TheCorporateCounsel.net

At their scheduled open meeting yesterday, the SEC Commissioners unanimously approved changes to Reg M to remove and replace references to “credit ratings” from the existing exceptions provided in Rule 101 and Rule 102, which had referred to certain securities being rated “investment grade” by at least one nationally recognized statistical rating organization and will now refer to alternative standards of creditworthiness. Specifically, according to the SEC’s Fact Sheet, the amendments:

– Remove existing rule exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities included in Rule 101 and Rule 102 of Regulation M;

– Replace those rule exceptions with new standards that are based on alternative standards of creditworthiness; and

– Add an amendment to a recordkeeping rule applicable to broker-dealers in connection with their reliance on the new exceptions.

As Dave blogged last week, this is the culmination of years of consideration, dating all the way back to the Dodd-Frank Act, and that history is also mentioned in the SEC’s press release and the various Commissioner statements about the rule change. The amendments fulfill the mandate from Section 939A(b) of the Dodd-Frank Act.

You may be wondering what “alternative standards of creditworthiness” actually means. The Fact Sheet explains:

New Rule 101(c)(2)(i) and Rule 102(d)(2)(i) except nonconvertible debt securities and nonconvertible preferred securities of issuers having a probability of default of 0.055 percent or less, as estimated as of the sixth business day immediately preceding the determination of the offering price, over the horizon of 12 full calendar months from such day, as determined and documented in writing by the distribution participant acting as the lead manager, using a “structural credit risk model,” as newly defined in Rule 100 of Regulation M. In addition, new Rules 101(c)(2)(ii) and 102(d)(2)(ii) except asset-backed securities that are offered pursuant to an effective shelf registration statement filed on the Commission’s Form SF-3.

Clear as mud, right? My first thought was that this seems to just move reliance from credit ratings agencies to distribution participants. I admittedly have not parsed through the entire adopting release – certainly not as deeply as the Staff who put this together. And I am not familiar with credit assessment services, although I’m sure I’ll come to know and love them. Point being though, that on its face, I am not sure that legal counsel, investors or others have the skills (or desire?) to figure out structural credit risk models, even if they are “commercially or publicly available” – or to easily determine whether a model meets the requirements to be used under the rule.

While all the Commissioners supported the rule, they acknowledged it wasn’t perfect – and in her statement, Commissioner Peirce raised three questions that seem worth considering:

– One commenter suggested that the Commission’s proposed use of a structural credit risk model for determining eligibility for the exception under Rule 101(c)(2)(i) was unnecessarily complex and suggested using a simpler alternative, such as whether the securities are offered pursuant to an effective registration statement filed on one of several specific forms. Another alternative this commenter suggested was to limit the exception to securities issued by well-known seasoned issuers. Why doesn’t the final rule take one of these approaches?

– How confident is the staff that we’ve gotten the threshold right for this exception?

– The International Institute of Law and Finance submitted a comment letter that asked the Commission to consider allowing market participants more flexibility in estimating probability of default. Among the alternatives IILF suggested would be appropriate were statistical models and market measures of credit risk, such as debt security prices and yields, credit spreads, and credit default swap spreads. Why doesn’t the final rule provide this extra flexibility?

The final rules go effective 60 days following the date of publication of the adopting release in the Federal Register (which usually takes about a month, depending on the volume of what needs to get published). For those who are gluttons for punishment, here’s the 120-page adopting release. We’ll be posting memos in our “Regulation M” Practice Area.

– Liz Dunshee