In its initial action designed to implement the mandate of Section 939A of the Dodd-Frank Act, which requires the SEC to remove any references to credit ratings from its rules and forms and to replace them with such substitute standards of creditworthiness as the SEC deems appropriate, the SEC recently issued proposed amendments that would, among other things, eliminate the current exception in Rules 101 and 102 of Regulation M for investment grade securities in favor of an exception that is predicated upon the trading characteristics of these securities. To view the proposed amendments, click here. To view the corresponding SEC press release and fact sheet, click here.
What is Regulation M?
Regulation M is designed to preserve the integrity of the securities trading market as an independent pricing mechanism by prohibiting manipulative activities that could artificially influence the market for a covered security. More specifically, Rules 101 and 102 of Regulation M prohibit issuers, selling security holders, underwriters and other distribution participants, and any of 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 an applicable restricted period. Rules 101(c)(2) and 102(d)(2) of Regulation M currently except from their respective provisions investment grade securities, including nonconvertible debt securities, nonconvertible preferred securities and asset-backed securities, that are rated by at least one nationally recognized statistical rating organization in one of its generic rating categories that signifies investment grade.
What are the New Standards for the Exception?
The proposed amendments would remove the current exception for investment grade securities in Rules 101 and 102 of Regulation M and would instead except nonconvertible debt, convertible preferred or asset-backed securities that satisfy the following standards.
- Liquid Relative to the Market for that Asset Class. The proposed amendments do not definitively state what attributes make a security liquid relative to its market but do provide certain factors which are indicative of relative liquidity, including (i) the size of the issuance, (ii) the overall trading volume of the security, (iii) the number of liquidity providers who participate in the market for the security and (iv) how quickly an investor could be expected to sell the security after purchase.
- Trade in Relation to General Market Interest Rates and Yield Spreads. This standard would limit the exception’s availability to those covered securities that trade in relation to changes in broader interest rates (i.e., based upon their comparable yield spreads) rather than those that trade in an idiosyncratic fashion due to issuer-specific information or credit quality.
- Relatively Fungible with Securities of Similar Characteristics and Interest Rate Yield Spreads. To be deemed “relatively fungible” (in terms of trading characteristics), a portfolio manager would have to be willing to purchase the covered security in lieu of another security that has similar characteristics such as comparable interest rate yield spreads and credit risk.
How Is Satisfaction of These Standards Determined and Verified?
According to the proposed amendments, a person seeking to rely upon the exception would have to utilize “reasonable factors of evaluation” in determining whether the exception is available and would thereafter be required to subject the determination to verification by an independent third party. Each person seeking to rely upon the exception would be required to (i) exercise reasonable judgment in conducting this analysis, though sole reliance on a third party’s determination without any further analysis would not be considered to be based upon reasonable judgment, and (ii) make a reasonable determination of the independence and qualifications of a third party based upon the third party’s relevant professional background, experience, knowledge and skills. The proposed amendments do not identify who would be eligible to make the independent third-party determination but do state that counsel to, or other affiliates of, the underwriter or issuer would not be eligible to make that determination.
What is the Potential Impact of the New Exception?
Unlike the current investment grade exceptions of Rules 101 and 102 of Regulation M which are more readily applied, the proposed exception, which is predicated upon the trading characteristics of the covered security, is considerably more subjective. Accordingly, if the proposed amendments are adopted, distribution participants would be required to assess whether the covered security qualifies for the exception and would have to incur the expenses (both temporal and monetary) necessary to verify this assessment with an independent third party. Moreover, the proposed standards could alter certain securities’ eligibility for the exception despite the fact that the SEC does not intend to modify the types of securities which are currently excepted from Rules 101 and 102 of Regulation M and could affect certain offerings such as subsequent rounds or reopenings of existing issues. Most offerings of nonconvertible debt, convertible preferred or asset-backed securities, however, will be unaffected by the changes because (i) distribution participants typically do not engage in the activities restricted by Regulation M and (ii) those securities trade primarily on the basis of yield spread and credit rating, thereby making it virtually impossible to manipulate the market price of a single issue.
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