On March 23, 2022 the Securities and Exchange Commission (the “SEC”) issued a proposing release (the “Release”) to implement changes to Regulation M. Specifically, the proposed rulemaking would remove references to credit ratings from Rules 101 and 102 of Regulation M. This rulemaking has arisen, in part, from the requirement under the Dodd-Frank Act to remove references to credit ratings from SEC regulations.
Regulation M comprises a set of rules designed to ensure the integrity of trading markets by, among other things, imposing limitations on whether and when issuers, selling securityholders, underwriters, and other distribution participants may purchase a class of securities when concurrently engaged in a distribution of such class of securities. Rule 101 imposes limitations on underwriters and affiliated purchasers from directly or indirectly, bidding for, purchasing, or attempting to induce any person to bid for or purchase, a covered security during an applicable restricted period. Rule 102 imposes similar limitations on issuers and selling securityholders. Rule 101 is generally more permissive than Rule 102, as the SEC recognizes that there are a wider range of circumstances in which underwriters may have legitimate need, as part of their normal operations, to purchase and sell a class of securities contemporaneously. In addition, the SEC views the risk of market manipulation from concurrent purchases and sales as higher when conducted by an issuer.
In their current forms, both Rule 101 and Rule 102 include exceptions for nonconvertible debt securities and nonconvertible preferred securities (together “Nonconvertible Securities”), and asset-backed securities that are rated investment grade by at least one nationally recognized statistical rating organization. In the Release, the SEC proposes to replace reference to a credit rating in the investment grade exception for Nonconvertible Securities under Rule 101 with an alternative method of establishing creditworthiness. In Rule 102, the SEC has proposed to eliminate entirely the exception for investment-grade Nonconvertible Securities and asset-backed securities.
As noted in the Release, issuers, underwriters and other offering participants do not generally have cause to purchase and sell a specific class of debt or preferred stock at the same time. One context in which market participants may have cause to rely on the investment grade exception is a re-opening, in which an issuer issues additional notes of an already outstanding class. Another situation in which the investment grade exception may become relevant is a sticky offering, in which an underwriter is unable to sell all of the securities in the distribution and continues to hold a portion of them. A third context noted in the Release in which the investment grade exceptions may be relevant is a best efforts offering, in which a broker dealer acts as agent, and which may continue for an extended period of time.
Proposed Amendment to Rule 101
In the Release, the SEC proposes to amend the investment grade exception for Nonconvertible Securities by replacing reference to an investment grade rating from a nationally recognized statistical rating organization with a designated probability of default as established using a structural credit risk model, which is used to determine the probability of an issuer defaulting on its loan obligations. The proposed amendment to Rule 101 would establish a bright-line threshold for the investment grade exception, excepting from the application of Rule 101 any Nonconvertible Security with a proposed probability of default threshold less than 0.055%, estimated as of the day of the determination of the offering pricing and over the horizon of 12 calendar months from such day, as determined and documented in writing by the underwriter, using a structural credit risk model.
Proposed Amendment to Rule 102
In the Release, the SEC proposes to eliminate the investment grade exception for Nonconvertible Securities, without replacement. In the SEC’s view, the limited reliance on this exception, coupled with the potential for market manipulation by issuers and others subject to Rule 102, warrants the elimination of the investment grade exception.
- We do not anticipate the elimination of the investment grade exception in Rule 102 for Nonconvertible Securities to impact most issuers, as companies rarely seek to purchase a class of debt or preferred stock within the applicable Regulation M restricted period for a distribution of the same class.
- In the limited situations where an underwriter may wish to purchase a class of debt or preferred stock while engaged in a distribution of such class, it would need to assess the probability of default for the security using an appropriate structural credit risk model, and preserve its analysis in accordance with new record keeping requirements.
- Underwriters will need to assess which commercially or publicly available structural credit risk model (or models) are acceptable for this type of analysis, which may raise questions of interpretation and judgment for the investment banks.
- In general, Regulation M often raises complicated questions when deal parties wish to distribute and purchase a class of securities contemporaneously, and it is best to consult with counsel as early in the process as possible to assess the facts and preserve optionality.