[Federal Register Volume 87, Number 61 (Wednesday, March 30, 2022)]
[Proposed Rules]
[Pages 18312-18338]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-06583]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-94499; File No. S7-11-22]
RIN 3235-AL14
Removal of References to Credit Ratings From Regulation M
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is re-
proposing amendments to remove the references to credit ratings
included in certain Commission rules. The Dodd-Frank Wall Street Reform
and Consumer Protection Act (``Dodd-Frank Act''), among other things,
requires the Commission to remove any references to credit ratings from
its regulations. In one rule governing the activity of distribution
participants, the Commission is proposing to remove the reference to
credit ratings, substitute alternative measures of credit-worthiness,
and impose related recordkeeping obligations in certain instances. In
another rule governing the activity of issuers and selling security
holders during a distribution, the Commission is proposing to eliminate
the exception for investment-grade nonconvertible debt, nonconvertible
preferred securities, and asset-backed securities.
DATES: Comments should be received on or before May 23, 2022.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/submitcomments.htm); or
Send an email to [email protected]. Please include
File Number S7-11-22 on the subject line; or
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-11-22. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method of submission. The Commission will post all comments on the
Commission's website (http://www.sec.gov/rules/proposed.shtml).
Comments are also available for website viewing and printing in the
Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. Operating conditions may limit access to the Commission's Public
Reference Room. All comments received will be posted without change; we
do not edit personal identifying information from comment submissions.
You should submit only information that you wish to make publicly
available.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: John Guidroz, Branch Chief, Laura
Gold, Special Counsel, Jessica Kloss, Attorney-Adviser, or Josephine
Tao, Assistant Director, in the Office of Trading Practices, at (202)
551-5777, Division of Trading and Markets, U.S. Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing to amend the
existing exceptions found in 17 CFR 242.101 (``Rule 101'') and 17 CFR
242.102 (``Rule 102'') for investment-grade nonconvertible debt
securities, nonconvertible preferred securities, and asset-backed
securities. Specifically, the Commission is proposing to remove the
requirement to qualify for the exception in each of these rules that
these securities be rated investment grade by at least one nationally
recognized statistical rating organization (``NRSRO''). In its place,
in Rule 101, the Commission proposes to except (1) nonconvertible debt
securities and nonconvertible preferred securities (collectively,
``Nonconvertible Securities'') that meet a specified probability of
default threshold, and (2) asset-backed securities that are offered
pursuant to an effective shelf registration statement filed on the
Commission's Form SF-3. In addition, the Commission is proposing to
eliminate the existing exception in Rule 102 for investment-grade
Nonconvertible Securities, and asset-backed securities. The Commission
is also proposing amendments to 17 CFR 240.17a-4(b) (``Rule 17a-4(b)'')
under the Securities Exchange Act of 1934 (``Exchange Act'') to require
broker-dealers to maintain the written probability of default
determination.
Table of Contents
I. Background
II. Prior Proposals To Remove References to Credit Ratings in
Regulation M
A. 2008 Proposal
B. 2011 Proposal
III. Application of Regulation M to Distributions of Nonconvertible
Securities and Asset-Backed Securities
IV. Proposed Amendments to Rules 101 and 102 To Remove References to
Credit Ratings
A. Rule 101
B. Rule 102
V. Recordkeeping Requirement: Rule 17a-4(b)(17)
A. Proposed Recordkeeping Requirement
B. Request for Comment
VI. General Request for Comment
VII. Paperwork Reduction Act Analysis
A. Background
B. Proposed Use of Information
C. Information Collections
D. Collection of Information Is Mandatory
E. Confidentiality
F. Retention Period of Recordkeeping Requirement
G. Request for Comment
[[Page 18313]]
VIII. Economic Analysis
A. Baseline
B. Benefits of the Proposed Amendment
C. Costs of the Proposed Amendment
D. Efficiency, Competition, and Capital Formation
E. Reasonable Alternatives
F. Request for Comment
IX. Regulatory Flexibility Act Certification
X. Consideration of Impact on the Economy
Statutory Basis and Text of Proposed Amendments
List of Subjects in 17 CFR Part 240 and 242
I. Background
Title IX, Subtitle C, of the Dodd-Frank Act includes provisions
regarding statutory and regulatory references to credit ratings in the
Exchange Act and the rules promulgated thereunder.\1\ One such
provision, Section 939A, requires the Commission to ``review any
regulation issued by [the Commission] that requires the use of an
assessment of the credit-worthiness of a security or money market
instrument and any references to or requirements in such regulations
regarding credit ratings.'' \2\ Upon completion of this review, the
Commission must ``remove any reference to or requirement of reliance on
credit ratings'' and ``substitute in such regulations such standard of
credit-worthiness'' as the Commission determines to be appropriate for
such regulations. In making such a determination, the Commission shall
seek to establish, to the extent feasible, uniform standards of credit-
worthiness for use by the Commission, taking into account the entities
it regulates and the purposes for which such entities would rely on
such standards of credit-worthiness.\3\ The statute also requires the
Commission to transmit a report to Congress upon the conclusion of the
review required in Section 939A(a).\4\
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\1\ See Public Law 111-203 secs. 931-939H, 124 Stat. 1376, 1872-
90 (2010). These provisions are designed ``[t]o reduce the reliance
on ratings.'' Joint Explanatory Statement of the Committee of
Conference, Conference Committee Report No. 111-517, to accompany
H.R. 4173, 864-79, 870 (June 29, 2010).
\2\ Public Law 111-203 sec. 939A(a); see infra note 4.
\3\ See id. at sec. 939A(b).
\4\ Id. at sec. 939A(c); see U.S. Securities and Exchange
Commission Staff, Report on Review of Reliance on Credit Ratings: As
Required by Section 939A(c) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (2011), available at https://www.sec.gov/news/studies/2011/939astudy.pdf. Staff reports, Investor Bulletins,
and other staff documents (including those cited herein) represent
the views of Commission staff and are not a rule, regulation, or
statement of the Commission. The Commission has neither approved nor
disapproved the content of these documents and, like all staff
statements, they have no legal force or effect, do not alter or
amend applicable law, and create no new or additional obligations
for any person.
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In reference to the requirements in Section 939A, the Commission is
proposing amendments to Rule 101 and Rule 102 to remove the existing
exceptions for nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities, that are rated by at least one
NRSRO, as that term is used in Rule 15c3-1 under the Exchange Act,\5\
in one of its generic rating categories that signifies investment
grade.\6\ Throughout this release, this exception referencing an
investment grade rating is referred to as the ``Investment Grade
Exception,'' or the ``Investment Grade Exceptions'' when referencing
the exception provided in Rule 101 and Rule 102 or the rules
collectively, as applicable. In place of the Investment Grade Exception
in Rule 101, the Commission proposes to substitute alternative
standards of credit-worthiness with respect to the type of security
that is the subject of a distribution. First, for distributions of
Nonconvertible Securities, the Commission is proposing a standard that
is based on the probability of default of the issuer.\7\ Second, for
distributions of asset-backed securities, the Commission is proposing
to except asset-backed securities that are offered pursuant to an
effective shelf registration statement filed on Form SF-3. Finally, the
Commission is proposing to eliminate the Investment Grade Exception in
Rule 102 and not replace it with an alternative standard.
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\5\ 17 CFR 240.15c3-1. In 1975, the Commission adopted the term
NRSRO as part of its amendments to Exchange Act Rule 15c3-1. In
2013, pursuant to Section 939A of the Dodd-Frank Act, the Commission
adopted amendments to Rule 15c3-1 to remove the reference to NRSROs.
See Removal of Certain References to Credit Ratings Under the
Securities Exchange Act of 1934, Release No. 34-71194 (Dec. 27,
2013) [79 FR 1522, 1527-28 (Jan. 8, 2014)].
\6\ See 17 CFR 242.101(c)(2), 17 CFR 242.102(d)(2).
\7\ To assist the Commission in conducting effective
examinations and oversight of distribution participants and their
affiliated purchasers, the Commission is also requiring the
maintenance and preservation of the written probability of default
determination. See infra Part V.
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As a set of prophylactic anti-manipulation rules, Regulation M is
designed to preserve the integrity of the securities trading markets as
independent pricing mechanisms by prohibiting activities that could
artificially influence the market for an offered security. Subject to
exceptions, Rules 101 and 102 prohibit issuers, selling security
holders, distribution participants,\8\ and any of their affiliated
purchasers \9\ from, directly or indirectly, bidding for, purchasing,
or attempting to induce another person to bid for or purchase a covered
security \10\ during a specified period referred to as the ``restricted
period.'' \11\
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\8\ See 17 CFR 242.100 (``Rule 100'') (defining ``distribution
participant'' as any ``underwriter, prospective underwriter, broker,
dealer, or other person who has agreed to participate or is
participating in a distribution'').
\9\ Specifically, Rule 101 governs the activities of
``distribution participants,'' while Rule 102 governs the activities
of the issuer and selling security holders. Rules 101 and 102 also
apply to the affiliated purchasers of underwriters and issuers or
selling security holders, respectively.
\10\ See 17 CFR 242.100 (defining ``covered security'' as any
security that is the subject of a distribution or any reference
security, and ``reference security'' as a security into which a
security that is the subject of a distribution may be converted,
exchanged, or exercised or which, under the terms of the subject
security, may in whole or in significant part determine the value of
the subject security).
\11\ The restricted period for any particular distribution
commences one or five business days before the day of the pricing of
the offered security and continues until the distribution is
complete. The restricted period that applies to a particular
offering is determined based on the trading volume value of the
offered security and the public float value of the issuer. See Rule
100. A person determines when it completes its participation in the
distribution based on its role. See Rule 100; Anti-Manipulation
Rules Concerning Securities Offerings, Release No. 34-38067 (Dec.
20, 1996) [62 FR 520, 522 (Jan. 3 1997)] (``Regulation M Adopting
Release''). In addition, securities acquired in the distribution for
investment purposes by any person participating in a distribution,
or any affiliated purchaser of such person, are deemed to be
distributed. Rule 100; Regulation M Adopting Release, 62 FR 523.
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The Investment Grade Exceptions are two of several exceptions to
the general prohibitions of Rules 101 and 102. The Commission expressed
its belief that certain securities and activities should be excepted
from the prohibitions in order to allow for activities necessary for
the distribution to occur; to limit adverse effects to the trading
market that could result from these prohibitions absent such
exceptions; and to allow conduct that is not likely to have a
manipulative impact.\12\ The Commission did not except other securities
and activities, however, expressing a belief that the application of
Regulation M is appropriate ``where the incentive to manipulate can
escalate.'' \13\ The securities and activities exceptions provided in
Regulation M take into account the different types of interests that
distribution participants, issuers, and selling security holders have
regarding the outcome of a distribution by providing different and
limited exceptions in Rule 102 to issuers and
[[Page 18314]]
selling security holders.\14\ Rule 102 contains fewer exceptions than
Rule 101 because issuers and selling security holders have the greatest
interest in an offering's outcome and generally do not have the same
market access needs as underwriters.\15\
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\12\ See Trading Practices Rules Concerning Securities
Offerings, Release No. 33-7282 (Apr. 11, 1996) [61 FR 17108, 17111,
17120 (Apr. 18, 1996)] (``Regulation M Proposing Release'').
\13\ Regulation M Adopting Release, 62 FR 528. The Commission
also stated more generally that Regulation M applies where there is
a ``readily identifiable incentive to manipulate the price of an
offered security.'' Id. at 540.
\14\ See Regulation M Adopting Release, 62 FR 530.
\15\ Id.
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II. Prior Proposals To Remove References to Credit Ratings in
Regulation M
The Commission has previously proposed two alternatives with
respect to the Investment Grade Exceptions, once in 2008 (``2008
Proposal'') \16\ and once in 2011 (``2011 Proposal'').\17\ The
Commission did not adopt any rules based on the 2008 Proposal or the
2011 Proposal.\18\
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\16\ References to Ratings of Nationally Recognized Statistical
Rating Organizations, Release No. 34-58070 (July 1, 2008) [73 FR
40088, 40095-97 (July 11, 2008)] (``2008 Proposing Release'').
\17\ Removal of Certain References to Credit Ratings Under the
Securities Exchange Act of 1934, Release No. 34-64352 (Apr. 27,
2011) [76 FR 26550 (May 6, 2011)] (``2011 Proposing Release'').
\18\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, Release No. 34-71194 (Dec. 27,
2013) [79 FR 1522 (Jan. 8, 2014)].
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A. 2008 Proposal
In 2008, prior to the enactment of the Dodd-Frank Act, the
Commission proposed to substitute the Investment Grade Exceptions with
a standard for Nonconvertible Securities based primarily on the well-
known seasoned issuers (``WKSI'') concept from Rule 405 of the
Securities Act of 1933 (``Securities Act''), as well as a standard for
asset-backed securities that were registered on Form S-3.\19\
Commenters expressed uniform opposition to the 2008 Proposal.\20\ Many
of these commenters stated their view that changes to the Regulation M
exceptions, such as those in the 2008 Proposal, were not necessary as
the Regulation M exceptions did not raise the same concerns about
investors' undue reliance on credit ratings as other rules could.\21\
Commenters also stated that a result of the 2008 Proposal would be new
burdens on issuers and underwriters from imposing the restrictions of
Regulation M on currently excepted investment grade securities.\22\
Additionally, commenters expressed the view that certain issuers of
high yield securities that are currently subject to Regulation M, but
are arguably more vulnerable to manipulation than securities currently
excepted from Regulation M, would have been excepted from Rules 101 and
102.\23\ These commenters generally did not suggest specific
alternatives to the proposed rule changes.\24\
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\19\ 2008 Proposing Release, 73 FR 40095-97. More specifically,
the 2008 Proposal--consistent with the definition of WKSI in
Securities Act Rule 405--would have excepted Nonconvertible
Securities of issuers who have issued at least $1 billion aggregate
principal amount of nonconvertible securities, other than common
equity, in primary offerings for cash, not exchange, registered
under the Securities Act. See 17 CFR 230.405, paragraph (1)(i)(B)(1)
of the definition of WKSI; see also 2008 Proposing Release, 73 FR
40096.
\20\ See 2011 Proposing Release at 26559 (discussing commenter
views about the 2008 Proposal). Comments received in response to the
2008 Proposal are contained in File No. S7-17-08, available at
https://www.sec.gov/comments/s7-17-08/s71708.shtml. Comments that
were received in response to the 2008 Proposal that are relevant to
the substance or scope of the amendments being proposed in this
release and are discussed below in Part IV. Comments that were
received in response to the 2008 Proposal that are relevant to the
economic effects of the amendments being proposed in this release
and are discussed below in Part VIII.
\21\ See, e.g., Letter from Deborah A. Cunningham and Boyce I.
Greer, Co-chairs, Securities Industry and Financial Markets
Association (``SIFMA'') Credit Rating Agency Task Force, to Florence
E. Harmon, Acting Secretary (Sep. 4, 2008) (``SIFMA Letter 1'') at
14 (``Regulation M is primarily directed at the actions of the
issuers of securities and the investment banks who underwrite them;
in contrast, the investors that the Commission is concerned with are
not users of Regulation M.'').
\22\ Letter from Keith F. Higgins, Chair, Committee on Federal
Regulation of Securities, American Bar Association (``ABA''), to
Florence E. Harmon, Acting Secretary (Oct. 10, 2008) (``ABA
Letter'') and SIFMA Letter 1 at 13.
\23\ ABA Letter at 16 and SIFMA Letter 1 at 13.
\24\ The ABA did, however, suggest that should the Commission
insist on using the WKSI standard for investment grade
Nonconvertible Securities, it do so only as an alternative to the
current exceptions in Rules 101(c)(2) and 102(d)(2). ABA Letter at
17. However, the ABA expressed its ``strong[ ] belie[f] that the
Commission should retain the current exceptions.'' Id. at 16.
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In 2009, in light of the uniform opposition by commenters and
continuing concern regarding the undue influence of credit ratings, the
Commission reopened the comment period for the 2008 Proposal and
invited comments suggesting alternative proposals to achieve the
Commission's goals.\25\ The Commission received three additional
comment letters. Of these, two reiterated earlier objections,\26\ and
the third stated that the 2008 Proposal would have resulted in adverse
effects on foreign sovereign issuers of debt securities.\27\ Although
the Commission invited commenters to suggest alternative proposals, no
new alternatives were suggested.\28\ As noted above, the Commission did
not adopt any rules based on the 2008 Proposal.
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\25\ References to Ratings of Nationally Recognized Statistical
Rating Organizations, Release No. 34-60790 (Oct. 5, 2009) [74 FR
52374, 52375 (Oct. 9, 2009)].
\26\ Letter from Mary Keogh, Managing Director, Regulatory
Affairs and Daniel Curry, President, DBRS, Inc., to Elizabeth M.
Murphy, Secretary (Nov. 13, 2009); Letter from Sean C. Davy,
Managing Director, Corporate Credit Markets Division, SIFMA, to
Elizabeth M. Murphy, Secretary (Dec. 8, 2009).
\27\ Letter from Steven G. Tepper, Arnold & Porter LLP, to the
Honorable Mary L. Schapiro, Chairman (Dec. 8, 2009) (``Arnold &
Porter Letter'').
\28\ See 2011 Proposing Release, 76 FR 26559.
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B. 2011 Proposal
In 2011, after the Dodd-Frank Act was signed into law, the
Commission issued a different proposal, which would have replaced the
Investment Grade Exceptions with a standard based on the trading
characteristics that the Commission believed made the exceptions apply
to securities that were less prone to the type of manipulation that
Regulation M seeks to prevent. The 2011 Proposal would have replaced
the Investment Grade Exceptions with an exception for Nonconvertible
Securities and asset-backed securities that (1) were liquid relative to
the market for that asset class, (2) traded in relation to general
market interest rates and yield spreads, and (3) were relatively
fungible with securities of similar characteristics and interest rate
yield spreads.\29\ The 2011 Proposal would have required the person
seeking to rely on the exception to make the determination that the
security in question met these standards utilizing reasonable factors
of evaluation. Further, this determination would have been required to
be subsequently verified by an independent third party.\30\
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\29\ 2011 Proposing Release, 76 FR 26559.
\30\ Id. at 26560.
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Almost all commenters expressed concerns about aspects of the 2011
Proposal.\31\ For example, commenters generally had concerns regarding
the practicality of the 2011 Proposal. More specifically, there were
concerns that, because of the forward-looking and subjective nature of
the proposed standards in this release, it would be impractical to make
consistent determinations among market participants, even in the same
distributions.\32\ Many commenters
[[Page 18315]]
contrasted these issues with the fact that using credit ratings under
the existing standard establishes a bright-line for market
participants.\33\ Many commenters also stated that the 2011 Proposal
would have added costs and delays to the offering process.\34\
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\31\ Comments received in response to the 2011 Proposal are
contained in File No. S7-15-11, available at https://www.sec.gov/comments/s7-15-11/s71511.shtml. Comments that were received in
response to the 2011 Proposal that are relevant to the substance or
scope of the amendments being proposed in this release are discussed
below, in Part IV. Comments that were received in response to the
2011 Proposal that are relevant to the economic effects of the
amendments being proposed in this release are discussed below, in
Part VIII. One commenter expressed complete support for the 2011
Proposal. See Letter from Kurt N. Schacht, Managing Director,
Standards and Financial Markets Integrity, and Linda L. Rittenhouse,
Director, Capital Markets Policy, CFA Institute to Elizabeth M.
Murphy, Secretary (Dec. 20, 2011) (``CFA Letter'').
\32\ Letter from Sullivan & Cromwell LLP to Elizabeth M. Murphy,
Secretary (July 5, 2011) (``Sullivan & Cromwell Letter'') at 3; see
also Letter from Suzanne Rothwell, Managing Member, Rothwell
Consulting LLC to Elizabeth M. Murphy, Secretary (July 5, 2011)
(``Rothwell Letter'') at 6-7 and Letter from Kenneth E. Bensten,
Jr., Executive Vice President, Public Policy and Advocacy, SIFMA to
Elizabeth M. Murphy, Secretary (July 5, 2011) (``SIFMA Letter 3'')
at 3-10. SIFMA Letter 3 stated that this could lead to market
participants being overly conservative in their analysis in fear of
other distribution participants taking more negative views of the
security or being overly optimistic regarding the security in order
to gain a competitive advantage, leaving the application of the
exceptions to something other than whether the security is less
susceptible to manipulation. See SIFMA Letter 3 at 7.
\33\ Letter from Davis Polk & Wardwell LLP to Elizabeth M.
Murphy, Secretary (July 5, 2011) (``Davis Polk Letter'') at 2;
Rothwell Letter at 7; Sullivan & Cromwell Letter at 3; SIFMA Letter
3 at 3; see also Letter from Dennis M. Kelleher, President & CEO,
and Stephen W. Hall, Securities Specialist, Better Markets, Inc., to
Elizabeth M. Murphy, Secretary (July 5, 2011) (``Better Markets
Letter'') at 5 (arguing for bright-line standards to ensure that
manipulation does not occur). Some commenters also pointed to the
success of the references to credit ratings in the current
exceptions at creating workable exceptions to Regulation M. See
Rothwell Letter at 2; Sullivan & Cromwell Letter at 3.
\34\ Davis Polk Letter at 3; Rothwell Letter at 7; Sullivan &
Cromwell Letter at 4; SIFMA Letter 3 at 7.
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One commenter suggested that the risk of manipulation is low for
the securities at issue.\35\ Another said that the 2011 Proposal was
contrary to the approach in Regulation M in general and the exceptions
specifically, which was to focus the restrictions of the regulation on
those circumstances where the chance for manipulation was
heightened,\36\ though others disagreed.\37\ One commenter suggested
that all fixed income securities be excepted from Rules 101 and
102.\38\ One commenter believed that the 2011 Proposal would have
excluded some investment grade securities, changing the scope of the
exception.\39\
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\35\ Davis Polk Letter at 1.
\36\ Davis Polk Letter at 1; SIFMA Letter 3.
\37\ Sullivan & Cromwell Letter at 2 (stating that ``[a]s a
purely conceptual matter, we think the new standard is logical and
consistent with the principles underlying Regulation M, as they have
been developed over time''); CFA Letter at 6-7 (stating that ``the
exemptions . . . appear to be reasonably focused at preventing the
types of manipulation that the regulation seeks to deter'').
\38\ This commenter said that the rationale for the exceptions
for investment grade fixed income securities applies equally to non-
investment grade fixed income securities. SIFMA Letter 3 at 14.
\39\ Davis Polk Letter at 4.
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Commenters also suggested that unintended consequences could have
resulted from the 2011 Proposal. Some suggested that, in light of the
fact that transactions in Rule 144A securities are generally excepted
from Rules 101 and 102,\40\ the lack of a bright-line could have
reduced the attractiveness of registered offerings because of the
complications in using the exceptions from Regulation M as changed by
the 2011 Proposal.\41\ However, one of these commenters agreed with the
Commission's assessment that the ``impact of the change should not be
substantial.'' \42\
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\40\ See, e.g., 17 CFR 242.101(b)(10).
\41\ Sullivan & Cromwell Letter at 4-5; SIFMA Letter 3 at 4.
\42\ Sullivan & Cromwell Letter at 2. However, this commenter
also stated that it did not ``perceive any real purpose being served
by this proposed change'' and while the change would not be
substantial, ``that is not a good reason to make it.'' Id. It also
described the potential impact of the proposal on distributions that
are not completed immediately after pricing. Id. at 3-5.
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Some commenters questioned whether Section 939A of the Dodd-Frank
Act requires that the Commission change Regulation M at all,\43\
whereas others suggested that the proposal did not go far enough to
comply with that section.\44\ One commenter suggested that the
Commission adopt amendments similar to those included in the 2008
Proposal in response to the 2011 Proposal in light of the apparent
mandate of 939A to not retain the status-quo.\45\ This commenter noted
that it preferred a proposal that utilized an objective, bright-line
standard.\46\ As noted above, the Commission did not adopt any rules
based on the 2011 Proposal.
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\43\ For example, commenters who questioned the need for the
changes pointed out that the underlying concern with Section 939A,
that market participants had become overly reliant on credit ratings
as a substitute for their own credit analysis, was not present in
the Regulation M exceptions at issue because Regulation M regulates
trading practices. See Rothwell Letter at 4; Sullivan & Cromwell
Letter at 3. One of these commenters also stated that, because the
credit rating process has been improved by regulatory changes in
recent years, including the Credit Rating Agency Reform Act of 2006,
the Commission did not need the 2011 Proposal. See Rothwell Letter
at 4.
\44\ See SIFMA Letter 3 at 4 (suggesting adopting a modified
version of the 2008 Proposal ``now that the Dodd-Frank Act requires
removal of references to credit ratings'') (emphasis added); see
also Letter from Chris Barnard to Elizabeth M. Murphy, Secretary
(June 6, 2011); Better Markets Letter at 13 (questioning whether the
2011 Proposal offered a sufficient ``standard of credit-worthiness''
as required in Section 939A).
\45\ SIFMA Letter 3 at 7-8.
\46\ SIFMA Letter 3 at 9; Letter from Sean C. Davy, Managing
Director, Corporate Credit Markets Division, SIFMA, to Elizabeth M.
Murphy, Secretary (Jan. 24, 2014) at 3.
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III. Application of Regulation M to Distributions of Nonconvertible
Securities and Asset-Backed Securities
The application of Regulation M's prohibitions to distributions of
Nonconvertible Securities and asset-backed securities generally is
limited because distribution participants and affiliated purchasers are
restricted only from bidding for or purchasing securities that are
identical in all of their terms to the security being distributed.\47\
In other words, the restrictions do not apply for a security if there
is a single basis point difference in coupon rates or a single day's
difference in maturity dates from the security in distribution.\48\
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\47\ Regulation M Adopting Release, 62 FR 524.
\48\ To illustrate with a simple example, absent an exception, a
broker-dealer who is participating in a distribution of XYZ Corp.'s
3% bonds maturing 12/31/2029 would be prohibited from making a
market in bonds with those terms prior to completing the
distribution. The broker-dealer would not, however, be prohibited
from making a market in XYZ Corp.'s 3% bonds maturing 12/31/2030
because the date of maturity, a term of the bond, is different from
the security in distribution.
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The Investment Grade Exceptions trace back to a 1975 no-action
position taken by Commission staff regarding former Exchange Act Rule
10b-6, the predecessor to Rules 101 and 102.\49\ This no-action letter
was premised on the principle that investment grade Nonconvertible
Securities and asset-backed securities are less likely to be subject to
manipulation because they are traded on the basis of their yields and
credit ratings rather than the identity of the particular issuer.\50\
This reasoning served as the basis for the Commission's adoption of the
[[Page 18316]]
Investment Grade Exceptions in Regulation M \51\ and continues to serve
in part as the basis for the proposed amendments to Rule 101.
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\49\ For a discussion of why the Commission considered replacing
former Exchange Act Rule 10b-6 (and other predecessor trading
practices rules) with Regulation M, see Review of Antimanipulation
Regulation of Securities Offerings, Release No. 34-33924 (Apr. 19,
1994) [59 FR 21681 (Apr. 26, 1994)].
\50\ Letter from Robert C. Lewis, Associate Director, Division
of Market Regulation, to Donald M. Feuerstein, General Partner and
Counsel, Salomon Brothers (Mar. 4, 1975). The request letter to the
staff states that debt securities ``are merely a right to receive a
fixed amount of money no later than a specified future date, and the
issuer's prospects are relevant only insofar as they reflect on its
ability to meet its obligations to the debtholders. Thus,
nonconvertible debt securities with similar economic terms and
similar degrees of assurance of payment are substantially fungible
even though their issuers may be different. The economic terms of
particular debt issues are susceptible to precise comparison,
particularly when mathematically translated into yield to maturity,
average life or call. Although the degree of assurance of payment
cannot be precisely quantified, debt investors are not influenced by
many developments in the issuer's affairs that are material to
equity investors. . . . Thus the identity of the issuers of
corporate bonds with similar risk factors is not important in the
analysis of fixed income securities.''
\51\ See Regulation M Adopting Release, 62 FR 527.
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While the Commission carried over its reasoning from former
Exchange Act Rule 10b-6 to serve as the premise of the Investment Grade
Exceptions, it did not adopt the former rule's broad application. In
contrast to Regulation M's limited applicability only to distributions
of securities that have identical terms, former Exchange Act Rule 10b-6
applied to distributions of ``any security of the same class and
series.'' \52\ The phrase ``same class and series'' was construed
broadly to encompass securities that were sufficiently similar in their
terms to the security in a distribution to raise the possibility that
bids for or purchases of the outstanding security might facilitate the
distribution, even in the absence of an inherent mathematical
relationship between the prices of the two securities.\53\
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\52\ Former Exchange Act Rule 10b-6(a)(3).
\53\ See Review of Antimanipulation Regulation of Securities
Offerings, Release No. 34-33924 (Apr. 19, 1994) [59 FR 21681, 21688
(Apr. 26, 1994)]; see also Gamble Skogmo, Inc., SEC No-Action
Letter, (Jan. 11, 1974), in which the staff took a no-action
position to permit bids for or purchases of the issuer's outstanding
debt securities that varied by at least 1% in coupon interest rate
and by at least ten years in maturity from those of the debt
securities being distributed.
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Accordingly, some commenters responding to the 2008 Proposal and
the 2011 Proposal stated that reliance on the Investment Grade
Exceptions largely is limited to two situations. The first situation is
a so-called ``reopening,'' which is an offering of an additional
principal amount of fixed-income securities that are identical to, and
fungible with, the securities that are already outstanding.\54\ One
commenter stated that an issuer may want to make a series of offerings
of its fixed-income securities via a reopening to match its funding
needs or the desires of its target investor class.\55\ Further, some
foreign sovereign issuers may conduct a reopening for public finance
purposes.\56\ The second situation identified by commenters is a so-
called ``sticky offering,'' which is an offering where a lack of demand
results in an underwriter being unable to sell all of the securities in
a distribution.\57\ One commenter stated that an investor failing to
honor a previously given indication of interest is an example of a
situation that can cause a sticky offering.\58\ Another example
provided by a commenter is a ``best-efforts'' offering.\59\
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\54\ See SIFMA Letter 3 at 6.
\55\ Id.
\56\ See Arnold & Porter Letter at 2-3.
\57\ Sullivan & Cromwell Letter at 4. The Commission also
indicated that a sticky offering could be a circumstance in which
Regulation M would impact debt securities, stating its belief that
``as a practical matter, Rule 101 and Rule 102 will have very
limited impact on debt securities, except for the rare situations
where selling efforts continue over a period of time.'' Regulation M
Adopting Release, 62 FR 528.
\58\ Sullivan & Cromwell Letter at 4.
\59\ Rothwell Letter at 9. In a best-efforts offering, the
underwriters are not required to sell any specific number or dollar
amount of securities but will use their best efforts to sell the
securities offered. See Plain English Disclosure, Release No. 34-
38164, (Jan. 14, 1997) [62 FR 3152 (Jan. 21, 1997)].
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One commenter noted that, absent the Investment Grade Exceptions,
underwriters would be prohibited from making a market in the
distribution securities while the distribution continued.\60\ The
implication of this is that underwriters would have to ``weigh (a) the
risk of . . . a continuing distribution occurring, against (b) the
possible disruptive effect of having no underwriters making a market in
the immediate post-pricing period.'' \61\ Another commenter identified
that the absence of an Investment Grade Exception from Rule 102 would
disrupt the ability of foreign sovereign issuers and their affiliates
to purchase any of the issuer's securities in connection with the
sovereign issuer's own general trading and investment activities, or
for other public purposes, during the applicable restricted period.\62\
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\60\ Sullivan and Cromwell Letter at 4.
\61\ Id. (discussing the alternative to following the steps
required for an underwriter to determine the availability of the
exception from Regulation M under the 2011 Proposal).
\62\ Arnold & Porter Letter at 3.
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IV. Proposed Amendments to Rules 101 and 102 To Remove References to
Credit Ratings
As discussed below, the Commission is proposing to eliminate the
Investment Grade Exceptions from both Rules 101 and 102. The Commission
is proposing to replace the Investment Grade Exception in Rule 101 with
two separate exceptions based on different standards: (1) With respect
to Nonconvertible Securities, an exception that is based on a
probability of default standard as an indicator of credit-worthiness,
and (2) an exception for asset-backed securities that are offered
pursuant to an effective shelf registration statement filed on Form SF-
3.
A. Rule 101
1. Excepted Securities: Nonconvertible Securities
With respect to Nonconvertible Securities, the Commission is
proposing to replace the NRSRO reference currently included in Rule
101(c)(2) with a standard utilizing a specified probability of default
threshold based on certain structural credit risk models (``Structural
Credit Risk Models'').\63\
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\63\ As discussed below, the term ``structural credit risk
model'' for purposes of the proposed exception in Rule 101(c)(2)(i)
shall mean 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.
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(a) Existing Exception for Investment Grade Nonconvertible Securities
As discussed above, Rule 101(c)(2) currently provides an exception
for Nonconvertible Securities that are rated by at least one NRSRO in
one of its generic rating categories that signifies investment grade.
The Commission excepted investment grade Nonconvertible Securities from
Rule 101 ``based on the premise that these securities traded on the
basis of their yield and credit ratings, are largely fungible and,
therefore, are less likely to be subject to manipulation.'' \64\
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\64\ Regulation M Adopting Release, 62 FR 527.
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(b) Overview of Structural Credit Risk Models
In 1974, Robert C. Merton published a paper that provided a method,
based on the Black-Scholes option pricing model,\65\ of analyzing a
company's credit risk by modeling a company's equity as a call option
on the company's assets (``Merton (1974) Model''), which is generally
regarded as the first Structural Credit Risk Model.\66\ Since 1974,
Structural Credit Risk Models, such as the Merton (1974) Model and
[[Page 18317]]
the Successor Models, have become widely relied upon to determine the
probability of an issuer defaulting on its loan obligations.\67\ Many
commercial data providers, as part of software suites that allow users
to analyze securities, employ Structural Credit Risk Models as a way to
measure the credit-worthiness of companies.\68\ Generally, these models
assume that owners of a company's equity will continue to pay the
company's liabilities if the company's value exceeds its liabilities.
Equivalently, if the equity owners were considered to own a call option
on the value of the company with a strike price equivalent to the
liabilities owed, the equity owners would exercise the call on the
value of the company. If, however, the company's liabilities exceed the
company's value, the models assume that the equity owners will choose
to default on the company's liabilities, or equivalently, the equity
owners would not exercise the call on the value of the company.
Accordingly, Structural Credit Risk Models, such as the Merton (1974)
Model and the Successor Models, provide a method to estimate the
probability that a company might default on its liabilities based on
the Black-Scholes option pricing model.
---------------------------------------------------------------------------
\65\ Fischer Black & Myron Scholes, The Pricing of Options and
Corporate Liabilities, 81 J. Pol. Econ. 637, 637-54 (1973). The
Black-Scholes option pricing model is used to determine the fair
price or theoretical value for a call or put option based on a
number of variables, including the volatility and price of the
underlying stock, the type of option, time, the option's strike
price, and the risk-free rate.
\66\ Robert C. Merton, On the Pricing of Corporate Debt: The
Risk Structure of Interest Rates, 29 J. Fin. 449, 449-70 (1974). The
Merton (1974) Model has been expanded upon and used to develop new
Structural Credit Risk Models that rely on its principles
(``Successor Models''), such as the Black-Cox (1976) model and the
Leland (1994) model. See, e.g., Suresh Sundaresan, A Review of
Merton's Model of the Firm's Capital Structure with its Wide
Applications, 5 Ann. Rev. Fin. Econ. 21, 21-41 (2013); Fischer Black
& John C. Cox, Valuing Corporate Securities: Some Effects of Bond
Indenture Provisions, 31 J. Fin. 351, 351-67 (1976); see also Hayne
E. Leland, Corporate Debt Value, Bond Covenants, and Optimal Capital
Structure, 49 J. Fin. 1213, 1213-52 (1994).
\67\ See infra Part VIII.B. For example, the Merton (1974) Model
and the Successor Models are included in the curriculum for such
credentials as the Chartered Financial Analyst. See, e.g., Credit
Analysis Models, CFA Inst. (2022), available at https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/credit-analysis-models.
\68\ See infra note 84.
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Structural Credit Risk Models typically use measures from firm
accounting statements and firm-specific and aggregate market prices.
Generally, Structural Credit Risk Models require input variables to
calculate an estimated probability of default for a specified horizon,
including market value and volatility of the assets, as well as
assumptions regarding the threshold for firm asset values, below which
the equity owner would default on its obligations (``Default
Point'').\69\ Structural Credit Risk Models provide a probability that
a firm's assets will fall below the Default Point at or by the
expiration of a defined period of time. Generally, the following
variables are needed to calculate the probability of default: (1) The
value of the firm, which can be based on observed market prices of a
firm's equity security or estimated based on a firm's balance sheet;
(2) the volatility of the firm's equity or assets, which can also be
based on market observations or estimated based on a firm's balance
sheet; (3) the risk-free rate; (4) a time horizon; and (5) the Default
Point. Application of Structural Credit Risk Models may be limited in
the absence of a market for a firm's equity securities if the market
price of the firm's assets, which is required to calculate the
probability of default, is difficult to determine.\70\
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\69\ The Default Point is frequently calculated as all short-
term liabilities plus half of the long-term liabilities. See Mario
Bondioli, Martin Goldberg, Nan Hu, Chengrui Li, Olfa Maalaoui, and
Harvey J, Stein, The Bloomberg Corporate Default Risk Model (DRSK)
for Public Firms (2021), available at https://ssrn.com/abstract=3911300.
\70\ Structural Credit Risk Models calculate the probability of
default based on inputs from an issuer's balance sheet. Transactions
in equity securities are frequently used as a proxy to determine the
value of the firm and the overall volatility of the issuer's assets
in Structural Credit Risk Models. Even though a market for an
issuer's equities may not exist, this alone does not preclude the
ability for a distribution participant to use a Structural Credit
Risk Model. Specifically, the issuer's balance sheet will include
the liabilities, assets, and equity, which, with further analysis,
can be used to determine the inputs for the models. Distribution
participants, based on their activities as an underwriter, broker-
dealer, or other person who has agreed to participate in a
distribution, would have access to an issuer's balance sheet to
calculate the probability of default.
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(c) Proposed Probability of Default Exception
As discussed above, Section 939A of the Dodd-Frank Act requires the
Commission to remove any reference to or requirement of reliance on
credit ratings, and to substitute in such regulations such standard of
credit-worthiness as the Commission determines is appropriate for that
regulation.\71\ The Commission believes that credit-worthiness, which
was the basis of the Investment Grade Exception for Nonconvertible
Securities in Rule 101, is still appropriate to use as an exception to
Rule 101.\72\ Specifically, securities of issuers of a certain credit
quality trade based on yield and credit-worthiness \73\ and are less
susceptible to manipulation because other similar Nonconvertible
Securities are available to investors as an alternative to the security
in distribution. If pricing of a Nonconvertible Security offering is
inconsistent with pricing in the overall secondary market for similar
Nonconvertible Securities, an investor may purchase alternative
Nonconvertible Securities that have a better yield, yet are of
comparable credit-worthiness, than the security being distributed.
Accordingly, the ability to substitute similar Nonconvertible
Securities in the market for the security in distribution limits the
potential impact that a distribution participant might attempt to exert
on the market and distribution of such security. Additionally, when
debt has a very low probability of default, the cashflows are close to
risk free. Thus, the price of the debt is mainly subject to
fluctuations based on aggregate interest rates rather than firm-
specific or security-specific news. Thus, Nonconvertible Securities of
credit-worthy issuers are less susceptible to the type of manipulation
that Rule 101 seeks to prevent.\74\ Furthermore, as
[[Page 18318]]
distribution participants have relied on the Investment Grade
Exception, which is based on credit-worthiness, to facilitate orderly
distributions of Nonconvertible Securities, the proposed exception has
limited potential to disrupt the trading market for securities that
have been the subject of a reopening.\75\
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\71\ Although two commenters to the 2011 Proposal believed that
Section 939A of the Dodd-Frank Act did not mandate the removal of
credit rating references from Regulation M, the Commission believes
that Section 939A of the Dodd-Frank Act requires the Commission to
remove such references from Regulation M, without flexibility to
retain the references, contrary to the suggestion made by these
commenters. See supra note 43. Specifically, Section 939A of the
Dodd-Frank Act requires the Commission to review ``any references to
or requirements in such regulations regarding credit ratings'' and
issue a report upon conclusion of the review. See Public Law 111-203
sec. 939A(a) and (c); see supra note 4. It then requires the
Commission to ``remove any reference to or requirement of reliance
on credit ratings, and to substitute in such regulations such
standard of credit-worthiness'' as the Commission determines to be
appropriate for such regulations. See Public Law 111-203 sec.
939A(b) (emphasis added). Accordingly, the Commission believes that
it does not have discretion to retain the Investment Grade
Exceptions provided in Rules 101 and 102.
\72\ See supra note 50 and accompanying text. Sticky offerings
of Nonconvertible Securities issued by credit-worthy issuers might
indicate that a security is not trading based upon its yield or
credit quality, due to some reason, despite the perceived credit-
worthy nature of the issuer (based on a probability of default
calculation or otherwise). As discussed below, a distribution
participant should be able to find someone willing to purchase the
Nonconvertible Securities of credit-worthy issuers because the
securities would be trading based on their yield and price in
relation to securities of similar credit-worthiness. The inability
to sell securities of credit-worthy issuers could reflect, for
example, a lag between the trading in the market for such
Nonconvertible Securities and the credit rating, or more recent
concerns related to the issuer of the securities reflected in the
market but not yet absorbed in credit-worthiness assessments or
inputs for such assessments. The Commission solicits comments below
regarding this particular issue.
\73\ Bonds trade among investors and dealers in secondary
markets at prices that depend on economy-wide interest rates, as
well as on market perceptions regarding the likelihood that the
issuing company will make the promised payments. Hendrik
Bessembinder & William Maxwell, Markets: Transparency and the
Corporate Bond Market, 22 J. Econ. Persp. 217, 220 (2008).
\74\ Some commenters to the 2008 Proposal, which would have
replaced a credit-worthiness standard with a WKSI standard, believed
that the 2008 Proposal would place burdens related to complying with
Regulation M on issuers and underwriters who are currently able to
rely on the Investment Grade Exceptions. The proposed exception
using Structural Credit Risk Models, in contrast to the 2008
Proposal, continues to rely on the premise underlying the Investment
Grade Exception--that certain Nonconvertible Securities trade based
on their yield and credit-worthiness. Accordingly, similar to how
the prohibitions related to Regulation M do not exist for securities
that currently meet the Investment Grade Exception, the prohibitions
associated with Rule 101 would not exist under the proposed
exception for Nonconvertible Securities that trade based on their
yield and credit-worthiness.
\75\ See Regulation M Proposing Release, 61 FR 17117 (stating
reasons for the exceptions from Regulation M).
---------------------------------------------------------------------------
As discussed below in Part VIII.B, Structural Credit Risk Models
calculate a probability of default that provides a measure of the
credit-worthiness of an issuer of a Nonconvertible Security. The
Commission preliminarily believes that the probability of default as
calculated by Structural Credit Risk Models is an appropriate
substitute as a standard of credit-worthiness in Rule 101(c)(2). In
particular, the probability of default \76\ as estimated by Structural
Credit Risk Models is widely used by market and distribution
participants to measure credit-worthiness of issuers.\77\ As such, the
Commission preliminarily believes that the use of Structural Credit
Risk Models to determine credit-worthiness could be used as an
alternative for Nonconvertible Securities with an investment grade
rating for purposes of proposed Rule 101(c)(2)(i).\78\
---------------------------------------------------------------------------
\76\ The term ``probability of default'' as used in this release
to describe the proposed requirement means the actual (or physical)
probability, rather than the risk-neutral probability.
\77\ See supra notes 65-68 and accompanying text; see also infra
note 158. The Commission considered including reduced-form models in
addition to Structural Credit Risk Models as part of the exception
in Rule 101(c)(2)(i). Reduced-form models rely on statistical
analysis rather than the balance sheet to determine a firm's
creditworthiness. However, unlike Structural Credit Risk Models,
they lack in rigorous theoretical justification as well as economic
interpretation of the resulted relationships between the model
inputs.
\78\ Securities with low probability of default (by credit-
worthy issuers) do not need to price default risk (because it is
very low) and therefore trade based on other, observable
characteristics, such as yields or maturity. This implies less price
uncertainty, which leaves less room for manipulation of prices.
---------------------------------------------------------------------------
The probability of default can be independently determined by
Structural Credit Risk Models based on observable market events and
information available on a firm's balance sheet without reliance on an
investment grade credit rating by an NRSRO. Probability of default can
be used to identify securities that trade based on their yield and high
credit-worthiness, similar to the Nonconvertible Securities that are
excepted based on the existing Investment Grade Exception, and thus
would be less susceptible to the manipulation that Rule 101 is designed
to prevent.
Commenters to the 2011 Proposal raised concerns regarding the 2011
Proposal that the Commission preliminarily believes are not present
regarding Structural Credit Risk Models. For example, commenters were
concerned that it would be impractical under the 2011 Proposal to make
consistent determinations among market participants even in the same
distributions and that the standard proposed in the 2011 Proposal is
impractical, forward-looking, and subjective.\79\ The Commission
preliminarily believes the Structural Credit Risk Models can result in
consistent determinations and can be replicated by distribution
participants, particularly if distribution participants utilize the
same model. Furthermore, the use of a bright-line test, such as a
probability of default of 0.055% as discussed below, should address the
concern of some commenters that the exception will impose new costs and
delays in the offering process and reduce the attractiveness of
registered offerings.\80\ Whereas the 2011 Proposal depended on a
distribution participant's subjective expectations about the future
regarding how a security would trade in the market, the proposed
standard specifically includes a 0.055% probability of default
threshold. The Commission acknowledges that the complex nature of the
models, assumptions, and estimated inputs used to estimate the
probability of default may not be comparable across different issuers
or if the estimates are done using different Structural Credit Risk
Models, the results may not be comparable. The Commission, however,
believes that the assumptions and estimates that are used to determine
the probability of default using Structural Credit Risk Models are
appropriately practical, as well as objective, and accordingly the
proposed standard is not impractical or overly subjective. In
particular, as noted throughout the release, market participants
currently rely on Structural Credit Risk Models to assess the credit-
worthiness of issuers.
---------------------------------------------------------------------------
\79\ See supra note 32.
\80\ See supra note 41.
---------------------------------------------------------------------------
Under the proposed amendment to Rule 101, the exception would be
available to the Nonconvertible Securities of issuers for which the
probability of default, estimated as of the day of the determination of
the offering pricing and over the horizon of 12 calendar months \81\
from such day, is less than 0.055%,\82\ as determined and documented in
writing \83\ by the distribution participant using a Structural Credit
Risk Model.\84\ As discussed in Part VIII.B, based on an analysis of
the probability of default and investment grade ratings of a sample of
Nonconvertible Securities available on the market as of October 22,
2021, the Commission preliminary believes that a probability of
default, estimated as of the day of the determination of the offering
pricing and over the horizon of 12 calendar months from such day, that
is less than 0.055%, as determined by a Structural Credit Risk Model,
provides an appropriate substitute for investment grade ratings.
Limiting the exception to issuers of Nonconvertible Securities that
have a probability of default of less than 0.055% should limit the
exception to Nonconvertible Securities that are less susceptible to the
type of manipulation that Regulation M is designed to prevent.
---------------------------------------------------------------------------
\81\ The proposed exception would specify 12 calendar months to
provide a uniform time horizon to use in the Structural Credit Risk
Models to calculate the probability of default. The Commission
preliminarily believes that 12 calendar months would provide a
minimum period of time for an estimation of probability of default
that could address investor concerns that a Nonconvertible Security
would default during or shortly after the distribution of the
securities. Furthermore, the Commission preliminarily believes that
12 calendar months is the appropriate horizon to include in the Rule
to calculate probability of default because it is the horizon that
corresponds with vendor models that use Structural Credit Risk
Models to calculate probability of default and map to investment
grade ratings. Specifying the time horizon in the rule is intended
to limit the ability of a distribution participant to modify the
time horizon to generate a more favorable probability of default if
such distribution participant chooses to calculate the probability
of default on its own.
\82\ See infra Part VIII.B.
\83\ See infra Part V.
\84\ Vendors offer a number of commercial applications based on
Structural Credit Risk Models. The Commission preliminarily believes
that these models are relied upon by market participants to analyze
the credit quality of Nonconvertible Securities or the issuers of
such securities. Furthermore, the probability of default calculated
by Structural Credit Risk Models, such as the Merton (1974) Model
and the Successor Models, can be calculated by distribution
participants without the use of a vendor.
---------------------------------------------------------------------------
Exceptions for investment grade rated Nonconvertible Securities
existed in former Exchange Act Rule 10b-6, which preceded the adoption
of Regulation M. As discussed above, Regulation M excepts securities
based on their credit-worthiness as determined by an investment grade
rating from a NRSRO. As noted by commenters to the 2008 Proposal and
2011 Proposal, the Investment Grade Exception has provided a bright-
line test to identify securities that are less prone to the type of
manipulation that Regulation M is designed to prevent.\85\ The
Commission preliminarily believes a standard utilizing a threshold
derived from
[[Page 18319]]
Structural Credit Risk Models provides the advantage of serving as a
bright-line test to identify securities that, similar to Nonconvertible
Securities currently excepted from Rule 101 based on the Investment
Grade Exception, trade based on their yield and credit-worthiness. In
particular, based on the Commission's analysis comparing probabilities
of default with NRSRO credit ratings, the Commission preliminarily
believes that the 0.055% threshold would effectively identify
securities that trade based on yield and credit-worthiness, because
this threshold appropriately captures most of those securities that
meet the credit-worthiness standard under the existing Investment Grade
Exception.\86\ Accordingly, the Commission preliminary believes that
the 0.055% threshold appropriately calibrates the probability of
default to determine the credit-worthiness of an issuer whose
Nonconvertible Securities would trade based on yield and credit-
worthiness, similar to the current Investment Grade Exception.\87\
---------------------------------------------------------------------------
\85\ See ABA Letter at 15-17; see also Rothwell at 2.
\86\ See infra Part VIII.B. Although the proposed standard would
include certain securities that are not investment grade as
determined by an NRSRO, the model-implied probabilities of default
generally use current estimates of equity valuation and volatility,
and hence incorporate the most recent news affecting the valuation
and perceived volatility of the firm. See infra Part VIII.B. As
such, an estimate derived from Structural Credit Risk Models is more
likely to reflect the most up-to-date indicator of an issuer's
credit-worthiness without being hampered by the lag that may exist
with NRSRO-determined credit ratings.
\87\ See infra note 159.
---------------------------------------------------------------------------
The Commission acknowledges that a probability of default less than
0.055% could be both under- and over- inclusive in capturing the
securities that are excepted under the existing Investment Grade
Exception in Rule 101. As a result, the restrictions of Rule 101 would
apply to certain Nonconvertible Securities that are currently excepted
securities under Rule 101(c)(2). Furthermore, some securities that are
not currently excepted securities under Rule 101 could become excepted
securities under the proposed probability of default metric. The
Commission preliminarily believes that it is appropriate to use a
0.055% threshold because even if it does not capture exactly the same
set of securities covered under the existing investment grade standard,
this 0.055% threshold would identify Nonconvertible Securities that are
less susceptible to the manipulation that Regulation M is designed to
prevent because they trade based on their yield and credit-worthiness
as determined by the current financial condition of the issuer.
Rule 101(c)(2)(i) would define the term Structural Credit Risk
Model to mean any commercially or publicly available model that
calculates the probability that the value of the issuer may fall below
the Default Point based on an issuer's balance sheet. These models,
which estimate the probability of default related to the financial
condition of the issuer based on the issuer's liabilities, provide a
measure of credit-worthiness specific to that issuer. Additionally, the
definition would include only commercially or publicly available
models. The Commission understands that distribution participants, such
as underwriters and broker-dealers, currently use commercially
available models from various vendors to measure and manage credit
risk. These commercially available vendor models estimate a probability
of default based on the issuer's balance sheet information to set
thresholds and market estimates of firm value and volatility.
Furthermore, distribution participants can use commonly available
spreadsheet software to calculate the probability of default based on
publicly available models, which may be found in academic and
professional journals.\88\ Limiting the definition of Structural Credit
Risk Models to commercially or publicly available models is intended to
capture these commercially and publicly available models that we
understand distribution participants already use and have access to. At
the same time, we intend to prevent parties with an interest in the
price of the security that is the subject of a distribution and outcome
of such distribution from developing their own models to achieve
favorable results.
---------------------------------------------------------------------------
\88\ See supra note 66.
---------------------------------------------------------------------------
(d) Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support their
views. Commenters are requested to provide empirical data, economic
studies, and other factual support for their views to the extent
possible.
1. Do commenters agree that the credit-worthiness of an issuer of
Nonconvertible Securities reduces the risk of manipulation that Rule
101 is designed to prevent? Please explain. Is an exception based on
probability of default appropriate to preserve Rule 101's anti-
manipulation goals? Why or why not?
2. Should the probability of default threshold be higher than
0.055%? For example, should the probability of default threshold be
0.06%, 0.07%, or some other threshold? If so, what should the
probability of the default threshold be and why?
3. Should the probability of default threshold be lower than
0.055%? For example, should the probability of default threshold be
0.05%, 0.04%, or some other threshold? If so, what should the
probability of the default threshold be and why?
4. Is the 12 calendar months used to calculate the probability of
default an appropriate time horizon? Or should some other time horizon
be used? Please explain. For example, should it be for the term of the
Nonconvertible Security? If so, what should the time horizon be to
calculate the probability of default for purposes of Rule 101? Please
explain.
5. Are there other models or model types besides Structural Credit
Risk Models that the Rule should use to calculate the probability of
default for purposes of Rule 101? If so, please provide the name of the
model and provide support regarding why it would be an appropriate
substitute for the Investment Grade Exception. Are there model types
other than Structural Credit Risk Models that calculate a probability
of default? For example, would a reduced-form model provide a
probability of default calculation that would indicate a Nonconvertible
Security is of such credit-worthiness that such security should be
excepted from Rule 101? Please explain.
6. What challenges, if any, would there be to relying on an
exception to Rule 101 based on the probability of default as calculated
using Structural Credit Risk Models, as defined in Rule 101(c)(2)(i)?
Is the definition of Structural Credit Risk Model clear? Should the
exception list which models would be considered Structural Credit Risk
Models? Is the requirement for the models to be commercially or
publicly available clear, or is further guidance needed? Should the
exception provide a test regarding what makes a model a Structural
Credit Risk Model? For example, should the test for a Structural Credit
Risk Model be limited to models published in academic or trade journals
that refine the Merton (1974) Model? Please explain.
7. Is there a standard other than Structural Credit Risk Models
that Rule 101 should use as a replacement for the Investment Grade
Exception? If so, what other standard should proposed Rule 101(c)(2)(i)
use and why?
8. Should the calculation of the probability of default in proposed
Rule
[[Page 18320]]
101(c)(2)(i) be limited to distribution participants? Should the Rule
permit distribution participants to rely on the probability of default
calculated by persons that are not distribution participants? If so,
who should the Rule include and why should such a person be
specifically included in proposed Rule 101(c)(2)(i)? Are there any
reasons why the Rule should not permit a distribution participant to
perform its own calculation (subject to recordkeeping requirements as
proposed)? Please explain. Should distribution participants be required
to post or make the probability of default public on their website to
rely on the exception? Please explain.
9. Do commenters disagree with the Commission's preliminary belief
that market participants are currently relying on vendors' widely
available commercial applications based on Structural Credit Risk
Models to analyze the credit quality of Nonconvertible Securities or
the issuers of such security? Do distribution participants currently
have access to vendor probability of default determinations? Please
explain why or why not.
10. How often do distribution participants rely on the Investment
Grade Exception for Nonconvertible Securities where no other exception
from Rule 101 is available?
11. As discussed in Part III, the Commission understands that the
Investment Grade Exception is used in limited circumstances, i.e., re-
openings, sticky offerings, best efforts offerings, and foreign
sovereign issuances. Are there other circumstances where distribution
participants rely on the Investment Grade Exception? Please explain.
Furthermore, as discussed above in this section, a sticky offering
might indicate that an offering is not trading based upon its yield or
credit quality. Specifically, the distribution participant is unable to
sell its allotment. If the underlying premise of the exception were
true, a distribution participant should be able to find someone willing
to purchase the Nonconvertible Securities because the security would be
trading based on its yield and price in relation to securities of
similar credit-worthiness. Do sticky offerings of credit-worthy issuers
disprove the underlying premise for excepting certain Nonconvertible
Securities (i.e., that securities offerings that become sticky do not
trade based on their yield and credit-worthiness, or are there other
characteristics of sticky offerings that impact how these securities
trade)? For example, do sticky offerings indicate that the credit-
worthiness of an issuer is not a sound basis on which to except
Nonconvertible Securities, or that there may be other characteristics
that may make the securities more at risk of manipulation? If so, what
tools are available to distribution participants that could serve as an
indicator of such characteristics that could be incorporated into the
exception? Since whether a nonconvertible security will become sticky
is unknown at the start of the Regulation M restricted period, should
the Commission remove the exception from Rule 101 for investment grade
Nonconvertible Securities completely? Why or why not?
12. Would the Nonconvertible Securities proposed to be excepted be
more vulnerable to manipulation than the securities that meet the
existing investment grade standard? Why or why not?
13. Please discuss whether and to what extent investors take into
account reliance on the Investment Grade Exception for Nonconvertible
Securities when making a decision to invest in such securities. Please
also discuss whether, given that Rule 101 is directed at distribution
participants and their affiliated purchasers, current Rule 101 poses
any danger of undue reliance on NRSRO ratings.
14. Are there factors other than those identified in the proposed
exception that influence the trading of Nonconvertible Securities? Are
there additional requirements that the Commission should consider with
respect to the proposed exception? Are there any requirements that the
Commission should remove from the proposal?
15. Would persons needing to use the proposed exception have access
to adequate information to determine whether a particular security
meets the exception in proposed Rule 101(c)(2)(i)? Why or why not?
Should the exception require the issuer's balance sheet to be audited?
16. If the exception as proposed is adopted should the Commission
include a period of time for distribution participants to implement the
exception based on probability of default? For example, should the
exception, if adopted, include a three month, nine month or twelve
month implementation period? Please explain. Should the exception, if
adopted, go into effect within a short period of time after
publication, such as 30-calendar days from being published in the
Federal Register? Please explain.
2. Excepted Securities: Asset-Backed Securities Offered Pursuant to an
Effective Shelf Registration Statement Filed on Form SF-3
To implement Section 939A(b) of the Dodd-Frank Act, the Commission
is, among other things, proposing to replace the existing exception
provided in Rule 101(c)(2) for investment grade asset-backed securities
\89\ with an exception for asset-backed securities that are offered
pursuant to an effective shelf registration \90\ statement filed on
Form SF-3,\91\ as discussed below.
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\89\ See 17 CFR 242.101(c)(2) (providing an exception for asset-
backed securities ``that are rated by at least one nationally
recognized statistical rating organization, as that term is used in
[Rule 15c3-1 under the Exchange Act], in one of its generic rating
categories that signifies investment grade'').
\90\ Shelf registration is a procedure that allows companies to
file a single registration statement covering more than one issuance
of the same security, subject to certain requirements. See generally
17 CFR 230.415 (providing requirements for securities to be
registered for an offering to be made on a continuous or delayed
basis in the future).
\91\ See Proposed Rule 101(c)(2)(ii). Currently, the exception
for asset-backed securities is provided in the same paragraph as the
exception for Nonconvertible Securities, in Rule 101(c)(2). See 17
CFR 242.101(c)(2). The Commission is proposing to separate the
existing exception into separate exceptions for Nonconvertible
Securities and asset-backed securities in Proposed Rules
101(c)(2)(i) and 101(c)(2)(ii), respectively.
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(a) Background: Form SF-3
In 2014, the Commission adopted shelf eligibility criteria for
asset-backed securities offerings registered on new Form SF-3 in part
to implement Section 939A(b) of the Dodd-Frank Act.\92\ Form SF-3
includes the following transaction requirements among other shelf
eligibility criteria:
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\92\ See Asset-Backed Securities Disclosure and Registration,
Release No. 34-72982 (Sept. 4, 2014) [79 FR 57184 (Sept. 24, 2014)]
(``Regulation AB II Adopting Release''). Form SF-3 also carried over
shelf-eligibility requirements for asset-backed securities that
previously were located in Form S-3, such as transaction
requirements regarding the percentage of delinquent assets and, for
certain lease-backed securitizations, the portion of the pool
attributable to residual value. See Regulation AB II Adopting
Release, 79 FR 57265, n.936.
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Delinquent assets do not constitute 20% or more, as
measured by dollar volume, of the asset pool as of the measurement
date;
With respect to securities backed by certain leases, the
portion of the securitized pool balance attributable to the residual
value of the physical property underlying the leases does not
constitute 20% or more, as measured by dollar volume, of the
securitized pool balance as of the measurement date;
A certification by the chief executive officer of the
depositor is made at the time of each takedown;
[[Page 18321]]
An asset review provision in the underlying transaction
agreements requires review of the pool assets, upon the occurrence of
certain trigger events, for compliance with the representations and
warranties made with regard to those assets;
A dispute resolution provision for repurchase requests is
contained in the underlying transaction documents; and
A disclosure provision, as required in an underlying
transaction agreement, of investors' requests to communicate with other
investors related to an investor's rights under the terms of the asset-
backed security was received during the reporting period by the party
responsible for making Form 10-D filings.\93\
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\93\ See Registration Statement Under the Securities Act of 1933
(Form SF-3), available at https://www.sec.gov/files/2017-03/formsf-3.pdf; Regulation AB II Adopting Release, 79 FR 57189.
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The Commission designed the shelf eligibility requirements to help
ensure a certain ``quality and character'' in light of the requirement
to reduce regulatory reliance on credit ratings.\94\ In particular, the
shelf eligibility requirements were designed to help ensure that
expected cash flows are sufficient to service payments or distributions
in accordance with their terms; \95\ that obligated parties more
carefully consider the characteristics and quality of the assets that
are included in the pool; \96\ that asset-backed securities shelf
offerings have transactional safeguards and features that make those
certain securities appropriate to be issued without prior Commission
staff review; \97\ and that issuers design and prepare asset-backed
securities offerings with greater oversight and care.\98\ As discussed
below, the Commission believes that the asset-backed securities offered
pursuant to an effective shelf registration statement filed on Form SF-
3 trade primarily on the basis of yield and credit-worthiness. This
proposed rule change would not limit a market participant's ability to
substitute a security that is similar, and that is of comparable
credit-worthiness, to the security that is the subject of a
distribution if the pricing of the security were inconsistent with
pricing in the overall secondary market for similar asset-backed
securities, thereby limiting the potential for manipulation. The
Commission continues to believe that its original basis for excepting
securities of a certain quality and character is appropriate and that
such securities are less at risk of the manipulation that Regulation M
addresses.\99\
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\94\ See Regulation AB II Adopting Release, 79 FR 57189.
\95\ See Regulation AB II Adopting Release, 79 FR 57265.
\96\ See Regulation AB II Adopting Release, 79 FR 57278.
\97\ See Regulation AB II Adopting Release, 79 FR 57283.
\98\ Regulation AB II Adopting Release, 79 FR 57265, 57285.
\99\ See Regulation M Adopting Release, 62 FR 527; see also
Prohibitions Against Trading by Persons Interested in a
Distribution, Release No. 34-19565 (Mar. 4, 1983) [48 FR 10628,
10631 (Mar. 14, 1983)] (stating the Commission's belief that the
``fungibility'' of certain types of securities makes manipulation of
their price very difficult); supra note 50 and accompanying text.
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(b) Existing Exception for Investment Grade Asset-Backed Securities
As discussed above, Rule 101(c)(2) currently provides an exception
for asset-backed securities that are rated by at least one NRSRO in one
of its generic rating categories that signifies investment grade. The
Commission excepted investment grade asset-backed securities from Rule
101 because such securities trade primarily on the basis of yield and
credit rating.\100\ In providing this rationale, the Commission stated
that the principal focus of investors in the asset-backed securities
market is on the structure of a class of securities and the nature of
the assets pooled to serve as collateral for those securities rather
than on the identity of a particular issuer.\101\ The Commission also
stated that Rule 101 excepts investment grade securities that are
``primarily serviced by the cashflows of a discrete pool of receivables
or other financial assets, either fixed or revolving, that by their
terms convert into cash within a finite time period plus any rights or
other assets designed to assure the servicing or timely distribution of
proceeds to the security holders.'' \102\
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\100\ See Regulation M Adopting Release, 62 FR 527.
\101\ See Regulation M Adopting Release, 62 FR 527.
\102\ See Regulation M Adopting Release, 62 FR 527 (citations
omitted). The Commission stated that such rationale also applies to
the existing identical exception provided in Rule 102(d)(2) of
Regulation M. Regulation M Adopting Release, 62 FR 531.
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(c) Proposed Amendments to Rule 101
As discussed above, in accordance with Section 939A of the Dodd-
Frank Act, the Commission proposes to remove Rule 101's current
exception for investment grade asset-backed securities based on NRSRO
ratings. In place of that exception, the Commission is proposing a new
exception in Rule 101(c)(2)(ii) for asset-backed securities that are
offered pursuant to an effective shelf registration statement filed on
Form SF-3. This proposed rule change, which would carry over the
standard of credit-worthiness included in the Commission's Form SF-3,
also helps to implement the mandate that, to the extent feasible,
uniform standards of credit-worthiness be used.\103\
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\103\ Public Law 111-203 sec. 939A(b) (requiring agencies to
``seek to establish, to the extent feasible, uniform standards of
credit-worthiness for use by each such agency, taking into account
the entities regulated by each such agency and the purposes for
which such entities would rely on such standards of credit-
worthiness'').
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The proposed rule is not based on a probability of default
threshold derived from Structural Credit Risk Models with respect to
asset-backed securities. An exception for asset-backed securities that
is based on a probability of default threshold may be unfeasible due to
the potential widespread inability of distribution participants and
their affiliated purchasers to collect all of the information required
to calculate the probability of default, such as the value and
volatility of the assets underlying asset-backed securities. Therefore,
the Commission is proposing an exception for certain asset-backed
securities based on a separate standard that is more consistent with
the existing Investment Grade Exception for asset-backed securities, as
discussed below. The proposed rule does not contain a standard of
credit-worthiness that relies on Form SF-3 with respect to
Nonconvertible Securities because the transaction requirements included
in Form SF-3 are relevant only to asset-backed securities. As discussed
below, because the transaction requirements included in Form SF-3 serve
as an indicator of credit-worthiness, the proposed exception that
relies on Form SF-3 would not apply to securities that are not subject
to those transaction requirements.
The proposed exception continues to be derived from the premise
that certain asset-backed securities are traded based on factors such
as their yield and credit-worthiness.\104\ The Commission is proposing
to except only the asset-backed securities offered pursuant to an
effective shelf registration statement filed on Form SF-3 to further
Regulation M's anti-manipulation goals. This proposed requirement
regarding an effective Form SF-3 would except from Rule 101 the types
of asset-backed securities that would trade based on their yield and
credit-worthiness due to their qualities and characteristics and that
are therefore less prone to the type of manipulation that Regulation M
seeks to prevent.\105\
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\104\ See Regulation M Adopting Release, 62 FR 527.
\105\ See supra note 50 and accompanying text. The ability of a
market participant to substitute a security that is similar, and
that is of comparable credit-worthiness, to the security that is the
subject of a distribution limits the ability of a distribution
participant or its affiliated purchaser from bidding up the price of
the subject security.
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[[Page 18322]]
The Commission believes that the transaction requirements included
in Form SF-3 allow for shelf offerings of only those asset-backed
securities that share the qualities and characteristics of the
investment grade asset-backed securities currently excepted from the
provisions of Rule 101: With respect to both sets of securities, the
principal focus of investors is the structure of a class of securities
and the nature of the assets pooled to serve as collateral for those
securities, rather than on the identity of a particular issuer.\106\
First, eligibility for offering securities pursuant to a Form SF-3 is
limited, in part, by the percentage of delinquent assets and, for
certain lease-backed securitizations, by the portion of the pool
attributable to the residual value.\107\ For an asset-backed securities
offering with an effective Form SF-3, delinquent assets cannot
constitute 20% or more of the asset pool. Delinquent assets may not
convert into cash within a finite period of time, as required by the
definition of ``asset-backed security,'' because they are not
performing in accordance with their terms and management or that other
action may be needed to convert the assets into cash. However, as
expressed at the adoption of Form SF-3, in principle, asset-backed
securities should be primarily dependent on the pool of assets self-
liquidating instead of on the ability of the entity performing
collection services.\108\ The application of the limitation on
delinquent assets included in Form SF-3 was designed to ensure that
attention is focused on the ability of collateral of the underlying
asset pool to generate cash flow rather than on the identity of the
issuer and its ability to convert those assets into cash,\109\
consistent with the Commission's original basis for excepting
investment grade asset-backed securities from Rule 101.\110\
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\106\ See supra note 102.
\107\ See 17 CFR 239.45(b)(v), (vi); Form SF-3, I.B.1(e).
\108\ Asset-Backed Securities, Release No. 33-8518 (Dec. 22,
2004) [70 FR 1506, 1517 (Jan. 7, 2005)] (``Regulation AB Release'').
In adopting the 20% delinquency concentration level, the Commission
codified a staff position that an asset-backed security will not
fail to meet the definition of ``asset-backed security'' solely
because such a security is supported by assets having total
delinquencies of up to 20% at the time of the proposed offering. See
Regulation AB Release, 70 FR 1517 (citing Bond Mkt. Ass'n, SEC Staff
No-Action Letter, 1997 WL 634124 (Oct. 8, 1997)). This threshold was
the same threshold that was applied to certain other matters
affecting registration and disclosure requirements for asset-backed
securities (e.g., non-recourse commercial mortgage securitizations,
pooling of corporate debt securities, and securitizations involving
third-party credit enhancement). See Bond Mkt. Ass'n, SEC Staff No-
Action Letter, 1997 WL 634124, at * 3. The staff position was based
on the premise that such a threshold for total delinquency
concentration would, by itself, not present a materially greater
risk of asset non-performance or default at the security level. See
Id., 1997 WL 634124, at * 4.
\109\ See Regulation AB Release, 70 FR 1517.
\110\ See Regulation M Adopting Release, 62 FR 527.
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Second, Form SF-3 includes certain transaction requirements with
respect to the structure of the asset-backed security being offered.
Such structural requirements include (1) a certification by the
depositor's chief executive officer that, among other things, the
securitization structure provides a reasonable basis to conclude that
the expected cash flows are sufficient to service payments or
distributions in accordance with their terms; (2) a review of the
asset-backed security's pool of assets upon the occurrence of certain
triggering events, including delinquencies, by a person that is
unaffiliated with certain transaction parties, such as the sponsor,
depositor, servicer, trustee, or any of their affiliates; and (3) a
dispute resolution provision, contained in the underlying transaction
documents, for any repurchase request. When adopting the requirements
included in Form SF-3, the Commission stated that sponsors may have an
increased incentive to carefully consider the characteristics of the
assets underlying the securitization and accurately disclose these
characteristics at the time of offering. The Commission also believed
that investors should benefit from the reduced losses associated with
nonperforming assets because, as a result of this new shelf
requirement, sponsors will have less of an incentive to include
nonperforming assets in the pool.\111\ Because the transactional
safeguards included in Form SF-3 provide incentives for obligated
parties to, among other things,\112\ more carefully consider the
quality and character of the assets that are included in the pool,\113\
asset-backed securities that are offered pursuant to an effective Form
SF-3 should trade based on their yield and credit-worthiness rather
than on the identity of a particular issuer.\114\ The application of
the transaction requirements included in the Commission's Form SF-3,
therefore, should result in the offering of asset-backed securities
that have similar qualities and characteristics to the investment grade
asset-backed securities currently excepted under the existing provision
in Rule 101(c)(2).
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\111\ See Regulation AB II Adopting Release, 79 FR 57283.
\112\ See supra notes 94-98 and accompanying text.
\113\ See Regulation AB II Adopting Release, 79 FR 57278.
\114\ See, e.g., Regulation AB II Adopting Release, 79 FR 57277-
78.
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The Commission believes that the requirement regarding an effective
shelf registration statement filed on Form SF-3 is an appropriate
substitute for the Investment Grade Exception currently provided in
Rule 101(c)(2) because the proposed standard intends to limit
eligibility for that exception to only those asset-backed securities
that trade based on their yield and credit-worthiness due to their
particular qualities and characteristics. Because the ability of
distribution participants and their affiliated purchasers to bid up the
price of an asset-backed security offered pursuant to an effective Form
SF-3, during a distribution, is limited by a market participant's
ability to substitute the security with other securities that are
similar and of comparable credit-worthiness,\115\ the Commission
believes that such a security is less susceptible to the types of
manipulation that Regulation M seeks to prevent.
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\115\ See Regulation M Adopting Release, 62 FR 527; see also
supra note 50 and accompanying text.
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(d) Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support their
views. Commenters are requested to provide empirical data, economic
studies, and other factual support for their views to the extent
possible.
17. How often and in which context is the Investment Grade
Exception for asset-backed securities utilized where no other exception
from Rule 101 is available?
18. As discussed above, the existing Investment Grade Exception for
asset-backed securities and the proposed exception provided in
paragraph (c)(2)(ii) of Rule 101 are premised on the ability of a
market participant to substitute a security (in distribution) with
other securities that are similar and of comparable credit-worthiness
if there is a pricing aberration in the secondary market for similar
securities. What is the universe of securities that is likely to be
substituted in such instance? Please explain.
19. If the Investment Grade Exception for asset-backed securities
is rarely, infrequently, or never used, or if the proposed standard for
asset-backed securities has limitations in practice or otherwise,
should the Commission
[[Page 18323]]
remove the exception for asset-backed securities completely? Why or why
not?
20. What specific trading activities that currently occur pursuant
to the Investment Grade Exception would then be prohibited during the
restricted period because no other exception is available? What are the
advantages and disadvantages of such trading activities? Should the
Commission explicitly except any such specific activities in lieu of
providing a generic exception for investment grade asset-backed
securities or an exception for asset-backed securities that are offered
pursuant to an effective shelf registration statement filed on Form SF-
3? What benefits or challenges would this approach create?
21. Should the proposed exception be expanded to apply to all
asset-backed securities, such as asset-backed securities registered on
Form SF-1? What activities would then be allowed that were previously
prohibited under Rule 101? To what extent would these additional
activities be at risk of manipulation? Why or why not?
22. Are there any types of asset-backed securities that should not
be covered by the proposed exception? Please explain.
23. Would the asset-backed securities excepted in the proposal be
more vulnerable to manipulation than the securities that meet the
existing investment grade standard? Why or why not?
24. Is the proposal to except only asset-backed securities that are
offered pursuant to an effective shelf registration statement filed on
the Commission's Form SF-3 an appropriate substitute for credit ratings
in this context? What effect(s), if any, would the proposed
modifications to the current exception have on the market for asset-
backed securities? Please explain.
25. How difficult and costly in practice would the requirements of
the proposed exception be to apply? If the requirements are more
difficult or costly to apply, how might this impact the scope of
securities subject to the prohibitions of Regulation M? For example, to
what extent, if any, might a narrower range of securities meet the
exception as a result of the proposal, if adopted? If fewer securities
are excepted from the prohibitions of Regulation M, in what ways and to
what extent, if any, would this impact the market for those securities
that would no longer qualify for an exception?
26. Will fewer asset-backed securities issuances meet the
requirement for this exception? If so, what impact would this proposed
exception have on the market for new issuances of these securities?
27. Please discuss whether and to what extent investors take into
account reliance on the current Rule 101(c)(2) exception for investment
grade asset-backed securities when making a decision to invest in such
securities.
28. Are there factors other than those identified in the proposed
exception that influence the trading of such securities? Are there
additional requirements that the Commission should adopt with respect
to the proposed exception? Are there any that the Commission should
remove from the proposal?
29. Would a probability of default standard be appropriate for the
exception for asset-backed securities? Are there models used to
calculate a probability of default threshold (e.g., reduced-form models
or structural models of credit risk) for asset-backed securities that
would be relevant to consider based on the type of security involved?
If so, what threshold should be included in the exception to Rule 101
for asset-backed securities? What benefits would this approach provide?
What other concerns could this approach raise? How would this approach
address potential conflicts of interest involving the distribution
participant or affiliated purchaser? Please explain.
30. Are there any concerns with regard to distribution participants
and affiliated purchasers' ability to collect any of the information
required for the probability of default calculation for asset-backed
securities? If so, please explain.
B. Rule 102
1. Existing Investment Grade Exception
Rule 102 contains fewer exceptions than Rule 101 does because
issuers and selling security holders have the greatest interest in an
offering's outcome (and thereby should be subject to Regulation M's
prohibitions) but generally do not have the same market access needs as
underwriters do (and as such are expected to have less of a desire to
seek an exception).\116\ Despite these differences in the situation of
issuers and selling security holders as compared to distribution
participants, the exception for certain investment grade securities
provided in former Exchange Act Rule 10b-6 was carried over to
Regulation M as paragraph (d)(2) at the adoption of Rule 102.\117\
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\116\ Regulation M Adopting Release, 62 FR 530. Further, the
Commission has also stated that ``[a]n issuer or selling shareholder
may have a substantial incentive to raise improperly the price of
offered securities.'' Regulation M Proposing Release, 61 FR 17120.
\117\ The Commission initially proposed not to include the
Investment Grade Exception in Rule 102. Regulation M Proposing
Release, 61 FR 17120 (``[T]he Commission preliminarily believes that
it may not be appropriate to extend the . . . the exception for
investment grade debt and investment grade preferred securities
provided in Rule 101, to issuers, selling security holders, or their
affiliated purchasers.'') The Commission, however, adopted the
Investment Grade Exception in Rule 102 ``based on commenters' views
and the rationales indicated . . . for an identical exception to
Rule 101.'' Regulation M Adopting Release, 62 FR 531.
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2. Proposed Removal of Investment Grade Exception
The Commission is proposing to amend Rule 102 to remove the
Investment Grade Exception. As noted above, there are limited
situations in which issuers, selling security holders, or their
affiliated purchasers rely on the Investment Grade Exception provided
in Rule 102.\118\ Given this apparent limited reliance, coupled with
the incentive for issuers, selling shareholders, and their affiliated
purchasers to manipulate the market for the distributed security exists
regardless of the credit quality of the security,\119\ the Commission
believes that the existing exception should be eliminated without
replacement.\120\
[[Page 18324]]
Further, the Commission believes that, while substituting an
alternative standard of credit-worthiness may except securities that
have little manipulative potential, retention of such an exception is
not likely necessary to facilitate orderly distributions of securities
or to limit potential disruptions in the trading market in light of
issuers' limited market access needs.\121\ Accordingly, the proposed
amendment to Rule 102 should protect investors and further Regulation
M's anti-manipulation goals in the rare event of an issuer or its
affiliate desiring to purchase or bid for Nonconvertible Securities or
asset-backed securities that are in distribution.
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\118\ No commenter responding to the 2011 Proposal mentioned
issuers, selling security holders, or their affiliated purchasers
relying on the Investment Grade Exception. However, one commenter to
the 2008 Proposal commented that the substitution of the Investment
Grade Exception with a WKSI standard would prevent foreign sovereign
issuers or affiliated purchasers from purchasing the foreign
sovereign's bonds for its own general trading and investment
activities, or for other public purposes, during the applicable
restricted period. See Arnold & Porter Letter at 3. Given that the
prohibitions of Regulation M apply only to bonds with the exact same
terms of the bond in distribution, as discussed above in Part III,
the Commission believes that the concerns raised by this commenter
would rarely occur. Furthermore, the bond in distribution could be
structured by the foreign sovereign in a manner so that Rule 102's
restrictions would not impede a foreign sovereign issuer or its
affiliated purchasers from engaging in its own general trading and
investment activities, or for other public purposes.
\119\ See supra Part IV.B.1.
\120\ Other than ``exempted securities,'' as defined in Section
3(a)(12) of the Exchange Act, the Investment Grade Exception
provided in Rule 102 is the only security-based exception that
permits an issuer, selling shareholder, or its affiliates to
purchase the securities in distribution absent a need for the issuer
to facilitate an orderly distribution or to limit potential
disruptions in the trading market. For example, the security-based
exception for open-ended investment companies is designed to ensure
that open-ended investment companies can redeem shares during a
continuous distribution without (by itself engaging in that exact
activity) violating Regulation M. See 17 CFR 242.102(d)(4). Rule 102
does not provide an actively-traded securities exception like Rule
101 does. Instead, the relevant exception provided in Rule 102 is
based on actively-traded reference securities, which is designed to
allow issuers or selling security holders to purchase an actively-
traded reference security issued by an unaffiliated entity in a
hedging transaction. See Rule 101(c)(1) and Rule 102(d)(1). As the
Commission stated in the adopting release regarding the actively-
traded reference securities exception, the Commission believes that
persons subject to Rule 102 should not be able to trade in their
securities. See Regulation M Adopting Release at 531. As stated in
the Regulation M Adopting Release, the Commission's view is based on
the issuers' and selling security holders' stake in the proceeds of
the offering, and their generally lesser need to engage in
securities transactions. Id.
\121\ See Regulation M Proposing Release, 61 FR 17117 (stating
reasons for exceptions from Regulation M). Disruption to the trading
market may be limited because distribution participants would still
be able to rely on the exception from Rule 101 if they meet the
requirements of the proposed rules. While the one commenter that
addressed sovereign issuers and Rule 102 pointed to certain
exemptive orders issued in the early 2000s to support a contention
that sovereign issuers should continue to be excepted from
Regulation M because the securities trade primarily on the basis of
a spread to a United States Treasury security, all but one of the
exemptive orders cited by the commenter only exempted the recipient
from Rule 101. See Arnold & Porter Letter at 3. For orders cited by
this commenter that only provided an exemption from Rule 101, see
Federative Republic of Brazil (Jan. 21, 2000; Apr. 29, 2003; July 3,
2003; Sept. 9, 2003; Oct. 15, 2003). See also Regulation M--
Sovereign Bond Exemption (Jan. 12, 2003) (order exempting certain
distributions of certain sovereign bonds from Rule 101, not Rule
102). For the one order cited by this commenter that provided an
exception from Rule 102, see United Mexican States (Feb. 17, 1999).
Because the proposed amendments would place distribution
participants in a similar position to distribution participants
trading the securities issued by the sovereign issuers pursuant to
existing Rule 101 exemptive orders, and given that the exception
under Rule 102 appears seldom used, we believe it is appropriate to
eliminate the exception in Rule 102 as proposed.
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Under the proposed amendment to Rule 102, an issuer of investment
grade Nonconvertible Securities and asset-backed securities that is
participating in a distribution of its own securities would not have an
exception and would need to ensure that the applicable restricted
period is complete before purchasing, bidding for, or attempting to
induce others to purchase or bid for, the covered security. Market
participants can structure their offerings to ensure compliance with
Rule 102 by, for example, completing the distribution prior to
purchasing any covered security and thus completing the applicable Rule
102 restricted period, or distributing bonds with different terms from
outstanding bonds. The Commission preliminarily believes that
eliminating the exception is appropriate because it would decrease the
risk of conduct raising improperly the price of an offered security
without impeding the facilitation of orderly distributions of
securities.\122\ For the same reason, while the Commission adopted the
Investment Grade Exception in Rule 102 in response to commenters
responding on the original Regulation M Proposing Release \123\ and
received one comment discussing this exception in response to the 2008
Proposal,\124\ the Commission is concerned that issuers and selling
security holders have the greatest interest in an offering's outcome
thereby heightening the risk of manipulation.
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\122\ Regulation M Proposing Release, 61 FR 17120. See also
Review of Antimanipulation Regulation of Securities Offerings,
Release No. 34-33924 (Apr. 19, 1994) [59 FR 21681, 21686 (Apr. 26,
1994)] (stating ``issuers and selling shareholders have a clear
incentive to manipulate the price of the securities to be
distributed. A very small change in the market price of a security,
which in some circumstances may be accomplished at relatively little
expense, can result in a substantial increase in offering
proceeds.'').
\123\ See Regulation M Adopting Release at 531.
\124\ See Arnold & Porter Letter.
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3. Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support
alternative recommendations. Please provide empirical data, when
possible, and cite to economic studies, if any, to support alternative
approaches.
31. Do issuers, selling security holders, and their affiliated
purchasers have an incentive to manipulate securities that currently
qualify for the Investment Grade Exception from Rule 102? If yes, would
substituting the probability of default approach for the current
exception address this incentive to manipulate?
32. If commenters are aware of situations where issuers, selling
security holders, or their affiliated purchasers are currently relying
on the Investment Grade Exception in Rule 102, do these activities
raise improperly the price of the offered securities? Why or why not?
33. If the Investment Grade Exception in Rule 102 proposed to be
removed is adopted, would it result in potential disruptions to trading
and if so, please explain. Can market participants structure their
distributions to comply with Regulation M? In light of the proposed
removal of the exception, would any alternative structures be
detrimental to the capital raising process?
34. Would the proposed removal of the Investment Grade Exception in
Rule 102 impede the facilitation of orderly distributions of securities
or result in potential disruptions to trading markets? Why or why not?
35. Should the Commission adopt an exception based on either the
probability of default standard for Nonconvertible Securities or asset-
backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3 for Rule 102 instead of
removing the Investment Grade Exception without substituting an
alternative? Why or why not? Should the Commission adopt an exception
for Rule 102 if a distribution participant determines that a security
is an excepted security pursuant to Rule 101(c)(2)?
36. As discussed above, one commenter to the 2008 Proposal believed
that the removal of the Investment Grade Exception for foreign
sovereign bonds would impede a foreign sovereign or its affiliated
purchasers from engaging in its own general trading and investment
activities, or other public purposes. Should the Commission adopt an
exception from Rule 102 for bonds issued by a foreign government or
political subdivision thereof? For example, should the Commission
except from Rule 102 any bond issued by a foreign sovereign or
political subdivision thereof filed with a registration statement
pursuant to Schedule B of the Securities Act? Do all bonds issued by
foreign sovereigns or political subdivisions thereof trade based on a
spread to U.S. Treasury securities? Please explain.
V. Recordkeeping Requirement: Rule 17a-4(b)(17)
A. Proposed Recordkeeping Requirement
The Commission is proposing a new recordkeeping requirement that
broker-dealers who are distribution participants or affiliated
purchasers must keep certain records pursuant to Rule 17a-4 under the
Exchange Act, the Commission's broker-dealer record retention rule.
Proposed paragraph (b)(17) of Rule 17a-4 would require broker-dealers
relying on the exception for Nonconvertible Securities to preserve the
written probability of default determination made pursuant to proposed
paragraph (c)(2)(i) of Rule 101. Accordingly, broker-dealers relying on
[[Page 18325]]
the exception in proposed paragraph (c)(2)(i) of Rule 101 would be
required to preserve for a period of not less than three years, the
first two years in an easily accessible place, the written probability
of default determination made pursuant to proposed paragraph (c)(2)(i)
of Rule 101.
Under proposed paragraph (c)(2)(i) of Rule 101, broker-dealers
relying on the exception would need to determine and document in
writing that the probability of default of the issuer of Nonconvertible
Securities is, estimated as of the day of the determination of the
offering pricing and over the horizon of 12 calendar months from such
day, less than 0.055% using a Structural Credit Risk Model. Broker-
dealers relying on the exception in proposed Rule 101(c)(2)(i) would be
required to preserve the written probability of default determination
pursuant to Rule 17a-4. The proposed amendment to Rule 17a-4 would
modify the existing practices of broker-dealers who are distribution
participants or affiliated purchasers to impose new recordkeeping
burdens when relying on the exception in proposed Rule 101(c)(2)(i). A
broker-dealer that uses a vendor to determine the probability of
default threshold could satisfy this recordkeeping 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 calculating the probability
of default on its own could satisfy the recordkeeping 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.
The proposed requirement to preserve the written probability of
default determination pursuant to Rule 17a-4 is consistent with other
retention obligations of records that Exchange Act rules impose on
broker-dealers.\125\ Exchange members and broker-dealers are currently
required to comply with the three-year preservation period in Rule 17a-
4 for other records and should have procedures to satisfy such
preservation requirements in place.\126\
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\125\ See id.
\126\ 17 CFR 240.17a-4(b).
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The proposed recordkeeping requirement is intended to aid the
Commission in its oversight of broker-dealers who are distribution
participants or affiliated purchasers and rely on the exception in
proposed paragraph (c)(2)(i) of Rule 101 by requiring such broker-
dealers to retain the written probability of default determination
supporting their reliance on the exception. The written records
documenting the probability of default determination would be subject
to review in regulatory examinations by Commission staff and self-
regulatory organizations.
B. Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support their
views.
37. Is the retention of information by distribution participants or
affiliated purchasers for a period of three years, the first two years
in an easily accessible place, in proposed paragraph (b)(17) of Rule
17a-4 appropriate? If not, what would be a more appropriate period of
time, and why? Would investors, the Commission, or the public benefit
from a retention period that is longer than three years? What would the
costs be for broker-dealers who are distribution participants or
affiliated purchasers for a retention period that is longer than three
years?
38. Is the retention requirement in proposed paragraph (b)(17) of
Rule 17a-4 burdensome or costly? Please explain. If so, in what ways
could modifications to the Rule as proposed reduce these burdens and
costs? What would the costs be for broker-dealers who are distribution
participants or affiliated purchasers to preserve the written
probability of default determination?
39. Should broker-dealers who are distribution participants or
affiliated purchasers relying on the exception in proposed paragraph
(c)(2)(i) of Rule 101 be required to document information in addition
to the proposed required documentation (i.e., the written probability
of default determination)? For example, should a broker-dealer be
required to retain the documentation governing the probability of
default estimation if the broker-dealer uses a vendor model?
VI. General Request for Comment
The Commission solicits comment on all aspects of the proposed
amendments to Rule 101, Rule 102, and Rule 17a-4, as well as any other
matter that may impact any of the proposals discussed above. Please
provide empirical data, when possible, and cite to economic studies, if
any, to support alternative approaches. In particular, the Commission
asks commenters to consider the following questions:
40. In proposing the criteria above, the Commission has focused on
indicators of credit-worthiness. Is credit-worthiness alone an
appropriate signifier of whether a security is susceptible to
manipulation under the conditions in which Rule 101 is concerned? Why
or why not?
41. Please comment in particular on any relevant changes to the
Nonconvertible Securities or asset-backed securities markets since
Regulation M was adopted in 1996 and how these developments should
affect the Commission's evaluation of the proposed amendments. How do
these changes fit within the relevant changes to the debt markets (more
generally) since Regulation M's adoption?
VII. Paperwork Reduction Act Analysis
A. Background
Certain provisions of proposed amendments impose ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\127\ Specifically, the Commission
estimates that respondents would incur PRA burden when determining
whether a distribution of a nonconvertible security qualifies for the
proposed exception from Regulation M. The Commission also believes that
there would be PRA burdens associated with documenting this
determination. These PRA burdens would be distinct from the existing
OMB-approved collection of information burden estimates under Rule 101
and Rule 17a-4 because the Commission has not estimated that
respondents incur PRA burdens when determining whether a security
qualifies for the current Investment Grade Exception.\128\ The
Commission is submitting the proposed amendments to the Office of
Management and Budget (``OMB'') for review in accordance with the PRA.
An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a current
valid control number.
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\127\ See 44 U.S.C. 3501 et seq. The burden associated with the
information collection requirements are referred to as ``PRA
burdens.''
\128\ The Commission preliminarily believes that the proposed
amendment to Rule 102 would not change the PRA burden estimates
under the current OMB-approved collections of information for that
rule because those estimates do not include any collections of
information or burden related to the determination of whether a
security qualifies for the Investment Grade Exception. The proposed
amendment would eliminate the exception under Rule 102, so
respondents would continue to incur no burden making a determination
because they would not be making one. See Supporting Statement for
the Paperwork Reduction Act Information Collection Submission for
Rule 102 of Regulation M (OMB Control No. 3235-0467) (Feb. 5, 2020),
available at https://www.reginfo.gov/public/do/PRAViewDocument?ref_nbr=201911-3235-012 (discussing the burden
estimates under Rule 102).
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[[Page 18326]]
The titles and control numbers for these collections of information
are as follows:
------------------------------------------------------------------------
OMB control
Rule Title No.
------------------------------------------------------------------------
Rule 101....................... Rule 101, 17 CFR 3235-0464
242.101 (Activities by
Distribution
Participants).
Rule 17a-4..................... Records to be Preserved 3235-0279
by Certain Brokers and
Dealers.
------------------------------------------------------------------------
As discussed above, Regulation M is designed to preserve the
integrity of the securities trading market as an independent pricing
mechanism by prohibiting activities that could artificially influence
the market for an offered security. Subject to exceptions, Rule 101
prohibits distribution participants and their affiliated purchasers
from directly or indirectly bidding for, purchasing, or attempting to
induce another person to bid for or purchase a covered security during
a restricted period. Rule 17a-4 requires a broker-dealer to preserve
certain records if it makes or receives them.
In reference to the requirement in Section 939A, the Commission is
proposing amendments to Rules 101 and 102 to remove the existing
exceptions for nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities that are rated by at least one
NRSRO in one of its generic rating categories that signifies investment
grade. With respect to Nonconvertible Securities in Rule 101, the
Commission proposes to substitute a standard that would except
securities for which the probability of default, estimated as of the
day of the determination of the offering pricing and over the horizon
of 12 calendar months from such day, is less than 0.055%, as determined
by a Structural Credit Risk Model. Broker-dealers who are distribution
participants and their affiliated purchasers that would be relying on
the proposed exception from Rule 101 would be required to preserve for
a period of not less than three years, the first two years in an easily
accessible place, the written probability of default determination. The
Commission is also proposing to except asset-backed securities that are
offered pursuant to an effective shelf registration statement filed on
Form SF-3.
The discussion of estimates that follows is limited to a discussion
of the new information collection requirements that result from the
proposed amendments. The Commission is not estimating that the proposed
amendments would increase or decrease the existing approved information
collections under Rule 101 and Rule 17a-4 because those information
collections are not related to making a determination about whether a
security qualifies for the Investment Grade Exceptions. The information
collections in the proposed amendments are distinct, so they are the
only information collections discussed herein.
B. Proposed Use of Information
The information collected under the proposal would be used to
ensure that the nonconvertible debt securities most resistant to
manipulation are excepted from Rule 101. Further, the Commission
preliminarily believes that the information contained in the records
required to be retained and kept pursuant to the proposed amendment to
Rule 17a-4 would be used to assist the Commission in conducting
effective examinations and oversight of distribution participants and
their affiliated purchasers.
C. Information Collections
The proposed amendments that impose information collection burdens
would apply to distribution participants and affiliated purchasers that
choose to rely on the exception for a distribution of Nonconvertible
Securities. As noted in Part VIII.A.1, there were 237 underwriters of
Nonconvertible Securities in 2020. The Commission preliminarily
believes that this number will remain roughly consistent because of the
capital, expertise, and relationships needed to underwrite a
Nonconvertible Security. The Commission, therefore, is estimating that
237 respondents would be subject to PRA burdens under the proposed
amendments.
As discussed below, the Commission preliminarily believes that
respondents would incur PRA burdens under the proposed amendments
because distribution participants and their affiliated purchasers would
be required to analyze each distribution of Nonconvertible Securities
to determine whether the distribution qualifies for the exception.
Respondents would also incur PRA burdens under Rule 17a-4 because
distribution participants would be required to keep certain records
documenting this determination that support their reliance on the
exception.
1. Rule 101
Under the proposed amendment to Rule 101, respondents wishing to
rely on the exception for a distribution of Nonconvertible Securities
would be required to gather the data serving as the inputs and then
perform the analysis necessary to calculate the probability of default
of the issuer whose securities are the subject of the
distribution.\129\ This requirement would result in respondents
incurring recordkeeping burden. The Commission preliminarily believes
that this process would likely be highly automated, and that
respondents would initially comply with this requirement by
reprograming systems to create a means to calculate electronically the
probability of default based on manually gathered and entered inputs
for financial modeling. The Commission preliminarily believes that all
respondents would be broker-dealers who have experience using their own
proprietary version of a publicly available Structural Credit Risk
Model so the initial configuration of systems will be handled
internally and take 3 hours per respondent. The Commission also
preliminarily believes that broker-dealers already have the software
and systems in place that would be required to make the
calculations.\130\
[[Page 18327]]
Accordingly, the Commission estimates that the total industry-wide
initial burden for the proposed amendment to Rule 101 would be 711
hours.\131\
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\129\ The Commission recognizes that some respondents may choose
to utilize the probability of default estimates calculated and made
available by a third-party vendor rather than perform the
calculations themselves. The Commission's burden estimate for the
proposed amendment to Rule 101 is based upon respondents gathering
the required data and calculating the probability of default
internally without the use of third-party vendors, because the
Commission lacks granular information from which to base an estimate
of the proportion of respondents that would use vendors. The
Commission welcomes comments on this approach, including regarding
the likelihood and cost of using third-party vendors, including any
time burden associated with using such services.
\130\ Further, the Commission preliminarily believes that
respondents that choose to utilize the probability of default
estimates calculated and made available by a third-party vendor
would already have access to the vendor's software and systems
containing these estimates, typically as part of an existing
subscription, so they would not need to procure further services or
subscriptions from these vendors. The Commission welcomes comments
on this preliminary belief and on any related costs and burdens.
\131\ 237 respondents x 3 hours = 711 hours.
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An issuer's probability of default is forward-looking and changes
over time, so the Commission preliminarily believes that respondents
would manually gather the inputs required to calculate probability of
default each time it participates in a distribution of debt securities.
There were 19,076 offerings of Nonconvertible Securities in 2020.\132\
Because financial modeling generally, and the probability of default
calculation more specifically, is well-known by industry participants,
the Commission preliminarily believes that respondents would have
employees that are familiar with how to gather the required inputs. The
Commission, therefore, estimates that would take respondents roughly 1
hour per distribution of Nonconvertible Securities on this requirement.
Accordingly, the Commission estimates that the amendment to Rule 101
will result in an aggregate annual ongoing industry-wide burden of
19,076 hours. The Commission, therefore, estimates that the total PRA
burden resulting from the proposed amendment to Rule 101 would be
19,787 hours in the first year \133\ and 19,076 hours thereafter.
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\132\ This number was obtained from Mergent, a financial data
provider. Data for 2021 is not yet available in Mergent.
\133\ 711 hours (initial burden) + 19,076 hours (ongoing annual
burden) = 19,787 hours.
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The Commission preliminarily believes that the proposed amendments
would not result in respondents incurring PRA burden when participating
in distributions of asset-backed securities because whether an asset-
backed security has an effective registration statement on Form SF-3 is
an objective, observable fact.\134\ Further, under the proposed
amendments, there is no requirement for distribution participants or
their affiliated purchasers to keep records documenting its reliance on
the exception for distributions of asset-backed securities.
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\134\ See 17 CFR 239.45.
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2. Rule 17a-4
The proposed amendment to Rule 17a-4 would require broker-dealers
relying on the exception in proposed paragraph (c)(2)(i) to preserve
for a period of not less than three years, the first two years in an
easily accessible place, the written probability of default
determination. Because the burden to make these records is accounted
for in the PRA estimates for the amendment to Rule 101, the burden
imposed by these proposed new requirements under Rule 17a-4 is limited
to the maintenance and preservation of the written records.\135\ The
Commission estimates that this recordkeeping requirement would impose
an initial burden of 25 hours per respondent for updating the
applicable policies and systems required to account for capturing the
records made pursuant to proposed paragraph (c)(2)(i). Accordingly, the
Commission estimates that the total industry-wide initial burden for
this requirement would be 5,925 hours.\136\ The Commission also
estimates that respondents would incur an ongoing annual burden of 10
hours per firm for maintaining such records as well as to make
additional updates to the applicable recordkeeping policies and systems
to account for the proposed rules, leading to a total ongoing industry-
wide burden of 2,370 hours.\137\ The Commission, therefore, estimates
that the total PRA burden resulting from the proposed amendment to Rule
17a-4 would be 8,295 hours in the first year \138\ and 2,370 hours
thereafter.
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\135\ As noted above, for the purposes of these estimates, the
Commission assumes that no registrants are using vendors to rely on
the proposed exceptions, however, the Commission also preliminarily
believes that the burden associated with the proposed amendment to
Rule 17a-4 would not differ between respondents that rely on a
third-party vendor and those that do not.
\136\ 237 respondents x 25 hours = 5,925 hours.
\137\ 237 respondents x 10 hours = 2,370 hours.
\138\ 5,925 hours (initial burden) + 2,370 hours (ongoing annual
burden) = 8,295 hours.
PRA Summary Table
----------------------------------------------------------------------------------------------------------------
Ongoing annual
burden hours Total PRA
Initial burden per year burden hours
hours (after first in first year
year)
----------------------------------------------------------------------------------------------------------------
Industry-Wide Burden due to Proposed Amendment to Rule 101...... 711 19,076 19,787
Industry-Wide Burden due to Proposed Amendment to Rule 17a-4.... 5,925 2,370 8,295
----------------------------------------------------------------------------------------------------------------
D. Collection of Information Is Mandatory
Each collection of information discussed above would be a mandatory
collection of information.
E. Confidentiality
The Commission would not typically receive confidential information
as a result of this collection of information. To the extent that the
Commission receives--through its examination and oversight program,
through an investigation, or by some other means--records or
disclosures from a distribution participant regarding the probability
of default determination, such information would be kept confidential,
subject to the provisions of applicable law.
F. Retention Period of Recordkeeping Requirement
Pursuant to proposed Rule 17a-4(b)(17) a broker-dealer who is a
distribution participant or affiliated purchaser would be required to
retain information for a period of not less than three years, the first
two years in an easily accessible place.
G. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to (1) evaluate whether the proposed collections of
information are necessary for the proper performance of the functions
of the Commission, including whether the information would have
practical utility; (2) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collections of information and
assumptions used therein; (3) determine whether there are ways to
enhance the quality, utility, and clarity of the information to be
collected; (4) determine whether there are ways to minimize the burden
of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology; and (5) evaluate whether the proposed
amendments would have any effects on any other collection of
information not
[[Page 18328]]
previously identified in this section. The Commission also requests
that commenters provide data to support their discussion of the burden
estimates.
While the Commission welcomes any public input on this topic, the
Commission asks commenters to consider the following questions:
42. Is the Commission adequately capturing the respondents that
would be subject to burdens under the proposed amendments?
Specifically, would more or fewer than the 237 respondents determine
the probability of default?
43. Is the Commission accurately estimating the amount of time it
would take to program systems and gather the data required to perform
the probability of default calculations?
44. Would any aspects of the proposed amendments that are not
discussed in this PRA Analysis affect the burden associated with the
collection of information?
45. Do commenters agree with the Commission's preliminary belief
that the proposed amendment to Rule 102 would not change PRA burdens?
46. Do commenters agree with the Commission's preliminary belief
that the proposed amendments would not result in respondents incurring
PRA burden when participating in distributions of asset-backed
securities?
Any member of the public may direct to us any comments concerning
the accuracy of these burden estimates and any suggestions for reducing
the burdens. Persons submitting comments on the collection of
information requirements should direct the comments to the Office of
Management and Budget, Attention: Desk Officer for the Securities and
Exchange Commission, Office of Information and Regulatory Affairs,
[email protected], and send a copy to Vanessa
Countryman, Secretary, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549-1090, with reference to File No. S7-11-22. OMB
is required to make a decision concerning the collection of information
between 30 and 60 days after publication of this release. Consequently,
a comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publication. Requests for materials
submitted to OMB by the Commission with regard to these collections of
information should be in writing, refer to File No. S7-11-22, and be
submitted to the Securities and Exchange Commission, Office of FOIA
Services, 100 F Street NE, Washington, DC 20549-2736.
VIII. Economic Analysis
The Commission is sensitive to the economic consequences and
effects, including costs and benefits, of its rules. Some of these
costs and benefits stem from statutory mandates, while others are
affected by the discretion exercised in implementing the mandates.
Section 3(f) of the Exchange Act provides that whenever the Commission
is engaged in rulemaking pursuant to the Exchange Act and is required
to consider or determine whether an action is necessary or appropriate
in the public interest, the Commission shall also consider, in addition
to the protection of investors, whether the action will promote
efficiency, competition, and capital formation.\139\ Additionally,
Section 23(a)(2) of the Exchange Act requires the Commission, when
making rules under the Exchange Act, to consider the impact such rules
would have on competition. Section 23(a)(2) also provides that the
Commission shall not adopt any rule which would impose a burden on
competition that is not necessary or appropriate in furtherance of the
purposes of the Exchange Act.
---------------------------------------------------------------------------
\139\ See 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
The analysis below addresses the likely economic effects of the
proposed amendments, including the anticipated benefits and costs of
the amendments, and their likely effects on efficiency, competition,
and capital formation. The Commission also discusses the potential
economic effects of certain alternatives to the approach taken by these
amendments. Some of the benefits and costs discussed below are
difficult to quantify. For example, sticky offerings are generally not
identified in the available data and may be difficult to trace in the
appropriate records of the distribution participants. Therefore, much
of the discussion of economic effects is qualitative.
A. Baseline
1. The Investment Grade Fixed Income Market
To assess the economic effects of the proposed amendments, the
Commission is using as the baseline the nonconvertible debt,
nonconvertible preferred, and asset-backed securities markets as they
exist at the time of this release, including applicable rules that the
Commission has already adopted.
The affected parties include Nonconvertible Security and asset-
backed security (collectively ``fixed-income securities'') \140\
distribution and market participants, such as issuers, selling security
holders, underwriters, banks, broker-dealers, and their affiliated
purchasers; fixed-income security investors, such as retail investors,
mutual funds, exchange traded funds, and separate investment accounts;
vendors of the relevant market data; and NRSROs. Currently a majority
of the distribution participants in the relevant markets are subscribed
to a major vendor of the market data necessary to evaluate various
aspects of the distribution. Further, a rating by an NRSRO is necessary
in order for distribution participants to rely on the Investment Grade
Exception. Today there are nine credit rating agencies registered with
the Commission as NRSROs.\141\ Three large NRSROs (S&P Global Ratings,
Moody's Investors Services, Inc., and Fitch Ratings, Inc.) have
historically accounted for most of the market share in this market. As
of December 31, 2020, these three market participants accounted for
94.7% of all of the NRSRO credit ratings outstanding.\142\
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\140\ The term ``fixed-income'' in the Economic Analysis section
refers to nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities.
\141\ U.S. Sec. and Exch. Comm'n, Annual Report on Nationally
Recognized Statistical Rating Organizations 2 (2022), available at
https://www.sec.gov/files/2022-ocr-staff-report.pdf.
\142\ Id. at 24.
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The affected securities are nonconvertible debt, nonconvertible
preferred, and asset-backed securities. In 2020, there were 19,076
issues of nonconvertible debt, with 694 issuers and 237 participating
underwriters involved.\143\ Additionally, in 2020, there were 152,069
issues of mortgage-backed securities with 195 underwriters involved and
7,255 issues of other asset-backed securities with 155
underwriters.\144\
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\143\ The statistics are based on the data from Mergent.
\144\ The data for the asset-backed securities (including
mortgage-backed securities) comes from Bloomberg.
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2. The Investment Grade Exception to Regulation M
Regulation M is designed to prevent manipulative activities that
could artificially influence the demand and pricing of covered
securities.\145\ In particular, Rules 101 and 102 of Regulation M
prohibit distribution and market participants from bidding for or
purchasing a covered security, unless an exception, such as the
Investment Grade Exception, applies.\146\ At the time the exception was
included, the investment grade securities, that is securities
characterized by sound credit-worthiness, were considered to be
[[Page 18329]]
traded primarily on yield and maturity, rather than the factors that
determine credit-worthiness of the issuer and add uncertainty to the
pricing of the issue.\147\ Thus sound credit-worthiness was considered
to be a good proxy for manipulation risk. Such issues were presumed to
have low probability of default and were thus considered to have low
pricing uncertainty and low manipulation risk, which formed the basis
for the exception. The Commission continues to believe that sound
credit-worthiness is a good proxy for manipulation risk since
securities issued by firms with sound credit-worthiness trade primarily
on yield and maturity and not on issuer-specific characteristics that
may increase pricing uncertainty.
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\145\ See supra Part 0.
\146\ See 17 CFR 242.101(a), 102(a); see, e.g., 17 CFR
242.101(c)(2), 102(d)(2).
\147\ See Regulation M Adopting Release, 62 FR 527.
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The Commission believes that the application of the Investment
Grade Exception to Rules 101 and 102 is primarily limited to two
cases:\148\ Reopenings (an offering of an additional principal amount
of securities that are identical to the securities already outstanding)
and sticky offerings (an offering where a lack of demand results in an
underwriter being unable to sell all of the securities in a
distribution). Reopenings are used infrequently and constitute about 3%
of the relevant securities' markets' issuance volume.\149\ Sticky
offerings are not identified in the relevant databases, making it
difficult to assess their relative magnitude.
---------------------------------------------------------------------------
\148\ Some commenters note that best efforts offerings (see
supra note 59) and foreign sovereign offerings (see supra note 62)
could also be affected by the exceptions in Rules 101 and 102.
\149\ The estimate is obtained using Mergent data for the
relevant fixed income securities during the past five years as of
Oct. 2021.
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Reopenings are used in situations when such financing method offers
the benefit of cost-effectiveness. For example, it may be cheaper for
an issuer to offer a series of small offerings as opposed to one large
offering, as the latter could result in a lower offering price due to
the supply pressure. Further, since a reopening issue is fungible with
securities already in circulation and can be traded interchangeably
with these securities in the secondary market, it provides additional
liquidity benefits to the investors.\150\
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\150\ See SIFMA Letter 3 at 6; John Berkery & Remmelt
Reigersman, Re-openings: Issuing Additional Debt Securities of an
Outstanding Series, Mayer Brown 1-2 (2020), available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/05/reopenings_-issuing-additional-debt-securities-of-an-outstanding-series.pdf. See also Arnold & Porter Letter at 3.
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Sticky offerings typically result when a large investor fails to
fulfill its expressed purchase interest in the issue,\151\ which could
be due to a negative factor that transpired in regard to the issue or
issuer. In such cases it may become challenging to trade the issue
based solely on the yield and maturity (otherwise it would have become
possible to find another purchaser in a timely manner). This may give
rise to a heightened risk of manipulation even if the security is rated
as investment grade.
---------------------------------------------------------------------------
\151\ Sullivan & Cromwell Letter at 4.
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The Commission preliminarily believes that the exception based on
investment grade rating is rarely used in practice in Rule 102. Rule
102 prohibits trading of the securities fungible with the securities
being issued by issuers, selling security holders, and their affiliated
purchasers.\152\ However, issuers and selling security holders
generally do not have the same market access needs as underwriters and
are not expected to buy the securities they are issuing.\153\
---------------------------------------------------------------------------
\152\ See supra Part IV.A.1.c. for a relevant discussion.
\153\ See supra Part IV.B.
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The Investment Grade Exception was included in the regulation as it
was considered a good proxy for the likelihood of manipulation
risk.\154\ However, the reference to NRSRO ratings in the Commission's
rules may encourage investors to place undue reliance on the NRSRO
ratings. Additionally, even though credit-worthiness has been
historically considered a good proxy for manipulation risk, it is still
not a precise measure of such risk and therefore there are costs
associated with using such a proxy that currently exist in the relevant
markets. Specifically, in some instances distribution participants may
choose to engage in manipulative activities of the securities of
issuers with sound credit-worthiness. As a result, under the existing
rules, situations may arise in which securities with high manipulation
risk are excepted from Regulation M.
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\154\ See supra Part III (discussing the history of the
Investment Grade Exceptions).
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B. Benefits of the Proposed Amendment
As mentioned above, Section 939A of the Dodd-Frank Act requires the
Commission to ``remove any reference to or requirement of reliance on
credit ratings, and to substitute in such regulations such standard of
credit-worthiness as the Commission determines to be appropriate.''
\155\ In this proposed rule, the Commission proposes to rely upon the
Structural Credit Risk Models to measure credit-worthiness.\156\ These
models have become widely used to estimate the probability of default
of an issuer.\157\
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\155\ Public Law 111-203 sec. 939A(a). The Commission has issued
several releases concerning the removal of references to credit
ratings: Security Ratings, Release No. 34-64975 (July 27, 2011) [76
FR 46603 (Aug. 3, 2011)]; Removal of Certain References to Credit
Ratings Under the Securities Exchange Act of 1934, Release No. 34-
71194 (Dec. 27, 2013) [79 FR 1522 (Jan. 8, 2014)]; Removal of
Certain References to Credit Ratings under the Investment Company
Act, Release No. IC-30847 (Dec. 27, 2013) [79 FR 1316 (Jan. 8,
2014)]; Asset-Backed Securities Disclosure and Registration, Release
No. 34-72982 (Sept. 4, 2014) [79 FR 57184 (Sept. 24, 2014)]; Removal
of Certain References to Credit Ratings and Amendment to the Issuer
Diversification Requirement in the Money Market Fund Rule, Release
No. IC-31828 (Sept. 16, 2015) [80 FR 58124 (Sept. 25, 2015)].
\156\ See for example the seminal model by Robert C. Merton, On
the Pricing of Corporate Debt: The Risk Structure of Interest Rates,
29 Journal of Finance 449, 449-70 (1974), along with related
successive refinement models such as Fischer Black & John C. Cox,
Valuing Corporate Securities: Some Effects of Bond Indenture
Provisions, 31 J. Fin. 351, 351-67 (1976); Robert Geske, The
Valuation of Corporate Liabilities as Compound Options, 12 J. Fin. &
Quantitative Analysis 541, 541-52 (1977); and Oldrich A. Vasicek,
Credit Valuation, KMV (Mar. 22, 1984), among others.
\157\ See supra note 67.
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Structural Credit Risk Models typically take the issuer balance
sheet measures of debt obligations as given and estimate a probability
of default based on the market value and volatility of the firm's
equity. The value of equity is viewed in these models as the value of a
call option on firm assets where the strike price is the total notional
value of debt. Since the market value of equity, the volatility of
equity, and the notional value of debt can be calculated from the
market and balance sheet data, under the Structural Credit Risk Models
the volatility of the value of the assets and the market value of
assets, which are not observable, can be estimated. The probability of
default can be calculated as the probability that the call option will
expire out-of-the-money, which occurs when the value of the company
falls below the book value of the debt.
As discussed above, Structural Credit Risk Models are based on the
structure of the balance sheet.\158\ The key
[[Page 18330]]
assumption of a Structural Credit Risk Model is that default occurs
when the value of the company falls below the book value of the debt.
Since the future value of the firm is unknown, a Structural Credit Risk
Model must make assumptions about the probability distribution of
possible firm values in different scenarios, some of which may trigger
default. These assumptions include the current firm value and the
volatility of firm value, for which the observed market value of equity
and the volatility of equity is often an input. Some models include
assumptions over the firm's dividend policy.
---------------------------------------------------------------------------
\158\ An alternative set of models used to derive probability of
default are `reduced-form models'. The reduced-form models rely on
statistical analysis rather than the balance sheet to determine a
firm's creditworthiness. However, compared to Structural Credit Risk
Models, they lack in rigorous theoretical justification as well as
economic interpretation of the resulted relationships between the
model inputs. See, e.g., Edward Altman, Andrea Resti, & Andrea
Sironi, Default Recovery Rates in Credit Risk Modeling: A Review of
the Literature and Empirical Evidence, 33 Econ. Notes 183 (2004)
(discussing the competing models), available at https://onlinelibrary.wiley.com/doi/10.1111/j.0391-5026.2004.00129.x.
---------------------------------------------------------------------------
The Commission preliminarily believes that the probability of
default based on the Structural Credit Risk Models is an appropriate
proxy for credit-worthiness. As discussed previously, the Commission
continues to believe that credit-worthiness is an appropriate standard
to reflect manipulation risk since securities issued by firms with
sound credit-worthiness trade primarily on yield and maturity and have
low pricing uncertainty. Thus, the probability of default based on
Structural Credit Risk Models is a reasonable proxy for manipulation
risk.
The Commission calibrated the 0.055% threshold in the sample of
nonconvertible fixed income securities so as to capture approximately
90% of the investment grade securities in our sample of nonconvertible
fixed income securities (2436 distinct investment grade issues with
probability of default below 0.055% out of 2710 total investment grade
rated issues in the sample). This threshold also captures 125 distinct
non-investment grade issues with probability of default below 0.055%.
Overall, 2561 issues meet the proposed exception as compared with the
2710 issues under the current exception.\159\ The securities with
probability of defaults within the first 12 months, as estimated based
on a widely accepted Structural Credit Risk Model, below the 0.055%
threshold are proposed to be excepted from Rule 101.
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\159\ The most recent available investment grade status (as of
the last available Mergent update through Dec. 2020) for
nonconvertible securities issued between 2016 and 2020 was obtained
from Mergent while the probability of default estimates were
obtained for a cross-section of securities available in Bloomberg as
of Oct. 22, 2021, which represents an average trading day with
respect to the relevant market metrics. Since the cross-section of
the relevant securities does not change considerably from day to day
and the relevant metrics are typically calculated based on the data
over a several months period or longer, it is unlikely that the
results of the analysis are considerably affected by the specific
day selected for the analysis. Please refer to Mario Bondioli,
Martin Goldberg, Nan Hu, Chngrui Li, Olfa Maalaoui, & Harvey J.
Stein, The Bloomberg Corporate Default Risk Model (DRSK) for Private
Firms (working paper Aug. 27, 2021), available at https://ssrn.com/abstract=3911330 (retrieved from SSRN Elsevier database), for
methodology description of Bloomberg probability of default measure.
---------------------------------------------------------------------------
An advantage of using probabilities of default implied by
Structural Credit Risk Models instead of NRSRO credit ratings is that
these model-implied probabilities of default generally use current
estimates of equity valuation and volatility, and hence incorporate
most recent news affecting the valuation and perceived volatility of
the firm. In contrast, credit rating agencies are generally slower than
the market in updating credit ratings and outlooks and thus may reflect
less up-to-date information.\160\ \161\
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\160\ This is consistent with the following SEC staff statement
in COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality
and Related Financial Stability Issues: Select Observations, SEC
(July 15, 2020) (``Cost of debt capital is driven by a wide range of
financial and non-financial factors and forces; ratings downgrades
are generally lagging indicators of cost of debt capital.''),
available at https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15.
\161\ Some academic studies find evidence that Structural Credit
Risk Models may be able to respond to aggregate and firm specific
news faster than credit ratings. Also, such models are able pick up
on differences in default risk within a credit rating bucket.
However, credit ratings do not necessarily imply probabilities of
default and thus may not be directly comparable to probability of
default estimated using a Structural Credit Risk Model. See Jing-zhi
Huang & Hao Zhou, Specification Analysis of Structural Credit Risk
Models (Fed. Res. Bd., Fin. & Econ. Discussion Series, 2008-552008),
available at https://www.federalreserve.gov/pubs/feds/2008/200855/200855pap.pdf; Moody's Analytics, EDF Overview (2011) (outlining the
approach by Moody's KMV), available at https://www.moodysanalytics.com/-/media/products/EDF-Expected-Default-Frequency-Overview.pdf; Giuseppe Montesi & Giovanni Papiro, Risk
Analysis Probability of Default: A Stochastic Simulation Model, 10
J. Credit Risk 29 (2014).
---------------------------------------------------------------------------
Distribution participants should be able to calculate the
probability of default internally using Structural Credit Risk Models.
One of the benefits of the proposed amendment is that the distribution
participants will have the flexibility of selecting the model they find
most convenient to assess the credit-worthiness of issuers for the
purposes of using the exception. This means the distribution
participants will no longer have to rely on an NRSRO rating for the
issue for purposes of the Regulation M exception and will no longer
have to rely on an NRSRO's choice of the model for such purposes.
Furthermore, the Commission preliminarily believes that multiple
vendors currently provide estimates of the probability of default based
upon Structural Credit Risk Models as a part of default packages that
include various market data and metrics.\162\
---------------------------------------------------------------------------
\162\ See a relevant discussion in supra Part IV.A.1.c).
---------------------------------------------------------------------------
Removing the reference to credit ratings from Rules 101 and 102 of
Regulation M may also have a benefit of expanded options available to
distribution participants compared to the Regulation M Investment Grade
Exception requirement, as the proposed requirement will no longer rely
on a limited number of vendors providing credit ratings, which may
reduce possible negative consequences from limited competition.
Structural Credit Risk Models as a measure for credit-worthiness could
therefore serve as a better proxy for manipulation risk than credit
ratings because, by prescribing a methodology rather than a metric
generated by only a certain category of regulated vendors (that is,
NRSROs), distribution participants may have more options for either
using a vendor supplied Structural Credit Risk Model or using their own
proprietary version of a publicly available Structural Credit Risk
Model.
Under the proposed amendments, the Structural Credit Risk Models
cannot, as a practical matter, apply to asset-backed securities due to
the complexity of the structure of such instruments. In the case of
asset-backed securities, the Commission preliminarily believes that
securities that are offered pursuant to an effective shelf registration
statement filed on Form SF-3 should also be excepted from Rule 101.
Form SF-3 requirements provide objective criteria that also ensure that
the securities with the least amount of manipulation risk are allowed
to rely on the Regulation M exception. Specifically, Form SF-3
requirements limit the number of nonperforming assets in the asset-
backed security pool, require review of the pool assets, and require
certification by the chief executive officer, among other things. The
Commission continues to believe, as noted when it adopted these
requirements, that use of Form SF-3 incentivizes sponsors to carefully
review and disclose the underlying assets' characteristics, reducing
the overall uncertainty about the asset-backed security and therefore
the risk of manipulation. Accordingly, asset-backed securities that are
offered pursuant to an effective shelf registration statement filed on
Form SF-3 have similar qualities and characteristics to the investment-
grade asset-backed securities currently excepted from Rule 101(c)(2).
Further, an analysis of a merged sample of Form SF-3 filers and
Bloomberg credit ratings
[[Page 18331]]
for year 2021 asset-backed securities issuances demonstrates that 78%
of Form SF-3 filers' issuances have investment grade status (362 out of
464 rated issuances), while the remaining 22% of issuances have non-
investment grade status (102 issuances).\163\ To the extent that asset-
backed securities for which a Form SF-3 is filed includes securities
that have low manipulation risk but lack an investment grade rating,
the additional benefit of the proposed amendments is allowing such low
manipulation risk issues to rely on the exception and encouraging
participation in the relevant market.
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\163\ We note that 770 investment grade asset-backed security
issuances (by 191 issuers) from the 2021 Bloomberg sample did not
merge with the sample of Form SF-3 filers in part due to necessarily
present imperfections in issuer name matching and in part due to a
much smaller number of Form SF-3 filers (62 issuers). This may imply
a possibility that a fairly large number of issuances that are able
to rely on the exception currently will be excluded under the
proposed standard. The asset-backed securities eligible for Rule
144A were excluded from the analysis as they are able to rely on a
different exception.
---------------------------------------------------------------------------
The Commission is proposing to eliminate the exception entirely
from Rule 102, as discussed above, given the heightened risk of
manipulation that exists for issuers and selling security holders and
absence of a need to facilitate an orderly distribution or to limit
potential disruptions in the trading market, coupled with our
understanding that the Investment Grade Exception is generally not
relied upon in practice, as issuers and selling security holders who
are subject to Rule 102, unlike broker-dealers, typically do not trade
outstanding issues of their own securities that are identical to the
issue being distributed in the secondary market.\164\ The economic
benefit of the proposed amendment is that it may contribute to the
Dodd-Frank Act goals of reducing perceived government endorsement of
NRSROs and over-reliance on credit ratings by market participants in
Regulation M by removing the relevant reference to credit ratings.
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\164\ See also a relevant discussion in supra note 120.
Eliminating the Investment Grade Exception, however, could affect
the ability of foreign sovereign issuers to purchase any of such
issuer's securities. See discussion in infra Part VIII.C.5 and
Arnold & Porter Letter at 3.
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C. Costs of the Proposed Amendment
The Commission recognizes that some of the affected distribution
participants may bear costs from the proposed amendments. The proposed
amendments may alter the universe of securities that can rely on the
exception and additionally may prevent issuers from using the exception
in some cases potentially leading to fewer issues of the affected
securities. If some distribution participants decide not to participate
in certain issues as a result of the proposed amendments, the costs of
the affected issues may increase. For example, when fewer banks or
broker-dealers are available, these distribution participants may be
able to charge higher fees. Additionally, as the result of the proposed
amendments fewer issues may take place, potentially limiting issuers'
ability to raise capital and affecting investors in the relevant
securities as the available security selection and liquidity may be
reduced.
There are several types of costs that could arise: (1) Costs
associated with calculations or obtaining the probability of default
estimate; (2) costs associated with maintaining records related to the
probability of default estimation; (3) costs due to the probability of
default being an imperfect proxy for credit-worthiness, (4) asset-
backed securities' costs associated with the proposed amendments, (5)
costs related to Rule 102 amendments (6) indirect and other costs of
the amendments. We discuss these costs in detail below.
1. Costs Associated With Obtaining the Estimate of the Probability of
Default
Distribution participants may incur costs related to determining
the probability of default. Consistent with the PRA section,\165\ the
Commission estimates that it would take a distribution participant 3
hours to establish a system to gather the data serving as the inputs
and then perform the analysis necessary to calculate the probability of
default of the issuer whose securities are the subject of the
distribution, for an aggregate cost of $240,318.\166\ Consistent with
the PRA section,\167\ the Commission also estimates that it would take
a distribution participant one hour to gather the inputs required to
calculate probability of default each time it participates in a
distribution of Nonconvertible Securities. There were 19,076 offerings
of Nonconvertible Securities in 2020. Therefore, it is estimated that
annually distribution participants would spend $6,447,688 \168\ in the
aggregate complying with this requirement.
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\165\ See supra Part VII.C.1.
\166\ The Commission estimates the wage rate based on salary
information for the securities industry compiled by SIFMA. See
Management & Professional Earnings in the Securities Industry--2013,
SIFMA (Oct. 7, 2013), available at https://www.sifma.org/resources/research/management-and-professional-earnings-in-the-securities-industry-2013/. These estimates are modified by the Commission staff
to account for an 1800 hour work-year and multiplied by 5.35
(professionals) or 2.93 (office) to account for bonuses, firm size,
employee benefits and overhead. These figures have been adjusted for
inflation through the end of 2021 using data published by the Bureau
of Labor Statistics. 237 distribution participants x 3 hours x $338
hour for a compliance manager = $240,318.00.
\167\ See supra Part V.C.1.
\168\ 19,076 offerings x 1 hour x $338 hour for a compliance
manager = $6,447,688.
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Any costs associated with using a vendor to obtain probability of
default estimate should be minimal, as the Commission preliminarily
believes that distribution participants engaged in the offering of
Nonconvertible Securities would typically already have subscriptions to
vendors that provide calculations regarding the probability of default
based on Structural Credit Risk Models.\169\ Furthermore, we believe
that distribution participants, in particular those that choose to
determine the probability of default estimate internally, would already
have the computational resources necessary to conduct such analysis
internally.\170\
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\169\ See supra note 84.
\170\ See supra Part IV.A.1.c).
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2. Costs Associated With Maintaining Records Related to the Probability
of Default Estimation
Distribution participants would also incur costs related to
capturing and maintaining records regarding the probability of default
determination. Consistent with the PRA section,\171\ the Commission
estimates that it would take a distribution participant 25 hours to
update the applicable policies and systems required to account for
capturing the records made pursuant to proposed Rule 101(c)(2)(i), for
an aggregate cost of $2,002,650.\172\ Consistent with the PRA
section,\173\ the Commission also estimates that it would take a
distribution participant 10 hours to maintain such records as well as
to make additional updates to the applicable recordkeeping policies and
systems to account for the proposed rules. Therefore, it is estimated
that annually broker-dealers would spend $801,060 \174\ in the
aggregate complying with this requirement.
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\171\ See supra Part VII.C.2.
\172\ 237 distribution participants x 25 hours x $338 hour for a
compliance manager = $2,002,650.
\173\ See supra Part V.C.1.
\174\ 237 distribution participants x 10 hours x $338 for a
compliance manager = $801,060.
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3. Costs Associated With Structural Credit Risk Model Based Probability
of Default Being an Imperfect Proxy for Credit-Worthiness
As discussed previously, the proposed Structural Credit Risk Models
are designed to measure credit-worthiness, and credit-worthiness itself
[[Page 18332]]
is considered to be a good measure of manipulation risk. There are
costs that are currently present in the relevant markets associated
with credit-worthiness being an imperfect proxy for manipulation risk.
However, in the absence of a better proxy for manipulation risk,
credit-worthiness has continued to successfully serve the purpose of
measuring such risk for many years. This is also supported by the
comments stating that investment grade standard has been successfully
used in Rules 101 and 102 exception.\175\ The proposed amendments are
not expected to alter those costs and the discussion that follows
focuses instead on the costs associated with the proposed Structural
Credit Risk Models as a proxy for credit-worthiness.
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\175\ See, for example, Rothwell at 2 and ABA at 15 -17.
---------------------------------------------------------------------------
The use of any model to estimate credit-worthiness necessarily
provides an imperfect measure. Structural credit risk models are no
exception. We note, however, that NRSROs similarly may rely on
imperfect models of estimating issuer credit-worthiness. Moreover,
models such as Structural Credit Risk Models often are a part of the
analysis involved in obtaining a credit rating.\176\
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\176\ See, e.g., John Y. Campbell, Jens Hilscher, & Jan
Szilagyi, In Search of Distress Risk, 63 J. Fin. 2899 (2008),
available at https://scholar.harvard.edu/files/campbell/files/campbellhilscherszilagyi_jf2008.pdf.
---------------------------------------------------------------------------
Some ways to implement Structural Credit Risk Models make use of
historical trading data to produce a reliable estimate of the model
input parameters. These data may not be available for certain
infrequently traded securities. In some circumstances the market for a
security has not yet been established and sufficient trading data are
unavailable, making it difficult to apply the exception.
Additionally, Structural Credit Risk Models rely on a number of
parameter estimates such as firm market value and volatility, which
could be difficult to assess as these values change with market
conditions and business fluctuations. A changing term structure of
interest rates and noise trading in the market can further distort the
probability of default estimates. Incorrect parameter estimates may
result in the incorrect estimates of default probability and allow
distribution participants to rely on the exception for risky issues or
prevent distribution participants from relying on the exception for
safe issues. Implied probabilities of default are sensitive to market
prices and estimates of market volatility and consequently tend to be
counter cyclical, increasing during market downturns, which are often
also periods of increased uncertainty. A constant threshold which is
not time-varying would potentially result in fewer firms qualifying for
the exception during market downturns, which may result in more
issuances during this period not qualifying or firms choosing not to
issue, hence increasing their cost of capital or limiting their access
to capital. While credit rating downgrades are also counter cyclical,
they tend to be slow in incorporating updates \177\ and relatively
fewer firms will have an investment grade credit rating during
downturns, the impact of the counter cyclicality of default
probabilities implied by Structural Credit Risk Models would be
stronger relative to using credit ratings: During periods of distress,
using these probabilities of default will likely result in fewer firms
with an investment grade credit rating falling below the threshold, and
thus fewer firms qualifying for the exception relative to using credit
ratings. Distribution participants would, however, be able to adjust
the required estimated model parameters and inputs frequently as market
conditions change, mitigating the costs discussed above.
---------------------------------------------------------------------------
\177\ See COVID-19 Market Monitoring Group, supra note 160
(``Cost of debt capital is driven by a wide range of financial and
non-financial factors and forces; ratings downgrades are generally
lagging indicators of cost of debt capital.'').
---------------------------------------------------------------------------
Due to the number of variations among Structural Credit Risk Models
and their estimated inputs, the probability of default estimates may be
subjective to some extent and not comparable across different issuers
or for the same issuer across different issues if estimates are based
on different models, or done by different researchers or vendors. The
latter may affect market participants' ability to effectively rely on
the estimates to make comparative assessments across multiple
securities. However, this is also true of the credit ratings that often
rely on similar models, which mitigates these costs of the proposed
amendments relative to the market baseline.
In addition, as discussed previously in reference to the selected
threshold, the amendment may expand slightly the universe of firms that
qualify for the exception and include firms that did not receive an
investment grade credit rating, but have a structural credit model
implied probability of default that falls below the threshold. The debt
prices of these firms may be prone to manipulation if the price of
their debt is relatively less sensitive to aggregate interest rate
changes.
Additionally, this amendment may create potential opportunities for
new products offered by the vendors designed specifically for a given
issue or issuer. A custom designed estimate paid for by the issuer may
lead to potential conflicts of interest since the vendor is
incentivized in this case to produce an estimate which would allow the
issuer to rely on the exception. However, the existing major vendors
supplying probability of default estimates have numerous clients
currently using this information for business purposes other than the
Rule 101 exception. Therefore, given the reputational concerns it is
unlikely that these vendors would produce a slightly different product
to cater specifically to the use of these estimates for purposes of
relying on the Rule 101 exception. Additionally, the model input
estimates or assumptions may be tweaked by the distribution
participants in such a way as to produce the desired estimation result
if the model is estimated internally and may result in market
participants' adjusting the models so as to be able to rely on the
exception.\178\ This may result in an additional cost of adding some
manipulation risk to the relevant markets if manipulation prone issues
are allowed to rely on the exception as a result.
---------------------------------------------------------------------------
\178\ The definition of Structural Credit Risk Models for
purposes of Rule 101(c)(2)(i) is limited to commercially or publicly
available models, which would limit a distribution participant's
ability to develop its own models to achieve favorable results.
---------------------------------------------------------------------------
Finally, the proposed threshold of 0.055% for the exception is
based on model assumptions and historical data. Future market evolution
may result in this threshold becoming either too large or too small,
allowing risky issues to rely on the exception or preventing safe
issues from using it. This may vary by industry, with the threshold
being more restrictive in some industries relative to the original
NRSRO investment grade designation. Moreover, probabilities of default
as implied by Structural Credit Risk Models tend to be counter-cyclical
and can spike in periods of crisis due to decreases in market valuation
and increases in equity volatility. Consequently, fewer investment
grade firms would fall below the threshold. Credit rating by NRSROs are
also countercyclical but tend to be slow moving, since credit rating
changes often lag updates to firm conditions that would impact cost of
capital.\179\
---------------------------------------------------------------------------
\179\ COVID-19 Market Monitoring Group, supra note 160 (``Cost
of debt capital is driven by a wide range of financial and non-
financial factors and forces; ratings downgrades are generally
lagging indicators of cost of debt capital.'').
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[[Page 18333]]
4. Costs Associated With Asset-Backed Securities' Amendments
The proposed amendments may render some asset-backed securities
ineligible to rely on the exception from the Regulation M. This may
increase issuance costs for the distribution participants. For
instance, broker-dealers may reduce an offering's size or increase fees
if required to comply with Regulation M. Additionally, distribution
participants may need to establish new business relationships due to
Regulation M restrictions. Furthermore, some issuers may decide not to
issue the affected securities if required to comply with Regulation M
restrictions. As a result, some asset-backed securities' issues may not
take place, which could affect issuers' ability to raise capital and
could affect investors in the relevant markets by potentially reducing
the selection of the available asset-backed securities.
5. Costs Associated With Amendments to Rule 102
As discussed previously, the effect of eliminating the exception
from Rule 102 is expected to be minimal since the exception is likely
not useful from a practical standpoint, because the issuers and selling
security holders who are subject to Rule 102 typically do not trade
their own securities that are being issued. However, as was identified
previously in a comment letter, an Investment Grade Exception from Rule
102 could affect the ability of foreign sovereign issuers or their
affiliates to purchase any of such issuer's securities.\180\ In the
past the Commission has issued exemptive relief for some foreign
sovereign issuers because they trade, as represented in incoming
letters, based on a yield spread to US treasuries.\181\ This might mean
that bonds of foreign sovereign issuers are less susceptible to
manipulation risk since there is less uncertainty in regards to their
valuation. Eliminating the exception from Rule 102 may increase
issuance costs or deter market participants from issuing such
securities with low manipulation risk.
---------------------------------------------------------------------------
\180\ Arnold & Porter Letter at 3.
\181\ See supra note 121.
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6. Indirect and Other Costs of the Amendments
Besides the direct effects on the distribution participants and
affected securities discussed above the proposed amendment may also
generate indirect effects on investors in these securities and NRSROs.
For instance, if issuer participation in the relevant security issues
becomes limited, some issues may not take place that otherwise would.
Investors may face a more limited choice of investment instruments as a
result, for example in the case of reopenings. This may further affect
liquidity of their portfolios since reopenings can offer additional
liquidity benefits as the securities offered in reopenings are
interchangeable with the existing issues. However, as already
discussed, these costs are expected to be minimal as reopenings are
used infrequently.
The proposed amendment does not rely on an NRSRO rating in order to
determine if an issue can rely on the exception. This may diminish
NRSROs' clientele to the extent NRSROs choose not to provide Structural
Credit Risk Model-based estimates of the probability of default for
their existing clients opting to rely on the exception. However, the
amendment may increase the clientele of the vendors that supply
relevant data and metrics to the distribution participants if such
vendors already supply probability of default estimates or choose to
offer this estimate as a part of their services. In addition, if firms
do not solicit credit rating services from NRSROs beyond the estimate
of a probability of default implied by a Structural Credit Risk Model,
investors will not be able to benefit from the information provided by
a credit rating report and ongoing coverage of the firm that otherwise
would be provided through the distribution participant.
D. Efficiency, Competition, and Capital Formation
As discussed previously, distribution participants will have
flexibility to select the best Structural Credit Risk Model to access
credit-worthiness as a measure of manipulation risk for their business.
This may encourage market participation in affected security issues
and, as a result, could improve competition between issuers for the
investors as well as between other distribution participants. Further,
widely available estimates of the probability of default as well as an
option of internal model estimation could lead to a more competitive
environment as the requirement to rely on proprietary credit risk
models of a small number of NRSROs is removed. The improved
competition, market participation and efficiency ultimately should lead
to more efficient capital formation as the access to and functioning of
the relevant fixed income markets improves. We note however that these
effects are not expected to be significant because the exceptions in
Rules 101 and 102 affect only a small portion of the relevant market as
discussed previously.
However, while unlikely, it is possible that a new business model
could emerge in the relevant markets that leads to conflicts of
interest and neutralizes the effects discussed above. For instance,
distribution participants could contract with a vendor or a credit
rating agency directly to create a custom estimate of the probability
of default. This could result in a business model where an issuer pays
for the supplied estimate and where vendors may be incentivized to
produce an estimate designed to fit the desired estimation result. Thus
issues that otherwise would not be able to rely on the exception could
end up being excepted potentially increasing the manipulation risk in
the relevant markets, which in turn could negatively affect competition
and capital formation.
Further, the positive effects discussed above could be offset by
the fact that some issuers may face higher costs or no longer be able
to use the exception, for example, due to imperfect model estimates as
a result of market fluctuations or changing market. High costs of
issuance or inability to rely on the exception may deter participants
from issuing the affected securities, which could impact the
competition and capital formation in the relevant markets. Further,
potential negative effects of non-uniform estimates and subjectivity
additionally reduce these benefits. Finally, potentially increased
issuance costs due to some asset-backed securities being ineligible for
the exception may also negatively affect market participation and
competition of the relevant markets.
E. Reasonable Alternatives
Alternative 1 discussed below deals with the proposed threshold, 2-
4 propose alternative approaches to using Structural Credit Risk Models
as a standard of credit-worthiness to measure manipulation risk.
Alternative 5 discusses elimination of the exception, alternative 6
deals with asset-backed securities, while alternative 7 discusses Rule
102 options.
1. Alternative Threshold for Probability of Default
The proposed threshold of 0.055% was chosen so as to capture most
of the investment grade securities while at the same time capturing the
fewest of the non-investment grade securities. However, a different
threshold could be used in the proposed exception, which would capture
different proportions of investment and non-investment grade
securities. For example, a higher
[[Page 18334]]
threshold of 0.5% is estimated to capture about 98.6% of investment
grade securities (2673 out of 2710 investment grade issues), overall
resulting in 2883 issues that can rely on the exception under the
proposed standard.\182\ A lower threshold of 0.01% is estimated to
capture about 65% of investment grade securities (1760 out of 2710
investment grade issues) and overall results in 1811 issues that can
rely on the exception under the proposed standard.\183\ The advantage
of a higher threshold is that it captures a larger set of investment
grade securities, but at the expense of also capturing a small set of
non-investment grade securities, which could be more prone to
manipulation risk. As alternatives, the Commission could increase the
threshold, which would allow more investment grade securities to rely
on the exception at expense of potentially a higher manipulation risk;
or decrease the threshold, which would limit the ability of some of the
investment grade securities to use the exception, but would potentially
also limit the number of non-investment grade securities allowed to
rely on the exception and, as a result, also limit manipulation risk.
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\182\ 2883 issues captured by the new proposed standard (with
probability of default below 0.5%) consist of 2673 investment grade
issues and 210 non-investment grade rated issues.
\183\ 1811 issues captured by the new proposed standard (with
probability of default below 0.01%) consist of 1760 investment grade
issues and 51 non-investment grade rated issues.
---------------------------------------------------------------------------
As an alternative to providing a specific number as a threshold,
the Commission could specify a method for distribution participants to
use in calculating such a threshold. For example, such method could
involve calculating probability of default for a sample of
nonconvertible securities similar to the distribution participant's
securities issued over a specified time interval and comparing it to
investment grade status or another specified standard of credit-
worthiness. A longer time interval would capture more issues and
improve statistical accuracy at expense of having market conditions
potentially changing and generating incorrect estimates. A shorter time
interval ensures the market conditions have not changed but includes
fewer issues resulting in a smaller sample and lower statistical
accuracy.
The main advantage of specifying a method as opposed to a number
for the threshold is its flexibility with respect to changing market
conditions. The main disadvantage of this alternative is subjectivity
of the analysis involved, which may lead to non-uniform application of
the Regulation M exception across issues or issuers; or lead to market
participants adjusting the estimation to be able to rely on the
exception.
2. Exception Based on Security Characteristics
As an alternative replacement for the reference to investment grade
securities, the Commission has considered analysis that could be based
on security characteristics, such as (1) total amount of issue
outstanding (public float); (2) yield to maturity of the security
during a past trading period; or (3) empirical duration.\184\ Other
relevant security characteristics that could be used are outlined in
the 2011 Proposal.\185\ Such analysis could be performed internally or
externally and could be additionally verified by a third party. Below
we discuss public float, yield to maturity and empirical duration
criteria in more detail.
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\184\ Empirical duration is bond duration calculated based on
historical data rather than a formula. Typically, it is estimated
using a regression analysis of the relationship between market bond
prices and Treasury yields.
\185\ 2011 Proposing Release, 76 FR 26557-64.
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Exception Based on the Total Amount of Issue Outstanding
(Public Float).
To the extent that it is more difficult to manipulate price of a
larger issue, public float could be used as an alternative criterion to
reflect manipulation risk. This criterion has the advantage of being
straightforward and easy to evaluate. Due to its simplicity it lacks
the estimation issues associated with other measures such as the
probability of default. However, determination of a threshold for
public float to select securities for the exception is complicated due
to its considerable variation across issuers or industries. A specific
threshold selection could potentially disadvantage smaller issuers--
especially during periods of market downturns when valuations are
low.\186\
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\186\ See also a related discussion in supra note 70.
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Exception Based on Yield to Maturity.
Securities that are traded primarily on yield and maturity have low
manipulation risk, as discussed before, since their pricing does not
reflect issuer specific risks. Yield to maturity, therefore, can be
used as an alternative criterion to evaluate manipulation risk.
However, using yield to maturity as a criterion for securities eligible
for the exception is also problematic. Even though this criterion is
similarly easy to obtain and lacks any major estimation issues,
selecting a threshold is not straightforward. For instance, yield to
maturity differs considerably by industry. Selecting a fixed threshold
may result in some industries being under-represented and others over-
represented in the pool of eligible issues. Moreover, yield to maturity
often moves with risk-free rates; thus fewer firms would be excepted
during periods of high interest rates.
Exception Based on Empirical Duration.
Empirical duration is another alternative proxy that can be used to
evaluate Nonconvertible Securities for an exception from Regulation M.
Negative empirical duration might be an indication that a
Nonconvertible Security or its issuer is of low credit-worthiness. A
Nonconvertible Security with negative empirical duration is less
impacted by changes in interest rates than Nonconvertible Securities of
credit-worthy issuers and trades similar to equity securities. Although
negative empirical duration may demonstrate that a particular issuer or
security is not credit-worthy, it has some limitations that impact the
viability of negative empirical duration as a substitute for the
Investment Grade Exception. In particular, this measure relies heavily
on statistical analysis, requires the Nonconvertible Security to be
traded, and may lack intuitive interpretation, which renders empirical
duration a poor proxy for the type of manipulation that Regulation M is
designed to prevent.
3. Exception Based on Issuer Characteristics
The Commission has also considered an exception based on issuer
characteristics, for example, the interest coverage ratio, the WKSI
standard, as suggested in the 2008 Proposal,\187\ or a criterion based
on a reduced-form credit risk model, as an alternative to the
Structural Credit Risk Models. We discuss these alternatives below.
---------------------------------------------------------------------------
\187\ 2008 Proposing Release, 73 FR 40095-97.
---------------------------------------------------------------------------
Exception Based on the WKSI Standard.
The Commission could adopt the WKSI standard as a criterion to
determine eligibility for the exception. The issuers that fall under
the WKSI definition are large and established firms that typically have
sound credit-worthiness. The advantage of this characteristic is its
simplicity and straightforward calculations. However, the WKSI standard
as discussed in the 2008 Proposal was heavily criticized, for instance
for allowing risky high-yield issues to be eligible for the exception
and preventing issues by smaller but
[[Page 18335]]
otherwise credit-worthy issuers from relying on the exception.\188\
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\188\ ABA Letter at 15-17 and SIFMA Letter 1 at 13.
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Exception Based on the Interest Coverage Ratio.
Another possible issuer-based criterion for exception eligibility
is the interest coverage ratio. A high interest coverage ratio
typically indicates the issuer's ability to repay debt and can be used
as a criterion to reflect credit-worthiness. It has the advantage of
being a simple and easy to calculate value. However, the interest
coverage ratio is an accounting measure that can result in inconsistent
outcomes as it is based on the reported earnings rather than cash
flows. Reported earnings may differ based on accounting practices of
the firm. The proposed Structural Credit Risk Models have an advantage
over interest coverage ratio since they are not dependent on reported
earnings, which are heavily influenced by accounting practices.
Exception Based on Reduced-Form Credit Risk Model.
An alternative to using Structural Credit Risk Models is reduced-
form credit risk models.\189\ The latter models could be a good measure
of credit-worthiness and of manipulation risk to the extent that
credit-worthiness is a good proxy for manipulation risk. Unlike
structural models, reduced-form models do not assume default occurs
when firm value falls below a threshold. The default is instead assumed
to follow an unobserved process and the default model can be fitted to
the market data. The advantage of these models is they do away with
some of the unrealistic requirements of Structural Credit Risk Models,
for example when the firm value, its volatility or other required
parameters are unobserved. Even though such models can be considered
more flexible and may provide better fit for the observed default
events, their ability to predict future defaults may not necessarily
exceed that of the structural models. In addition, unlike structural
models, they suffer from a lack of theoretical background of the
assumed relationships, or the intuitive interpretation of the model
dependencies and why the defaults occur. Unrestricted use of these
models might also provide more opportunity to choose a reduced-form
model specification which enables use of the exception.
---------------------------------------------------------------------------
\189\ The reduced-form credit risk models are discussed, for
example, in Robert Litterman & Thomas Iben, Corporate Bond Valuation
and the Term Structure of Credit Spreads, 17 (3) Fin. Analysts J.
52, 52-64 (1991); Robert A. Jarrow & Stuart M. Turnbull, Pricing
Derivatives on Financial Securities Subject to Default Risk, 50 J.
Fin. 53, 53-86 (1995); Robert A. Jarrow, David Lando, & Stuart M.
Turnbull, A Markov Model for the Term Structure of Credit Risk
Spreads, 10 Rev. Fin. Stud. 481, 481-523 (1997); Darrell Duffie &
Kenneth J. Singleton, Modeling the Term Structures of Defaultable
Bonds, 12 Rev. Fin. Stud. 687, 687-720 (1999).
---------------------------------------------------------------------------
4. Exception Based on Issuer and Issue Characteristics
The Commission considered, as another alternative, an analysis
based on both security and issuer characteristics; for example,
characteristics outlined in Exchange Act Rule 15c3-1. Rule 15c3-1
specifies a set of factors to determine a minimum amount of credit risk
broker-dealers can use to determine if a security can qualify for lower
haircuts: (1) Credit spreads; (2) securities-related research; (3)
internal or external credit assessments; (4) default statistics; (5)
inclusion in an index; (6) enhancements and priorities; (7) price,
yield and/or volume; or (8) asset-class specific factors.\190\ Some of
these factors, such as default statistics or credit assessments,
measure issuer credit-worthiness, while others, such as price, yield,
or volume, measure the manipulation risk present in each specific
issue, providing a good overall assessment of manipulation risk.
---------------------------------------------------------------------------
\190\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, Release No. 34-71194 (Dec. 27,
2013) [79 FR 1522, 1527-28 (Jan. 8, 2014)].
---------------------------------------------------------------------------
The advantage of this alternative is that it would align the
exception with already existing standards that broker-dealers might
apply to determine whether a security has a minimal amount of credit
risk. The standard in Rule 15c3-1 was adopted in 2013 as a replacement
for a reference to investment grade securities pursuant to Section 939A
of the Dodd-Frank Act. Such test could have minimum additional costs
for broker-dealers who already have all the necessary procedures in
place for its application.
However, the scope and objectives of the 15c3-1 standard and the
exception in Rules 101 and 102 of Regulation M are different: The 15c3-
1 standard applies only to broker-dealers, which already have the
necessary arrangements in place to apply 15c3-1 standard, whereas the
Regulation M exceptions affect a broader range of market participants.
For example, banks involved in the relevant security issues will also
be affected. Depending on these other participants' systems and
regulatory obligations, it may be costly for them to replace the
investment grade standard with the minimal credit risk standard. This
could result in a situation where different distribution participants
are facing different costs,\191\ possibly deterring some market
participants.
---------------------------------------------------------------------------
\191\ This is unlike the Structural Credit Risk Model based
probability of default that would imply the same costs for all the
participants who obtain the estimated values.
---------------------------------------------------------------------------
5. Elimination of the Exception
The Commission also considered eliminating the exception for fixed-
income securities. The advantage of this alternative is a more uniform
application of Regulation M, which eliminates the situations when
manipulation-prone securities fall under the exception due to
limitations of proxies used to select the securities to be excepted.
For instance, as discussed above, there are various limitations of the
Structural Credit Risk Models' applications, which may limit the
ability of certain issuers to rely on the exception or allow issuers
with a higher risk of having their securities manipulated to avoid
Regulation M. If the exception is eliminated, any limitations of such a
proxy for manipulation risk are eliminated as well.
In addition, this approach could ultimately relieve broker-dealers
from the need to spend time or costs to implement, understand, and
calibrate any proposed standard such as a Structural Credit Risk Model.
The Commission preliminarily believes that most broker-dealers already
have the capability to undertake those calculations themselves or
procure them from a data vendor and would benefit from the continued
availability of an exception despite the costs.
However, this approach raises a number of concerns. Specifically,
eliminating the exception could make some offerings in the excepted
securities considerably more costly. For example, with respect to
reopenings, broker-dealers who might otherwise elect to reopen a bond
offering may determine not to do so to avoid restrictions of Regulation
M that could arise during such a reopening if it becomes a sticky
offering. This could increase the cost of the issue that has to rely on
the next-best alternative structure. Further, an alternative
transaction structure, if selected, may decrease the liquidity of the
securities being issued because they would not be fungible with the
previously issued securities. This may also result in some distribution
participants, such as broker-dealers, deciding not to participate. This
could limit the number of available participants, potentially
increasing fees faced by the issuers. Further, if certain
[[Page 18336]]
issues do not take place under the proposed amendments, it could reduce
the selection of available securities for the investors in the relevant
markets and may limit issuers' ability to raise capital.
However, these costs might be mitigated because a party subject to
the prohibitions of Rules 101 or 102 could structure its buying
activity before or after the applicable restricted period so as not to
incur any costs associated with relying on the exceptions.
The above arguments apply to all currently excepted investment
grade securities because any such issue can become a sticky offering
and the distribution participants have to account and adjust for this
possibility ex-ante. In a scenario where an underwriter is unable to
sell its allotted securities to the public on or promptly after the
pricing date, there is no exception on which to rely, the underwriter/
broker-dealer would likely ex-ante adjust the cost of issuance to
reflect this added risk. Broker-dealers could be more cautious in
structuring potentially sticky offerings if they know they will be
required to comply with Regulation M (and have no exceptions
available), by reducing an offering's size or increasing fees as a risk
premium. This could potentially raise the cost of investment grade
offerings. However, this could also decrease the probability of an
offering to become sticky, potentially reducing manipulation risk in
the relevant markets.
The removal of the exception could also affect the liquidity of the
fixed-income issues if reopenings of issues already in circulation are
more costly, potentially reducing issuers' reliance on this financing
structure, which negatively impacts the investors in the relevant
markets.
This alternative could also disrupt some established business
relationships. In certain circumstances new relationships may need to
be established. For example, if an offering becomes sticky, the issuer
may need to seek a different broker-dealer to comply with the
Regulation M requirements. This would increase costs of the affected
security offerings, including the new broker dealer fees or the search
costs, especially when the market has a limited number of available
broker-dealers.
6. Alternative for Asset-Backed Securities
As an alternative for asset-backed securities the Commission could
use a standard based on the value at risk. Value at risk measures the
percentage loss of the security in the worst case scenarios over a
specified time period. It can be estimated by performing a simulation
over the underlying securities' pool and determining the cash flows
available to the asset-backed security in each scenario. A number of
commercially available options can be used to perform this analysis.
Value at risk can be a good indicator of manipulation risk since low
value at risk indicates that the majority of the cash flows are
sufficiently assured. The price of the asset-backed security in this
case is more certain and is less subject to manipulation risk.
However, value at risk is by construction estimated for a specified
time period and thus only accounts for the potential losses during such
period, while losses may also occur after this time period. In this
case the price of the asset-backed security may depend on issue-
specific factors and be prone to manipulation despite the estimated
value at risk over the specified time period being low. This may allow
securities with high manipulation risk to rely on the exception.
7. Alternatives for Rule 102 Exception
The Commission considered exempting all bonds issued by a foreign
government or political subdivision thereof from Rule 102 of Regulation
M. This would allow such issuers to avoid compliance costs associated
with Regulation M requirements as discussed above. However, this
alternative implies excepting non-investment grade foreign sovereign
securities along with investment grade foreign sovereign securities.
This may introduce considerable risk that some foreign sovereign
issuers with low credit-worthiness and which are subject to a
considerable geopolitical risk are allowed to rely on Regulation M
exception. This could potentially result in a high pricing uncertainty
and a high manipulation risk introduced into the relevant markets.
The Commission also considered excepting asset-backed securities
from Rule 102 that are offered pursuant to an effective shelf
registration statement filed on Form SF-3. However, this alternative
might introduce risk regarding issuers, selling shareholders, or their
affiliated purchasers engaging in activity to favorably affect the
distribution based on their interest in an offering's outcome, without
any benefit to facilitating orderly distributions or to limiting
potential disruptions in the trading market.\192\ These market
participants, unlike distribution participants, may have an interest in
the specific pricing of the issue and could benefit from engaging in
activity that impacts the market. Thus, excepting such asset-backed
securities from requirements of Regulation M could introduce
manipulation risk in the relevant markets.
---------------------------------------------------------------------------
\192\ See supra note 120.
---------------------------------------------------------------------------
F. Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support
alternative recommendations. Please provide empirical data, when
possible, and cite to economic studies, if any, to support alternative
approaches.
47. Are commenters aware of any additional examples of situations
when Structural Credit Risk Models cannot be applied or are difficult
to apply? Please explain why these situations occur.
48. Are there any assumptions or inputs of Structural Credit Risk
Models that may be relevant to the estimation of the probability of
default and may require additional clarification?
49. Do commenters agree with the Commission's assessment of the
availability and associated costs of the estimates for probability of
default based on Structural Credit Risk Models? Similarly, do
commenters agree with the Commission's assessment of availability and
associated costs of the necessary software or other resources necessary
to obtain the estimates internally? Are there any factors that the
Commission failed to consider?
50. Do commenters agree with the Commission's assessment of the
proposed method of threshold measurements? Would a different method of
threshold have greater benefits or fewer costs than the proposed method
of threshold measurements? It is difficult to select a threshold that
would capture all of the investment grade securities and none of the
non-investment grade securities due to the imperfect correlation of
credit ratings and probability of default. Should the current method
used to calculating the threshold aim at capturing a larger set of
investments grade securities, such as a set above 90%, or aimed at
capturing a smaller set of non-investment grade securities, such as
fewer than 125 issues? Should a different date other than October 22,
2021, for the analysis be selected? Should the Commission propose a
method for calculating the threshold instead of proposing a number?
Should the Commission provide guidance on the sample of securities,
time interval, standard of credit-worthiness as a basis for comparison,
or other specifications that should be used in this method?
[[Page 18337]]
51. Are commenters aware of any available data that may help
identify how many issuances of asset-backed securities with investment
grade rating might be excluded under the proposed standard?
52. Are commenters aware of cases when incorrect estimates of
Structural Credit Risk Models' parameters result in inaccurate
probability of default estimates? For example, cases when the estimated
probability of default is high for an issuer with sound credit-
worthiness and vice versa. Please provide the supporting data and
calculations if available.
53. Are there cases where probability of default is not a
reasonable proxy for credit-worthiness and therefore manipulation risk?
If so, why is it a poor proxy in those cases?
54. What concerns, if any, do commenters have regarding the counter
cyclicality of probabilities of default implied by Structural Credit
Risk Models?
IX. Regulatory Flexibility Act Certification
Section 3(a) of the Regulatory Flexibility Act of 1980 \193\
(``RFA'') requires the Commission to undertake an initial regulatory
flexibility analysis of the proposed rule on small entities unless the
Commission certifies that the rule, if adopted, would not have a
significant economic impact on a substantial number of small
entities.\194\ Pursuant to Section 605(b) of the RFA, the Commission
hereby certifies that the proposed amendments to the rule, would not,
if adopted, have a significant economic impact on a substantial number
of small entities. For purposes of Commission rulemaking in connection
with the RFA, small entities include broker-dealers with total capital
(net worth plus subordinated liabilities) of less than $500,000 on the
date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Rule 17a-5(d) under the Exchange
Act,\195\ or, if not required to file such statements, a broker or
dealer that had total capital (net worth plus subordinated liabilities)
of less than $500,000 on the last day of the preceding fiscal year (or
in the time that it has been in business, if shorter); and is not
affiliated with any person (other than a natural person) that is not a
small business or small organization.\196\
---------------------------------------------------------------------------
\193\ 5 U.S.C. 603(a).
\194\ 5 U.S.C. 605(b).
\195\ See 17 CFR 240.17a-5(d).
\196\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------
With respect to the amendments to Rules 101 and 102, it is unlikely
that any broker-dealer who is defined as a ``small business'' or
``small organization'' as defined in Rule 0-10 \197\ could be an
underwriter or other distribution participant as it would not have
sufficient capital to participate in underwriting activities. Small
business or small organization for purposes of ``issuers'' or
``person'' other than an investment company is defined as a person who,
on the last day of its most recent fiscal year, had total assets of $5
million or less.\198\ We believe that none of the various persons that
would be affected by this proposal would qualify as a small entity
under this definition as it is unlikely that any issuer of that size
had investment grade securities that could rely on the existing
exception. Therefore, we believe that these amendments would not impose
a significant economic impact on a substantial number of small
entities.
---------------------------------------------------------------------------
\197\ 17 CFR 240.0-10.
\198\ 17 CFR 240.0-10(a).
---------------------------------------------------------------------------
We encourage written comments regarding this certification. The
Commission solicits comment as to whether the proposed amendments to
Rules 101 and 102, and Rule 17a-4 could have an effect on small
entities that has not been considered. We request that commenters
describe the nature of any impact on small entities and provide
empirical data to support the extent of such impact.
X. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996,\199\ the Commission is also requesting information
regarding the potential impact of the proposed amendments on the
economy on an annual basis. In particular, comments should address
whether the proposed changes, if adopted, would have a $100,000,000
annual effect on the economy, cause a major increase in costs or
prices, or have a significant adverse effect on competition,
investment, or innovations. Commenters are requested to provide
empirical data and other factual support for their views to the extent
possible.
---------------------------------------------------------------------------
\199\ Public Law 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------
Statutory Basis and Text of Proposed Amendments
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly Sections 3(b), 15, 23(a), and 36 (15 U.S.C. 78c(b), 78o,
78w(a), and 78mm) thereof, and Sections 939 and 939A of the Dodd-Frank
Act, the Commission is proposing to amend Exchange Act Rules 101 and
102.
List of Subjects in 17 CFR Part 240 and 242
Broker-dealers, Fraud, Issuers, Reporting and recordkeeping
requirements, Securities.
Text of Rule Amendments
For the reasons in the preamble, title 17, chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
Section 240.17a-4 also issued under secs. 2, 17, 23(a), 48 Stat.
897, as amended; 15 U.S.C. 78a, 78d-1, 78d-2; sec. 14, Pub. L. 94-
29, 89 Stat. 137 (15 U.S.C. 78a); sec. 18, Pub. L. 94-29, 89 Stat.
155 (15 U.S.C. 78w);
* * * * *
0
2. Amend Sec. 240.17a-4 by adding paragraph (b)(17) to read as
follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(17) The written probability of default determination pursuant to
Sec. 242.101(c)(2)(i) of this chapter (Rule 101 of Regulation M).
* * * * *
PART 242--REGULATIONS M, SHO, ATS, AC, NMS, AND SBSR AND CUSTOMER
MARGIN REQUIREMENTS FOR SECURITY FUTURES
0
3. The authority citation for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
0
4. Amend Sec. 242.101 by revising paragraph (c)(2) to read as follows:
[[Page 18338]]
Sec. 242.101 Activities by distribution participants.
* * * * *
(c) * * *
(2) Certain nonconvertible and asset-backed securities. (i) The
nonconvertible debt securities and nonconvertible preferred securities
of issuers for which the probability of default, estimated as of the
day of the determination of the offering pricing and over the horizon
of 12 calendar months from such day, is less than 0.055%, as determined
and documented in writing by the distribution participant using a
structural credit risk model; provided, however, that, for purposes of
this paragraph, the term ``structural credit risk model'' shall mean
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; or
(ii) Asset-backed securities that are offered pursuant to an
effective shelf registration statement filed on Form SF-3 (17 CFR
239.45).
* * * * *
Sec. 242.102 [Amended]
0
5. Amend Sec. 242.102 by removing and reserving paragraph (d)(2).
By the Commission.
Dated: March 23, 2022.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2022-06583 Filed 3-29-22; 8:45 am]
BILLING CODE 8011-01-P