SEC Removes “Investment Grade” Exceptions from Regulation M

Key takeaways

• The Regulation M investment grade exception has been replaced by “probability of default” standard for nonconvertible bond offerings.
• Lead managers must adopt new procedures for determining probability of default using a structural credit risk model.
• Some offerings that would have satisfied the old investment grade exception are expected to fall outside the new “probability of default” standard, meaning Regulation M prohibitions will apply more frequently.
• It is not clear whether a FINRA Form 5190 filing is required for nonconvertible debt securities offerings subject to Regulation M, or even how to complete the form in a manner that makes any sense for a debt offering.
• Certain offerings in which there is no lead manager (e.g., self-underwritten offerings or other shelf offerings) may be unable to rely on the new exception.
• The SEC does not address how the structural credit risk model should be applied to sovereign issuers.

The U.S. Securities and Exchange Commission (“SEC”) recently adopted amendments to Regulation M to remove the “investment grade” exceptions in Rule 101 and Rule 102 of Regulation M and replace them with exceptions that use alternate standards of creditworthiness that are not based on credit ratings. The amendments became effective on August 21, 2023.

In particular, the new exception for nonconvertible debt securities and nonconvertible preferred securities (together, “nonconvertible securities”) requires the lead manager to make a written “probability of default” determination that it must preserve for at least three years.   

Regulation M restrictions 

Regulation M is a set of rules designed to preserve the pricing integrity of the securities trading markets by prohibiting issuers, selling security holders, distribution participants (such as underwriters and participating broker-dealers), and any of their affiliated purchasers from engaging in activities that could artificially influence the market for an offered security or a “reference security” into which the offered security may be converted or exchanged. 

Rule 101 of Regulation M generally prohibits distribution participants and their affiliated purchasers from bidding for, purchasing, or attempting to induce others to bid for or purchase, covered securities during the applicable “restricted period.” Rule 102 imposes similar restrictions on issuers, selling securityholders and their affiliated purchasers. 

The restricted period generally begins (i) on the first business day prior to the pricing of the offering if the security has an average daily trading volume (“ADTV”) of at least $100,000 and the issuer of the security has a public float of at least $25 million or (ii) on the fifth business day prior to the pricing of the offering for all other securities. The restricted period ends when the distribution participant has completed its participation in the distribution. For an underwriter, this means when the securities it has underwritten have been distributed and all stabilization arrangements and syndicate trading restrictions have been terminated.

Regulation M has a more limited impact on fixed income securities, due to certain exceptions in the rule (as discussed further below) and because an issuer’s already outstanding debt securities are not considered to be the same as the debt security being distributed if there is a single basis point difference in coupon rates or a single day’s difference in maturity dates. Consequently, Regulation M generally does not restrict trading in an issuer’s already outstanding fixed income securities during the distribution of its newly issued securities. By contrast, an equity security that differs only in voting rights from the security in distribution is deemed to be the same security as the security in distribution and thus is a covered security under Regulation M. 

Recent amendments

Prior to the 2023 amendments, Rule 101(c)(2) and Rule 102(d)(2) excepted from the prohibitions in Rule 101 and Rule 102, respectively, nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that were rated “investment grade” by at least one nationally recognized statistical rating organization. Although, as discussed above, Regulation M has a more limited application to fixed income securities, its restrictions can apply in the context of “sticky deals” (an offering where a lack of demand results in an underwriter being unable to sell all of the securities in a distribution, such as when an investor failed to honor a previously expressed indication of interest) and re-openings of debt issuances (an offering of an additional principal amount of securities that are identical to the securities already outstanding, such as when an issuer wishes to make a series of offerings via a re-opening to match its funding needs or when some sovereign issuers conduct a re-opening for public finance purposes). In these situations, the Regulation M exceptions for investment grade nonconvertible debt securities meant that market activities in already outstanding securities of the same issue could continue without regard to the prohibitions in Rule 101 and Rule 102. 

In order to reduce reliance on credit ratings as mandated by the Dodd-Frank Act, the SEC’s recent amendments to Regulation M have removed the references to “investment grade” from these exceptions and replaced them with new exceptions that employ alternative standards of creditworthiness, depending on the type of security in the distribution. Asset-backed securities are excepted from the prohibitions in Rule 101 and Rule 102 if they are offered pursuant to an effective shelf registration statement filed on Form SF-3. For nonconvertible securities, however, the new standard is based on the issuer’s probability of default. 

The SEC’s amendments did not alter the other excepted activities, transactions and securities to which the prohibitions in Rule 101 and Rule 102 do not apply, including certain transactions in securities eligible for resale pursuant to Rule 144A. 

Probability of default determination

The amended rules except 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 a 12-calendar month horizon, thereafter, is 0.055% or less, as determined and documented in writing by the lead manager of a distribution, using a “structural credit risk model.” The lead manager of a distribution (or a person acting in a similar capacity) must make a written determination of the issuer’s probability of default. “Structural credit risk model” is defined as “any commercially or publicly available model that calculates, based on an issuer’s balance sheet, the probability that the value of the issuer may fall below the threshold at which the issuer would fail to make scheduled debt payments, or by the expiration of a defined period.”

Under both amended Rule 101(c)(2) (covering distribution participants) and Rule 102(d)(2) (covering the issuer and selling securityholders), the exception for nonconvertible securities relies on a written determination made by the lead manager (or a person acting in a similar capacity). In other words, an issuer or selling securityholder cannot use a probability of default determination made by themselves to rely on the new exception. 

Recordkeeping

The amended rules also require broker-dealers 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 supporting their reliance on the exceptions for nonconvertible securities. The SEC did not adopt any new recordkeeping requirements in connection with the new asset-backed security exception.

Practical implications

The amendments to Regulation M will require broker-dealers, in particular lead managers, that seek to rely on the new exceptions for nonconvertible securities to adopt new policies and procedures and incur additional costs connected with obtaining the estimate of the probability of default and preserving records related to the probability of default estimation.

The lead manager may itself perform the probability of default analysis internally, or it may employ third-party vendors or commercial data providers to do so or assist in the assessment. Lead managers must bear in mind that there are minimum standards to be observed, including that the model employed must be a commercially or publicly available model, and that it should calculate, based on an issuer’s balance sheet, the probability that the value of the issuer will fall below the default point by the expiration of the defined time period.

Market participants should be aware that the balance-sheet basis of the structural credit risk model may give rise to certain risks and anomalies. For example, it is likely that there will be a non-trivial number of issuers whose securities were previously excepted on the basis of offering investment grade nonconvertible debt securities that, due to the timing and sensitivities of their balance sheets, may now fall within Regulation M, either generally or depending on the relevant calculation date. As the SEC noted in its adopting release, as of March 2023, the 0.055% probability of default threshold captured approximately 76% of the investment grade securities issued between 2018 and 2023, according to data obtained from the financial data provider Mergent. 

The SEC does not address how the structural credit risk model should be applied to sovereign issuers, given the centrality of a balance sheet as the starting point of the model.

Lead managers will also need to determine whether and how to share their probability of default determinations with other distribution participants, as well as with the issuer and selling security holders. While the amendments do not require that the lead manager share the determination, the other distribution participants, the issuer and selling securityholders will not be able to rely on the nonconvertible securities exception if the lead manager does not share the probability of default determination. Among other things, the syndicate could decide by contract (such as in an agreement among underwriters) to specifically authorize the lead manager to share its probability of default determination with other distribution participants. The syndicate could also decide not to allow the lead manager to share its probability of default determination with unrelated distribution participants to keep tighter control of the distribution. 

With respect to recordkeeping, a lead manager using a vendor to determine the probability of default could satisfy the 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, according to the SEC’s adopting release. 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. Broker-dealers relying on a lead manager’s written probability of default determination 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.

FINRA Rule 5190

By its terms, Rule 5190 of the Financial Industry Regulatory Authority (“FINRA”) would appear to apply to an offering of nonconvertible debt securities subject to Regulation M. At present there appears to be a division of views and practices in the market as to whether it is required or sensible for a distribution “manager” (or where there is no manager, a distribution “participant” or “affiliated purchaser”) to file a Form 5190 notification filing with respect to an offering of nonconvertible debt securities subject to Regulation M. Form 5190 is required to be filed through “FINRA Gateway,” an online portal. A number of Form 5190 requirements and features do not map in a straightforward way to typical market, syndicate and pricing practice with respect to fixed-income securities and result in difficulties in its application, completion and filing. Market and interpretive practices with respect to Rule 5190 and Form 5190 for nonconvertible debt securities now subject to Regulation M are likely to continue to develop. 

Offerings with no lead manager

Notably, since the nonconvertible debt securities exception relies on the lead manager making the probability of default determination, certain offerings in which there is no distribution participant to act as the lead manager – such as self-underwritten offerings or other shelf offerings, to the extent such offerings fall within the definition of a “distribution” under of Regulation M – may not be able to rely on the exception. With respect to shelf offerings, each takedown must be individually examined to determine whether the offering constitutes a “distribution.” If the nonconvertible debt securities exception 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 its affiliated purchasers would be subject to the Rule 102 restricted period when sales off a shelf by an issuer, or by any affiliated purchaser, constitute a distribution of securities.

We will continue to monitor developments in this area and welcome any queries you may have.