Introduction

Section 939A of the Dodd-Frank Act requires the SEC to review (i) any regulation that requires the use of an assessment of the creditworthiness of a security and (ii) any reference to or requirement in such regulations regarding credit ratings, and to modify them to remove those references and substitute standards of creditworthiness the SEC determines to be appropriate.1 The SEC’s proposed amendments to Regulation M, announced during the second quarter of 2011, would remove the references to credit ratings in Rules 101(c)(2) and 102(d)(2) of Regulation M, and replace them with new standards relating to the trading characteristics of covered securities.

In this article, we discuss the potential impact of these amendments on the structured notes market. In its proposing release,2 the SEC stated that it intended generally to except from Regulation M the same types and amounts of securities that are currently excepted in Rules 101(c)(2) and 102(d)(2), without referencing credit ratings. However, the approach outlined in the proposed rules does not appear likely to satisfy this goal as to structured note issuances.

Proposed Amendments to Rules 101 and 102 of Regulation M

Regulation M prohibits activities that could artificially influence the market for a “covered security.”3 Rules 101 and 102 of Regulation M prohibit issuers, underwriters, 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 security during the applicable restricted period. Rules 101(c)(2) and 102(d)(2) except from their respective provisions “investment grade nonconvertible and asset-backed securities,”4 which are nonconvertible debt securities (as well as nonconvertible preferred securities and asset-backed securities) that are rated by at least one nationally recognized statistical rating organization in one of its generic rating categories that signifies investment grade.5 This category, nonconvertible debt securities, has been generally deemed to include most structured notes issued by financial company issuers that have an investment grade rating for their senior debt securities, other than structured notes that are exchangeable for another type of security, such as, for example, “reverse convertible securities.”

We have summarized the proposed amendments in our recent news bulletin (available at: http://www.mofo.com/files/Uploads/Images/110524-Regulation-M.pdf). However, we repeat here some of the key provisions, in order to indicate how they could apply to structured notes.

The SEC’s proposed amendments would replace the references to credit ratings in Rules 101(c)(2) and 101(d)(2) with new standards relating to trading characteristics of investment grade nonconvertible debt securities. Those securities will be excepted from Rules 101 and 102 if they:

  1. are liquid relative to the market for that asset class;
  2. trade in relation to general market interest rates and yield spreads; and
  3. are relatively fungible with securities of similar characteristics and interest rate yield spreads.  

As described in more detail below, a wide variety of structured notes are not likely to fit within these standards.

Proposed New Standards

Liquid Relative to the Market for that Asset Class

To determine whether nonconvertible debt securities are liquid relative to the market for their respective asset class, the following factors could be considered:

  • the size of the issuance;
  • the percentage of the average daily trading volume by persons other than the persons seeking to rely on the exception;
  • the number of market makers in the security being distributed other than the persons seeking to rely on the exception;
  • the overall trading volume of the security;
  • the number of liquidity providers who participate in the market for the security;
  • the trading volume in similar securities or other securities of the same issuer;
  • the overall liquidity of all outstanding debt issued by the same issuer; and
  • how quickly an investor could be expected to sell the security after purchase.

The list of proposed factors is illustrative and the SEC does not intend it to be exhaustive or mutually exclusive. However, most structured note issuances are likely not to satisfy these standards. The small aggregate principal amount of many issuances, the limited number of marketmakers for them, and their limited liquidity are likely to be barriers for most issuances to qualify, even if they are listed on a securities exchange.

Trade in Relation to General Market Interest Rates and Yield Spreads

Nonconvertible debt securities would need to trade at prices that are primarily driven by general market interest rates and spreads applicable to a broad range of similar securities to qualify for the proposed exception. As a result, the exception is limited to securities that trade in relation to changes in broader interest rates (based on their comparable yield spreads), and securities that trade in relation to issuer-specific information or credit quality would not qualify. The SEC also noted that it would be more difficult for market participants to determine that a security trades in relation to changes in broader interest rates if it trades in an idiosyncratic fashion based primarily on its specific characteristics, such that the traded price could not readily be compared to similar issues. This standard will eliminate many types of structured notes from the exemption provided from Rule 101 and Rule 102, in light of the customized terms of most structured products.

Relatively Fungible with Securities of Similar Characteristics and Interest Rate Yield Spreads

In order for a security to be relatively fungible (in terms of trading characteristics) under the proposed amendments, a portfolio manager would be willing to purchase it in lieu of another security with similar characteristics, such as yield spreads and credit risk.6 As to this standard, the unique characteristics and terms of different types of structured notes would seem to disqualify many or most of them from this test.

Evaluation Under the Proposed Standards

An issuer or underwriter seeking to rely on the new exception must determine that the specific nonconvertible debt security being distributed meets the proposed standards using reasonable factors. These entities would be required to exercise reasonable judgment in conducting their analysis, and the determination must be subsequently verified by an independent third party.7 However, sole reliance on a third party’s determination, without any further analysis, would not be considered to be based on reasonable judgment. Persons seeking to rely on the exception must demonstrate compliance with the requirements of the proposed amendments.

Accordingly, if adopted, these proposals will require significant changes in the operations of underwriters and other distribution participants. Such changes, including the retention of an independent third party, would likely add significant cost to each issuance, making a variety of potential offerings less attractive to the offerors, even assuming that the relevant issuances could satisfy the new standards.

Potential Impact

Assuming that a particular structured note issuance would not satisfy the new standards for exclusion from Regulation M, the marketing and trading of such issuances could change in a number of ways. These changes would arise from Rule 101’s and Rule 102’s prohibition of bidding for, purchasing, or attempting to induce any person to bid for or purchase, a covered security.

Reopenings and Multiple Tranches. A variety of structured note issuances are (a) “reopened” with an additional principal amount of fully fungible securities after the closing date or (b) priced on multiple days prior to their initial closing. For example, in the case of (b), an issuer could agree on successive business days to offer different principal amounts of the same series of notes to different investors, and to close these offerings on the same closing date.

In these cases, the issuer and the underwriter would be barred by the proposed new rules from posting bids or quotes on the initially offered securities until the distribution of that series has been completed. Because the initial offering of the relevant notes would typically not qualify for the exemption from the definition of “covered securities,” issuers and underwriters would be limited in terms of their ability to make a market.

Variable Price Reofferings. In variable price reofferings, underwriters typically offer the relevant securities for several days or several weeks, at offering prices that vary based on prevailing market prices. In this context as well, the brokers participating in the distribution would have a limited ability to make a market for the securities that investors previously agreed to purchase, until the termination of the variable price reoffer.

Length of Restricted Period. Rule 100’s definition of “restricted period” would not be affected directly by the proposed amendments. However, because many structured notes would no longer be exempted from Regulation M, the parties to an offering would need to consider whether Rule 100’s (a) five-business-day or (b) one-businessday restricted period would apply. As a practical matter, the five-business-day period would generally apply, so that the restricted period for most issuances would generally begin five-business-days prior to the determination of the offering price. This is because most structured notes would not qualify for the shorter restricted period of one business day — they would not satisfy Rule 100’s requirement of having an average daily trading volume of at least $100,000. As a result, in the case of a reopening, a broker would generally need to cease its market-making activities at least five business days prior to the time at which it proposed to commence the offering of the issuance to be reopened.

Unsolicited Transactions. These potential restrictions would not fully eliminate the ability of a broker to agree to repurchase structured notes that were otherwise subject to Regulation M. Issuers and broker-dealers would retain the exemption for “unsolicited transactions” that are contained in existing Rule 101 and Rule 102. For example, if a customer sought to sell back to a broker a structured note that was subject to a variable price reoffer or a reopening, it could reach out to the broker to propose the repurchase.

Request for Comments

The SEC seeks public comment on the proposed rules by July 5, 2011. In addition to comments on the proposed standards, the SEC is interested in whether and in what circumstances issuers, selling security holders, distribution participants, and their affiliated purchasers rely on the current exception for investment grade securities, including with respect to specific activities, and whether it serves a continuing purpose with respect to nonconvertible debt. The SEC is also soliciting comments as to whether the current investment grade exception should be eliminated or, alternatively, whether it should be expanded to except from Rules 101 and 102 all nonconvertible debt, nonconvertible preferred, and asset-backed securities (or some subset of those types of securities). The SEC seeks comments generally on any relevant changes to the debt markets since Regulation M’s adoption in 1996 and how those developments should affect the SEC’s evaluation of the proposed amendments. In light of the emergence of the structured note market since that time, and the impact of the proposals on this market, we anticipate that a variety of comments will address the unintended consequences of the proposed amendments on this market.