Rule2023-12591
Removal of References to Credit Ratings From Regulation M
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Published
June 20, 2023
Effective
August 21, 2023
Issuing agencies
Securities and Exchange Commission
Abstract
The Securities and Exchange Commission ("Commission") is adopting rule amendments to implement section 939A(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), which requires, among other things, that the Commission remove from its regulations any references to credit ratings and substitute in their place alternative standards of creditworthiness. The amendments remove certain existing rule exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities and substitute in their place new exceptions that are based on alternative standards of creditworthiness. These substitutes include exceptions for nonconvertible debt securities and nonconvertible preferred securities (together, "Nonconvertible Securities") of issuers who meet a specified probability of default threshold, as well as exceptions for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on a certain form that is tailored to asset-backed securities offerings. The Commission is also adopting an amendment to a recordkeeping rule applicable to broker-dealers in connection with their reliance on an exception involving probability of default determinations.
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[Federal Register Volume 88, Number 117 (Tuesday, June 20, 2023)]
[Rules and Regulations]
[Pages 39962-39994]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2023-12591]
[[Page 39961]]
Vol. 88
Tuesday,
No. 117
June 20, 2023
Part III
Securities and Exchange Commission
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17 Parts 240 and 242
Removal of References to Credit Ratings From Regulation M; Final Rule
Federal Register / Vol. 88, No. 117 / Tuesday, June 20, 2023 / Rules
and Regulations
[[Page 39962]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-97657; File No. S7-11-22]
RIN 3235-AL14
Removal of References to Credit Ratings From Regulation M
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting rule amendments to implement section 939A(b) of the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (``Dodd-Frank
Act''), which requires, among other things, that the Commission remove
from its regulations any references to credit ratings and substitute in
their place alternative standards of creditworthiness. The amendments
remove certain existing rule exceptions that reference credit ratings
for nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities and substitute in their place
new exceptions that are based on alternative standards of
creditworthiness. These substitutes include exceptions for
nonconvertible debt securities and nonconvertible preferred securities
(together, ``Nonconvertible Securities'') of issuers who meet a
specified probability of default threshold, as well as exceptions for
asset-backed securities that are offered pursuant to an effective shelf
registration statement filed on a certain form that is tailored to
asset-backed securities offerings. The Commission is also adopting an
amendment to a recordkeeping rule applicable to broker-dealers in
connection with their reliance on an exception involving probability of
default determinations.
DATES: Effective date: The final rules are effective on August 21,
2023.
FOR FURTHER INFORMATION CONTACT: Jessica Kloss, Attorney-Adviser, Laura
Weber, Branch Chief, Josephine Tao, Assistant Director, Office of
Trading Practices, or Carol McGee, Associate Director, Office of
Derivatives Policy and Trading Practices, at (202) 551-5777, Division
of Trading and Markets, Securities and Exchange Commission, 100 F
Street NE, Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION: The Commission is amending the following
rules adopted under the Securities Exchange Act of 1934 (``Exchange
Act''):
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\1\ 17 CFR 242.100 through 242.105. Regulation M is also adopted
under the Securities Act of 1933 (``Securities Act'') and under the
Investment Company Act of 1940.
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Commission reference CFR citation
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Rule 17a-4............................. 17 CFR 240.17a-4
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Regulation M: \1\
Rule 100............................. 17 CFR 242.100
Rule 101............................. 17 CFR 242.101
Rule 102............................. 17 CFR 242.102
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Table of Contents
I. Introduction
II. Discussion of the Final Rule Amendments
A. Rule 101(c)(2) of Regulation M: Implementing Section 939A(b)
in Certain Exceptions for Distribution Participants
1. Rule 101(c)(2)(i): Nonconvertible Securities of Issuers Who
Meet a Specified Probability of Default Threshold
2. Rule 101(c)(2)(ii): Asset-Backed Securities Offered Pursuant
to an Effective Shelf Registration Statement Filed on Form SF-3
B. Rule 102(d)(2) of Regulation M: Implementing Section 939A(b)
in Certain Exceptions for Issuers and Selling Security Holders
1. Rule 102(d)(2)(i): Nonconvertible Securities of Issuers Who
Meet a Specified Probability of Default Threshold
2. Rule 102(d)(2)(ii): Asset-Backed Securities Offered Pursuant
to an Effective Shelf Registration Statement Filed on Form SF-3
C. Exchange Act Rule 17a-4(b)(17): Adding a Record Preservation
Requirement for Broker-Dealers in Connection With Probability of
Default Determinations
III. Other Issues
IV. Other Matters
V. Economic Analysis
A. Baseline
1. The Investment Grade Fixed Income Market
2. The Investment Grade Exception
B. Benefits of the Amendments
C. Costs of the Amendments
1. Costs Associated With Obtaining the Estimate of the
Probability of Default
2. Costs Associated With Maintaining Records Related to the
Probability of Default Estimation
3. Costs Associated With Structural Credit Risk Model Based
Probability of Default Being an Imperfect Proxy for Creditworthiness
4. Costs Associated With Asset-Backed Securities' Amendments
5. Indirect and Other Costs of the Amendments
D. Efficiency, Competition, and Capital Formation
E. Reasonable Alternatives
1. Alternative Threshold for Probability of Default
2. Exception Based on Security Characteristics
3. Exception Based on Issuer Characteristics
4. Exception Based on Issuer and Issue Characteristics
5. Elimination of the Investment Grade Exception From Rule 101
6. Alternative for Asset-Backed Securities
7. Alternatives for Rule 102 Exception
8. Alternative for the Record Preservation Requirement
VI. Paperwork Reduction Act
A. Respondents
B. Use of Information
C. Collection of Information
1. Burden and Cost Estimates Related to the Rule 101 Amendments
2. Burden and Cost Estimates Related to the Rule 17a-4
Amendments
D. Collection of Information Is Mandatory
E. Confidentiality of Responses to Collection of Information
F. Retention Period for Record Preservation Requirement
VII. Regulatory Flexibility Act Certification
Statutory Authority
I. Introduction
To reduce reliance on credit ratings,\2\ section 939A(b) of the
Dodd-Frank Act requires the Commission, among other things, to ``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 those
regulations.\3\ In making such a determination, the Commission must
seek to establish, to the extent feasible, uniform standards of
creditworthiness for use by the Commission, taking into account the
entities it regulates and the purposes for which those entities would
rely on such standards of creditworthiness.\4\
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\2\ See 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).
\3\ See Public Law 111-203, sec. 939A(b), 124 Stat. 1376, 1872-
90 (2010). Section 939A of the Dodd-Frank Act also 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.'' Public
Law 111-203, sec. 939A(a). The Commission must transmit a report to
Congress upon the conclusion of the review required in section
939A(a). Public Law 111-203, 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
<a href="https://www.sec.gov/news/studies/2011/939astudy.pdf">https://www.sec.gov/news/studies/2011/939astudy.pdf</a>. 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.
\4\ Public Law 111-203, sec. 939A(b).
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Regulation M, which is a set of prophylactic anti-manipulation
rules
[[Page 39963]]
that 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,
contains references to credit ratings in identical exceptions under 17
CFR 242.101 (``Rule 101'') and 242.102 (``Rule 102'') for investment
grade Nonconvertible Securities and asset-backed securities.\5\ The
Investment Grade Exceptions are two of several exceptions to Rule 101's
and Rule 102's general prohibitions: in connection with a distribution
\6\ of covered securities,\7\ distribution participants,\8\ issuers,
selling security holders, and their affiliated purchasers are
prohibited from, directly or indirectly, bidding for, purchasing, or
attempting to induce any person to bid for or purchase, a covered
security \9\ during the applicable ``restricted period.'' \10\ These
prohibitions exist to protect the integrity of the offering process by
precluding activities that could artificially influence the market for
the offered security.\11\
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\5\ See 17 CFR 242.101(c)(2) (``Rule 101(c)(2)''), 17 CFR
242.102(d)(2) (``Rule 102(d)(2)''). Both of these rules except
Nonconvertible Securities and asset-backed securities that are rated
by at least one nationally recognized statistical rating
organization, as that term is used in 17 CFR 240.15c3-1 (``Rule
15c3-1''), in one of its generic rating categories that signifies
investment grade. Throughout this release, each exception in Rule
101(c)(2) or Rule 102(d)(2) that references credit ratings is
referred to as an ``Investment Grade Exception,'' and, together,
those exceptions are referred to as the ``Investment Grade
Exceptions,'' as applicable.
\6\ See 17 CFR 242.100(b) (``Rule 100(b)'') (defining
``distribution'' as ``an offering of securities, whether or not
subject to registration under the Securities Act, that is
distinguished from ordinary trading transactions by the magnitude of
the offering and the presence of special selling efforts and selling
methods'').
\7\ See 17 CFR 242.100(b) (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'').
\8\ See 17 CFR 242.100(b) (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\ See 17 CFR 242.100(b) (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).
\10\ See 17 CFR 242.100(b).
\11\ Anti-Manipulation Rules Concerning Securities Offerings,
Release No. 34-38067 (Dec. 20, 1996) [62 FR 520 (Jan. 3, 1997)]
(``Regulation M Adopting Release''), 62 FR 521. Rule 101's
prohibitions apply to distribution participants and their affiliated
purchasers, while Rule 102's prohibitions apply to issuers, selling
security holders, and their affiliated purchasers.
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In adopting the Investment Grade Exceptions, the Commission stated
that certain securities and activities should be excepted to allow for
activities that are 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 permit conduct that is not
likely to have a manipulative impact.\12\ The Investment Grade
Exceptions were premised on the principle that investment grade
Nonconvertible Securities and asset-backed securities are less likely
to be subject to the type of manipulation that Regulation M seeks to
address because they are largely fungible and trade primarily on the
basis of yield and creditworthiness (traditionally measured by credit
ratings),\13\ rather than the identity of the particular issuer.\14\
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\12\ See Trading Practices Rules Concerning Securities
Offerings, Release No. 34-37094 (Apr. 11, 1996) [61 FR 17108 (Apr.
18, 1996)] (``Regulation M Proposing Release''), 61 FR17111, 17120.
\13\ See Regulation M Adopting Release, 62 FR 527; see also
infra note 38 (discussing how the ability to substitute similar
securities in the market for the security in distribution limits the
potential impact a covered person might attempt to exert on the
market and distribution of such security). The Investment Grade
Exceptions trace back to a 1975 Commission staff no-action position
regarding Exchange Act Rule 10b-6, the predecessor to Rules 101 and
102 of Regulation M. See Letter from Robert C. Lewis, Assoc. Dir.,
Div. Mkt. Reg., SEC, to Donald M. Feuerstein, Gen. Partner &
Counsel, Salomon Bros. (Mar. 4, 1975) (emphasizing the following
representations from the lead underwriter-requestor in taking its
position: (1) ``because the non-convertible bonds of particular
issuers are not considered unique and because of the concept of
relative value, it is simply not possible to manipulate the price of
a corporate bond that has broad investor interest,'' and (2)
purchasing activities in such securities generally are ``unlikely to
materially affect the price of [a nonconvertible debt security being
offered] because of the availability of large amounts of securities
of other issuers which have comparable quality yield [spreads]'').
For a further discussion of the history of the Investment Grade
Exceptions, see Removal of References to Credit Ratings From
Regulation M, Release No. 34-94499 (Mar. 23, 2022) [87 FR 18312
(Mar. 30, 2022)] (``Proposal''), 87 FR 18315.
\14\ Regulation M Proposing Release, 61 FR 17112.
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In accordance with section 939A(b)'s requirements, in 2022, the
Commission proposed rule amendments to remove the Investment Grade
Exceptions and substitute them with new exceptions that are based on
alternative standards of creditworthiness.\15\ The Commission proposed
to except from Rule 101 (1) Nonconvertible Securities of issuers who
meet a specified probability of default threshold,\16\ and (2) asset-
backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3.\17\ The Commission proposed
to eliminate, without replacing, the Investment Grade Exception from
Rule 102.\18\ The Commission also proposed to amend 17 CFR 240.17a
(``Rule 17a-4''), specifically paragraph (b) of Rule 17a-4 (``Rule 17a-
4(b)''), to require broker-dealers to preserve written probability of
default determinations pursuant to Rule 101.\19\
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\15\ See Proposal, 87 FR 18316-24. The Commission previously
proposed two alternatives to the Investment Grade Exceptions. See
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)]; References to Ratings of Nationally Recognized
Statistical Rating Organizations, Release No. 34-58070 (July 1,
2008) [73 FR 40088 (July 11, 2008)] (``2008 Proposing Release''), 73
FR 40095-97. The Commission did not adopt any rule amendments with
regard to the Investment Grade Exceptions based on either of these
proposals.
\16\ See Proposal, 87 FR 18317-19.
\17\ See Proposal, 87 FR 18321-22.
\18\ See Proposal, 87 FR 18323-24.
\19\ See Proposal, 87 FR 18324-25.
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The Commission received comments from an industry group, a data
provider, nonprofit organizations, and individuals.\20\ Commenters
broadly recognized and acknowledged the objectives of the Proposal.
Some commenters, including individual commenters, provided general
support for the Proposal \21\ and stated that reliance on credit
ratings is outdated \22\ and can be harmful to investors or the
markets.\23\ Another commenter
[[Page 39964]]
supported the Proposal and stated that its adoption will lead to
increased market competition.\24\ Some commenters opposed or expressed
concerns about the Proposal, and offered certain recommendations with
regard to particular aspects of the proposed rule amendments,\25\ which
are addressed below, in Parts II.A through C. After reviewing and
carefully considering the public comments and recommendations, and in
accordance with the requirements of section 939A(b), the Commission is
adopting final rule amendments, with targeted modifications to address
comments received and to streamline and clarify the rule text from the
Proposal. As discussed below in Parts II.A and II.B, the Commission
believes that its original basis for excepting investment grade
Nonconvertible Securities and asset-backed securities from Rules 101
and 102 continues to apply to the securities that are captured by the
amendments' substitute standards of creditworthiness.
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\20\ Comments received in response to the Proposal are contained
in File No. S7-11-2022, available at <a href="https://www.sec.gov/comments/s7-11-22/s71122.htm">https://www.sec.gov/comments/s7-11-22/s71122.htm</a>.
\21\ See, e.g., Letter from Chris Carr (May 19, 2022); Letter
from Daniel Kuo (May 19, 2022); Letter from Fred Carter (May 19,
2022); Letter from Biren Patel (May 19, 2022); Letter from Robert
Tso (May 23, 2022); Letter from Stephen W. Hall, Legal Dir. & Secs.
Specialist, Better Mkts, Inc., to Vanessa A. Countryman, Sec'y, SEC
(May 23, 2022) (``Better Markets Letter''), at 3.
\22\ See, e.g., Letter from Alexandra Merz (May 18, 2022)
(``Merz Letter''); Letter from Gerhard Krohmer (May 19, 2022);
Andriy Granovsky (May 19, 2022); Letter from Jason Smith (May 20,
2022); Letter from Craig Faison (May 20, 2022); Letter from Jaymin
Patel (May 20, 2022); Letter from Paul K. Sacco (May 21, 2022);
Letter from David Navari (May 22, 2022) (``Navari Letter''); Letter
from Jim Protsenko (May 24, 2022); Letter from John Hall (May 26,
2022); Letter from Andrew Macafee (May 30, 2022). The Commission
also received two anonymous comments on May 19, 2022, both of which
stated that credit rating agencies ``have become obsolete.''
\23\ See, e.g., Merz Letter; Letter from Robert Long (May 19,
2022); Letter from James R. Brown (May 19, 2022); see also Letter
from William Desavigny (May 19, 2022); Letter from Kevin Price (May
19, 2022); Letter from Jason MacKenzie (May 19, 2022); Letter from
James Zarbock (May 19, 2022); Letter from Carsten Hensch (May 19,
2022); Letter from Thomas Sutton (May 19, 2022); Letter from Harold
VanPatten (May 19, 2022); Letter from Aaron Grimshaw (May 19, 2022);
Letter from Andre M (May 19, 2022); Letter from Andrew Oshea (May
19, 2022); Letter from Steven Calvino (May 19, 2022); Letter from
Dennis Smith (May 19, 2022); Letter from Devin Dasbach (May 19,
2022); Letter from Mark A. Fritzke (May 19, 2022); Letter from
Cameron Beebe (May 19, 2022); Letter from Nick Parasiris (May 19,
2022).
\24\ See Letter from Jacob Rajan (May 19, 2022).
\25\ See, e.g., Letter from Joseph Corcoran, Managing Dir. &
Assoc. Gen. Counsel, Secs. Indus. & Fin. Mkts. Ass'n, to Vanessa
Countryman, Sec'y, SEC (May 23, 2022) (``SIFMA Letter 1''); Better
Markets Letter.
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II. Discussion of the Final Rule Amendments
The amendments remove the existing Investment Grade Exceptions from
both Rule 101 and Rule 102 of Regulation M. For distributions of
Nonconvertible Securities, the Commission is adopting two new
exceptions--one in 17 CFR 242.101(c)(2)(i) (``Rule 101(c)(2)(i)''), for
reliance by distribution participants and their affiliated purchasers,
and one in 17 CFR 242.102(d)(2)(i) (``Rule 102(d)(2)(i)''), for
reliance by issuers, selling security holders, and their affiliated
purchasers. Both exceptions are based on the requirements more fully
described in Parts II.A.1 and B.1 that relate to the determination of
an issuer's probability of default as derived from a structural credit
risk model.\26\ As discussed below, in Part II.A.1, final Rule
101(c)(c)(i) differs from the Proposal with regard to the exception's
conditions involving who is eligible to make probability of default
determinations pursuant to Rule 101(c)(2)(i) and when such probability
of default determination must be made to rely on the exception. While
the Proposal would have allowed any distribution participant to make
the probability of default determination in meeting the conditions of
Rule 101(c)(2)(i), the final amendments require the probability of
default determination to be made by the distribution participant acting
as the lead manager (or in a similar capacity) of a distribution.\27\
In addition, final Rule 101(c)(2)(i) will require five additional
business days before the price determination date from what was
proposed to make the probability of default determination in satisfying
the exception's conditions.\28\ Finally, the Commission is making some
technical, non-substantive changes from the Proposal with regard to the
wording of the standard,\29\ as well as some clarifying changes to the
proposed definition of ``structural credit risk model.'' \30\
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\26\ See 17 CFR 242.101(c)(2)(i), as amended, 242.102(d)(2)(i),
as amended (requiring, for reliance by issuers, selling security
holders, and their affiliated purchasers, that the distribution
participant acting as the lead manager (or in a similar capacity) of
a distribution have made the probability of default determination,
as applicable to the subject security, pursuant to Rule
101(c)(2)(i), as amended).
\27\ See infra Part II.A.1.
\28\ See infra Part II.A.1.
\29\ See infra note 126.
\30\ See infra Part II.A.1.
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Because the term ``structural credit risk model'' is used
identically in both Rule 101(c)(2)(i) and Rule 102(d)(2)(i), as
amended, the Commission is adding a definition for the term
``structural credit risk model'' in Rule 100(b) of Regulation M.\31\ In
addition, the Commission is adopting new paragraph (b)(17) of Rule 17a-
4 (``Rule 17a-4(b)(17)'') requiring the preservation of the written
probability of default determination, relied upon by a broker-dealer,
pursuant to new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i), as
applicable, to facilitate Commission staff examinations.\32\
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\31\ See 17 CFR 242.100(b).
\32\ See 17 CFR 240.17a-4(b)(17), as amended.
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For distributions of asset-backed securities, the Commission is
adopting identical, new exceptions--one in 17 CFR 242.101(c)(2)(ii)
(``Rule 101(c)(2)(ii)''), for reliance by distribution participants and
their affiliated purchasers, and one in 17 CFR 242.102(d)(2)(ii)
(``Rule 102(d)(2)(ii)''), for reliance by issuers, selling security
holders, and their affiliated purchasers--requiring that such
securities be offered pursuant to an effective shelf registration
statement filed on Form SF-3.\33\
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\33\ See 17 CFR 242.101(c)(2)(ii), as amended,
242.102(d)(2)(ii), as amended.
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A. Rule 101(c)(2) of Regulation M: Implementing Section 939A(b) in
Certain Exceptions for Distribution Participants
The application of Rule 101's prohibitions to distributions of
Nonconvertible Securities and asset-backed securities generally is
limited because, under Regulation M, bids for and purchases of
outstanding Nonconvertible Securities are not restricted unless the
security being purchased is identical in all of its terms to the
security being distributed.\34\ For example, Rule 101's 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.\35\ In addition, as stated in the Proposal,
commenters on the Commission's previously proposed alternatives to the
Investment Grade Exception \36\ stated that reliance on the Investment
Grade Exceptions largely is limited to two situations: re-openings
(e.g., when an issuer may want to make a series of offerings of its
fixed-income securities via a re-opening to match its funding needs or
the desires of its target investor class, or when a foreign sovereign
issuer may conduct a re-opening for public financing purposes) and
sticky offerings.\37\ The securities that meet the
[[Page 39965]]
requirements of Rule 101's Investment Grade Exception are less likely
to be subject to the type of manipulation that Rule 101 seeks to
prevent because these securities trade on the basis of their yield and
creditworthiness (traditionally measured by credit ratings), rather
than the identity of the particular issuer, and are largely
fungible.\38\
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\34\ Regulation M Adopting Release, 62 FR 524.
\35\ See Regulation M Adopting Release, 62 FR 524. 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 that of the security in distribution.
\36\ See supra note 15.
\37\ Proposal, 61 FR 18316. In addition, the Commission also
stated in the Proposal that another example provided by a commenter
is a ``best-efforts'' offering. Proposal, 61 FR 18316. One commenter
on the Proposal stated that firms rely on the Investment Grade
Exceptions in the context of ``sticky deals'' and ``re-openings'' of
debt issuances. See SIFMA Letter 1, at 4. As discussed below, in
Part V.E.5, any offering can become a sticky offering. In such case,
it may become challenging for the issue to trade based solely on its
yield and maturity, notwithstanding the issuer's creditworthiness.
Therefore, a sticky offering does not necessarily indicate a lack of
creditworthiness on the part of the issuer. In the Proposal, the
Commission asked if sticky offerings of creditworthy issuers
disprove the underlying premise for excepting certain Nonconvertible
Securities. See Proposal, 87 FR 18320. The Commission also asked if
the Investment Grade Exception should be removed from Rule 101,
without a replacement, because whether an offering will become
sticky is unknown at the beginning of the Regulation M restricted
period. See Proposal, 87 FR 18320. One commenter stated that it is
unaware of any manipulative issues associated with reliance on the
Investment Grade Exceptions in connection with sticky offerings. See
SIFMA Letter 1, at 2. However, no commenter suggested that the
Commission should remove the Investment Grade Exception from Rule
101, without a replacement.
\38\ See Regulation M Adopting Release, 62 FR 527; see also
Regulation M Proposing Release, 61 FR 17112. For purposes of
Regulation M, securities of issuers of a certain credit quality
trade on the basis of their yield and creditworthiness
(traditionally measured by credit ratings) and are less susceptible
to manipulation because other similar Nonconvertible Securities or
asset-backed securities are available to investors as an
alternative. If the pricing of an offering is inconsistent with
pricing in the overall secondary market for similar Nonconvertible
Securities or asset-backed securities, an investor may purchase
alternative securities that have a better yield, yet are of
comparable creditworthiness, in relation to the security being
distributed. Accordingly, the ability to substitute similar
Nonconvertible Securities or asset-backed securities for the
security in distribution limits the ability of a distribution
participant to impact the market and distribution of such security.
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1. Rule 101(c)(2)(i): Nonconvertible Securities of Issuers Who Meet a
Specified Probability of Default Threshold
The Commission proposed to except 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 from such day, is less than 0.055%, as determined and
documented in writing by the distribution participant as derived from a
structural credit risk model.\39\ The Commission included a definition
for the term ``structural credit risk model'' as a proviso in proposed
Rule 101(c)(2)(i) to 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.'' \40\
Accordingly, as proposed, a distribution participant's (or its
affiliated purchaser's) reliance on proposed Rule 101(c)(2)(i) would
have been conditioned on a probability of default determination that
was made by use of 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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\39\ Proposal, 87 FR 18338. The Commission stated that, as
discussed in that release, 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 Oct. 22,
2021, this was an appropriate substitute standard of
creditworthiness in place of the reference to credit ratings in the
Investment Grade Exception for Nonconvertible Securities. See
Proposal, 87 FR 18318.
\40\ Proposal, 87 FR 18338.
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As discussed in the Proposal, since 1974, structural credit risk
models, such as the model first proposed by Robert C. Merton and its
successor models, have become widely relied upon to determine the
probability that an issuer will default on its loan obligations.\41\
Many commercial data providers, as part of software suites that allow
users to analyze securities, employ certain structural credit risk
models that are based on the Black-Scholes option pricing model as a
way to measure the creditworthiness of companies. These types of
structural credit risk models typically use measures from company
accounting statements and company-specific and aggregate market prices
and require input variables to calculate an estimated probability of
default for a specified horizon, including the market value and
volatility of the assets, as well as assumptions regarding the
threshold for company asset values, below which the equity owner would
default on its obligations (``Default Point'').\42\ In addition, these
structural credit risk models provide the probability that a company's
assets will fall below the Default Point at or by the expiration of a
defined period.
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\41\ See generally Proposal, 87 FR 18316-17 (providing a history
and overview of structural credit risk models). 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, these structural credit risk
models provide a method, based on the Black-Scholes option pricing
model, to estimate the probability that a company might default on
its liabilities. See Proposal, 87 FR 18317.
\42\ The Default Point frequently is calculated as all short-
term liabilities plus half of the long-term liabilities. See Mario
Bondioli et al., The Bloomberg Corporate Default Risk Model (DRSK)
for Public Firms (Mar. 2021), available at <a href="https://ssrn.com/abstract=3911300">https://ssrn.com/abstract=3911300</a>.
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Generally, the following variables are needed to derive an issuer's
probability of default from a typical structural credit risk model: (1)
the issuer's value, which can be based on observed market prices of an
issuer's equity security or estimated based on an issuer's balance
sheet; (2) the volatility of the issuer's equity or assets, which also
can be based on market observations or estimated based on an issuer's
balance sheet; (3) the risk-free rate; (4) a time horizon; and (5) the
Default Point. A structural credit risk model's application may be
limited in the absence of a market for an issuer's equity securities if
the market price of the issuer's assets, which, as discussed above, is
required to calculate the probability of default, is difficult to
determine.\43\
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\43\ These models calculate the probability of default based on
inputs from an issuer's balance sheet. Transactions in equity
securities frequently are used as a proxy to determine the value of
the firm and the overall volatility of the issuer's assets. Even the
absence of a market for an issuer's equities alone does not preclude
the ability of a distribution participant to use certain structural
credit risk models because 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, can access an issuer's balance sheet to calculate the
issuer's probability of default.
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Some commenters supported the proposed exception for Nonconvertible
Securities that is based on an issuer's probability of default.\44\ One
commenter stated that the proposed application of a structural credit
risk model requirement will provide additional transparency for
investors and other market participants.\45\ Another commenter agreed
with the Commission that the estimated probability of default of a debt
security ``is and should be a central component of the analysis of the
credit risk'' \46\ and that the ``expected 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 having to rely on an investment grade rating.\47\
However, this commenter also stated that balance sheet measures
frequently are inaccurate and that comparisons of market values to book
values are subject to concerns about ``garbage in, garbage out.'' \48\
While the Commission requested comments regarding whether the exception
proposed in Rule 101(c)(2)(i) should require the issuer's balance sheet
to be audited,\49\ it did not receive any
[[Page 39966]]
comments in response to this question. In addition, the Commission
considered including in the exception models that may not necessarily
rely on an issuer's balance sheet to determine a firm's
creditworthiness, such as reduced-form models. Reduced-form models,
however, do not necessarily predict future defaults better than
structural credit risk models do, and they suffer from a lack of
theoretical foundation of the assumed relationships, or the intuitive
interpretation of the model dependencies and why the defaults
occur.\50\ For these reasons, and as discussed throughout this Part,
the Commission is adopting a standard that is based on the use of a
structural credit risk model as it is appropriately designed to measure
creditworthiness of Nonconvertible Securities in new Rule 101(c)(2)(i),
in accordance with the requirements of section 939A(b).
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\44\ Letter from Gregory Babyak, Global Head of Reg. Affairs,
Bloomberg L.P., to Vanessa A. Countryman, Sec'y, SEC (May 23, 2022)
(``Bloomberg L.P. Letter''), at 1; Letter from Robert E. Bishop,
Fellow, Ctr. Law & Bus., UC Berkeley School of Law, & Frank Partnoy,
Adrian A. Kragen Professor of Law, UC Berkeley School of Law, to
Vanessa Countryman, Sec'y, SEC (May 23, 2022) (``IILF Letter''), at
2; Better Markets Letter, at 2.
\45\ Bloomberg L.P. Letter, at 1.
\46\ IILF Letter, at 2.
\47\ IILF Letter, at 5.
\48\ IILF Letter, at 6.
\49\ Proposal, 87 FR 18320. Such a requirement could present
operational challenges in connection with deriving an issuer's
probability of default from a structural credit risk model. As
discussed below, in this Part, the determinations must be
``estimated as of the sixth business day immediately preceding the
determination of the offering price,'' which helps to ensure that
timely information regarding the issuer is used as a model input. A
lead manager may encounter difficulties in obtaining model input
information from an issuer's audited balance sheet each time it
needs to determine an issuer's probability of default for purposes
of reliance on the exception for Nonconvertible Securities if such a
determination were being made in between audits.
\50\ See infra Part V.E.3.
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One commenter suggested an exception based on alternative standards
of creditworthiness that do not utilize structural credit risk models.
First, this commenter suggested that the Commission adopt an exception
for Nonconvertible Securities that are offered pursuant to an effective
registration statement filed on any of the following forms: (1) Form S-
3; \51\ (2) Form S-4; \52\ (3) Form F-3; \53\ (4) Form F-4; \54\ or (5)
Form F-10,\55\ provided that, for an offering registered on Form F-10,
the offering also meets the transactional requirements of General
Instruction I.B.2 of Form F-3.\56\ The commenter stated several reasons
for which the use of this standard would be desirable,\57\ and that
allowing some amount of high yield issuers to be eligible for the
exception would be an acceptable compromise in light of the benefits
the commenter's proposed standard otherwise provides.\58\ In addition,
this commenter stated that the ``consistently very high percentage of
registered nonconvertible debt tranches that were investment grade
demonstrates that Securities Act registration alone serves as a
reliable proxy for identifying offerings of nonconvertible debt
securities that trade primarily based upon their yield and
creditworthiness.'' \59\
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\51\ 17 CFR 239.13.
\52\ 17 CFR 239.25.
\53\ 17 CFR 239.33.
\54\ 17 CFR 239.34.
\55\ 17 CFR 239.40.
\56\ SIFMA Letter 1, at 5-8; see Letter from Joseph Corcoran,
Managing Dir. & Assoc. Gen. Counsel, Secs. Indus. & Fin. Mkts.
Ass'n, to Vanessa Countryman, Sec'y, SEC (Oct. 28, 2022) (``SIFMA
Letter 2'').
\57\ SIFMA Letter 1, at 3-4 (stating that this standard would
provide a straightforward, uniform standard; align with how the
Commission addressed the Dodd-Frank Act-related removal of
references to credit ratings from the eligibility criteria for use
of certain provisions under the Securities Act and related forms;
promote the conduct of offerings on a registered basis by limiting
the exception to qualifying registered offerings; afford
predictability; avoid complex calculations that could lead to errors
or differing results, depending on the particular structural credit
risk model used; allow the availability of the exception to be
readily and independently verified through a review of the issuer's
Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database
filings, which would minimize additional regulatory burdens and
obviate the need for any additional broker-dealer recordkeeping
obligations; ease the burden on all involved, including for
regulators; and provide greater legal certainty to the affected
issuers and any selling shareholders).
\58\ SIFMA Letter 2, at 1; SIFMA Letter 1, at 5-7.
\59\ SIFMA Letter 2, at 3.
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The Commission acknowledges that the commenter's suggested standard
may capture a consistently very high percentage of registered
nonconvertible debt tranches that were rated investment grade and may
seem operationally easier to determine whether the new exception in
Rule 101(c)(2)(i) for Nonconvertible Securities is available, may help
to promote the conduct of offerings on a registered basis, and allow
for the use of an exception that can be verified with publicly
available information, among other things. The commenter's suggested
standard, however, would not be appropriate because it does not
sufficiently focus on creditworthiness. When the Commission revised the
eligibility criteria for use of Forms S-3 and F-3 to remove any
references to credit ratings, it specifically stated that the
eligibility criteria included in those forms did not distinguish among
issuers by the quality of their credit but rather focused exclusively
on whether the issuer has a wide following in the marketplace to
identify issuers who should be eligible for short-form registration and
faster access to capital markets through the shelf registration
process.\60\ This is distinct from the basis for adopting the
Investment Grade Exceptions, including under Rule 101(c)(2), which was
that Nonconvertible Securities are appropriate to except from
Regulation M's requirements because they are fungible and traded on the
basis of their yield and creditworthiness, and therefore are less
likely to be manipulated.\61\
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\60\ Security Ratings, Release No. 33-9245 (July 27, 2011) [76
FR 46603 (Aug. 3, 2011)] (``Form S-3 and Form F-3 Release''), 76 FR
46607. When the Commission revised the eligibility criteria for use
of Form S-3 and Form F-3 to remove any references to credit ratings,
it noted that none of the criteria are a standard of
creditworthiness. Form S-3 and Form F-3 Release, 76 FR 46607 n.60.
The Commission stated that ``any alternative standard for Forms S-3
and F-3 eligibility that does not refer to credit ratings should
preserve the forms and access to the shelf registration process for
issuers who have a wide following in the marketplace.'' Form S-3 and
Form F-3 Release, 76 FR 46607. Form SF-3, the shelf registration
statement form for asset-backed securities that is discussed below,
in Part II.A.2, differs from these other forms raised by the
commenter that rely on the eligibility criteria for use of Form S-3
or Form F-3. Whereas the eligibility criteria included in Forms S-3
and F-3 focus exclusively on whether the issuer has a wide following
in the marketplace to identify issuers who should be eligible for
short-form registration and faster access to capital markets through
the shelf registration process, the eligibility criteria and
offering requirements included in Form SF-3 help to ensure that
asset-backed securities issued in shelf offerings are designed to
help ensure that that the securitization is designed to produce
expected cash flows that are sufficient to service payments or
distributions in accordance with their terms; that obligated parties
more carefully consider the characteristics and quality of the
assets that are included in the pool; and 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. 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''), 79 FR 57267, 57278, 57283.
\61\ See Regulation M Adopting Release, 62 FR 524; supra note
13. For these reasons discussed above, as related to the eligibility
criteria of Forms S-3 and F-3, the commenter's suggestion of
excepting Nonconvertible Securities that are offered pursuant to an
effective registration statement filed on Form S-4 or F-4 would not
be an appropriate substitute standard of creditworthiness in place
of the reference to credit ratings in the Investment Grade Exception
pursuant to section 939A(b) because Forms S-4 and F-4 include the
Forms S-3 and F-3 eligibility criteria by allowing registrants that
meet the registrant eligibility requirements of Form S-3 or F-3 and
that are offering investment grade securities to incorporate by
reference certain information. See Form S-3 and Form F-3 Release, 76
FR 46611 (citing General Instruction B.1 of Forms S-4 and F-4).
Similarly, the commenter's suggestion of excepting Nonconvertible
Securities that are offered pursuant to an effective registration
statement filed on Form F-10, provided that the offering also meets
the transactional requirements of General Instruction I.B.2. of Form
F-3, would not be an appropriate substitute standard of
creditworthiness in place of the reference to credit ratings in the
Investment Grade Exception pursuant to section 939A(b) because that
measure references transactional requirements that have a distinct
purpose from the Commission's original basis for adopting the
Investment Grade Exception. As discussed in this Part, the
probability of default is an appropriate measure to identify low
manipulation risk of Nonconvertible Securities because it allows for
the selection of issuers whose securities trade on the basis of
yield and creditworthiness.
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Specifically, securities of issuers of a certain credit quality
trade based on
[[Page 39967]]
yield and creditworthiness \62\ 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 creditworthiness, 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. In addition, when debt
has a very low probability of default, the cash flows are close to
risk-free. Thus, the price of the debt is mainly subject to
fluctuations based on aggregate interest rates rather than issuer-
specific or security-specific news.
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\62\ 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).
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The probability of default is an appropriate measure to identify
low manipulation risk of such securities, as it allows for the
selection of issuers whose securities trade on the basis of yield and
creditworthiness (traditionally measured by credit ratings). For
issuers with sound creditworthiness, the pricing of securities is
unrelated to other risks associated with the identity of the issuer,
greatly reducing their uncertainty and manipulation risk. A standard
based on a criterion such as being widely followed in the market does
not allow for such a clear distinction because such a standard does not
differentiate securities that are traded solely on their yield and
creditworthiness from securities that trade solely on the issuer's
identity and thus could present a high manipulation risk.\63\
Accordingly, it is appropriate to implement the section 939A(b) mandate
by adopting an exception that is based on a standard that is likewise
premised specifically on creditworthiness rather than on whether a
particular issuer has a wide following in the marketplace.
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\63\ See infra Part V.E.3.
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Second, the commenter suggested that its recommended standard
described above, which is based on the Forms S-3 and F-3 eligibility
criteria, could be modified by prohibiting reliance on the exception
for Nonconvertible Securities that include both a ``limitation on
restricted payments covenant'' and a ``limitation on sales of assets
and subsidiary stock covenant,'' which the commenter stated are two
covenants that typically are associated with non-investment grade debt
securities and are almost never used in investment grade debt
securities.\64\
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\64\ SIFMA Letter 1, at 8.
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However, despite the commenter's suggestions, the covenant
restrictions are features of current market practices \65\ but are not
necessarily inherent characteristics of the securities related to their
creditworthiness. Conditioning the exception on the absence of certain
covenants poses the risk that, should market practice change, the
exception would quickly become outdated. Therefore, even with the
commenter's two suggested modifications, a standard that is focused on
the Form S-3 or Form F-3 eligibility criteria and is premised
exclusively on whether an issuer is widely followed,\66\ rather than on
an issuer's creditworthiness, is not an appropriate substitute standard
of creditworthiness in place of the references to credit ratings in
Rule 101's Investment Grade Exception for Nonconvertible Securities to
sufficiently respond to the requirements of section 939A(b).
---------------------------------------------------------------------------
\65\ See, e.g., SIFMA Letter 1, at 8.
\66\ Form S-3 and Form F-3 Release, 76 FR 46607.
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Finally, this commenter suggested that the Commission adopt a
modified version of the 2008 Proposing Release involving a well-known
seasoned issuer (``WKSI'') standard \67\ to except: (1) a WKSI that, as
of a date within 60 days of the applicable determination date, has a
worldwide market value of its outstanding voting and non-voting common
equity held by non-affiliates of $700 million or more; and (2) a non-
WKSI to the extent it is carved out of the WKSI definition solely by
virtue of the application of paragraph (1)(v), (vi), or (ix) of the
definition of ``ineligible issuer'' under Rule 405 under the Securities
Act.\68\ The Commission recognizes the advantage a WKSI-based standard
might have in terms of its simplicity and straightforward calculation.
As noted in the Proposal, however, a WKSI-based standard as proposed in
2008 was criticized for allowing many risky, high-yield issues to be
excepted and preventing issues by smaller but otherwise credit-worthy
issuers from being eligible for the exception.\69\ This WKSI-based
standard, however, unlike the probability-of-default-based standard,
would fail to capture the pricing point where the sound
creditworthiness of the issuer eliminates other risks associated with
the issuer identity. The Nonconvertible Securities of such issuers
trade solely based on their yields and creditworthiness and not on
issuer characteristics, where pricing uncertainty and manipulation risk
are at their minimum.\70\ The WKSI-based standard, therefore, is a less
effective measure of manipulation risk as compared to the probability
of default measure.
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\67\ In 2008, prior to the enactment of the Dodd-Frank Act, the
Commission proposed to substitute credit ratings references in Rules
101 and 102 with a standard for Nonconvertible Securities that was
based primarily on the WKSI concept from 17 CFR 230.405 (``Rule
405''), as well as a standard for asset-backed securities that were
registered on Form S-3. See 2008 Proposing Release, 73 FR 40095-97.
The WKSI-based approach, consistent with the definition of WKSI
under Rule 405, would have excepted the Nonconvertible Securities of
companies that 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.
\68\ See SIFMA Letter 1, at 10. This commenter stated that its
suggested exception based on Forms S-3 and F-3 is more appropriate
than this WKSI-based approach because the Form S-3/F-3-based
approach ``recognizes several different means of qualifying under
the transactional requirement, only one of which is based upon the
aggregate principal amount of non-convertible securities issued over
the preceding three years.'' SIFMA Letter 1, at 9-10. For the
reasons discussed in this Part, neither of these approaches is an
appropriate standard of creditworthiness in place of the reference
to credit ratings in the Investment Grade Exception.
\69\ Proposal, 87 FR 18334-35.
\70\ See infra Part V.E.3.
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For these reasons, and pursuant to the requirements of section
939A(b), the probability of default measure is a more appropriate
substitute of creditworthiness for the reference to credit ratings in
the existing Investment Grade Exception than is the commenter's
suggested WKSI-based standard.\71\ As discussed above, in this Part,
when debt has a very low probability of default, its price fluctuations
are mainly based on aggregate interest rates rather than on company-
specific or security-specific news. The probability of default measure,
in contrast to the commenter's suggested WKSI-based standard, continues
to rely on the premise underlying the Investment Grade Exception:
Nonconvertible Securities
[[Page 39968]]
that trade primarily based on their yield and creditworthiness are less
susceptible to the type of manipulation that Rule 101 seeks to prevent.
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\71\ See Proposal, 87 FR 18317. Similar to how securities
covered by the existing Investment Grade Exception are excepted from
Rule 101's prohibitions, Nonconvertible Securities that trade based
on their yield and creditworthiness would be excepted under Rule 101
as amended to include the probability of default-based standard.
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Some commenters stated that the Commission should specify a
particular structural credit risk model to be used by all parties in
making probability of default calculations.\72\ These commenters stated
their concerns regarding the potential for inconsistent outcomes
resulting from the discretion to choose what structural credit risk
models to apply.\73\ One commenter stated that the adoption of the
proposed model-based standard would create the risk that the new
standard would be manipulated because firms would have a wide variety
of models from which to select.\74\ This commenter stated that, while
the proposed probability-of-default-based standard is a reasonable
alternative standard of creditworthiness, the use of structural credit
risk models would create challenges for the Commission, with regard to
implementing the probability of default standard, and for investors,
with regard to confidence in the consistency and reliability of
determinations made under the new standard.\75\ In addition, this
commenter stated that setting no minimum standards for the models and
allowing market participants the discretion to choose among a wide
range of models threatens to create a ``race to the bottom'' as market
participants seek to avoid competitive disadvantages that will arise
from having an appropriately rigorous risk of default evaluation.\76\
Another commenter, however, stated that it would be ``risky'' for the
Commission to engage in ``model preferencing.'' \77\
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\72\ See SIFMA Letter 1, at 10; Better Markets Letter, at 5.
\73\ See SIFMA Letter 1, at 5; Better Markets Letter, at 4.
\74\ Better Markets Letter, at 4 (stating, in part, that the use
of structural credit risk models will create a lack of uniformity
that conflicts with the mandate in section 939A(b) for the
Commission to establish, to the extent feasible, uniform standards
of creditworthiness). But see Bloomberg L.P. Letter, at 2 (stating
that, although the application of a particular threshold across
multiple models may have some unintended consequences (e.g.,
different point-in-time probability of default models may produce
different results for the same issuance), the proposed exception
provides an alternative measure of creditworthiness that is
practical, appropriately based on objective factors, and can be
consistently applied by market participants). The mandate in section
939A(b) to seek to establish uniform standards of creditworthiness
is limited ``to the extent [that it is] feasible.'' Public Law 111-
203, sec. 939A(b). As discussed in this Part, the use of structural
credit risk models to derive an issuer's probability of default is
an appropriate standard of creditworthiness in accordance with
section 939A(b)'s requirements.
\75\ Better Markets Letter, at 4.
\76\ Better Markets Letter, at 4.
\77\ See IILF Letter, at 6 (stating that requiring a particular
type of model could potentially distort the behavior of market
participants in their estimations of probability of default and
discouraging further and alternative inquiries into the probability
of default). The use of structural credit risk models is required
only for purposes of deriving an issuer's probability of default
pursuant to new Rule 101(c)(2)(i). Distribution participants, as
well as other market participants, may use other types of models in
evaluating the creditworthiness of an issuer outside of making a
Rule 101(c)(2)(i) probability of default determination.
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The Commission agrees with the comment against requiring the use of
a specific structural credit risk model.\78\ On balance, the use of a
structural credit risk model to derive an issuer's probability of
default pursuant to Rule 101(c)(2)(i), as amended, provides an
appropriate degree of flexibility in terms of model selection while
also providing certainty to distribution participants as to the
standards for the structural credit risk model required for purposes of
compliance in making probability of default determinations. The ability
to use an unrestricted universe of models for purposes of meeting the
conditions of new Rule 101(c)(2)(i) could provide distribution
participants with the opportunity to choose model specifications that
enable abuse of the exception for Nonconvertible Securities. In this
regard, the definition of ``structural credit risk model,'' as
discussed below in this Part, sets minimum standards for the structural
credit risk models that may be used to derive an issuer's probability
of default to meet the conditions of new Rule 101(c)(2)(i). These
minimum standards include that the model be a commercially or publicly
available model and that it calculate, based on an issuer's balance
sheet, the probability that the value of the issuer will fall below the
Default Point, at or by the expiration of a defined period. As
discussed below, in Part V.C.3, the standard's use of structural credit
risk models could incentivize lead managers to select models and
estimation specifics in such a way to ensure the resulted estimates are
below the threshold, thus allowing securities of issuers with low
creditworthiness and high manipulation risk to be eligible for the
exception. The public availability of alternative estimates for
investors, however, should mitigate this concern.\79\ Specifically, the
limitation that the structural credit risk model must be a commercially
or publicly available model would limit a distribution participant's
ability to develop models for the purpose of abusing the exception.\80\
In this regard, use of a structural credit risk model that is not
commercially or publicly available, or one that does not calculate,
based on an issuer's balance sheet, the probability that the value of
the issuer will fall below the Default Point, at or by the expiration
of a defined period, would not be permissible in meeting the conditions
of the exception.
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\78\ See IILF Letter, at 6.
\79\ Also, as discussed below, in Part II.C, because 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 requirement associated with
reliance on new Rule 101(c)(2)(i) to preserve written probability of
default determinations is designed to facilitate the Commission's
examinations of broker-dealers who rely on the exception in new Rule
101(c)(2)(i) or new Rule 102(d)(2)(i).
\80\ See infra Part V.C.3.
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While a standard that relies on the use of a structural credit risk
model retains a certain level of subjectivity,\81\ this standard also
leaves room for improvement if the market adopts more accurate
structural credit risk models in the future. As the Commission stated
in the Proposal, the use of any model to estimate creditworthiness
necessarily provides an imperfect measure.\82\ This flexibility in
selection may result in an outcome-oriented selection of structural
credit risk models, as one commenter suggested.\83\ However, a
selection that meets the definition of ``structural credit risk
model,'' as provided in Rule 100(b), as well as the requirements of new
Rule 101(c)(2)(i), would be consistent with the aims of section 939A as
well as those of Regulation M.\84\ In addition, the new record
preservation requirement set forth in Rule 17a-4(b)(17), as discussed
below in Part II.C, is designed to aid Commission examinations of
broker-dealers who rely on the exception in Rule 101(c)(2)(i) or Rule
102(d)(2)(i), as amended, and can help deter improper adjusting of the
estimation to meet the conditions of either of the exceptions.\85\
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\81\ See infra Part V.C.3; see also Proposal, 87 FR 18334.
\82\ Proposal, 87 FR 18332.
\83\ SIFMA Letter 1, at 5.
\84\ See infra Part V.B (discussing how structural credit risk
models, as defined in Rule 100(b), are designed to measure
creditworthiness, and creditworthiness itself is considered to be a
good measure of manipulation risk).
\85\ See 17 CFR 240.17a-4(b)(17), as amended; infra Part II.C.
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The Commission requested comment on whether there are ``any reasons
why the Rule should not permit a distribution participant to perform
its own calculation (subject to recordkeeping requirements, as
proposed).'' \86\ To address concerns that the proposed flexibility in
structural
[[Page 39969]]
credit risk model selection could lead to different underwriters coming
to different conclusions on the availability of an exception from
Regulation M based on which structural credit risk model they use, as
well that this flexibility could contribute to inefficiencies,
confusion, and dissension among distribution participants,\87\ the
final amendments limit the universe of those who are eligible to
determine an issuer's probability of default under new Rule
101(c)(2)(i) to include only the distribution participant who is acting
as the lead manager (or in a similar capacity) \88\ of a
distribution.\89\ This limitation will help to ensure consistent
reliance on the exception across all distribution participants for the
same distribution through use of the same written probability of
default determinations and through the new record preservation
requirements under Rule 17a-4(b)(17).\90\ The lead manager's role and
responsibilities in overseeing the distribution process \91\ should,
for these same reasons, help alleviate concerns regarding the
consistency and reliability of the determinations within any particular
distribution.\92\
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\86\ Proposal, 87 FR 18320.
\87\ SIFMA Letter 1, at 5.
\88\ Distribution participants who act as the ``lead manager''
of a distribution for purposes of the exception in Rule 101 may, as
a practical matter, also use or be known by different titles, such
as ``lead underwriter,'' ``managing lead underwriter,'' ``syndicate
manager,'' ``stabilizing manager,'' ``lead bookrunner,'' or ``co-
managing underwriter.'' The parenthetical ``(or in a similar
capacity)'' is included in FINRA's underwriting-related rules, such
as FINRA Rule 5110, to recognize this common industry practice, as
well as to prevent evasion by persons attempting to avoid regulatory
responsibility under a particular provision by using a different
title or term to refer to themselves, even though they perform the
same or similar function.
\89\ See 17 CFR 242.101(c)(2)(i), as amended.
\90\ As discussed below, in Part II.C, broker-dealers who rely
on the new exception for Nonconvertible Securities in new Rule
101(c)(2)(i) or new Rule 102(d)(2)(i), as applicable, must preserve
certain records pursuant to Rule 17a-4 under the Exchange Act. New
paragraph (b)(17) of Rule 17a-4 requires broker-dealers to preserve
the written probability of default determination, relied upon
pursuant to the exception for Nonconvertible Securities.
Accordingly, broker-dealers relying on the exception for
Nonconvertible Securities are 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.
\91\ The term ``lead manager'' under new Rule 101(c)(2)(i) is
consistent with how the term ``manager'' is applied, for
recordkeeping purposes, in 17 CFR 240.17a-2(b)(1) with respect to
any person who acts as a manager of a distribution for its sole
account or for the account of a syndicate or group in which it is a
participant with respect to keeping records of any syndicate
covering transactions, penalty bids, and all related stabilizing
activity, all three of which are governed under 17 CFR 242.104,
which cross-references the recordkeeping requirement in 17 CFR
240.17a-2, as well as the ``managing underwriter'' in connection
with TRACE-reporting of eligible fixed-income securities, or FINRA
Rule 5131's requirement that the lead managing underwriter of a
distribution disclose indications of interest and final allocation
information to the issuer's pricing committee, or notify the issuer
of any impending release or waiver of lock-ups. Thus, similar to the
traditional role played by the lead or managing underwriter in firm
commitment offerings--which generally include overseeing the
offering process to ensure that the marketing, pricing, and
allocation processes all go smoothly; providing critical advice on
the structure, size, timing, and price of the offering; and advising
on how to best present the issuer's business in the prospectus or
other offering documents--the distribution participant acting as the
lead manager (or in a similar capacity) of a distribution is the
only market participant who is eligible to derive the issuer's
probability of default for purposes of meeting the conditions of new
Rule 101(c)(2)(i), in recognition that it is in the best position to
do so. There may be distributions with more than one distribution
participant acting as the lead manager (or in a similar capacity).
In such a distribution, because the rule text refers to ``the
distribution participant acting as the lead manager,'' only one of
the distribution participants acting as the lead manager would be
permitted to make the probability of default determination for the
particular distribution.
\92\ See, e.g., infra Part V.C.3 (discussing that the
requirement related to the lead manager's probability of default
determination should mitigate the subjectivity (of the analysis
involved in probability of default estimation, as well as of the
selection of the model and data sample specifics) and the concerns
regarding non-uniform probability of default estimates for the same
issue--and to some degree across issues for the same issuer to the
extent the same parties are engaged by the issuer for different
issues).
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The lead-manager requirement is intended to broadly reflect current
market practices.\93\ Lead managers will be incentivized to share their
probability of default determinations with other distribution
participants and their affiliated purchasers (as well as with the
issuer, selling security holders, and their affiliated purchasers) in
order to rely on the exception for Nonconvertible Securities given
their primary role and responsibilities in overseeing the distribution
process, which can include providing liquidity and facilitating an
orderly distribution and aftermarket in connection with the
offering.\94\ While Regulation M does not require the lead manager to
coordinate the activities of the other syndicate members, lead managers
are, as a practical matter, concerned that the other underwriters in
the syndicate are, among other things, complying with Regulation M's
trading prohibitions \95\ so as not to extend the Regulation M
restricted period.\96\ However, Rule 101(c)(2)(i), as amended, does not
require that the lead manager making the probability of default
determination share the determination with other distribution
participants or their affiliated purchasers in order for those parties
to rely on the exception.\97\ Therefore, non-lead manager distribution
participants and their affiliated purchasers (as well as issuers,
selling security holders, and their affiliated purchasers, as discussed
below, in Part II.B.1) may not be able to rely on the exception for
Nonconvertible Securities if the lead manager does not share the
probability of default determination or there is no distribution
participant to act as the lead manager for the distribution, such as
with self-underwritten offerings, at-the-market offerings, or other
shelf offerings, to the extent such an offering meets the definition of
a ``distribution'' under Rule 100(b) of Regulation M. \98\
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\93\ See, e.g., supra notes 88, 91.
\94\ See, e.g., Regulation M Adopting Release, 62 FR 534-35.
\95\ See, e.g., supra notes 88, 91; SIFMA, Model Form of Master
Agreement Among Underwriters (Dec. 10, 2018), <a href="https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf">https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf</a> <a href="https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf">https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf</a>.
\96\ See Regulation M Adopting Release, 62 FR 522-23 (discussing
Rule 100's definition of ``completion of participation in a
distribution'' when underwriters in a syndicate are involved).
\97\ The Commission asked in the Proposal whether distribution
participants should be required to post or make the probability of
default public on their website to rely on the exception. See
Proposal, 87 FR 18320. As discussed below, in Part II.C, one
commenter stated that the Commission also could publish, or require
publication of, default probability estimates that market
participants derive from various models, along with default
probabilities implied by both market prices and credit default swap
spreads. See IILF Letter, at 8. However, the Commission did not
receive any comment suggesting that distribution participants making
probability of default determinations should be required to post or
make the probability of default determinations public on their
website in order to rely on the exception. Nor did the Commission
receive any comment suggesting that the sharing of probability of
default determinations among other covered persons should be
included as a condition to the exception.
\98\ Rule 100 of Regulation M defines the term ``distribution''
as ``an offering of securities, whether or not subject to
registration under the Securities Act that is distinguished from
ordinary trading transactions by the magnitude of the offering and
the presence of special selling efforts and selling methods.'' With
regard to shelf offerings, each takedown of a shelf is to be
individually examined to determine whether such offering constitutes
a ``distribution'' (i.e., whether it satisfies the ``magnitude'' of
the offering and ``special selling efforts and selling methods''
criteria of a distribution). Regulation M Adopting Release, 62 FR
526. In those situations where a broker-dealer sells shares on
behalf of an issuer or selling security holder in ordinary trading
transactions into an independent market (i.e., without any special
selling efforts), the offering will not be considered a
distribution, and the broker-dealer will not be subject to Rule 101.
Regulation M Adopting Release, 62 FR 526.
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This potential impact is mitigated, however, if the syndicate
adjusts the way it interacts with lead managers. For example, the
syndicate could decide, by contract (e.g., in an agreement among
underwriters) and for the same reason of consistency as discussed
above, to specifically authorize the lead manager
[[Page 39970]]
to share its probability of default determination with other
distribution participants. The syndicate could also make the decision
not to allow the lead manager to share its probability of default
determination with unrelated distribution participants in order to keep
a tighter control of the distribution. Because the facts and
circumstances vary across issues, it is reasonable to let the syndicate
decide how widely the probability of distribution determination is
shared by the lead manager. If such information is shared, it must be
used consistently across the syndicate to rely on the new exception in
Rule 101(c)(2)(i) because such reliance is conditioned on the lead
manager's probability of default determination.
The lead-manager requirement, however, could affect current market
practices by resulting in fewer Nonconvertible Securities being
excepted under the new standard in comparison to those currently
excepted under the Investment Grade Exception if, as a practical
matter, only Nonconvertible Securities that are subject to underwritten
offerings become eligible for the new exception in Rule 101(c)(2)(i).
With regard to the types of distributions covered, as a result of the
condition requiring that the lead manager perform the probability of
default determinations in order for reliance on the exception, this
exception will be available to a subset of distributions of
Nonconvertible Securities covered under the existing Investment Grade
Exception and to a subset of the distributions that would have been
captured under the Proposal.\99\ Accordingly, any potential challenges,
as a commenter suggested,\100\ are likely to be faced in carrying out
obligations in order to rely on the new exception in Rule 101(c)(2)(i).
The estimated costs associated with the requirement related to the lead
manager making the probability of default determination are included
below, in Part V.C.1.\101\
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\99\ See Proposal, 87 FR 18330.
\100\ See Better Markets Letter, at 4.
\101\ However, as discussed below, in Parts V.C.1 and VI.C.1,
some lead managers may rely on third party vendors rather than
internally calculate the probability of default.
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The bright-line requirements of Rule 101(c)(2)(i), as amended, and
the corresponding record preservation requirements of new Rule 17a-
4(b)(17) also help to promote confidence in the consistency and
reliability of the lead manager's determinations by limiting the degree
to which there are variances between probability of default
calculations within any one distribution as well as by deterring any
improper tweaking of model inputs.\102\ The bright-line threshold of
0.055%, as well as the pre-determined time horizon, are model inputs
that are uniform and predictable and, thus, should provide the
necessary clarity as to what is expected in evaluation and
documentation. In addition, the bright-line threshold of 0.055% will
help to ensure that only those Nonconvertible Securities that trade on
the basis of yield and creditworthiness, and are fungible,\103\ will
meet the exception, regardless of the model picked. Accordingly, the
probability-of-default-based standard articulates an appropriate
alternative measure of creditworthiness that is practical and is
appropriately based on objective factors.
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\102\ As discussed below, in Part II.C, the record preservation
requirements provided in new Rule 17a-4(b)(17) are sufficient to
help the Commission's examinations of broker-dealers relying on the
new probability-of-default-based standard.
\103\ See, e.g., supra notes 13, 38.
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One commenter stated that commercially or publicly available
structural credit risk models are not used by all firms in the context
of evaluating whether to underwrite a security and that such a
decision, instead, is focused on the adequacy and accuracy of
disclosures.\104\ The Commission acknowledges that, when a firm
evaluates whether to underwrite a distribution of securities, it
typically focuses on the adequacy and accuracy of an issuer's
disclosures. However, the adequacy and accuracy of disclosures are a
separate question from the creditworthiness of securities for purposes
of the exception for Nonconvertible Securities. It is possible that an
accurate disclosure statement did not reveal the issuer's low
creditworthiness, making the offered securities inappropriate to be
eligible for the exception for Nonconvertible Securities that trade on
the basis of their yield and creditworthiness.
---------------------------------------------------------------------------
\104\ SIFMA Letter 1, at 5.
---------------------------------------------------------------------------
One commenter stated that the proposed probability of default
calculations would create a heightened risk for errors.\105\ Another
commenter stated that market participants can reliably estimate the
probability of default, not only by using the proposed ``structural
credit risk models'' but also by using other statistical models,\106\
market measures of credit risk, and other credit risk measures.\107\
This commenter encouraged the Commission to adopt a final rule that
references market measures of credit risk as part of the estimation of,
or as an alternative to, the probability of default.\108\
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\105\ SIFMA Letter 1, at 5.
\106\ IILF Letter, at 2 (stating that the inability to reliably
estimate the probability of default on a debt security using any of
a variety of statistical models and market measures is strong
evidence that the security should not fall within an exception to
Regulation M and could also be evidence that the market participant
is not in a position to trade or hold that specific security). As
discussed in this Part, new Rule 101(c)(2)(i) requires that the
probability of default determination be derived from a structural
credit risk model. Distribution participants and their affiliated
purchasers may not avail themselves of the exception in new Rule
101(c)(2)(i) with regard to any security that does not meet the
requirements of that exception.
\107\ IILF Letter, at 2.
\108\ IILF Letter, at 2, 6-8 (stating its concerns about the use
of balance sheets and suggested that the Commission reference more
flexible alternatives, such as the probability of default threshold
could vary annually on an ongoing basis depending on a similar
analysis of more recent data going forward or peg the annual
probability of default threshold based on an analysis of a sample of
securities from the previous year). The Commission has considered
this comment and, on balance, concerns about the use of an issuer's
balance sheet should be addressed by the rigorous theoretical
justification as well as by the economic interpretation of the
resulting relationships between the inputs that are embedded in such
structural credit risk models. See, e.g., infra note 243. However,
allowing a more flexible threshold, as would be done under the
commenter's suggestion, would result in increased subjectivity and
non-uniformity of the application of the exception.
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The Commission agrees with the comments that market participants
can reliably estimate the probability of default derived from a
structural credit risk model.\109\ The Commission also acknowledges
that probability of default estimates are not free of subjectivity and
can vary across structural credit risk models, researchers, or
vendors.\110\ The use of any model or market measure to estimate issuer
creditworthiness is imperfect.\111\ The new exception's bright-line
probability of default threshold and time horizon, however, provides
predictability and allows for the exception to be applied consistently
by distribution participants who are eligible to make probability of
default determinations.\112\ As discussed below, in Part V.E.3, the
Commission has considered other types of models, such as reduced-form
models, which would generally provide less stable predictions than
structural credit risk models do because they can be so flexible that
they suffer from a lack of theoretical foundation and a lack of
intuitive interpretation of why the defaults occur. Also, unrestricted
use of these models might also provide more opportunity to choose a
reduced-form model specification to enable use of the exception for
Nonconvertible Securities. The Commission therefore is adopting
[[Page 39971]]
an exception that is based on the use of a structural credit risk model
as this model is appropriately designed to measure creditworthiness of
Nonconvertible Securities in Rule 101(c)(2)(i), as amended, in
accordance with the requirements of section 939A(b).
---------------------------------------------------------------------------
\109\ IILF Letter, at 2.
\110\ See Proposal, 87 FR 18332.
\111\ See Proposal, 87 FR 18332.
\112\ Bloomberg L.P. Letter, at 2.
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One commenter recommended that the proposed probability of default
threshold should be increased to 0.5% in order to capture the maximum
amount of issuers who, currently, are eligible under the existing
exception (i.e., the proposed threshold of 0.055% is too restrictive
with regard to scoping in securities that currently are excepted).\113\
Other commenters supported the proposed probability of default
threshold of 0.055% as reasonable.\114\ One commenter stated that the
bright-line threshold of 0.055% will provide clarity as to what is
expected in evaluation and documentation.\115\
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\113\ SIFMA Letter 1, at 10. The Commission estimated in the
Proposal that, while the proposed threshold of 0.055% would capture
approximately 90% of the investment grade securities in its sample
of nonconvertible fixed income securities, a threshold of 0.5% would
capture about 98.6% of investment grade securities. See Proposal, 87
FR 18330, 18334.
\114\ See Bloomberg L.P. Letter, at 2; IILF Letter, at 6.
\115\ Bloomberg L.P. Letter, at 2. Another commenter stated that
it is not necessary to state a precise bright-line measure. IILF
Letter, at 6. The exception's use of a bright-line threshold, by
imposing specific and clear requirements, helps to ensure that the
exception captures only those Nonconvertible Securities that trade
on the basis of yield and creditworthiness. It also helps to ensure
that the exception is based on objective factors and can be
consistently applied by market participants. See Bloomberg L.P.
Letter, at 2.
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The Commission has considered these comments and concluded that the
0.055% threshold appropriately calibrates the probability of default to
determine the creditworthiness of an issuer whose Nonconvertible
Securities trade based on their yield and creditworthiness.\116\ While
the higher threshold of 0.5% captures a larger set of securities of
creditworthy issuers whose securities are eligible for the existing
Investment Grade Exception, it also allows for an exception that
captures a larger set of securities that could be prone to manipulation
risk in comparison to the 0.055% threshold (i.e., non-investment grade
securities).\117\ Because the commenter's suggested 0.5% threshold, in
comparison to the 0.055% threshold, risks capturing a majority of the
securities that are not traded on the basis of their yield and
creditworthiness in the same way that Nonconvertible Securities
excepted under the existing Investment Grade Exception are traded, too
many distributions of these types of securities would be included,
which reflects that a 0.5% threshold may not be an appropriate
replacement standard of creditworthiness, in accordance with of section
939A(b).
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\116\ See infra Part V.B; Proposal, 87 FR 18319, 18330.
\117\ See also Proposal, 87 FR 18334. Based on an analysis of
the available data as of Mar. 2023, a 0.5% threshold would make the
new exception less restrictive and would result in 124 additional
non-investment grade securities being captured by the standard, from
64 non-investment grade issues under the 0.055% threshold to 188
issues under the 0.5% threshold. See infra Part V.B. These figures
differ from those included in the Proposal because they are based on
an analysis of the available data as of Mar. 2023, whereas the
Proposal's figures were based on an analysis of the data available
as of Oct. 2021. See infra Part V.B.
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Further, even if the 0.055% threshold does not capture the exact
same set of Nonconvertible Securities captured by the Investment Grade
Exception, the 0.055% threshold nevertheless identifies Nonconvertible
Securities that are less susceptible to the manipulation that Rule 101
is designed to prevent because they trade based on their yield and
creditworthiness, As discussed above, Regulation M seeks to protect the
offering price of a security during a distribution, when there are
heightened incentives on the part of those who are involved in the
offering process to influence the subject security's price. Because
these Nonconvertible Securities are traded on the basis of their yield
and creditworthiness, and are largely fungible, they are less
susceptible to manipulation.\118\
---------------------------------------------------------------------------
\118\ See Regulation M Adopting Release, 62 FR 527; supra note
38.
---------------------------------------------------------------------------
In other words, the ability of distribution participants and their
affiliated purchasers to bid up the price of a Nonconvertible Security
of an issuer that meets the 0.055% probability of default threshold is
limited by investors' ability to substitute the security with other
securities that are similar and of comparable creditworthiness. In
contrast, a non-investment grade security that has a much higher
probability of default tends to have idiosyncratic risks that make them
less substitutable and hence more susceptible to manipulation. The
threshold of 0.5% would capture more than the majority of non-
investment grade securities (approximately 69.9% of non-investment
grade securities),\119\ which indicates that it may not be an
appropriate measure of creditworthiness to replace the reference to
credit ratings in Rule 101's Investment Grade Exception. Accordingly,
the 0.055% threshold appropriately calibrates the probability of
default to determine the creditworthiness of an issuer whose
Nonconvertible Securities should trade based on yield and
creditworthiness and is an appropriate substitute standard of
creditworthiness to replace the credit ratings reference in the
Investment Grade Exception pursuant to section 939A(b).
---------------------------------------------------------------------------
\119\ See infra Part V.E.1.
---------------------------------------------------------------------------
While the probability of default measure uses a threshold of
0.055%, as was proposed, the final rule text is changed from the
proposed rule text of ``less than 0.055%'' to state ``0.055% or less.''
The Commission is clarifying that a determination of a 0.055%
probability of default is eligible for the exception, so long as all
other conditions of the exception are met. This change is consistent
with the estimates included in the Proposal, including with how the
Commission calibrated the probability of default threshold in the
Proposal.\120\
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\120\ See Proposal, 87 FR 18330; see also Proposal, 87 FR 18319,
18332.
---------------------------------------------------------------------------
The same commenter also suggested that the probability of default
calculations should be permitted to be made within a specified duration
of time in advance of pricing (rather than as of the day of determining
the offering price), for example, within 10 calendar days prior to
pricing of the offering, similar to the approach taken with respect to
average daily trading volume (``ADTV'') calculations, to afford
distribution participants adequate time to adjust their market
activities as necessary.\121\ The Commission acknowledges that lead
managers who make probability of default determinations pursuant to
Rule 101(c)(2)(i) may need additional time prior to the pricing of an
offering to make the required calculations. However, in light of the
comments received, the 10-calendar-day period suggested by the
commenter would be unnecessarily long for the lead manager to determine
and document in writing the issuer's probability of default because the
determination is likely to be highly automated.\122\ In addition, the
suggested 10-calendar-day period may not encourage as timely of
information about the issuer as possible if the model inputs are taken
farther away from the day of the determination of the offering price,
as proposed.
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\121\ SIFMA Letter 1, at 10.
\122\ See infra Part VI.C.1. For example, because commonly
available spreadsheet software can be used to calculate the
probability of default, lead managers would not need 10 calendar
days to derive an issuer's probability of default. See, e.g.,
Proposal, 87 FR 18319.
---------------------------------------------------------------------------
The Commission is, therefore, modifying the proposed time horizon
of ``the day of the determination of the
[[Page 39972]]
offering pricing'' to allow the lead manager to make its probability of
default determination as of ``the sixth business day immediately
preceding the determination of the offering price'' for purposes of the
new exception. This change from the proposed time horizon of ``the day
of the determination of the offering price'' is being made in response
to comment that additional time is needed because ``[i]t would be very
damaging to the issuer to launch a re-opening, subsequently determine
that there is no exception under the probability of default
calculation, and then have to extend the pricing of the offering by at
least one (or five) business days.'' \123\ The Commission agrees with
the commenter that more time would be useful to address the potential
of an offering by at least one to five business days but is concerned
that the model inputs supporting the probability of default
determination may become stale with additional time beyond that.\124\
Accordingly, the Commission is extending the time horizon to allow for
the potential of an offering being extended up to five business days.
Further, this will allow the determination to be made before Regulation
M's otherwise applicable five-business-day restricted period (i.e.,
preceding the determination of the offering price) and should provide a
sufficient amount of additional time for the lead manager to account
for any relevant market activities and timely information regarding the
issuer as a model input in determining the probability of default.\125\
This essentially allows these distribution participants, in relation to
the proposed ``day of the determination of the offering price''
requirement, five additional business days, as defined in Rule 100(b),
before the actual pricing and launch of the offering to make the
probability of default determination.
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\123\ SIFMA Letter 1, at 11.
\124\ See, e.g., infra Part V.B (discussing how probabilities of
default implied by structural credit risk models generally use
current estimates of equity valuation and volatility based on the
recent trading activity, and hence incorporate more recent news
affecting the valuation and perceived volatility of the firm).
\125\ See, e.g., Proposal, 87 FR 18330.
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In view of the nature and trading characteristics of Nonconvertible
Securities, the impact, if any, of a corporate or market event in the
intervening five business days would be unlikely to result in the
manipulation that Regulation M seeks to prevent. Nonconvertible
Securities are priced and traded differently than equity securities in
that the focus (with Nonconvertible Securities) is placed on receiving
periodic interest payments during the life of the instrument rather
than on any potential equity upside or increase in the current trading
or offering price. Therefore, trading activity in Nonconvertible
Securities at or around the time of the distribution is unlikely to
influence the pricing or trading of such securities, particularly
during Regulation M's (otherwise applicable) restricted period.
Accordingly, the Commission is adopting, with targeted
modifications in consideration of the comments received, as discussed
in this Part, as well as certain technical changes,\126\ a new
exception in Rule 101(c)(2)(i) for Nonconvertible Securities of issuers
for which the probability of default, estimated as of the sixth
business day immediately preceding the determination of the offering
price and over the horizon of 12 full calendar months from such day, 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 a distribution, as derived from a structural credit risk
model. For the reasons discussed above, in this Part, and as supported
by an analysis of the probability of default and investment grade
credit ratings of a sample of Nonconvertible Securities available on
the market,\127\ the standard used in the new exception is an
appropriate substitute standard of creditworthiness to replace the
credit ratings reference in the Investment Grade Exception for
Nonconvertible Securities.
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\126\ The final amendments make the technical change of deleting
the word ``the'' from the beginning of the exception in order to
mirror the beginning of new Rule 101(c)(2)(ii). The final rule
amendments also make an edit to use the words ``as derived from''
instead of ``by using,'' as proposed, to clarify that a structural
credit risk model must be the only method of determining an issuer's
probability of default, as opposed to one method among others. This
change also conforms the standard to how it was discussed in the
Proposal. See, e.g., Proposal, 87 FR 18318-19. The final amendments
also make a conforming edit from the proposed rule text to add the
word ``full'' preceding the time horizon of 12 calendar months to
make the phrasing of the exception's time horizon consistent with
Regulation M's other time horizons. See, e.g., 17 CFR 242.100(b)
(defining the terms ``ADTV,'' which uses a time horizon of ``two
full calendar months,'' and ``principal market,'' which uses the
time horizon of ``12 full calendar months'').
\127\ See infra Parts V.A through E.
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Finally, the Commission is adopting, substantially as proposed,
with certain clarifying \128\ and technical \129\ changes, a definition
under Rule 100(b) of Regulation M for the term ``structural credit risk
model'' that means ``any commercially or publicly available model that
calculates, based on an 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.'' \130\ Accordingly, a covered person's
reliance on Rule 101(c)(2)(i) or Rule 102(d)(2)(i), as amended, is
conditioned on a probability of default determination that was derived
from any commercially or publicly available structural credit risk
model that calculates, based on an 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.
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\128\ The Commission is making clarifying changes to the
proposed definition of the term ``structural credit risk model''
that conform it to its description in the Proposal. As discussed
above, in Part II.A.1, the Proposal stated that a structural credit
risk model ``provide[s] a probability that a firm's assets will fall
below the Default Point at or by the expiration of a defined period
of time.'' Proposal, 87 FR 18317. The final rule amendments conform
the proposed definition to that description and clarify that the
``threshold'' referenced in the proposed definition is the Default
Point.
\129\ The Commission is also making a non-substantive, technical
change from the proposed definition of the term ``structural credit
risk model.'' As discussed below, because the final rule amendments
include the term ``structural credit risk model'' in both new Rule
101(c)(2)(i) and new Rule 102(d)(2)(i), the Commission is adding to
Rule 100(b) a definition for the term ``structural credit risk
model.'' The addition of this definition in Rule 100(b) does not
change the definition of the term ``structural credit risk model''
but rather simplifies the final text of new Rules 101(c)(2)(i) and
102(d)(2)(i) by obviating the need for a proviso containing a
definition in each of those rules. Accordingly, use of the term
``structural credit risk model'' is identical across new Rules
101(c)(2)(i) and 102(d)(2)(i).
\130\ 17 CFR 242.100(b).
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2. Rule 101(c)(2)(ii): Asset-Backed Securities Offered Pursuant to an
Effective Shelf Registration Statement Filed on Form SF-3
The Commission proposed an amendment to add 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.
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.\131\ The Commission
designed the shelf eligibility requirements to help ensure a
[[Page 39973]]
certain ``quality and character'' in light of the requirement to reduce
regulatory reliance on credit ratings.\132\ The shelf eligibility
requirements included in Form SF-3 are designed to help ensure that the
securitization is designed to produce expected cash flows that are
sufficient to service payments or distributions in accordance with
their terms; \133\ that obligated parties more carefully consider the
characteristics and quality of the assets that are included in the
pool; \134\ 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; \135\ and that issuers design and prepare asset-backed
securities offerings with greater oversight and care.\136\ The asset-
backed securities offered pursuant to an effective shelf registration
statement filed on Form SF-3 should trade primarily on the basis of
yield and creditworthiness, rather than on the identity of a particular
issuer and its idiosyncratic risk.
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\131\ See Regulation AB II Adopting Release.
\132\ See Regulation AB II Adopting Release, 79 FR 57189.
\133\ See Regulation AB II Adopting Release, 79 FR 57267.
\134\ See Regulation AB II Adopting Release, 79 FR 57278.
\135\ See Regulation AB II Adopting Release, 79 FR 57283.
\136\ Regulation AB II Adopting Release, 79 FR 57265, 57285.
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One commenter supported the adoption of the proposed exception for
asset-backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3 and stated that it
appreciated the straightforward nature of the standard, which allows
all interested parties to easily determine whether the exception is
available.\137\
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\137\ See SIFMA Letter 1, at 11.
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Another commenter disagreed with the Commission's statement that an
exception for asset-backed securities that is based on a probability of
default threshold may be unfeasible.\138\ This commenter stated that
market participants are able to estimate the probability of default for
these securities, not only using statistical models but also based on
market measures such as credit spreads.\139\ In response to Request for
Comment (``RFC'') 29,\140\ this commenter stated that a probability of
default standard based on market measures would have indicated that the
exception to Regulation M no longer applied for certain debt securities
during the months leading up to the collapse of Lehman Brothers, and
available data shows that, if such a market measure-based standard had
been implemented, the exceptions for Regulation M would not have been
available for debt securities as early as fall 2007.\141\ Despite this
example, the Commission has considered this comment and determined that
an exception for asset-backed securities that is based on a structural
credit risk model to derive an issuer's probability of default would be
unfeasible because distribution participants (including those acting as
the lead managers) may not be able to collect all of the information
required to calculate the probability of default, such as the value and
volatility of the equity.\142\ In other words, practical challenges of
obtaining reliable fundamental information about the equity would make
a probability of default measure unfeasible for an exception for asset-
backed securities that trade on the basis of their yield and
creditworthiness. The Commission has also determined that a measure
based on credit spreads or the use of other models, such as reduced-
form models, would not be appropriate to use due to their flexible or
unstructured nature, which could result in a standard that can be used
to abuse the exception.\143\
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\138\ IILF Letter, at 6.
\139\ IILF Letter, at 6-7 (stating that asset-backed securities
are widely traded and have frequently quoted prices and credit
spreads and that it is straightforward to calculate the probability
of default based on these market measures). For the reasons
discussed above, in Part II.A.1, the Commission is requiring that an
issuer's probability of default be derived from a structural credit
risk model, and not from other market measures.
\140\ Proposal, 87 FR 18323 (requesting comment on whether a
probability-of-default-based standard would be appropriate for the
exception for asset-backed securities; whether there are models that
are used to calculate a probability of default threshold for asset-
backed securities that would be relevant to consider based on the
type of security involved and, if so, what the threshold should be;
what benefits this approach would provide; what other concerns this
approach could raise; and how this approach would address potential
conflicts of interest involving the distribution participant or
affiliated purchaser making the determination).
\141\ IILF Letter, at 7 (citing Flannery, Houston & Partnoy,
Credit Default Swap Spreads, 158 U. PA. L. REV. 2085, 2087 (2010)).
The available data referenced in the commenter's statement, as well
as the article the commenter cited, pertains to debt and credit
default swaps. It does not appear from the cited article that the
analysis performed related to credit default swaps was performed
with regard to asset-backed securities. Further, this commenter did
not provide similar information about asset-backed securities.
\142\ See infra Part VI.B (discussing model inputs).
\143\ See infra Part V.E.6.
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The same commenter stated that ``any final rules governing asset-
backed securities also could reference expected recovery in the event
of default and default correlation.'' \144\ The commenter suggested to
require under the exception that the applicable market participant
determine and document a conclusion that the credit risk associated
with a security was ``minimal'' (or some other similar standard) based
on these variables, without any requirement that they use a particular
model.\145\ The commenter's suggested exception, by conditioning
reliance on a list of variables and a judgment of ``minimal'' credit
risk, without any bright-line requirements to help deter abuse of the
exception through self-serving conclusions, would not be sufficiently
objective.
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\144\ IILF Letter, at 8.
\145\ IILF Letter, at 8.
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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.\146\ As discussed above, the Commission
excepted investment grade asset-backed securities from Rule 101 because
such securities trade primarily on the basis of yield and
creditworthiness (traditionally measured by credit ratings).\147\ 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.\148\ The Commission also stated that Rule
101(c)(2) 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.'' \149\
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\146\ 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 that the ``fungibility'' of certain
types of securities makes manipulation of their price very
difficult).
\147\ See Regulation M Adopting Release, 62 FR 527.
\148\ See Regulation M Adopting Release, 62 FR 527.
\149\ See Regulation M Adopting Release, 62 FR 527 (citations
omitted). The Commission stated that such rationale also applies to
the existing identical exception in Rule 102(d)(2) of Regulation M.
Regulation M Adopting Release, 62 FR 531.
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As discussed above, in this Part, the practical challenge of
obtaining reliable fundamental information about the equity makes a
probability of default determination difficult or infeasible. The
Commission believes that an appropriate and pragmatic approach is
[[Page 39974]]
to add an exception based on Form SF-3, as proposed, because it
sufficiently focuses on creditworthiness.\150\ In addition, as stated
in the Proposal, a standard that relies on Form SF-3 with respect to
Nonconvertible Securities would not be appropriate because the
transaction requirements included in Form SF-3 are relevant only to
asset-backed securities and thus would not be a sufficient measure of
creditworthiness for securities that are not subject to the Form SF-3
transaction requirements.\151\
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\150\ See, e.g., supra notes 60-61 (contrasting the focus of
creditworthiness in the eligibility criteria and offering
requirements included in Form SF-3 with that of other Commission
Forms, such as Form S-3 and Form F-3).
\151\ See Proposal, 87 FR 18321.
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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 in Rule 101(c)(2): with respect to either
set 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.\152\ 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 of the physical
property underlying the leases.\153\ 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 the
Commission stated at the time it adopted the 20% delinquency limitation
for shelf eligibility, 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.\154\ The
application of the limitation on delinquent assets 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,\155\
consistent with the Commission's original basis for excepting
investment grade asset-backed securities from Rule 101.\156\
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\152\ See supra note 149.
\153\ See 17 CFR 239.45(b)(v), (vi); Form SF-3, General
Instruction I.B.1(e) and (f).
\154\ 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) (``BMA NAL'')). 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 BMA
NAL, 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 BMA NAL, 1997
WL 634124, at * 4.
\155\ See Regulation AB Release, 70 FR 1517.
\156\ 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.\157\ When adopting the
transaction 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.\158\
The Commission also stated 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.\159\ Because the
transactional safeguards included in Form SF-3 provide incentives for
obligated parties to, among other things,\160\ more carefully consider
the characteristics and quality of the assets that are included in the
pool,\161\ asset-backed securities that are offered pursuant to an
effective Form SF-3 should trade based on their yield and
creditworthiness rather than on the identity of a particular
issuer.\162\
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\157\ Form SF-3, General Instruction I.B.1(a)-(c).
\158\ See Regulation AB II Adopting Release, 79 FR 57283.
\159\ See Regulation AB II Adopting Release, 79 FR 57283.
\160\ See supra notes 132-136.
\161\ See Regulation AB II Adopting Release, 79 FR 57278.
\162\ See, e.g., Regulation AB II Adopting Release, 79 FR 57277-
78.
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The requirement regarding an effective shelf registration statement
filed on Form SF-3 is an appropriate substitute for the reference to
credit ratings in the Investment Grade Exception because the standard
is designed to limit eligibility for that exception to only those
asset-backed securities that should trade based on their yield and
creditworthiness 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 creditworthiness,\163\
such a security is less susceptible to the types of manipulation that
Regulation M seeks to prevent. 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). In addition, the exception for asset-backed securities that
are offered pursuant to an effective shelf registration statement filed
on Form SF-3 carries over the standard of creditworthiness included in
the Commission's Form SF-3 and helps to implement the mandate that, to
the extent feasible, uniform standards of creditworthiness be
used.\164\
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\163\ See Regulation M Adopting Release, 62 FR 527.
\164\ 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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[[Page 39975]]
Accordingly, the Commission is adopting, substantially as proposed,
with a technical change,\165\ an amendment to add 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.
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\165\ The final rule amendments make a non-substantive,
technical change that replaces the proposed reference to ``17 CFR
239.45'' with a reference to ``Sec. 239.45 of this chapter'' when
referencing Form SF-3.
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B. Rule 102(d)(2) of Regulation M: Implementing Section 939A(b) in
Certain Exceptions for Issuers and Selling Security Holders
The Commission proposed to remove, without replacing, the
Investment Grade Exception in Rule 102(d)(2) of Regulation M. The
Commission stated in the Proposal that this removal without replacement
was appropriate given that the retention of an exception for
creditworthy Nonconvertible Securities and asset-backed securities
would not likely be necessary to facilitate orderly distributions or
limit disruptions in the trading market in light of issuers' limited
market access needs and the apparent limited reliance on Rule 102's
Investment Grade Exception, coupled with the incentive for issuers,
selling security holders, and their affiliated purchasers to manipulate
the market for the distributed security, regardless of the security's
credit quality.\166\
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\166\ See Proposal, 87 FR 18323-24.
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Two commenters supported the proposed elimination, without
replacement, of Rule 102(d)(2)'s Investment Grade Exception.\167\ One
commenter stated that it is ``appropriate in contexts where deference
arguably should be made to independent decisions and judgment by market
participants, without the crutch of reliance on credit ratings.'' \168\
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\167\ See Better Markets Letter, at 3-4 (stating that the
proposal to eliminate, without replacing, the exception in Rule 102
for certain investment grade securities is appropriate because
issuers and selling security holders have comparatively strong
incentives to manipulate the price of the distributed security);
IILF Letter, at 7. As discussed below, in Part II.B.1, the new
exception for Nonconvertible Securities takes account of this
consideration.
\168\ IILF Letter, at 7.
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One commenter objected to the proposed elimination, without
replacement, of the Investment Grade Exception in Rule 102(d)(2) and
stated that the ``continued availability of such an exception would be
important to broker-dealers who are affiliated with an issuer but are
not, for whatever reasons, serving as an underwriter or other
participant in connection with the distribution.'' \169\ This commenter
stated that the Commission, instead, should substitute the existing
standard in Rule 102(d)(2) with ``the same standards as used for
purposes of the exceptions under Rule 101(c)(2).'' \170\ For reasons
explained below, the Commission agrees with this commenter and is
replacing the Investment Grade Exception in Rule 102, rather than
eliminating the exception, without replacement, as proposed. The
Commission continues to believe that its original basis for excepting
Nonconvertible Securities and asset-backed securities of a certain
quality and character from Rule 102's prophylactic prohibitions is
appropriate and that the substitute standards discussed below are
appropriate to ensure that those securities are less at risk of the
manipulation that Regulation M addresses.\171\
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\169\ SIFMA Letter 1, at 12-13. This commenter stated that the
Investment Grade Exception in Rule 102 is relied upon in the context
of sticky offerings and re-openings of debt issuances. See SIFMA
Letter 1, at 4.
\170\ See SIFMA Letter 1, at 12. With regard to replacing the
Investment Grade Exception in Rule 102 pursuant to section 939A(b)'s
requirements, the Commission requested comment on whether it should
adopt an exception based on either the probability-of-default-based
standard for Nonconvertible Securities or the standard for asset-
backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3 instead of removing the
Investment Grade Exception, without substituting an alternative, and
whether it should adopt an exception in Rule 102 if a distribution
participant determines that a security is an excepted security
pursuant to Rule 101(c)(2). Proposal, 87 FR 18324 (request for
comment (RFC) 35). One commenter replied, in response to RFC 35,
that, to the extent the Commission receives comments that market
participants on their own cannot make decisions and judgments about
credit risk related to Rule 102, an exception based on probability
of default would be a viable alternative. See IILF Letter, at 7. The
Commission did not receive any such comment in response to the
Proposal.
\171\ 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)].
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The Commission is adopting rule amendments that remove the
Investment Grade Exception from Rule 102 of Regulation M and substitute
in its place exceptions based on alternative standards of
creditworthiness to except Nonconvertible Securities. The reasons for
adding these new exceptions are discussed below with regard to
Nonconvertible Securities, in Part II.B.1, and asset-backed securities,
in Part II.B.2.
1. Rule 102(d)(2)(i): Nonconvertible Securities of Issuers Who Meet a
Specified Probability of Default Threshold
The Commission acknowledges that eliminating the exception, without
replacement, may impact entities, such as broker-dealers who are not
distribution participants (and are not eligible to quality for an
exception under Rule 101) but may qualify for a comparable exception
under Rule 102 as a result of being an affiliate of an issuer or
selling security holder and meeting the exception's conditions. The
continued availability of an exception for the Nonconvertible
Securities will also provide issuers and selling security holders with
more flexibility during distributions as compared to the Proposal. The
elimination, without replacement, of the Investment Grade Exception
from Rule 102 for issuers and selling security holders could increase
issuance costs or deter market participants from issuing Nonconvertible
Securities with low manipulation risk.\172\
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\172\ See Proposal, 87 FR 18333.
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In adopting the Investment Grade Exception, the Commission stated
that it determined to include the Investment Grade Exception in Rule
102 based, in part, on the rationales indicated for an identical
exception to Rule 101.\173\ 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.'' \174\ As discussed above, in Part II.A.1, the new
exception in Rule 101(c)(2)(i) for Nonconvertible Securities of issuers
for which the probability of default, estimated as of the sixth
business day immediately preceding the determination of the offering
price and over the horizon of 12 full calendar months from such day, 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 a distribution, as derived from a structural credit risk
model, is an appropriate substitute standard of creditworthiness in
place of the reference to credit ratings in the Investment Grade
Exception for Nonconvertible Securities.
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\173\ Regulation M Adopting Release, 62 FR 531.
\174\ Regulation M Adopting Release, 62 FR 527.
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The standard of creditworthiness, which was the basis of the
Investment Grade Exception for Nonconvertible Securities in Rule 102,
is still appropriate to use as the basis of an
[[Page 39976]]
exception to Rule 102 for Nonconvertible Securities.\175\ In addition,
the standard of creditworthiness used in the exception in Rule
101(c)(2)(i), as amended, is an appropriate standard of
creditworthiness to use in place of the reference to credit ratings in
the Investment Grade Exception in Rule 102 pursuant to the requirements
of section 939A(b). That standard, which is based on an issuer's
probability of default, is designed to 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 creditworthiness, as determined by the current financial
condition of the issuer. However, given that issuers and selling
security holders have the greatest interest in an offering's
outcome,\176\ regardless of the credit quality of the security,\177\ it
would not be appropriate for the exception to permit those parties to
make their own probability of default determinations (by their own or a
third party calculation) in order to meet the conditions of the
exception.
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\175\ See supra note 13 and accompanying text.
\176\ See Regulation M Adopting Release, 62 FR 530.
\177\ See Proposal, 87 FR 18323.
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Therefore, Rule 102(d)(2)(i), as amended, uses the same bright-line
test for excepting Nonconvertible Securities. For issuers, selling
security holders, and their affiliated purchasers to use the exception
in Rule 102(d)(2)(i), as amended, however, they must rely on the
probability of default determination made by the distribution
participant acting as the lead manager (or in a similar capacity) \178\
of the distribution and documented in writing pursuant to Rule
101(c)(2)(i), as amended. Rule 102(d)(2)(i), as amended, does not
permit reliance on the exception if issuers, selling security holders,
or their affiliated purchasers make the required probability of default
determinations themselves, or rely on a determination made by a non-
lead manager or any other third party. This condition to the exception
means that issuers, selling security holders, and their affiliated
purchasers would not be able to rely on the new Rule 102(d)(2)(i)
exception when selling securities directly, unless a lead manager is
involved in the distribution and had made (and documented) the
qualifying probability of default determination. This condition
provides for the continued availability of an exception under Rule 102
for creditworthy Nonconvertible Securities for broker-dealers who are
affiliated with an issuer but are not serving as an underwriter or
other participant in connection with the distribution. At the same
time, this condition is designed to prevent abuse of the exception by
issuers, selling security holders, and their affiliated purchasers by
taking into account that these market participants have the greatest
interest in an offering's outcome and generally do not have the same
market access needs as underwriters.\179\ In addition, the condition
regarding lead-manager probability of default determinations in new
Rule 102(d)(2)(i) is consistent with the condition regarding lead-
manager probability of default determinations in new Rule 101(c)(2)(i).
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\178\ See supra note 88.
\179\ See Regulation M Adopting Release, 62 FR 530.
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Even though probability of default determinations made by or
directly for issuers or selling security holders or affiliated
purchasers cannot be used in order for such parties to rely on the new
exception in Rule 102(d)(2)(i) for Nonconvertible Securities, these
parties would, however, be able to avail themselves of the exception in
reliance on a probability of default determination made by the
distribution participant acting as the lead manager (or in a similar
capacity) of the distribution pursuant to Rule 101(c)(2)(i), as
amended. Similar to how the lead or managing underwriter in a firm
commitment offering communicates certain pricing, allocation, and other
distribution-related information to the issuer or selling security
holder in connection with that particular distribution, the lead
managing underwriter's communications regarding its probability of
default determination may vary based on the parties and their prior
course of conduct as to the frequency and manner or mode of such
communication.
However, Rule 101(c)(2)(i), as amended, does not require that the
lead manager making the probability of default determination share the
determination with the issuer, selling security holders, or their
affiliated purchasers in order for those parties to rely on the
exception. Therefore, issuers, selling security holders, and their
affiliated purchasers will not be able to rely on the exception for
Nonconvertible Securities if the lead manager does not share the
probability of default determination or there is no distribution
participant to act as the lead manager for the distribution. With
regard to the types of distributions covered, as a result of the
condition related to lead-manager probability of default
determinations, the exception for Nonconvertible Securities is
available to a subset of distributions covered under the existing
Investment Grade Exception \180\ but more distributions than what was
covered under the Proposal given that the Proposal would have removed,
and not replaced, the Investment Grade Exception in Rule 102.\181\ The
estimated costs associated with the condition related to the lead
manager making the probability of default determination are included
below, in Part V.C.1.
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\180\ See, e.g., Proposal, 87 FR 18330. As discussed above, in
Part II.A.1, this may be the case in, for example, self-underwritten
offerings, at-the-market offerings, or other shelf offerings, to the
extent such an offering meets the definition of a ``distribution''
under Rule 100(b) of Regulation M. With regard to shelf offerings,
each takedown is to be individually examined to determine whether
such offering constitutes a ``distribution.'' Regulation M Adopting
Release, 62 FR 526. If, as a result of the amendments, the exception
for Nonconvertible Securities is no longer available in connection
with a distribution, and if no other exception is available, Rule
102's prohibitions would apply. Accordingly, an issuer and all of
its affiliated purchasers would be subject to the applicable
restricted period of Rule 102 when sales off a shelf by an issuer,
or by any affiliated purchaser, constitute a distribution of
securities. Similarly, when a selling security holder sells off the
shelf and such sales constitute a distribution, all other shelf
security holders who are affiliated purchasers of the selling
security holder would be subject to the applicable restricted period
of Rule 102. See Regulation M Adopting Release, 62 FR 531.
\181\ See Proposal, 87 FR 18333.
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As discussed below, in Part II.C, broker-dealers who rely on the
new exception in Rule 102(d)(2)(i) are required to preserve the written
probability of default determination made pursuant to Rule
101(c)(2)(i), as amended. This record preservation requirement could
help facilitate Commission examinations of broker-dealers who rely on
Rule 102(d)(2)(ii), as amended, and could deter their misuse of the
exception through relying on determinations that do not meet the
conditions of the exception or through relying on the exception when no
determination has been made.
2. Rule 102(d)(2)(ii): Asset-Backed Securities Offered Pursuant to an
Effective Shelf Registration Statement Filed on Form SF-3
The Commission is adopting in new Rule 102(d)(2)(ii) an exception
for asset-backed securities that are offered pursuant to an effective
shelf registration statement filed on Form SF-3. The Commission stated
in the Proposal that the incentive for issuers, selling shareholders,
and their affiliated purchasers to manipulate the market of a
distributed security exists regardless of the credit quality of the
security.\182\
[[Page 39977]]
While this incentive may exist, 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 that meet the Investment Grade
Exception \183\ and thus are less likely to be subject to the type of
manipulation that Regulation M seeks to address.
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\182\ See Proposal, 87 FR 18323.
\183\ See supra notes 153-161 and accompanying text.
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In addition, in contrast to how Nonconvertible Securities would be
excepted, whether an asset-backed security is rated investment grade is
an objective, observable fact, as is whether an asset-backed security
is offered pursuant to an effective shelf registration statement filed
on Form SF-3. Reliance on the new exception in Rule 102(d)(2)(i) does
not require issuers, selling security holders, or their affiliated
purchasers to make a calculation in determining whether the subject
asset-backed security meets the conditions of that exception (i.e.,
that the asset-backed security is offered pursuant to an effective
shelf registration statement filed on Form SF-3), in contrast to how
reliance on the new exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i)
for Nonconvertible Securities is conditioned on a calculation
determining whether the issuer's probability of default meets the
specified threshold. Because the Investment Grade Exception for asset-
backed securities does not focus on the potential interests of those
covered persons seeking to rely on the exception but rather the
particular qualities of the securities themselves (i.e., that the
asset-backed securities are appropriate to except from Regulation M
because they trade on the basis of their yield and creditworthiness,
traditionally measured by credit ratings, and are largely fungible),
the measure based on the Form SF-3 shelf eligibility requirements,
which similarly focuses on the particular qualities of the asset-backed
securities, is an appropriate substitute standard of creditworthiness
to replace the reference to credit ratings in the existing Investment
Grade Exception in accordance with section 939A(b)'s requirements,
without having to restrict or place any further conditions on who may
rely on the exception under Rule 102(d)(2)(ii), as amended.
The Commission stated that it determined to include the Investment
Grade Exception in Rule 102 based, in part, on the rationales indicated
for an identical exception to Rule 101.\184\ As discussed above, in
Part II.A.2, the Commission excepted investment grade asset-backed
securities from Rule 101 because such securities trade primarily on the
basis of yield and credit rating.\185\ When the Commission adopted the
Investment Grade Exception in Rule 101, it 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.\186\ The Commission also stated that the
Investment Grade Exception is for 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.'' \187\
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\184\ Regulation M Adopting Release, 62 FR 531.
\185\ See Regulation M Adopting Release, 62 FR 527.
\186\ See Regulation M Adopting Release, 62 FR 527.
\187\ See Regulation M Adopting Release, 62 FR 527 (citations
omitted).
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The standard in new Rule 102(d)(2)(i) that relies on the Form SF-3
eligibility requirements continues to be derived from the premise that
certain asset-backed securities are traded based on factors such as
their yield and creditworthiness.\188\ As discussed above, in Part
II.A.2, 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 that meet the Investment Grade Exception: with respect to
either set 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.\189\
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\188\ See Regulation M Adopting Release, 62 FR 527.
\189\ See supra note 149.
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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 asset-backed securities currently excepted under Rule 102's
Investment Grade Exception. Because the ability of issuers, selling
security holders, 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 creditworthiness,\190\ such a security is less susceptible
to the types of manipulation that Regulation M seeks to prevent. In
accordance with section 939A(b), it is appropriate to continue to
except in Rule 102(d)(2) asset-backed securities that trade on the
basis of their yield and creditworthiness.
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\190\ See Regulation M Adopting Release, 62 FR 527.
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For these reasons, the Commission is adopting in new Rule
102(d)(2)(ii) an exception for asset-backed securities that are offered
pursuant to an effective shelf registration statement filed on Form SF-
3. The new exception in Rule 102(d)(2)(i) may be relied upon by
issuers, selling security holders, and their affiliated purchasers if
all conditions of the exception are met.
C. Exchange Act Rule 17a-4(b)(17): Adding a Record Preservation
Requirement for Broker-Dealers in Connection With Probability of
Default Determinations
The Commission proposed a new record preservation \191\ requirement
that broker-dealers who are distribution participants or affiliated
purchasers must preserve 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 have required 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, those broker-
dealers 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.\192\
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\191\ In the Proposal, this requirement was described as a
``recordkeeping'' requirement. For clarity and consistency with the
title of Rule 17a-4 (``Records to be preserved by certain exchange
members, brokers, and dealers''), this requirement is referred to
throughout this release as a record preservation requirement.
\192\ Proposal, 87 FR 18324.
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One commenter stated that the proposed record preservation
requirement for certain broker-dealers is ``plainly appropriate as a
means of facilitating the Commission in its examination and oversight
of broker-dealers who rely on the exception in Rule 101 and would be
required to
[[Page 39978]]
conduct the new probability of default determination.'' \193\
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\193\ Better Markets Letter, at 4.
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Another commenter stated that the Commission should not adopt the
proposed record preservation requirement for broker-dealers relying on
new Rule 101(c)(2)(i)'s exception for Nonconvertible Securities because
``firms are already subject to extensive recordkeeping requirements
[and] should continue to have flexibility in determining the precise
nature and types of records they make and retain for such purpose, just
as they do for purposes of the various other exceptions to Rule 101 of
Regulation M.'' \194\
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\194\ SIFMA Letter 1, at 12; see also SIFMA Letter 2, at 2.
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However, unlike the other securities-based exceptions in Rule 101,
which apply to ``actively-traded securities,'' \195\ ``exempted
securities,'' \196\ and ``face-amount certificates or securities issued
by an open-end management investment company or unit investment
trust,'' \197\ and which are based on standards that rely on the use of
publicly available information that can be verified, this exception is
subject to the specific requirements in section 939A(b) to use
``standards of credit-worthiness.'' As discussed above, in Parts II.A.1
and B.1, the probability of default, as derived from structural credit
risk models, is an appropriate substitute standard of creditworthiness
to replace the reference to credit ratings in the existing Investment
Grade Exceptions in accordance with section 939A(b)'s requirements. 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.\198\ As discussed below, in Part V.A.2,
creditworthiness is an appropriate standard to reflect manipulation
risk because securities issued by firms with sound creditworthiness
trade primarily on yield and creditworthiness (traditionally measured
by credit ratings) and have low pricing uncertainty and manipulation
risk. Reliance on the new exception in Rule 101(c)(2)(i) or Rule
102(d)(2)(i) for issuers of Nonconvertible Securities is conditioned on
the use of a written probability of default calculation that has been
determined and documented, in writing, by the distribution participant
acting as the lead manager. This exception is in contrast to the other
Regulation M exceptions that require the use of publicly available
information that can be verified. Accordingly, requiring a record of
the written probability of default determination to be preserved will
help facilitate the Commission's examinations of broker-dealers relying
on the new exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i). The
record preservation requirement, therefore, is appropriate to help
deter improper adjusting of the estimation to meet the conditions of
either of the exceptions. Further, because 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 requirement associated with reliance on new
Rule 101(c)(2)(i) to preserve written probability of default
determinations is designed to facilitate the Commission's examinations
of broker-dealers.
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\195\ 17 CFR 242.101(c)(1).
\196\ 17 CFR 242.101(c)(3).
\197\ 17 CFR 242.101(c)(4).
\198\ See infra Part V.C.3; see also Proposal, 87 FR 18334.
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Another commenter stated that the Commission could publish, or
require publication of, point estimates at a particular time and as
rolling averages of default probabilities during a specified period,
default probability estimates that market participants derive from
various models, along with default probabilities implied by both market
prices and credit default swap spreads (to the extent those are traded
for a particular issuance).\199\ While access to such information could
be informative for certain market participants and investors, the
record preservation requirement set forth in new Rule 17a-4(b)(17), as
stated in the Proposal, was designed to aid the Commission in its
examinations of broker-dealers relying on the exception in Rule
101(c)(2)(i), as amended, by requiring such broker-dealers to retain
the written probability of default determination supporting their
reliance on the exception.\200\ As such, a requirement for these
entities to publish the information from the commenter's suggestion
would not serve this purpose because such a requirement may not
necessarily involve the type of information needed to meet the
conditions new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i) \201\ and,
therefore, would not facilitate the Commission's examinations of
broker-dealers relying on those exceptions. In addition, the cost
burden of doing so on a regular basis could be disproportionate to the
infrequent usage of the exception, as these entities could incur other
burdens associated with disclosing such information.\202\ Accordingly,
it could discourage some entities from participating in certain issues,
which could increase the costs of the affected issues.\203\ Similarly,
for the Commission to publish this information, such that parties could
rely on the information, would also not be appropriate because this
approach would not facilitate its examinations of broker-dealers
relying on the exception.
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\199\ IILF Letter, at 8.
\200\ Proposal, 87 FR 18324.
\201\ See, e.g., 17 CFR 242.101(c)(2)(i), as amended,
242.102(d)(2)(i), as amended. Both of the new exceptions for
Nonconvertible Securities in Rules 101 and 102 require that the
issuer's probability of default be documented and determined, in
writing, without necessarily requiring the other information
included in the commenter's suggestion.
\202\ See Proposal, 87 FR 18329; infra Part V.A.2.
\203\ See, e.g., infra Part V.C.
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After reviewing the comments, the Commission is adopting Rule 17a-
4(b) under the Exchange Act largely as proposed, by adding new
paragraph (17), which requires broker-dealers to preserve the written
probability of default determination, relied upon pursuant to the new
exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i), as applicable. As
discussed above in Part II.B.1, the new exception in Rule 102(d)(2)(i)
was not originally proposed. However, proposed Rule 17a-4(b)(17) was
intended to capture ``broker-dealers relying on the exception for
Nonconvertible Securities'' \204\ and, therefore, the Commission
believes it is appropriate to apply it to both exceptions for
Nonconvertible Securities that are being adopted. Moreover, broker-
dealers relying on either exception should be in a position to comply
with the requirements of new Rule 17a-4(b)(17) because both exceptions
require that the lead manager of a distribution make and document in
writing the probability of default determination pursuant to Rule
101(c)(2)(i), as amended.\205\ Accordingly, the final rule adds ``or
Sec. 242.102(d)(2)(i) . . . or Rule 102 . . . as applicable'' in light
of the addition of the new exception for Nonconvertible Securities in
Rule 102(d)(2)(i) and that broker-dealers may be relying on the new
exception either in Rule 101(c)(2)(i) or in Rule 102(d)(2)(i),
depending on whether they are a covered person under Rule 101 or Rule
102. In addition, the final rule adds the text ``, relied upon by such
broker-dealer,'' to clarify that the written probability of default
determination must be preserved in connection with a broker-dealer's
[[Page 39979]]
reliance on the new exception in Rule 101(c)(2)(i) or in Rule
102(d)(2)(i), as applicable.
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\204\ Proposal, 87 FR 18324.
\205\ New Rule 17a-4(b)(17) requires broker-dealers to preserve
the written probability of default determination, relied upon by
such broker-dealer, pursuant to Sec. 242.101(c)(2)(i) or Sec.
242.102(d)(2)(i) (Rule 101 or Rule 102 of Regulation M), as
applicable.
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New paragraph (b)(17) of Rule 17a-4 would affect the existing
practices of broker-dealers by imposing new record preservation
requirements when relying on the exception in new Rule 101(c)(2)(i) or
new Rule 102(d)(2)(i). A broker-dealer who is a distribution
participant acting as the lead manager (or in a similar capacity) of a
distribution and uses a vendor to determine the probability of default
could satisfy this record preservation 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. Such a broker-dealer calculating the probability of
default on its own could satisfy the record preservation 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,
namely those that rely on the written probability of default
determination of another broker-dealer acting as the lead manager (or
in a similar capacity), could satisfy the record preservation
requirement by maintaining a copy of the documentation described above,
or by retaining a written notice it received of the probability of
default determination.
The requirement to preserve, pursuant to Rule 17a-4(b), the written
probability of default determination is consistent with other record
retention obligations that Exchange Act rules impose on broker-
dealers.\206\ Exchange members and broker-dealers currently are
required to comply with the three-year preservation period in Rule 17a-
4(b) for other records and should have in place procedures to satisfy
such preservation requirements.\207\
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\206\ See Proposal, 87 FR 18325.
\207\ 17 CFR 240.17a-4(b).
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III. Other Issues
Certain commenters urged the Commission to take additional or
different regulatory and non-regulatory actions than the approaches
that were proposed, including actions that the Commission did not
propose. These suggestions covered a variety of areas, including use of
the term ``investors,'' \208\ SEC enforcement actions,\209\ other
provisions of Regulation M,\210\ insurance company ratings,\211\
individual securities,\212\ credit ratings industry reforms,\213\
agency operations,\214\ and nondisclosures.\215\ These issues are
outside the scope of the Proposal and that the final amendments to
Rules 100(b), 101(c)(2), 102(d)(2), and 17a-4(b) appropriately further
the Commission's objectives of promoting investor protection, enhancing
market efficiency, and facilitating capital formation by implementing
the requirements of section 939A(b) of the Dodd-Frank Act and
facilitating the Commission during examinations of broker-dealers.
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\208\ Letter from Brian (Mar. 25, 2022).
\209\ Letter from Patrick Lawson (Mar. 26, 2022).
\210\ SIFMA Letter 2, at 4-5.
\211\ Letter from Jason Wallace (May 19, 2022).
\212\ See, e.g., Letter from Anthony Frattin (May 19, 2022);
Kern Letter; Wang Letter; Ferguson Letter; Navari Letter.
\213\ See Better Markets Letter, at 2.
\214\ See Letter from Senator Thom Tillis to Vanessa Countryman,
Sec'y, SEC (Nov. 4, 2022).
\215\ Letter from The Delois Albert Brassell Estate and the
Robert James Brassell Estate (June 1, 2022).
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IV. Other Matters
If any of the provisions of these rules, or the application thereof
to any person or circumstance, is held to be invalid, such invalidity
shall not affect other provisions or application of such provisions to
other persons or circumstances that can be given effect without the
invalid provision or application.
Pursuant to the Congressional Review Act,\216\ the Office of
Information and Regulatory Affairs has designated these rules as not a
``major'' rule as defined by 5 U.S.C. 804(2).
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\216\ 5 U.S.C. 801 et seq.
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V. 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 \217\ 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. Additionally,
section 23(a)(2) of the Exchange Act \218\ 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.
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\217\ 15 U.S.C. 78c(f).
\218\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
The analysis below addresses the likely economic effects of the
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
impracticable 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 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 Securities and asset-
backed securities (collectively ``fixed-income securities'') \219\
distribution and other 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 nationally
recognized statistical rating organizations (``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 ten credit rating agencies
registered with the Commission as
[[Page 39980]]
NRSROs.\220\ Three large NRSROs (S&P Global Ratings, Moody's Investors
Service, Inc., and Fitch Ratings, Inc.) have historically accounted for
most of the market share in this market. As of December 31, 2021, these
three market participants accounted for 94.4% of all of the NRSRO
credit ratings outstanding.\221\
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\219\ The term ``fixed-income securities'' in the Economic
Analysis section refers to nonconvertible debt securities,
nonconvertible preferred securities, and asset-backed securities.
\220\ See Current NRSROs, U.S. Sec. & Exch. Comm'n, available at
<a href="https://www.sec.gov/about/divisions-offices/office-credit-ratings/current-nrsros">https://www.sec.gov/about/divisions-offices/office-credit-ratings/current-nrsros</a>.
\221\ See Staff Report on Nationally Recognized Statistical
Rating Organizations (Feb. 2023) at 23, available at <a href="https://www.sec.gov/files/2023-ocr-staff-report.pdf">https://www.sec.gov/files/2023-ocr-staff-report.pdf</a>.
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The affected securities are nonconvertible debt, nonconvertible
preferred, and asset-backed securities. In 2021, there were 33,798
issues of nonconvertible debt securities,\222\ with 687 issuers and 301
agents involved (266 reported as participating underwriters, of which
201 were the lead underwriters; 39--as trustees, and 10--as fiscal
agents).\223\ Additionally, in 2021, there were 114 filed prospectuses
for public offerings of asset-backed securities.\224\
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\222\ The nonconvertible debt securities also include preferred
securities.
\223\ The statistics are based on the data from Mergent. Some
agents were reported as performing two or more functions, for
example as an underwriter and as a lead underwriter.
\224\ The information is based on EDGAR data for public
offerings of asset-backed securities. It should be noted that
prospectuses may contain multiple tranches, including non-offered
tranches excluded from the public offering of asset-backed
securities.
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2. The Investment Grade Exception
Regulation M is designed to prevent manipulative activities that
could artificially influence the demand and pricing of covered
securities.\225\ In particular, Rules 101 and 102 of Regulation M
prohibit distribution and certain other market participants from
bidding for or purchasing a covered security, in connection with a
distribution of securities unless an exception, such as the Investment
Grade Exception, applies.\226\ At the time the exception was included,
the investment grade securities, that is securities characterized by
sound creditworthiness, as measured by credit rating, were considered
to be traded primarily on yield and credit ratings, and to be largely
fungible.\227\ Therefore, sound creditworthiness was considered to be a
good proxy for low manipulation risk. Investment Grade 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. For purposes of these amendments sound
creditworthiness is a good proxy for low manipulation risk since
securities issued by firms with sound creditworthiness trade primarily
on yield and creditworthiness (traditionally measured by credit
ratings).\228\ Further, none of the commenters on the Proposal raised
concern that creditworthiness would not be an adequate proxy for
manipulation risk.
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\225\ See supra Part I.
\226\ See 17 CFR 242.101(a), 242.102(a); see, e.g., 17 CFR
242.101(c)(2), 242.102(d)(2).
\227\ See Regulation M Adopting Release, 62 FR 527.
\228\ There are other metrics that could serve as a proxy for
manipulation risk in Rules 101 and 102, such as security public
float or visibility to other market participants. One commenter for
instance proposed Form S-3 and F-3 standard and a WKSI-based
standard to measure manipulation risk (SIFMA Letter 1). However,
unlike measures of creditworthiness, such criteria fail to capture
the pricing point where the security is trading solely based on its
yield and maturity and thus has low pricing uncertainty and low
manipulation risk. Therefore, measures of creditworthiness are a
better proxy for manipulation risk.
---------------------------------------------------------------------------
The application of the Investment Grade Exception to Rules 101 and
102 is primarily limited to two cases: re-openings (an offering of an
additional principal amount of securities that are identical to the
securities already outstanding, for example, when an issuer wishes to
make a series of offerings via a re-opening to match its funding needs
or when some foreign sovereign issuers conduct a re-opening for public
finance purposes \229\) 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, for example, when an investor failed to
honor a previously expressed indication of interest; also, as stated in
the Proposal, another example a commenter provided is in a best-efforts
offering \230\).\231\ Re-openings are used infrequently and constitute
about 0.3% of the relevant securities' markets' issuance volume.\232\
Sticky offerings are not identified in the relevant databases, making
it difficult to assess their relative magnitude.
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\229\ See Proposal, 87 FR 18316. Note, however, that not every
foreign sovereign issue is conducted in the form of re-opening.
\230\ See Proposal, 87 FR 18316. In a `best-effort' 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)]. Note,
however, that not every best-effort offering will become sticky,
where the underwriter is unable to sell all of the securities in the
distribution.
\231\ See Proposal, 87 FR 18329. Note that the Commission
received no comments on the types of issues that typically rely on
the exception.
\232\ The estimate is obtained using Mergent data for relevant
securities during 2021.
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Re-openings 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 re-opening 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.\233\
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\233\ See Letter from Kenneth E. Bensten, Jr., Executive Vice
President, Public Policy and Advocacy, SIFMA to Elizabeth M. Murphy,
Secretary (July 5, 2011) at 6; John Berkery & Remmelt Reigersman,
Re-openings: Issuing Additional Debt Securities of an Outstanding
Series, Mayer Brown 1-2 (2020), available at <a href="https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/05/reopenings_-issuing-additional-debt-securities-of-an-outstanding-series.pdf">https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/05/reopenings_-issuing-additional-debt-securities-of-an-outstanding-series.pdf</a>. See also Proposal, 87 FR 18329.
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As discussed above, sticky offerings typically result when a large
investor fails to fulfill its expressed purchase interest in the issue,
which could be due to a negative factor that transpired about the issue
or issuer.\234\ Any offering of the relevant security thus can become a
sticky offering. 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 in some cases to a heightened risk of manipulation in
connection with a distribution of securities even if the security is
rated as investment grade.\235\
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\234\ See Proposal, 87 FR 18329.
\235\ We note, however, that not all sticky offerings are issued
by an issuer with a low creditworthiness and have a high
manipulation risk. It is thus important to have a standard of
creditworthiness that is able to capture most recent available
information on issuer creditworthiness, such as probability of
default, and account for the cases of possible sudden declines in
creditworthiness.
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Rule 102 provides that, in connection with a distribution of
securities effected by or on behalf of an issuer or selling security
holder, it shall be unlawful for such person, or any affiliated
purchaser of such person, directly or indirectly, to bid for, purchase,
or attempt to induce any person to bid for or purchase, a covered
security during the applicable restricted period.\236\ 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. However, as pointed out by one of the commenters, their
affiliated broker-dealers, which do not serve as an underwriter, may
seek to rely on Rule 102 exception.\237\
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\236\ See supra Part I for a relevant discussion.
\237\ SIFMA Letter 1, at 12-13.
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[[Page 39981]]
The Investment Grade Exception was included in Regulation M as it
was considered a good proxy for the likelihood of manipulation
risk.\238\ However, the reference to credit ratings in the Commission's
rules may encourage investors to place undue reliance on the credit
ratings. Credit ratings themselves are potentially imprecise and often
lagging indicators of creditworthiness.\239\
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\238\ See supra Part I.
\239\ We note that the SEC staff took a similar position in the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC Staff
(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 <a href="https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15">https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15</a>.
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B. Benefits of the Amendments
As mentioned above, section 939A(b) 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 creditworthiness as the Commission determines to be appropriate.''
\240\ In this amendment, the Commission will require distribution
participants, issuers, selling security holders and affiliated
purchasers, in order to avail themselves of these exceptions from
Regulation M, to rely upon the structural credit risk models as a
measure of creditworthiness.\241\ These models have been used to
estimate the probability of default of an issuer.\242\
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\240\ 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)].
\241\ See, e.g., 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.
\242\ 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 <a href="https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/credit-analysis-models">https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/credit-analysis-models</a>. One commenter, however, suggested that ``most of
our member firms do not use them [the credit risk models] for other
purposes either, to the extent such models are used at all, they
serve merely as a supplement to member firms' own proprietary credit
analysis as part of their decision making on whether to extend a
loan or other credit.'' (SIFMA Letter 1 at 5). See also Part II.A.1
for a relevant discussion.
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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 trading 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.\243\ 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.
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\243\ 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 <a href="https://onlinelibrary.wiley.com/doi/10.1111/j.0391-5026.2004.00129.x">https://onlinelibrary.wiley.com/doi/10.1111/j.0391-5026.2004.00129.x</a>.
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For purposes of these amendments, the probability of default
derived from the structural credit risk models is an appropriate proxy
for creditworthiness. As discussed previously in Part V.A.2,
creditworthiness is an appropriate standard to reflect manipulation
risk since securities issued by firms with sound creditworthiness trade
primarily on yield and creditworthiness (traditionally measured by
credit ratings) and have low pricing uncertainty and manipulation risk.
The Commission received several comments supporting the probability of
default as a standard for Rules 101 and 102 exception.\244\ However,
one commenter opposed this option and suggested a standard based on
Forms S-3 and F-3 or on WKSI standard.\245\ However, these alternatives
are not good measures of sound creditworthiness as compared to
probability of default because they fail to reflect the pricing point
where a security is traded solely on its yield and maturity. Thus, the
probability of default based on structural credit risk models is a more
appropriate proxy for creditworthiness, and thereby for manipulation
risk.
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\244\ See, e.g., IILF Letter, Bloomberg L.P. Letter, and Better
Markets Letter.
\245\ See SIFMA Letters 1 and 2 and the relevant discussion in
Part II.A.1.
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Consistent with the Proposal, the Commission is adopting a 0.055%
probability of default threshold. The Commission requested and received
comments on this proposed threshold level. Specifically, one commenter
expressed support of the proposed threshold and also noted that at any
given date, the composition and population of any selected sample
meeting the threshold could change; \246\ as such some variation of the
estimated percentages of the captured universe of securities eligible
for the existing Investment Grade Exception is to be expected. Another
commenter expressed that the threshold should be increased to 0.5%
because it believes the exceptions as amended should be crafted to
capture as many of the securities covered under the existing investment
grade exceptions as possible; this commenter did not address the
corresponding increase in the percentage of currently ineligible
securities or the costs of that increase.\247\ No other commenters
suggested a different or lower threshold and, overall, the commenters
did not identify any economic effects of the proposed threshold level
that were not considered in the Proposal.
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\246\ See Bloomberg L.P. Letter, at 2.
\247\ See SIFMA Letter, at 10.
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The Commission acknowledges that the percentage of investment grade
securities that would be captured under a specific threshold fluctuates
over time and as conditions change that affects the various inputs into
the models. As of March 2023, the 0.055% probability of default
threshold captured
[[Page 39982]]
approximately 76% of the investment grade securities in the final
sample of nonconvertible Fixed-Income Securities used (1996 distinct
investment grade issues with probability of default below 0.055% out of
2637 total investment grade rated issues in the sample).\248\ This
threshold also captured approximately 24% of non-investment grade
issues (64 out of 269 non-investment grade issues in the sample).
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\248\ The investment grade status for nonconvertible securities
issued between 2018 and 2023 was obtained from Mergent (as of the
last available Mergent update through Mar. 2023) while the
probability of default estimates were obtained for a cross-section
of securities available in Bloomberg (as of Mar. 28, 2023). Please
refer to Mario Bondioli, Martin Goldberg, Nan Hu, Chengrui Li, Olfa
Maalaoui Chun, & Harvey J. Stein, The Bloomberg Corporate Default
Risk Model (DRSK) for Public Firms (working paper Aug. 28, 2021),
available at <a href="https://ssrn.com/abstract=3911300">https://ssrn.com/abstract=3911300</a> (retrieved from SSRN
Elsevier database), for methodology description of Bloomberg
probability of default measure.
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This estimation differs from that in the Proposal. In the Proposal,
we observed, using data from October 2021, that the 0.055% threshold
captured about 90% of investment grade securities (2436 out of 2710
issues) and about 37% of non-investment grade issues (125 of 341 non-
investment grade issues).\249\ Overall, at the time of the analysis of
data as of March 2023, 2060 issues met the proposed exception as
compared with the 2637 issues under the current exception.
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\249\ See Proposal, 87 FR 18330.
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Given the reaction of commenters to the proposed 0.055% threshold
\250\ and that there is an unavoidable trade-off between capturing
securities that are ineligible for the existing Investment Grade
Exception and leaving out some securities that are currently eligible,
the proposed threshold is intended to strike a reasonable balance
between these two statistical realities over time.\251\
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\250\ As discussed above, one commenter expressed general
support of the proposed 0.055% threshold (see Bloomberg L.P. Letter,
at 2) while another commenter suggested increasing the level to 0.5%
(See SIFMA Letter 1, at 10).
\251\ As pointed out by one commenter, some variation of the
estimates is unavoidable, and ``this highlights the importance of
selecting an objective, data driven model that is consistently
applied over time and documented by the distribution participant.''
See Bloomberg Letter, at 2.
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Nonconvertible debt securities and nonconvertible preferred
securities of issuers for which the probability of default, estimated
as of the sixth business day immediately preceding the determination of
the offering price and over the horizon of 12 full calendar months from
such day, 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 a distribution, as derived from a structural
credit risk model are to be excepted from Rules 101 and 102.
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 based on the recent
trading activity, and hence incorporate more 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.\252\
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\252\ We note that the SEC staff took a similar position in the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC Staff
(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 <a href="https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15">https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15</a>. 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 <a href="https://www.federalreserve.gov/pubs/feds/2008/200855/200855pap.pdf">https://www.federalreserve.gov/pubs/feds/2008/200855/200855pap.pdf</a>; Moody's
Analytics, EDF Overview (2011) (outlining the approach by Moody's
KMV), available at <a href="https://www.moodysanalytics.com/-/media/products/EDF-Expected-Default-Frequency-Overview.pdf">https://www.moodysanalytics.com/-/media/products/EDF-Expected-Default-Frequency-Overview.pdf</a>; Giuseppe Montesi &
Giovanni Papiro, Risk Analysis Probability of Default: A Stochastic
Simulation Model, 10 J. Credit Risk 29 (2014).
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The Proposal did not limit which distribution participants are
allowed to produce probability of default estimations for the purposes
of the exception. In order to ensure consistency and reliability of the
estimates within any particular distribution and reduce the potential
subjectivity and non-uniformity of the estimates the amendments specify
that only lead managers are responsible for estimating the probability
of default for a given distribution.\253\ Lead managers would have
flexibility of either calculating the probability of default internally
using structural credit risk models, given the wide availability of
software products available on the market that perform such
calculations, or obtaining an estimate from a vendor. One of the
benefits of the amendment is that the lead managers will have the
flexibility of selecting the model they find most appropriate to assess
the creditworthiness of issuers for the purposes of using the
exception.\254\ This means the lead managers will not have to rely on a
credit rating for the issue in order to determine its eligibility for
Rules 101 and 102 exception and will no longer have to rely on an
NRSRO's choice of the model for such purposes.\255\ Furthermore,
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.\256\
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\253\ Some of the costs associated with this option are
discussed in the Costs Section of the Economic Analysis.
\254\ However, this will not be the case for other distribution
participants who are not considered the lead manager of the
distribution, which may deter such participants from relying on the
exception. Further, this may result in lead managers' selecting a
model that allows them to rely on the exception but is not
necessarily the best model of the securities' creditworthiness and
manipulation risk. These issues are discussed in more detail in
infra Part V.C.
\255\ Even though the lead manager would have to use a
structural credit risk model, there are many versions of such models
available, and the specific model parameters can be selected as
well, providing considerable flexibility of the estimates as
compared to the specific choices used in the assessments by NRSROs.
\256\ Vendors offer a number of commercial applications based on
structural credit risk models. The probability of default calculated
by structural credit risk models, such as the Merton (1974) Model
and the Successor Models, can also be calculated by lead managers
without the use of a vendor. One commenter, however, suggested that
currently firms seldom use probability of default models in
connection with issuances of the relevant securities. See SIFMA
Letter 1 at 5.
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Removing and replacing the references to credit ratings from Rules
101 and 102 of Regulation M may also have a benefit of expanding the
number of options available to lead managers compared to what they
would have under the requirements of the Investment Grade Exception.
Specifically, the exceptions' 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 creditworthiness 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 lead managers 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 final rule amendments, the structural credit risk models
cannot be applied to asset-backed securities due to
[[Page 39983]]
the complexity of the structure of such instruments.\257\ Even though
one commenter suggested that probability of default can be estimated
for asset-backed securities \258\ such estimation based on structural
credit risk models is not routinely used due to the complexity of the
structure of these securities and the corresponding complex application
of such models. Further, another commenter supported proposed Form SF-3
standard for the Investment Grade Exception with respect to asset-
backed securities.\259\ The final amendments provide that securities
that are offered pursuant to an effective shelf registration statement
filed on Form SF-3 should also be excepted from Rules 101 and 102. The
Form SF-3 shelf eligibility requirements provide objective criteria
that can also ensure that the securities are consistent with the
Commission's original basis for the Investment Grade Exceptions. Asset-
backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3 are less at risk of the
manipulation that Regulation M addresses. Specifically, the Form SF-3
shelf eligibility requirements limit the number of nonperforming assets
in the asset-backed security pool, require review of the pool assets if
certain conditions are met, and require certification by the chief
executive officer, among other things.
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\257\ See a relevant discussion in supra Part II.B.2.
\258\ See IILF Letter, at 6.
\259\ SIFMA Letter 1, at 11.
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As the Commission noted when adopting Form SF-3, the Form
incentivizes sponsors to carefully review and disclose the underlying
assets' characteristics, reducing the overall uncertainty about the
asset-backed security \260\ and, with respect to these final
amendments, the risk of manipulation. The Commission received no
comments that suggest otherwise. 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 in Rule
101(c)(2).\261\ A review of recent EDGAR database filings confirms that
almost all asset-backed securities issued pursuant to an effective
shelf registration statement filed on Form SF-3 have investment grade
ratings.\262\
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\260\ See supra notes 121-125 and accompanying text.
\261\ One commenter opposed use of SF-3 standard for asset-
backed securities and suggested relying on the probability of
default instead (IILF Letter, at 7). However, probability of default
calculations based on a structural credit risk model are complex for
this type of securities due to their complex structure and are not
routinely used. Another commenter in fact expressed support of using
SF-3 standard for asset-backed securities (SIFMA Letter 1
[…truncated; see source link]Indexed from Federal Register on June 20, 2023.
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