to retention requirements of less than 5% if their underlying loans carry low risk.

Sigal wants issuers to urge the SEC to clearly exempt muni ABS — which could include tobacco securitizations, student loan bonds, and multifamily housing deals — from the 5% provision.

Speaking before the National Association of State Treasurers’ annual meeting here Sunday, he recommended the treasurers and other issuers seek clarification that their securities qualify for retention exemptions.

In doing so, Sigal suggested that the issuers advise the SEC to rely on existing Internal Revenue Service (IRS) standards.

If a muni bond is tax-exempt under IRS standards,, he argued, “then by definition it meets the public purpose requirement of the SEC statute.” .

Similarly, taxable muni deals, like Build America Bonds — which Sigal described as “tax-exempt first and then subsidized” by the federal government — should also be exempted from the 5% retention provisions, he argued.

Following this blueprint frees the SEC from ­writing “a whole new set of rules and regulations,” Sigal said.

Sources said lawmakers are concerned that a blanket muni exemption would cause corporate borrowers to circumvent the retention requirements by issuing debt through municipal conduits.

But Sigal noted that Congress previously determined that a bond’s tax-exempt status is an appropriate litmus test for whether there is a sufficient “public purpose” for the muni bond, even if there is an underlying benefit to a corporation.

Specifically, in 1970, Congress amended Rule 3(a)(2) of the Securities Act of 1933 to extend exemptions from its registration requirements to lease, sale, or loan arrangements with industrial or corporate enterprises that underlie tax-exempt industrial revenue bonds. Such bonds are tax-exempt if they meet certain criteria for private-activity bonds under the federal tax code.

“We’re not asking the SEC to defer for the first time,” Sigal said. “We’re asking the SEC to follow a precedent that it has already followed in the past with respect to their rules and law exempting municipals from registration.”

Not all muni market participants are worried about the provision.

Though other bond attorneys are aware of it and that it might apply to some municipal deals, they said they do not believe the provision should cause issuers to alter their plans to issue bonds or to change their disclosures.

Even if the retention provision ends up applying to some muni transactions, its impact will be muted by legislatively mandated delays in its implementation. The SEC and federal banking regulators have 270 days from enactment to jointly write the retention regulations.

But they will not become effective until one year after they are published in the Federal Register for securitizers and originators of ABS backed by residential mortgages, and two years after they are published in the Federal Register for securitizers and originators of all other ABS.

Susan Gaffney, director of the Government Finance Officers Association’s federal liaison center, said: “We don’t believe that munis are effected by this provision, but as the SEC seeks comments on this section, we’ll be seeking clarification to ensure that munis are not caught up in this.”

An SEC spokesman declined to comment on the issue.


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