updated 7/9/2009 8:42:39 PM ET 2009-07-10T00:42:39

The recipients of billions of dollars in IOUs being issued by California soon may be able to sell them on a regulated market, following action taken Thursday by federal regulators.

Some of the nation’s largest banks say that, starting Friday, they will no longer accept the IOUs. The banks want to pressure the state to end its budget impasse, but their action could leave many businesses and families with fewer options for getting their money.

Therefore, the Securities and Exchange Commission recommended Thursday that the IOUs, which carry an annual interest rate of 3.75 percent, be regulated by the Municipal Securities Rulemaking Board as a form of municipal debt.

A regulated market for the IOUs would make it easier for individuals holding them to sell them at a fair price, analysts said.

The SEC oversees rules set by the nongovernment MSRB, which polices the municipal securities markets for fair pricing, disclosure and adherence to the requirement that the securities sold be suitable for the buyer.

The SEC said in an announcement that its staff “has expressed its belief that California’s recently issued IOUs are ’securities’ under federal securities law.”

“As such, holders of these IOUs and those who may purchase them are protected by the provisions of the federal securities laws that prohibit fraud in the purchase or sale of securities,” the SEC said.

In addition, it said, those acting as intermediaries between buyers and sellers of the IOUs may need to register with regulators as brokers, dealers or municipal securities dealers.

With Bank of America Corp., Wells Fargo & Co., Citigroup Inc. and some regional banks in the state having said they won’t accept the IOUs for payment after Friday, attention has turned to the possibility of a secondary market to buy up the notes.

A spokesman for JPMorgan Chase & Co. left open the possibility Thursday of a change in that bank’s policy, but spokesmen for Bank of America and Wells Fargo said those banks still planned to cease honoring the notes. Citigroup had no immediate comment.

According to the California Credit Union League, more than 60 credit unions in the state will continue to accept the IOUs after Friday.

The Federal Reserve, meanwhile, advised bank customers with an IOU that they should first check with their bank to make sure it will be accepted for deposit and whether any fees could be incurred.

A regulated market for the IOUs “makes it even more advantageous” for individuals holding them, who could sell them at a fair price, said Paul Maco, an attorney at Vinson & Elkins in Washington who was a director of the SEC’s Office of Municipal Securities. The price they receive may be discounted in accordance with the market’s perception of the risk of the state repaying the notes, but it would be an orderly market price, he said.

The SEC advised investors that it hasn’t approved or disapproved of the IOUs, which also are referred to as registered warrants. If you hold an IOU and wish to sell it prior to the Oct. 2 redemption date, you should consider whether you think you’re getting a fair price for it, the SEC said. Those selling their IOUs at less than face value will forfeit the difference in price and any interest that would have accrued.

As with any new securities, the robustness of the trading market that will develop “cannot be predicted with certainty,” the agency said. Investors looking to buy IOUs should understand who the seller is and should ask if the person is registered for that sort of transaction when buying from a third party, it said. Registered brokerage firms and their employees are listed on a database at www.finra.org.

SecondMarket, which creates marketplaces for the trading of illiquid assets, has received “decent interest” from hedge funds, municipal bond and distressed asset investors as potential buyers of the IOUs, Jeremy Smith, the New York-based company’s chief strategy officer, said this week.

As California legislators haggle over how to close a $26.3 billion budget deficit, the state is expected to send out $3.3 billion in IOUs this month to an array of individuals, small businesses and local governments.

It marks the first time since 1992, and only the second time since the Great Depression, that California has sent out notes promising repayment at a later date instead of paying its bills on time.

Most California state government offices will be closed on Friday, the first of three monthly furlough days intended to save the state money. The shutdowns are part of Gov. Arnold Schwarzenegger’s order to give state employees three days off a month without pay, effectively cutting their income by about 14 percent.

California Attorney General Jerry Brown has said the IOUs are valid and binding obligations of the state, a characterization that experts say qualifies them as municipal securities.

Federal bank regulators, including the Federal Reserve and the Federal Deposit Insurance Corp., told banks in guidance issued Wednesday that they should exercise “the same prudent judgment and sound risk management practices” regarding the IOUs as they would with any other state debt securities.

“The California registered warrants have the hallmarks of securities, and if they are securities, they are pretty clearly municipal securities,” MSRB General Counsel Ernesto Lanza said. “To the extent that municipal securities dealers are involved in the sale and trading of the warrants, our rules would apply. We would be especially concerned about dealers’ obligations to customers with respect to fair pricing.”

Copyright 2009 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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