U.S. SEC Replaces the Investment Grade Exceptions to Regulation M

On June 7, 2023, the U.S. Securities and Exchange Commission (SEC) unanimously voted to amend Regulation M to eliminate the current “investment grade exceptions” to Rules 101 and 102 and replace them with exceptions that use alternate standards of creditworthiness that are not based on credit ratings, as mandated by Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA).¹ The amendments become effective 60 days after the SEC’s adopting release² (Adopting Release) is published in the Federal Register.

Since their adoption in 1996, Rules 101(c)(2) and 102(d)(2) of Regulation M have contained identical exceptions from the rules’ prohibitions for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are in each case rated investment grade by at least one nationally recognized statistical rating organization (commonly referred to as the “investment grade exceptions”). To comply with Section 939A of the DFA, the SEC is eliminating the historical “investment grade exceptions” and replacing them with two alternate exceptions — one for nonconvertible debt and nonconvertible preferred securities (Nonconvertible Securities) that uses a new “structural credit risk model” standard and another for asset-backed securities that uses a Form SF-3 standard.

While the new Form SF-3 standard for asset-backed securities is very straightforward in its application and ease of administration, the newly crafted structural credit risk standard for Nonconvertible Securities is considerably more complex and operationally burdensome. As such, the SEC is also adopting a new recordkeeping requirement for broker-dealers relying on the new structural credit risk model exception for Nonconvertible Securities (but not for those relying on the Form SF-3 exception for asset-backed securities).

Overview of Rules 101 and 102 of Regulation M

Rules 101 and 102 of Regulation M govern the activities of issuers, selling security holders, underwriters, and other persons participating in a “distribution”³ of securities. Rule 101 governs the activities of underwriters, selling dealers, and other distribution participants, as well as their respective affiliated purchasers. Rule 102 governs the activities of issuers, selling security holders, and their respective affiliated purchasers. Both rules generally prohibit the relevant parties from bidding for, purchasing, or inducing others to bid for or purchase the security being distributed (the “subject security”) or any “reference security”⁴ during a specified restricted period.⁵ Various exceptions to the rules’ general prohibitions are intended to permit an orderly distribution of securities and limit disruption to the market. 

Limited Implications for Fixed Income Distributions 

For purposes of Regulation M, an issuer’s already outstanding debt securities are not considered to be the same as the debt security presently in distribution if there is even so much as a single day’s difference in maturity and/or a single basis point difference in coupon.⁶ Similarly, already outstanding fixed income securities are not considered a “reference security” with respect to the fixed income security presently being distributed, provided that the security being distributed (i) is not convertible, exchangeable, and/or exercisable for the already outstanding fixed income security and (ii) does not, pursuant to its terms, have its value determined, in whole or significant part, by the already outstanding security.⁷

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

Relevance of the Exceptions

Notwithstanding the more limited implications of Rules 101 and 102 for fixed income distributions, the historical investment grade exceptions (and their new replacements) remain important to issuers, selling security holders, and distribution participants alike. The exceptions prove valuable in connection with “reopenings” of eligible fixed income issuances because market activities in already outstanding securities of the same issue need not be restricted in connection with the reopening. Similarly, the exceptions are useful in the context of a “sticky deal,” where the security begins to trade before participation in the distribution is completed. The utility of the exceptions extends to other situations as well. For example, the exception to Rule 102 allows an issuer of a qualifying fixed income security to redeem/repurchase the security even while it is engaged in a continuing distribution of the same issue.⁹

The New (Replacement) Exceptions Under Rules 101(c)(2) and 102(d)(2)

As noted, the amendments will replace the historical investment grade exceptions to Rules 101 and 102 with two alternative exceptions — one for Nonconvertible Securities and another for asset-backed securities. While the exceptions significantly differ in the complexity of their criteria, each is intended to capture a universe of securities generally similar to those eligible under the historical investment grade exceptions — that is, securities that are less susceptible to the manipulation Regulation M is designed to prevent because they trade based on their yield and creditworthiness. In a welcome change from the proposal, the exceptions will be available under both Rules 101 and 102 of Regulation M. As proposed, the exceptions would have been limited to distribution participants and their affiliated purchasers subject to Rule 101 of Regulation M.

• Exception for Nonconvertible Securities Using a Structural Credit Risk Model; Definition of Structural Credit Risk Model

The SEC is replacing the exception for investment grade rated Nonconvertible Securities with an alternative standard of creditworthiness based on an estimate of the issuer’s probability of default. Specifically, the SEC is amending both Rules 101 and 102 to except Nonconvertible Securities of issuers for which the probability of default, estimated as of the sixth business day immediately preceding pricing and over the horizon of 12 full calendar months from such date, is 0.055% or less, as determined and documented in writing by the distribution participant acting as the lead manager (or in a similar capacity) of the distribution, using a “structural credit risk model.”¹⁰ In choosing to move forward with the probability of default standard, the SEC expressly rejected several more straightforward standards proffered by commenters and acknowledged that some Nonconvertible Securities previously eligible under the investment grade exception may no longer be eligible under the new standard. Nonetheless, the SEC believes the probability of default standard, as determined using a structural credit risk model, best identifies the universe of Nonconvertible Securities that are less susceptible to manipulation because they trade based on their yield and creditworthiness.¹¹ The new exceptions for Nonconvertible Securities will be set forth in Rules 101(c)(2)(i) and 102(d)(2)(i) of Regulation M.

The SEC is also adopting a new definition of “structural credit risk model” in Rule 100 of Regulation M (the definitional provision of Regulation M). Specifically, a “structural credit risk model” is defined as “any commercially or publicly available model that calculates, based on the issuer’s balance sheet, the probability that the value of the issuer will fall below the threshold at which the issuer would fail to make scheduled debt payments, at or by the expiration of a defined period” (i.e., in this case, the period beginning six business days prior to pricing and over the horizon of 12 full calendar months from such date). By requiring that the structural credit risk model be commercially or publicly available, the SEC is seeking to prevent parties with an interest in the distribution from developing their own proprietary models for the purpose of abusing the exception.

The exception requires that the determination be made and documented by a distribution participant acting as the lead manager or in a similar capacity. The rule does not itself require the distribution participant serving in such capacity to share the determination with the issuer or other syndicate participants. As such, the Adopting Release acknowledges that there may be instances in which the exception is not available to the issuer and/or certain distribution participants, even if the issuer is otherwise capable of satisfying the criteria — for example, in the case of a self-underwritten offering or where the lead declines to share the determination with other syndicate participants.¹² As a practical matter, at least for underwritten offerings, we anticipate that industry convention will be for the lead manager to share the results of the determination with all relevant parties.

Of note, the exception permits — but does not require — the broker-dealer serving in the lead (or comparable) capacity to use a vendor for purposes of making the required calculations. Regardless of whether the lead uses a vendor or makes the calculations itself, all broker-dealers relying on the exception will need to maintain a record demonstrating satisfaction of the necessary criteria, as further discussed herein.

• Exception for Asset-Backed Securities

The SEC is replacing the exception in Rules 101 and 102 for investment grade rated asset-backed securities with an exception for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3. The new exceptions will be set forth in Rules 101(c)(2)(ii) and 102(d)(2)(ii) of Regulation M.

Noting that the eligibility requirements for Form SF-3 were designed to “help ensure a certain ‘quality and character’ in light of the requirement to reduce regulatory reliance on credit ratings,”¹³ the SEC believes that securities satisfying this standard trade primarily based on yield and creditworthiness and hence are less susceptible to manipulation. The Adopting Release further explains that attempting to use a “probability of default” standard for asset-backed securities may be unfeasible, due to the potential challenges in collecting all of the information required to calculate the probability, including the value and volatility of the equity.¹⁴

Like the historical investment grade exception, the proposed new exception for asset-backed securities is attractive in that it is straightforward and easily verified through the SEC filing process. On the other hand, it excludes all asset-backed securities registered on Form SF-1 regardless of the creditworthiness of the related issuer, the underlying assets, or the asset-backed securities.

New Recordkeeping Requirement for Broker-Dealers Relying on the Nonconvertible Securities Exception to Rules 101(c)(2)(i) and 102(d)(2)(i)

The SEC is adopting a new recordkeeping requirement for broker-dealers under Exchange Act Rule 17a-4. Specifically, new Rule 17a-4(b)(17) will require broker-dealers relying on the Nonconvertible Securities exception in Rules 101(c)(2)(i) and 102(d)(2)(i) to maintain a record of the written probability of default determination required by the rule. The record will be required to be maintained for at least three years, the first two in an easily accessible place. The new requirement is intended to aid the SEC and self-regulatory organizations (SROs) in their oversight of broker-dealers that are distribution participants or affiliated purchasers and relying on the exception.

The Adopting Release notes that if the broker-dealer acting as the lead manager (or in a similar capacity) uses a vendor to determine the probability of default, it may satisfy this recordkeeping requirement by maintaining documentation of the assumptions used in the vendor model as well as the output provided by the vendor in support of the determination. By contrast, if the broker-dealer calculated the probability of default on its own, it may satisfy the recordkeeping requirement by maintaining documentation of the value of each variable in deriving the probability of default along with a record identifying the specific source(s) of such information for each variable. Other broker-dealers (i.e., those relying on the written probability of default determination of the broker-dealer acting in the lead manager (or comparable) capacity) may satisfy the recordkeeping requirement by maintaining a copy of the documentation described above or by retaining a written notice it received of the probability of default determination.

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

Other Matters

Unlike Rules 101 and 102, Rule 104 of Regulation M (governing syndicate covering, stabilization and penalty bid activity) does not contain an exception for investment grade rated Nonconvertible Securities or asset-backed securities. Thus, as a general matter, Rule 104 applies (and will continue to apply) to such securities, and the SEC is not adopting any new exceptions to Rule 104 for Nonconvertible Securities or asset-backed securities.

In a 1997 letter to the Bond Market Association, however, the SEC provided limited exemptive relief from the requirements of Rule 104(h)(2) (relating to certain notification requirements in connection with syndicate covering transactions and penalty bids) in the context of investment grade rated Nonconvertible Securities and asset-backed securities.¹⁵ This exemptive relief permits any person to effect a syndicate covering transaction or impose a penalty bid with respect to such securities without providing prior notice to the market or to the SRO, as would otherwise be required by Rule 104(h)(2).

Although the recent amendments do not directly address or rescind this exemptive relief, Chairman Gary Gensler and Commissioner Mark Uyeda did, at the end of the SEC open meeting, indicate that it is also the SEC’s intention to eventually eliminate or replace, as it deems appropriate, historical exemptive and no-action relief based on ratings assigned to a security by a nationally recognized statistical rating organization. To that end, distribution participants should bear in mind that the SEC may withdraw or amend this relief at some point in the future.