United States: SEC Proposes To Remove Credit Ratings References From Regulation M

On March 23, 2022, the US Securities and Exchange Commission (the "SEC") proposed amendments to remove  references to credit ratings from Regulation M, replace them with alternative measures of creditworthiness and  impose related recordkeeping obligations on broker-dealers (the "Proposal").¹

Background

Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank")  directed the SEC to: review its rules that use credit ratings to assess the creditworthiness of a security or money  market instrument; remove any reference to or requirement of reliance on credit ratings; and substitute such  standard of creditworthiness as the SEC determines to be appropriate.²  The SEC has completed much of this  work, with the only remaining references to credit ratings found in Rules 101 and 102 of Regulation M. The SEC  had proposed amendments in 2008 and 2011 to remove credit ratings references from Regulation M and  introduced, back then, alternative measures of creditworthiness. However, the SEC did not adopt those  proposed rule changes. According to SEC Chair Gensler, enactment of the present Proposal would fulfill  Congress's mandate to the SEC.³

REGULATION M

Regulation M is intended to limit the activities of certain participants in a distribution, which activities may have  a manipulative effect on the market for the offered security.⁴  In connection with a distribution, Rule 101 of  Regulation M prohibits a distribution participant (such as an underwriter, broker or dealer) or an affiliated  person of such person from, directly or indirectly, bidding for, purchasing, or attempting to induce any person  to bid for or purchase, a covered security (which includes the security that is the subject of the distribution (the  "subject security") as well as any "reference security") during the applicable restricted period; provided that, if a  distribution participant or affiliated purchaser is the issuer or selling securityholder of the securities subject to  the distribution, that person will be subject to the provisions of Rule 102, rather than those of Rule 101 of  Regulation M.

EXISTING EXCEPTIONS IN RULES 101 AND 102 FOR INVESTMENT GRADE SECURITIES

The general prohibitions in Rules 101 and 102 of Regulation M do not apply to certain securities (excepted  securities) and do not apply to certain activities (excepted activities). Among such exceptions, Rule 101(c)(2) and  Rule 102(d)(2) of Regulation M exempt offerings of nonconvertible debt securities, nonconvertible preferred  securities, and asset-backed securities rated investment grade by at least one nationally recognized statistical  rating organization ("NRSRO"). We refer to these existing exceptions as the "Investment Grade Exceptions."⁵  The  SEC had excepted investment grade securities in these rules "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."⁶

Proposed Amendments

Under the Proposal, the SEC is proposing to replace the Investment Grade Exception in Rule 101 with two  alternative standards that aim to assess creditworthiness. For nonconvertible debt securities and nonconvertible  preferred securities (collectively, "Nonconvertible Securities"), the proposed standard is based on the issuer's  probability of default. For asset-backed securities, the proposed amendment would except asset-backed  securities that are offered pursuant to an effective shelf registration statement filed on the SEC's Form SF-3. In  addition, the SEC proposes to eliminate the Investment Grade Exception in Rule 102 and not replace it with any  alternative standard.

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Footnotes

1  SEC Release No. 34-94499 available at https://www.sec.gov/rules/proposed/2022/34-94499.pdf (the "Proposing Release").

2 See Pub. L. 111-203 secs. 931–939H, 124 Stat. 1376, 1872-90 (2010).

3 See Press Release, SEC Proposes Amendments to Remove References to Credit Ratings from Regulation M, available at  https://www.sec.gov/news/press-release/2022-47 (March 23, 2022).

4  SEC Release Nos. 33-7375 and 34-38067 available at https://www.sec.gov/rules/final/34-38067.txt (the "Regulation M Adopting Release").

5 The SEC appears to be under the working assumption that the application of the Investment Grade Exception to Rules 101 and 102 is  primarily limited to two cases: reopenings and sticky offerings (See Proposing Release, at 64). We believe, however, that this assumption is  not necessarily true for nonconvertible preferred securities.

6 See Regulation M Adopting Release, at 40; see also Proposing Release, at 18.

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