SEC Proposal Would Replace Regulation M Exemption for Investment Grade Securities with Exemption Based on Non-Equity Security's Trading Characteristics

May 18, 2011

As part of its efforts to remove reliance on and references to credit ratings from its rules and forms as required by Section 939A of Dodd-Frank, the SEC has issued proposed rules that would, among other things, eliminate the current exemption in Rules 101 and 102 of Regulation M for investment grade securities and replace it with an exemption based on a non-equity security's trading characteristics.


While most investment grade offerings will be unaffected by the changes since investment grade offering participants and their affiliates generally do not engage in the activities restricted by Regulation M, there are a significant number of offerings, including "reopenings" of existing issues, that will be impacted.  While the SEC does not intend for the proposal to modify the types of non-equity securities currently exempt from these rules, the proposed exemption criteria are less definitive than the current investment grade criterion and could change certain securities' eligibility for the exemption.


Rules 101 and 102 of Regulation M

Regulation M is designed to prevent anyone with a financial interest in a distribution from manipulating the market price and thereby misleading potential investors as to the "true" state of the public market for the securities being distributed.  Rules 101 and 102 of Regulation M prohibit issuers, selling security holders, 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" until the applicable restricted period has ended.  "Covered securities" for this purpose mean the securities being distributed or any "reference security," into which a subject security may be converted, exchanged or exercised, or under which the terms of the subject security may "in whole or significant part" determine its price.


In addition to the current exemption for investment grade securities, Rules 101 and 102 also contain a number of other exceptions and exemptions, such as an exception for transactions in Rule 144A securities, which would not be modified by the proposed rules.


New Exemption Criteria

The proposed rules would eliminate the current exception for investment grade securities in Rules 101 and 102 of Regulation M but exempt nonconvertible debt, convertible preferred, or asset-backed securities that are each of the following:


(1) Liquid relative to the market for that asset class.  The proposed rules do not define what characteristics would need to be present for a security to be considered "liquid relative to its market" for these purposes but rather seek comment on what might be indicative of relative market liquidity, for example, the size of the issuance or the percentage of ADTV or amount of market making by persons other than those relying on the exemption.


(2) Trading at prices that are primarily driven by general market interest rates and spreads applicable to a broad range of similar securities.  In other words, securities would meet this criterion if they trade in relation to changes in broader interest rates (i.e., based on their comparable yield spreads), rather than in relation to issuer-specific information or credit quality.


(3) Relatively fungible in terms of trading characteristics with similar securities (i.e., securities with similar interest rate yield spreads).  Being "relatively fungible" for these purposes would not require that the security be deliverable for a purchase order for a different security, but rather that a portfolio manager would be willing to purchase the security in lieu of another security that has similar characteristics such as comparable yield spreads.


Determination and Verification of Exemption Criteria

The proposed rules do not provide definitive thresholds that would need to be met for a security to meet the exemption criteria but provide that those seeking to rely on the new exemption must utilize "reasonable factors of evaluation" in determining whether the exemption is available.  This determination would also need to be verified by an independent third party.  The proposing release does not define who would qualify as independent for this purpose but does state that counsel to, or other affiliates of, the underwriter or issuer would not qualify, although this is not an exhaustive list.  The SEC is seeking comment on what types of entities should be eligible to make the independent third-party determination, and more specifically, whether the role should be limited to "qualified independent underwriters" or "QIUs" under the SRO rules.


Impact of the Proposed Exemption

While the current investment grade exemption is straightforward and fairly easy to apply, the proposed exemption is more opaque and subjective. The new exemption will require distribution participants to expend time to assess whether the distribution qualifies for the exemption and expense to verify this assessment with an independent third party.  The cost/benefit of such an exercise, particularly the independent verification requirement, as well as the prospect that the new criteria will modify certain securities' eligibility for exemption will be key areas of comment.  We urge you to contact us or the SEC directly to discuss your views.


Comments are due by July 5, 2011.


The SEC's press release and fact sheet on the proposal is available here.

The proposing release is available here.


If you have any questions regarding this publication, please contact any of the lawyers listed below or your regular Davis Polk contact.

Julia K. Cowles650 752
Richard A. Drucker 212 450 4745
Michael Kaplan212 450
Warren Motley212 450
Richard J. Sandler212 450
Richard D. Truesdell, Jr.212 450
Janice Brunner212 450
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