Introduction

In response to the subprime mortgage crisis, on June 16, 2008 the Securities and Exchange Commission (the "SEC") proposed amendments to its rules governing nationally recognized statistical rating organizations ("Rating Agencies"). In three companion releases issued on July 1, 2008, the SEC proposed amendments to rules and forms that rely on credit ratings issued by Rating Agencies. In the first of the three releases, the SEC has proposed to remove references to Rating Agencies in the following rules and forms: Rule 3a1-1, Rule 10b-10, Rule 15c3-1, and Rule 15c3-3 of the Securities Exchange Act of 1934 ("Exchange Act"); Rules 101 and 102 of Regulation M; Regulation ATS; Form ATS-R; Form PILOT; and Form X-17A-5, Part IIB. The SEC believes that the proposal will reduce undue reliance on Rating Agencies and, therefore, improve the analysis that underlies investment decisions.

Proposed Amendments to Rule 3a1-1

Under Rule 3a1-1(b), the SEC may require an alternative trading system ("ATS") to register as a national securities exchange if, during three of the preceding four calendar quarters, the trading system had: (1) 50% or more of the average daily dollar trading volume in any security and 5% or more of the average daily dollar trading volume in any class of securities; or (2) 40% or more of the average daily dollar volume in any class of securities. Currently, an ATS may be required to register if the trading in any of eight classes of securities, including investment grade corporate debt securities and noninvestment grade corporate debt securities, surpass the volume thresholds.

The SEC has proposed to eliminate the distinction between investment grade and noninvestment grade securities when determining the trading volume. Under the proposal, all corporate debt securities would fall into a single class for assessing whether an ATS should register as an exchange. "Corporate debt security" would be defined, in revised Rule 3a1-1(b)(3)(v), as any security that: (1) evidences a liability of the issuer of such security; (2) has a fixed maturity date that is at least one year following the date of issuance; and (3) is not an exempted security, as defined in Section 3(a)(12) of the Exchange Act. The SEC believes that exceeding a volume threshold for a combined class of all corporate debt securities would be a sufficient indication that an ATS should be required to register as an exchange.

Proposed Amendments to Regulation ATS, Form ATS-R, and Form PILOT

The SEC has proposed similar changes to Rules 301(b)(5) and 301(b)(6) of Regulation ATS,1 Form ATS-R,2 and Form PILOT3 by eliminating the distinction between investment grade and noninvestment grade securities. Instead, the rules and forms would refer to a single class of corporate debt securities, which would be defined as in proposed Rule 3a1-1 above. Specifically,

  • revised Rule 301(b)(5)(i)(D) would require an ATS to comply with a fair access requirement4 if, with respect to corporate debt securities, the trading system accounts for 5% or more of the average daily volume traded in the United States for the requisite number of months;

  • revised Rule 301(b)(6)(i)(D) would require an ATS to comply with standards regarding the capacity, integrity, and security of its automated systems if, with respect to corporate debt securities, the ATS accounts for 20% or more of the average daily volume traded in the United States for the requisite number of months;

  • revised Form ATS-R would require an ATS to report the total unit volume and the total dollar volume of corporate debt securities on a quarterly basis; and

  • revised Form PILOT would require a trading system to report, on a quarterly basis, trading activity for the combined class of corporate debt securities.

Proposed Amendments to Rule 10b-10

Currently, paragraph (a)(8) of Rule 10b-10 requires that broker-dealers provide a transaction confirmation for a nongovernmental debt security which states if the security is unrated by a Rating Agency. However, this may have suggested that an unrated security is inherently riskier than a rated security, which was not the SEC's intent. Therefore, the SEC has proposed to delete paragraph (a)(8) and, as a result, broker-dealers would no longer be required, but may voluntarily, inform customers if a debt security is unrated.

Proposed Amendments to Rule 15c3-1

Under Rule 15c3-1 (the "Net Capital Rule"), broker-dealers are required to maintain a minimum amount of net capital. In computing net capital, broker-dealers must deduct a certain percentage ("haircut") of the market value of their proprietary securities. If a broker-dealer holds securities that a Rating Agency has rated as investment grade, the SEC applies a lower haircut because investment grade securities are more liquid and less volatile than securities that are not as highly rated.

The SEC has proposed to remove, with limited exceptions, references to Rating Agencies from the Net Capital Rule. Since broker-dealers are sophisticated and regulated entities, the SEC believes that they do not need to rely exclusively on credit ratings to assess the creditworthiness of securities. The SEC has proposed two new subjective standards to replace the current Rating Agency standard.

  • For the purposes of determining the haircut on commercial paper, the SEC has proposed to replace the current Rating Agency standard5 with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately.

  • For the purposes of determining haircuts on nonconvertible debt securities or preferred stock, the SEC has proposed to replace the current Rating Agency standard6 with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.

The SEC believes that the new standards will achieve the same purpose as the Rating Agency standard, a computation of net capital that reflects market risk. Under the proposal, a broker-dealer would have to be able to explain how the securities it uses for net capital purposes meet the standards set forth in the proposed amendments. However, a broker-dealer could refer to credit ratings as one means of compliance.

The SEC has also proposed to remove references to credit ratings from Appendices E and F of the Net Capital Rule. Currently, under both Appendices E and F, a dealer may elect to determine counterparty risk either based on credit ratings or by requesting SEC approval to use internal calculations. The SEC has proposed to delete the provisions of Appendices E and F that permit dealers to determine counterparty risk based on credit ratings and, as a result, dealers would be required to request SEC approval to use internal calculations to determine counterparty risk.

Finally, the SEC has proposed to make conforming changes to Appendix G of the Net Capital Rule and the General Instructions to Form X-17A-5, Part IIB, removing references to the provisions of Appendices E and F that the SEC has proposed to delete.

Proposed Amendments to Rule 15c3-3

Note G to Exhibit A of Rule 15c3-3 provides the formula for determining a broker-dealer's reserve requirement. Currently, Note G allows a broker-dealer to include, as a debit in the formula, the amount of customer margin related to security futures products that are posted to a registered clearing or derivatives organization that maintains the highest investment grade rating from a Rating Agency. The SEC has proposed to amend Rule 15c3-3 to allow a broker-dealer to debit the amount of customer margin related to securities futures products that are posted to a registered clearing or derivatives organization that has the highest capacity to meet its financial obligations and is subject to no greater than minimal credit risk. The SEC believes that the new standard will achieve the same purpose that the credit ratings standard was designed to advance, an assurance of the long-term financial strength and creditworthiness of the clearing or derivatives organization. The SEC believes that broker-dealers, as sophisticated and regulated entities, can make assurances about financial strength and creditworthiness without reliance on Rating Agencies. Although the broker-dealer would have to be able to explain how the registered derivatives or clearing organization meets the standard in the proposed amendment, it could refer to credit ratings as one means of compliance.

Proposed Amendments to Rules 101 and 102 of Regulation M

Currently, Rules 101 and 102 of Regulation M prohibit issuers, selling security holders, underwriters, brokers, dealers, other distribution participants, and any of their affiliated purchasers from directly or indirectly bidding for, purchasing, or attempting to induce another person to bid for or purchase a covered security7 during an applicable period. Both rules currently exempt nonconvertible debt securities, nonconvertible referred securities, and asset-backed securities if at least one Rating Agency has rated the securities as investment grade. The SEC has proposed two new exceptions to replace the current exceptions for investment grade securities.

First, under proposed Rules 101(c)(2)(i) and 102(d)(2)(i), nonconvertible debt and nonconvertible preferred securities would be exempt from Rules 101 and 102 if the issuer of the securities meets the requirements of a well-known seasoned issuer ("WKSI") and the requirements for nonconvertible securities other than common equity in Rule 405 of the Securities Act of 1933 (the "Securities Act"). Therefore, the issuer would be required to 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.

Second, under proposed Rules 101(c)(2)(ii) and 102(d)(2)(ii), asset-backed securities would be exempt from Rules 101 and 102 if the offer and sale of the security are registered using Form S-3.

Questions

Any person who has a question regarding the issues raised in this Corporate and Securities Update may obtain additional guidance from a member of our Public Companies Group.

  1. Regulation ATS establishes requirements for trading systems that choose to comply with Regulation ATS by registering as broker-dealers in lieu of an exchange registration.

  2. Form ATS-R is used by ATSs to report their activities on a quarterly basis.

  3. Form Pilot is a report filed by a self-regulatory organization which operates a pilot trading system.

  4. Under the fair access requirement, an ATS that exceeds certain trading volume thresholds must establish written standards for granting access to trading on its system, and the ATS cannot unreasonably limit any person from accessing the services that the ATS offers.

  5. Currently, the broker-dealer must hold an instrument that at least two Rating Agencies have rated in one of the top three highest rating categories.

  6. Currently, the broker-dealer must hold an instrument that at least two Rating Agencies have rated in one of the four highest ratings categories.

  7. 17 C.F.R. 242.100 defines a "covered security" as "any security that is the subject of a distribution or any reference security."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.