Academic

Wednesday the SEC Staff announced its view that California?s IOUs are ?securities? for federal securities law purposes.  California?s IOUs, which the state began issuing on July 2, pay an interest rate of 3.75% and are to be redeemed on October 2 or earlier if California manages to reach a budget deal.  On the one hand, classifying these IOUs as securities seems like a good move.  AS the SEC announcement noted, the purpose of characterizing the IOUs as securities is to ensure that those who purchase and sell the IOUs will have the protection of the federal securities law, especially the antifraud protections.  This protection seems necessary.  Indeed, several major banks have stated that after today they will no longer accept California?s IOUs.  The banks insist that they have taken such an action to force California to deal with its budget crisis.  Apparently the last time the state issued IOUs in 1992, it was only after several banks stopped accepting them that the state eventually reached a budget deal.  Hence, the banks believe that their acceptance of the IOUs may prolong the process of the state resolving its budget problems.  But with banks indicating their refusal to accept IOUs, those holding them must look elsewhere to turn them into cash.  And as their options narrow, apparently ads have begun popping up on sites like Craigslist offering to buy the IOUs at a discount from face value.  If a secondary market develops in these IOUs, there certainly seems to be some potential for abusive practices both on the buying and selling side.  And hence the need for some regulation and oversight. 

And yet, as some have noted, the regulation may pose problems for those trying to convert their IOUs to cash.  Indeed, as the SEC Staff Statement notes, trading in these IOUs means being subject to the federal securities laws and may even require people to register as brokers or dealers.  Thus, given the extra hurdles involved with trading in these IOUs, the characterization could make it more difficult for people to redeem their IOUs, even if that difficulty is warranted.  To be sure, banks have said that they are willing to work with individuals and businesses, and credit unions have indicated that they will continue to redeem the IOUs.  Hence there may be other options.  And the SEC has issued an investor alert urging both buyers and sellers to be careful, and among other things, consider if they are getting a fair price and ascertain that the IOUs are accompanied with appropriate documentation so that they can be presented for payment.  However, apparently by Wednesday California had sent out 91,213 IOUs totaling over $354 million and by the end of the month the amount is expected to reach nearly $3.4 billion.  These figures suggest that there are a lot of people and entities in California that may be looking to convert their IOUs into cash.  And if people and businesses need the cash badly enough, it is hard to imagine that they will be particularly prudent.  In that kind of environment, it is not clear whether and to what our securities laws will be able to protect investors.