SEC Regulation M is designed to help ensure the integrity of the securities markets. It prohibits certain activities by distribution participants (such as issuers, underwriters, and selling group members) that could potentially manipulate the market for a security that is the subject of an offering. In this article, we discuss some of the key ways in which this regulation impacts the market for structured notes.4 We note that Regulation M concerns market manipulation; however, it is a prophylactic rule, and prohibits certain conduct, whether or not that conduct involves any fraudulent intent. Accordingly, market participants need to have a good understanding of the rule and its provisions in order to avoid an inadvertent violation of the rule.
Rule 101 of Regulation M prohibits distribution participants and their affiliated purchasers from bidding for, purchasing, or attempting to induce any person to bid for or purchase a security covered by the rule during a "restricted period."5 For example, if additional notes of an outstanding series of structured notes are being marketed in a reopening" the relevant underwriter would not be permitted to post a bid to purchase outstanding notes in market-making transactions, absent an exemption.
Regulation M's key provisions, Rule 101 and 102, apply in connection with a distribution. Rule 100 defines a "distribution" as a securities offering that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and methods. In the context of structured notes, typical market-making transactions will not constitute a distribution. However, a registered shelf offering of structured notes, bank note offerings, and even private offerings affected under Regulation D may all constitute a distribution.
"Covered securities" are securities that are the subject of a distribution or a reference security. A reference security is a security into which the covered security may be converted, exchanged or exercised, or which may impact the value of the covered security. Derivative securities are not subject to Rule 101 and, therefore, an offering participant can bid for or purchase options, warrants, rights, convertible securities, or equity-linked securities without violating Rule 101.6 However, during a distribution of derivative securities, such as a structured note linked to a common stock, Rule 101 does apply to the underlying security, the value of which affects the return of the derivative security.7 In practice, equity-linked notes tend to be linked to common stocks that would constitute "exempt securities" under Regulation M they have a worldwide average daily trading volume (ADTV) of at least $1 million and are issued by an issuer with a public float value of at least $150 million, enabling the offering participant to purchase these securities even while a related structured note is being offered.
Rule 101 vs. Rule 102
Under Regulation M, Rule 101 applies to distribution participants, such as underwriters, and their affiliated purchasers. Rule 102 applies to issuers and their affiliated purchasers.
Rule 102 prohibits the same activities during the same restricted period as Rule 101. It has comparable exemptions to Rule 101, but it does not have all of Rule 101's exemptions. While issuers must comply with Rule 102, affiliated purchasers of the issuer may comply with either Rule 101 or Rule 102. This is important because Rule 101 is generally less restrictive than Rule 102, broker-dealer affiliates of financial holding companies may comply with Rule 101 as to their parent company's securities. In the structured notes market, these broker-dealers are frequently offering and purchasing their parent company's securities. As a result, the following sections of this article principally focus on the requirements and exemptions of Rule 101, where most of the action occurs.
The Rule 101 Restricted Period
Rule 101 applies only during the applicable restricted period. For most structured notes, the restricted period begins on the later of five business days prior to the pricing date of an offering (or the time at which a person becomes a distribution participant) and ends on the completion of its participation in the distribution. Structured notes are typically offered on a "riskless principal" basis, in the sense that broker-dealers do not hold inventory, and only purchase from the issuer the aggregate principal amount for which they have orders from investors. Accordingly, for a typical structured note offering, the distribution is completed on the pricing date itself. In contrast, if any of the notes are taken for the underwriter's own investment (an "unsold allotment"), the underwriter could resell the securities under a current prospectus or sell the securities after a significant holding period. The SEC usually presumes that an investment bank that has purchased securities from the issuer in a primary offering does not have the requisite investment intent to avail itself of exemptions from registration. Accordingly, subject to the discussion below about investment grade nonconvertible securities, most practitioners advise that an underwriter hold securities that form part of an unsold allotment for a substantial period of time before reselling them.
Investment Grade Nonconvertible Securities
Rule 101 includes an exemption that is of significant interest in the structured note market: investment grade nonconvertible securities. "Investment grade" debt securities are rated by at least one nationally recognized statistical rating organization in one of its generic rating categories that signifies investment grade. In the Regulation M adopting release, the SEC noted that the exception for investment grade nonconvertible debt securities is based on the fact that these securities trade principally on the basis of their yields and credit ratings and, therefore, are less susceptible to manipulation.
Regulation M does not contain a definition of a "nonconvertible debt security"; however, in practice, this term is understood to apply to debt securities that are not convertible or exchangeable for equity securities of the same or of a third-party issuer. Similarly, many practitioners are of the view that nonconvertible debt securities that have not received an individual rating but are of the same class or series as, and are considered pari passu with, other investment grade rated securities of the same issuer should be treated as investment grade for purposes of Regulation M.
As a result, many practitioners believe it is reasonable to conclude that an issuer's rate-linked notes, which are pari passu with that issuer's investment grade rated nonconvertible "plain vanilla" debt securities, including rate-linked notes that reference the performance of commonly used interest rate benchmarks, such as LIBOR, ISDAFIX, and CMS, are "nonconvertible debt securities" for purposes of the Rule 101 and Rule 102 exclusions. That conclusion is not necessarily impacted by the particular payoffs, economic terms, or optionality of these rate-linked notes. For example, the conclusion would apply to zero coupon notes (fixed, callable, and accreting), fixed-to-floating or floating-to-fixed rate notes, capped callable notes, notes with floors or collars, step-up callable notes, and CPI-linked notes, as well as securities that have terms that include different types of contingencies in the note terms, such as range accruals. We note that, in considering the predecessor to Regulation M, Rule 10b-6, the SEC, in its 1982 proposing release for amendments to Rule 10b-6,8 specifically discussed and rejected the notion of limiting the exclusion for nonconvertible investment grade debt to "fixed rate" instruments and noted that there was no basis for excluding securities tied to a benchmark.
This view is relied upon by market participants for making a market in outstanding securities of an issuance of this type, while holding an inventory of them for potential issuances to additional investors.
Additional Regulation M Exemptions
In addition to investment grade nonconvertible securities, a number of additional activities that occur in the structured note market are exempt from Rule 101:
· publishing and disseminating research materials that are in compliance with Rules 138 and 139 of the Securities Act;
· transactions with QIBs and non-U.S. persons involving Rule 144A securities; and
· participating in unsolicited brokerage transactions or unsolicited purchases not effected from or through a broker or dealer, securities exchange or inter-dealer quotation system, or electronic communications network.
We describe these and other exemptions in more detail in the FAQ referenced above.