SEC Takes Another Try at Removing Credit Rating References From Regulation M

Overview of Rules 101 and 102 of Regulation M

Rules 101 and 102 of Regulation M govern the activities of issuers, selling security holders, underwriters, and other persons participating in a “distribution”⁴ of securities. Rule 101 governs the activities of underwriters, selling dealers, and other distribution participants, as well as their respective affiliated purchasers. Rule 102 governs the activities of issuers, selling security holders, and their respective affiliated purchasers. Both rules generally prohibit the relevant parties from bidding for, purchasing, or inducing others to bid for or purchase the security being distributed (the “subject security”) or any “reference security”⁵ during a specified restricted period.⁶ Various exceptions to the rules’ general prohibitions are intended to permit an orderly distribution of securities and limit disruption to the market.

Limited Implications for Fixed Income Distributions

For purposes of Regulation M, the SEC takes the position that an issuer’s already outstanding debt securities will not be considered the same as the debt security presently in distribution if there is even so much as a single day’s difference in maturity and/or a single basis point difference in coupon.⁷ Similarly, already outstanding fixed income securities will not be considered a “reference security” with respect to the fixed income security presently being distributed so long as the security being distributed (i) is not convertible, exchangeable, and/or exercisable for the already outstanding fixed income security and (ii) does not, pursuant to its terms, have its value determined, in whole or significant part, by the already outstanding security.

In the absence of a “reopening,” this generally means that Rules 101 and 102 do not restrict trading in an issuer’s already outstanding fixed income securities during a distribution of an issuer’s newly issued fixed income securities.⁸ Thus, even without the benefit of the investment grade exceptions, the SEC’s strict interpretation of what constitutes the same security serves to substantially limit the effect of Rules 101 and 102 on fixed income distributions.

Industry Reliance on the Investment Grade Exceptions

Notwithstanding the more limited implications of Rules 101 and 102 for fixed income distributions, the investment grade exceptions remain important to issuers and distribution participants alike. As the SEC recognizes in the Proposal, the exceptions prove valuable in connection with “reopenings” of fixed income issuances that qualify for the investment grade exceptions because market activities in already outstanding securities of the same issue need not be restricted in connection with the reopening. Similarly, the investment grade exceptions prove useful in the context of a “sticky deal,” where the security begins to trade before participation in the distribution is completed. The utility of the investment grade exceptions extends to other situations as well. For example, the investment grade exception to Rule 102 allows an issuer of an investment-grade rated nonconvertible note to redeem/repurchase outstanding notes even while it is engaged in a continuing distribution of notes of the same issue.⁹

Proposed Alternative Exceptions Under Rule 101(c)(2)

As previously noted, the Proposal would replace the current investment grade exception to Rule 101 with two alternative exceptions — one for nonconvertible debt and nonconvertible preferred securities and another for asset-backed securities. While the exceptions differ in their criteria, each is intended to capture a universe of securities generally similar to those eligible under the current investment grade exception — that is, securities that are less susceptible to the manipulation Regulation M is designed to prevent because they trade based on their yield and creditworthiness.

• Proposed Alternative Exception for Nonconvertible Debt and Nonconvertible Preferred Securities Using a Structural Credit Risk Model (Proposed Rule 101(c)(2)(i))

The SEC is proposing to replace the exception for investment-grade rated nonconvertible debt and nonconvertible preferred securities with an alternative standard of creditworthiness that is based on a measure of the issuer’s probability of default. Specifically, the SEC is proposing to except nonconvertible debt securities and nonconvertible preferred securities of issuers for which the probability of default, estimated as of the pricing date and over the horizon of 12 calendar months from such date, is less than 0.055%, as determined and documented in writing using a “structural credit risk model.” For purposes of the rule, a “structural credit risk model” would be defined as “any commercially or publicly available model that calculates the probability that the value of the issuer may fall below a threshold based on an issuer’s balance sheet.” The SEC believes this standard would capture “most” of the securities that currently qualify under the existing investment grade exception.¹⁰

By requiring that the probability of default calculation be made using a structural credit risk model that is commercially or publicly available, the SEC is seeking to prevent parties with an interest in the distribution from developing their own proprietary models to achieve favorable results. The SEC understands that distribution participants already use such commercially or publicly available models to measure and manage credit risk;¹¹ however, reactions from a number of major market participants suggest otherwise. Requiring the calculation to be made as of the pricing date may also present challenges. Permitting the calculation to be made within a specified amount of time prior to pricing (similar to the approach taken with respect to the calculation of ADTV)¹² would seem preferable and allow for better planning.

Of note, the rule would permit — but not require — the use of a vendor for purposes of making the required calculations (e.g., distribution participants could make the calculations themselves, provided they use a commercially or publicly available model when doing so). In either case, broker-dealers relying on the exception would need to maintain a record demonstrating satisfaction of the necessary criteria, as further discussed herein.

In addition to being more complex than the current investment grade exception, the proposed new alternative could lead to certain anomalies. For example, because distribution participants would have flexibility in determining which particular structural credit risk model to use, it is possible that different firms would arrive at different conclusions regarding the availability of the exception. A uniform standard demonstrating a liquid and transparent market such as that proposed for asset-backed securities (see below) would seem to promote consistency and workability.

• Proposed Alternative Exception for Asset-Backed Securities (Proposed Rule 101(c)(2)(ii))

The SEC is proposing to replace the exception for investment-grade rated asset-backed securities with an exception for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3.

Noting that the eligibility requirements for Form SF-3 were designed to “help ensure a certain ‘quality and character’ in light of the requirement to reduce regulatory reliance on credit ratings,”¹³ the SEC believes that securities satisfying this standard trade primarily on the basis of yield and creditworthiness and hence are less susceptible to the manipulation addressed by Regulation M. The Proposal further explains that attempting to use a “probability of default” standard for asset-backed securities may be unfeasible, due to the potential challenges in collecting all of the information required to calculate the probability, including the value and volatility of the underlying assets. 

Similar to the current investment grade standard, the proposed new standard for asset-backed securities is attractive in that it is straightforward and easily verified through the SEC filing process. On the other hand, it excludes all SF-1 issuers, regardless of the creditworthiness of the issuer or the underlying assets.

Proposed New Recordkeeping for Broker-Dealers Relying on the Nonconvertible Debt and Nonconvertible Preferred Exception Under Proposed Rule 101(c)(2)(i)

The SEC is proposing a new recordkeeping requirement for broker-dealers under Exchange Act Rule 17a-4. Specifically, proposed new Rule 17a-4(b)(17) would require broker-dealers relying on the nonconvertible debt and nonconvertible preferred exception in Rule 101(c)(2)(i) to maintain a record of the written probability of default determination required by the rule. The record would be required to be maintained for at least three years, the first two in an easily accessible place. The proposed new requirement is intended to aid the SEC and self-regulatory organizations (SROs) in their oversight of broker-dealers that are distribution participants or affiliated purchasers and relying on the exception.

The Proposal notes that a broker-dealer that uses a vendor to determine the probability of default threshold could satisfy this requirement by maintaining documentation of the assumptions used in the vendor model as well as the output provided by the vendor supporting the probability of default determination. A broker-dealer that calculates the probability of default on its own could satisfy the requirement by maintaining documentation of the value of each variable used to calculate the probability of default, along with a record identifying the specific source(s) of such information for each variable.

Although the rule would allow distribution participants and their affiliated purchasers to perform their own calculations (so long as they use a commercially or publicly available structural credit risk model), we anticipate that most firms would prefer to use a vendor for this purpose.

The SEC is not proposing any new recordkeeping requirements associated with reliance on the proposed new asset-backed security exception, presumably because the appropriateness of reliance is readily discernible from the SEC’s own records and the availability of an issuer’s EDGAR database filings.

Proposed Elimination of the Investment Grade Exception Under Rule 102

In lieu of proposing an alternative standard, the SEC instead is proposing to simply eliminate the investment grade exception to Rule 102.

Although the SEC does not identify any specific concerns regarding issuers’ (and selling security holders’) historical reliance on the investment grade exception, the SEC reasons that elimination of the exception is appropriate, given issuers’ perceived lesser need for an exception and greater incentive to manipulate. This is the same rationale the SEC used when, at the time of Regulation M’s adoption, it determined to limit the “actively-traded security” exception to Rule 101.¹⁴

Issuers should carefully consider how the elimination of the exception may affect their market activities, including but not limited to the circumstance of reopenings and sticky deals. As previously noted, the SEC’s proposed elimination of the investment grade exception from Rule 102 (without the adoption of any alternative exception based on creditworthiness) would preclude an issuer from redeeming/repurchasing outstanding nonconvertible notes while it is engaged in a continuing distribution of notes of the same issue.¹⁵

Other Matters

Unlike Rules 101 and 102, Rule 104 of Regulation M (governing syndicate covering, stabilization and penalty bid activity) does not contain any exception for investment-grade rated nonconvertible debt, nonconvertible preferred, or asset-backed securities. Thus, as a general matter, Rule 104 applies (and will continue to apply) to such securities. In a 1997 letter to the Bond Market Association (BMA), however, the SEC provided limited exemptive relief from the requirements of Rule 104(h)(2) (relating to certain notification requirements in connection with syndicate covering transactions and penalty bids) in the context of such investment-grade rated securities.¹⁶ This exemptive relief permits any person to effect a syndicate covering transaction or impose a penalty bid with respect to such securities without providing prior notice to the market or to the SRO, as would otherwise be required by Rule 104(h)(2).

Distribution participants commenting upon Rule 101 will likely want to request that the staff confirm that the relief afforded under the 1997 BMA letter would continue to apply with respect to any securities qualifying under the proposed new exceptions in Rule 101(c)(2)(i)-(ii).

Request for Comment

The SEC seeks comment on all aspects of the Proposal, including but not limited to (i) the appropriateness of the probability of default standard for nonconvertible debt and nonconvertible preferred securities under proposed new Rule 101(c)(2)(i); (ii) challenges to using and relying on the “proposed probability of default” standard; (iii) whether the SEC should consider alternative standards for calculating the probability of default, including through the use of models other than a “structural credit risk model”; (iv) whether distribution participants should be permitted to rely on calculations by other parties (e.g., vendors) and whether they should be required to post or make the probability of default calculations public in order to rely on the exception; (v) the appropriateness of the exception for asset-backed securities registered on Form SF-3 and whether the exception should be expanded to apply to all asset-backed securities, including those registered on Form SF-1; (vi) alternatively, whether a probability of default standard would be appropriate for asset-backed securities and if so, what threshold criteria should be used for asset-backed securities; (vii) the impact the proposed asset-backed security exception under Rule 101 would have on the market for asset-backed securities; (viii) the appropriateness of the proposed new recordkeeping requirement for broker-dealers relying on the probability of default standard for nonconvertible debt and nonconvertible preferred securities under proposed new Rule 101(c)(2)(i); (ix) the extent to which issuers, selling security holders, and their respective affiliated purchasers are currently relying on the investment grade exception to Rule 102 and whether their activities in reliance on the exception improperly raise the price of the offered securities; and (x) whether the proposed elimination (without replacement) of the current investment grade exception to Rule 102 would result in potential disruption to trading markets or otherwise negatively affect the capital raising process.

¹ SEC Release No. 34-94499 (March 23, 2022), 87 FR 18312 (March 30, 2022) (available at https://www.govinfo.gov/content/pkg/FR-2022-03-30/pdf/2022-06583.pdf).

² Section 939A of the DFA requires the SEC to, among other things, remove any references to credit ratings from its regulations and to instead “substitute in such regulations such standard of credit-worthiness” as the SEC determines to be appropriate. The SEC had issued two prior proposals to remove references to credit ratings from the provisions of Regulation M — one in 2008, prior to the DFA, and one in 2011, following the DFA. See SEC Release Nos. 34-58070 (July 1, 2008) (available at https://www.sec.gov/rules/proposed/2008/34-58070.pdf) and 34-64352 (April 27, 2011) (available at https://www.sec.gov/rules/proposed/2011/34-64352.pdf). Neither proposal was adopted.

³ See Rules 101(c)(2) and 102(d)(2) of Regulation M.

⁴ For purposes of Regulation M, a distribution is defined as an offering of securities that is distinguished from ordinary trading transactions by both the magnitude of the offering and the presence of special selling efforts and selling methods.

⁵ For purposes of Regulation M, a reference security is any security into which the subject security may be converted, exchanged, or exercised or which, pursuant to the terms of the subject security, determines the value of the subject security in whole or significant part.

⁶ For a traditional underwritten offering, the commencement of the restricted period depends on the “average daily trading volume” (ADTV) value of the particular security (as calculated in accordance with Regulation M) as well as the issuer’s public float value. For securities with an ADTV value of at least $100,000, where the issuer’s common equity securities have a public float value of at least $25 million, the restricted period will commence one business day prior to the determination of the offering price. For all other securities, the restricted period will begin five business days prior to pricing. In all cases, the restricted period continues until the party’s participation in the distribution is deemed complete. Rule 101 includes an exception for certain “actively-traded” subject and reference securities; by contrast, Rule 102 provides a substantially more narrow exception for certain “actively-traded” reference securities only. For purposes of Regulation M, “actively-traded” securities are securities that have an ADTV value of at least $1 million and are issued by an issuer whose public float value is at least $150 million.

⁷ SEC Release No. 34-38067 (December 20, 1996) (Reg M Adopting Release) (available at https://www.sec.gov/rules/final/34-38067.txt). In the context of equity securities, the SEC has noted that equity securities that differ only as to voting rights will be considered the same security for purposes of Regulation M.

⁸ It also generally means that there will be no trading history for the security in distribution and hence that the applicable restricted period for the distribution will generally begin five full business days prior to pricing.

⁹ The SEC staff has previously taken the position that redemptions at the option of the holder may not be effected by an issuer in reliance upon the “unsolicited transactions” exception to Rule 102, even if the issuer takes no further steps to induce redemptions and in fact would prefer that holders not redeem.

¹⁰ Proposal, 87 FR at 18319.

¹¹ Id.

¹² See the definition of “ADTV” under Rule 100 of Regulation M (which, in the context of shelf offerings, permits ADTV value to be calculated over any consecutive 60 calendar days ending within 10 calendar days prior to pricing).

¹³ Proposal, 87 FR at 18321 (citing SEC Release No. 34-72982 (September 4, 2014) (Regulation AB II Adopting Release) (available at https://www.sec.gov/rules/final/34-38067.txt).

¹⁴ See Reg M Adopting Release at Section II.C.5.a.

¹⁵ See note 9, supra.

¹⁶ See Bond Market Association, SEC No-Action Letter, 1997 SEC No-Act. LEXIS 1055 (December 10, 1997).