United States: The SEC's Proposed Amendments To Regulation M

On March 23, 2022, the SEC proposed amendments to remove references to credit ratings from Regulation M.⁸ The proposed amendments would replace such references with alternative measures of creditworthiness and add recordkeeping obligations for broker-dealers. This aligns with the SEC's direction under the DoddFrank Wall Street Reform and Consumer Protection Act of 2010 to remove reference or reliance on credit rating and substitute, as appropriate.

Regulation M limits the activities of certain participants in a distribution which activities may manipulate the market for an offered security. There are certain exceptions in Rules 101 and 102 of Regulation M, which apply to nonconvertible debt, nonconvertible preferred securities, and asset-backed securities referenced herein as "Investment Grade Exceptions." The proposed amendments would replace the Investment Grade Exceptions in Rule 101(c)(2) with two alternatives: (1) Rule 101(c)(2)(i), which would address nonconvertible securities, and (2) Rule 101(c)(2)(ii), which would address asset-backed securities.

Rule 101(c)(2)(i) would exempt nonconvertible securities of issuers having a probability of default of less than 0.055% as determined by the distribution participant using a "structural credit risk model" and measured as of pricing day over a 12-calendar month period. Under the proposed amendments, a "structural credit risk model" is defined as "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."⁹

Rule 101(c)(2)(ii) would replace the existing exception for asset-backed securities offered pursuant to Form SF-3. There are certain safeguards in Form SF-3 for asset-backed securities that the SEC believes are sufficient to replace the existing rule. Under Form SF-3, the principal focus of investors is the structure of securities and the nature of the assets pooled to serve as collateral, as opposed to the issuer's identity. Form SF-3 addresses this focus because it permits only a limited percentage of delinquent assets; they cannot constitute 20% or more of the asset pool. Form SF-3 also includes transactional requirements. The aforementioned requirements of Form SF-3 are viewed by the SEC as incentive for parties to consider the assets in the pool and do not require an assessment of creditworthiness of the issuer. In addition, the proposed amendments would eliminate the Rule 102(D)(2) exception. This rule applies only to issuers and selling security holders. The SEC noted that there was limited reliance on this exception and those to which it applies continue to have an incentive to manipulate the market regardless of their credit quality, which justifies the removal of the current exception without replacement.

With regard to the proposed amendments, the SEC proposes to amend Rule 17a-4(b) under the Exchange Act to require broker-dealers who are distribution participants or affiliated purchasers to keep written records of their probability of default determination. The proposal would add an additional paragraph to Rule 17a-4(b) requiring broker-dealers to retain written probability of default and to preserve it for a period no less than three years and with the first two years readily accessible. Provided that a broker-dealer uses a vendor to determine the probability of default threshold, they can satisfy this requirement by maintaining documentations of the assumptions and output of the vendor model. Our recent Legal Update¹⁰ outlines practical considerations of these recordkeeping requirements for broker-dealers.

Although the SEC has stated that broker-dealers can reprogram their systems to calculate probability of default, many of the calculations required are not currently undertaken by debt capital markets and add additional risks associated with determining the default threshold on the date of the deal's launch. These concerns are related to the proposed Rule 101(c)(2)(i), however, they do not exist in connection with the proposed new Rule 101(c)(2)(ii). The comment period for the proposed amendments ended on May 22, 2022.

Footnotes

8 See the SEC Proposed Amendments in Release No. 34-9449 at: https://www.sec.gov/rules/proposed/2022/34-94499.pdf.

9 See Release No. 34-9449, page 98, at: https://www.sec.gov/rules/proposed/2022/34-94499.pdf.

10 For further discussion and summary on the proposed amendments, see Mayer Brown LLP's Legal Update (April 5, 2022).

Originally published in REVERSEinquiries: Volume 5, Issue 2.
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