# Removal of References to Credit Ratings From Regulation M

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2023-12591

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** June 20, 2023
- **Citation:** 88 FR 39962

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-97657; File No. S7-11-22]
RIN 3235-AL14
Removal of References to Credit Ratings From Regulation M

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is adopting rule amendments to implement section 939A(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), which requires, among other things, that the Commission remove from its regulations any references to credit ratings and substitute in their place alternative standards of creditworthiness. The amendments remove certain existing rule exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities and substitute in their place new exceptions that are based on alternative standards of creditworthiness. These substitutes include exceptions for nonconvertible debt securities and nonconvertible preferred securities (together, “Nonconvertible Securities”) of issuers who meet a specified probability of default threshold, as well as exceptions for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on a certain form that is tailored to asset-backed securities offerings. The Commission is also adopting an amendment to a recordkeeping rule applicable to broker-dealers in connection with their reliance on an exception involving probability of default determinations.

DATES:

Effective date:
The final rules are effective on August 21, 2023.

FOR FURTHER INFORMATION CONTACT:

Jessica Kloss, Attorney-Adviser, Laura Weber, Branch Chief, Josephine Tao, Assistant Director, Office of Trading Practices, or Carol McGee, Associate Director, Office of Derivatives Policy and Trading Practices, at (202) 551-5777, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commission

is amending the following rules adopted under the Securities Exchange Act of 1934 (“Exchange Act”):

1
17 CFR 242.100 through 242.105. Regulation M is also adopted under the Securities Act of 1933 (“Securities Act”) and under the Investment Company Act of 1940.

Commission reference
CFR citation

Rule 17a-4
17 CFR 240.17a-4

Regulation M:
1

Rule 100
17 CFR 242.100

Rule 101
17 CFR 242.101

Rule 102
17 CFR 242.102

Table of Contents

I. Introduction

II. Discussion of the Final Rule Amendments

A. Rule 101(c)(2) of Regulation M: Implementing Section 939A(b) in Certain Exceptions for Distribution Participants

1. Rule 101(c)(2)(i): Nonconvertible Securities of Issuers Who Meet a Specified Probability of Default Threshold

2. Rule 101(c)(2)(ii): Asset-Backed Securities Offered Pursuant to an Effective Shelf Registration Statement Filed on Form SF-3

B. Rule 102(d)(2) of Regulation M: Implementing Section 939A(b) in Certain Exceptions for Issuers and Selling Security Holders

1. Rule 102(d)(2)(i): Nonconvertible Securities of Issuers Who Meet a Specified Probability of Default Threshold

2. Rule 102(d)(2)(ii): Asset-Backed Securities Offered Pursuant to an Effective Shelf Registration Statement Filed on Form SF-3

C. Exchange Act Rule 17a-4(b)(17): Adding a Record Preservation Requirement for Broker-Dealers in Connection With Probability of Default Determinations

III. Other Issues

IV. Other Matters

V. Economic Analysis

A. Baseline

1. The Investment Grade Fixed Income Market

2. The Investment Grade Exception

B. Benefits of the Amendments

C. Costs of the Amendments

1. Costs Associated With Obtaining the Estimate of the Probability of Default

2. Costs Associated With Maintaining Records Related to the Probability of Default Estimation

3. Costs Associated With Structural Credit Risk Model Based Probability of Default Being an Imperfect Proxy for Creditworthiness

4. Costs Associated With Asset-Backed Securities' Amendments

5. Indirect and Other Costs of the Amendments

D. Efficiency, Competition, and Capital Formation

E. Reasonable Alternatives

1. Alternative Threshold for Probability of Default

2. Exception Based on Security Characteristics

3. Exception Based on Issuer Characteristics

4. Exception Based on Issuer and Issue Characteristics

5. Elimination of the Investment Grade Exception From Rule 101

6. Alternative for Asset-Backed Securities

7. Alternatives for Rule 102 Exception

8. Alternative for the Record Preservation Requirement

VI. Paperwork Reduction Act

A. Respondents

B. Use of Information

C. Collection of Information

1. Burden and Cost Estimates Related to the Rule 101 Amendments

2. Burden and Cost Estimates Related to the Rule 17a-4 Amendments

D. Collection of Information Is Mandatory

E. Confidentiality of Responses to Collection of Information

F. Retention Period for Record Preservation Requirement

VII. Regulatory Flexibility Act Certification

Statutory Authority

I. Introduction

To reduce reliance on credit ratings,
2

section 939A(b) of the Dodd-Frank Act requires the Commission, among other things, to “remove any reference to or requirement of reliance on credit ratings” and “substitute in such regulations such standard of credit-worthiness” as the Commission determines to be appropriate for those regulations.
3

In making such a determination, the Commission must seek to establish, to the extent feasible, uniform standards of creditworthiness for use by the Commission, taking into account the entities it regulates and the purposes for which those entities would rely on such standards of creditworthiness.
4

2

See
Joint Explanatory Statement of the Committee of Conference, Conference Committee Report No. 111-517, to accompany H.R. 4173, 864-79, 870 (June 29, 2010).

3

See
Public Law 111-203, sec. 939A(b), 124 Stat. 1376, 1872-90 (2010). Section 939A of the Dodd-Frank Act also requires the Commission to “review any regulation issued by [the Commission] that requires the use of an assessment of the credit-worthiness of a security or money market instrument and any references to or requirements in such regulations regarding credit ratings.” Public Law 111-203, sec. 939A(a). The Commission must transmit a report to Congress upon the conclusion of the review required in section 939A(a). Public Law 111-203, sec. 939A(c);
see
U.S. Securities and Exchange Commission Staff, Report on Review of Reliance on Credit Ratings: As Required by Section 939A(C) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (2011),
available at https://www.sec.gov/news/studies/2011/939astudy.pdf.
Staff reports, Investor Bulletins, and other staff documents (including those cited herein) represent the views of Commission staff and are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content of these documents and, like all staff statements, they have no legal force or effect, do not alter or amend applicable law, and create no new or additional obligations for any person.

4
Public Law 111-203, sec. 939A(b).

Regulation M, which is a set of prophylactic anti-manipulation rules

that is designed to preserve the integrity of the securities trading markets as independent pricing mechanisms by prohibiting activities that could artificially influence the market for an offered security, contains references to credit ratings in identical exceptions under 17 CFR 242.101 (“Rule 101”) and 242.102 (“Rule 102”) for investment grade Nonconvertible Securities and asset-backed securities.
5

The Investment Grade Exceptions are two of several exceptions to Rule 101's and Rule 102's general prohibitions: in connection with a distribution
6

of covered securities,
7

distribution participants,
8

issuers, selling security holders, and their affiliated purchasers are prohibited from, directly or indirectly, bidding for, purchasing, or attempting to induce any person to bid for or purchase, a covered security
9

during the applicable “restricted period.”
10

These prohibitions exist to protect the integrity of the offering process by precluding activities that could artificially influence the market for the offered security.
11

5

See
17 CFR 242.101(c)(2) (“Rule 101(c)(2)”), 17 CFR 242.102(d)(2) (“Rule 102(d)(2)”). Both of these rules except Nonconvertible Securities and asset-backed securities that are rated by at least one nationally recognized statistical rating organization, as that term is used in 17 CFR 240.15c3-1 (“Rule 15c3-1”), in one of its generic rating categories that signifies investment grade. Throughout this release, each exception in Rule 101(c)(2) or Rule 102(d)(2) that references credit ratings is referred to as an “Investment Grade Exception,” and, together, those exceptions are referred to as the “Investment Grade Exceptions,” as applicable.

6

See
17 CFR 242.100(b) (“Rule 100(b)”) (defining “distribution” as “an offering of securities, whether or not subject to registration under the Securities Act, that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods”).

7

See
17 CFR 242.100(b) (defining “covered security” as any security that is the subject of a distribution or any reference security, and “reference security” as a security into which a security that is the subject of a distribution may be converted, exchanged, or exercised or which, under the terms of the subject security, may in whole or in significant part determine the value of the subject security”).

8

See
17 CFR 242.100(b) (defining “distribution participant” as any “underwriter, prospective underwriter, broker, dealer, or other person who has agreed to participate or is participating in a distribution”).

9

See
17 CFR 242.100(b) (defining “covered security” as any security that is the subject of a distribution or any reference security, and “reference security” as a security into which a security that is the subject of a distribution may be converted, exchanged, or exercised or which, under the terms of the subject security, may in whole or in significant part determine the value of the subject security).

10

See
17 CFR 242.100(b).

11

Anti-Manipulation Rules Concerning Securities Offerings,
Release No. 34-38067 (Dec. 20, 1996) [62 FR 520 (Jan. 3, 1997)] (“Regulation M Adopting Release”), 62 FR 521. Rule 101's prohibitions apply to distribution participants and their affiliated purchasers, while Rule 102's prohibitions apply to issuers, selling security holders, and their affiliated purchasers.

In adopting the Investment Grade Exceptions, the Commission stated that certain securities and activities should be excepted to allow for activities that are necessary for the distribution to occur; to limit adverse effects to the trading market that could result from these prohibitions absent such exceptions; and to permit conduct that is not likely to have a manipulative impact.
12

The Investment Grade Exceptions were premised on the principle that investment grade Nonconvertible Securities and asset-backed securities are less likely to be subject to the type of manipulation that Regulation M seeks to address because they are largely fungible and trade primarily on the basis of yield and creditworthiness (traditionally measured by credit ratings),
13

rather than the identity of the particular issuer.
14

12

See Trading Practices Rules Concerning Securities Offerings,
Release No. 34-37094 (Apr. 11, 1996) [61 FR 17108 (Apr. 18, 1996)] (“Regulation M Proposing Release”), 61 FR17111, 17120.

13

See
Regulation M Adopting Release, 62 FR 527;
see also infra
note 38 (discussing how the ability to substitute similar securities in the market for the security in distribution limits the potential impact a covered person might attempt to exert on the market and distribution of such security). The Investment Grade Exceptions trace back to a 1975 Commission staff no-action position regarding Exchange Act Rule 10b-6, the predecessor to Rules 101 and 102 of Regulation M.
See
Letter from Robert C. Lewis, Assoc. Dir., Div. Mkt. Reg., SEC, to Donald M. Feuerstein, Gen. Partner & Counsel, Salomon Bros. (Mar. 4, 1975) (emphasizing the following representations from the lead underwriter-requestor in taking its position: (1) “because the non-convertible bonds of particular issuers are not considered unique and because of the concept of relative value, it is simply not possible to manipulate the price of a corporate bond that has broad investor interest,” and (2) purchasing activities in such securities generally are “unlikely to materially affect the price of [a nonconvertible debt security being offered] because of the availability of large amounts of securities of other issuers which have comparable quality yield [spreads]”). For a further discussion of the history of the Investment Grade Exceptions, see
Removal of References to Credit Ratings From Regulation M,
Release No. 34-94499 (Mar. 23, 2022) [87 FR 18312 (Mar. 30, 2022)] (“Proposal”), 87 FR 18315.

14
Regulation M Proposing Release, 61 FR 17112.

In accordance with section 939A(b)'s requirements, in 2022, the Commission proposed rule amendments to remove the Investment Grade Exceptions and substitute them with new exceptions that are based on alternative standards of creditworthiness.
15

The Commission proposed to except from Rule 101 (1) Nonconvertible Securities of issuers who meet a specified probability of default threshold,
16

and (2) asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3.
17

The Commission proposed to eliminate, without replacing, the Investment Grade Exception from Rule 102.
18

The Commission also proposed to amend 17 CFR 240.17a (“Rule 17a-4”), specifically paragraph (b) of Rule 17a-4 (“Rule 17a-4(b)”), to require broker-dealers to preserve written probability of default determinations pursuant to Rule 101.
19

15

See
Proposal, 87 FR 18316-24. The Commission previously proposed two alternatives to the Investment Grade Exceptions.
See Removal of Certain References to Credit Ratings Under the Securities Exchange Act of 1934,
Release No. 34-64352 (Apr. 27, 2011) [76 FR 26550 (May 6, 2011)];
References to Ratings of Nationally Recognized Statistical Rating Organizations,
Release No. 34-58070 (July 1, 2008) [73 FR 40088 (July 11, 2008)] (“2008 Proposing Release”), 73 FR 40095-97. The Commission did not adopt any rule amendments with regard to the Investment Grade Exceptions based on either of these proposals.

16

See
Proposal, 87 FR 18317-19.

17

See
Proposal, 87 FR 18321-22.

18

See
Proposal, 87 FR 18323-24.

19

See
Proposal, 87 FR 18324-25.

The Commission received comments from an industry group, a data provider, nonprofit organizations, and individuals.
20

Commenters broadly recognized and acknowledged the objectives of the Proposal. Some commenters, including individual commenters, provided general support for the Proposal
21

and stated that reliance on credit ratings is outdated
22

and can be harmful to investors or the markets.
23

Another commenter

supported the Proposal and stated that its adoption will lead to increased market competition.
24

Some commenters opposed or expressed concerns about the Proposal, and offered certain recommendations with regard to particular aspects of the proposed rule amendments,
25

which are addressed below, in Parts II.A through C. After reviewing and carefully considering the public comments and recommendations, and in accordance with the requirements of section 939A(b), the Commission is adopting final rule amendments, with targeted modifications to address comments received and to streamline and clarify the rule text from the Proposal. As discussed below in Parts II.A and II.B, the Commission believes that its original basis for excepting investment grade Nonconvertible Securities and asset-backed securities from Rules 101 and 102 continues to apply to the securities that are captured by the amendments' substitute standards of creditworthiness.

20
Comments received in response to the Proposal are contained in File No. S7-11-2022,
available at https://www.sec.gov/comments/s7-11-22/s71122.htm.

21

See, e.g.,
Letter from Chris Carr (May 19, 2022); Letter from Daniel Kuo (May 19, 2022); Letter from Fred Carter (May 19, 2022); Letter from Biren Patel (May 19, 2022); Letter from Robert Tso (May 23, 2022); Letter from Stephen W. Hall, Legal Dir. & Secs. Specialist, Better Mkts, Inc., to Vanessa A. Countryman, Sec'y, SEC (May 23, 2022) (“Better Markets Letter”), at 3.

22

See, e.g.,
Letter from Alexandra Merz (May 18, 2022) (“Merz Letter”); Letter from Gerhard Krohmer (May 19, 2022); Andriy Granovsky (May 19, 2022); Letter from Jason Smith (May 20, 2022); Letter from Craig Faison (May 20, 2022); Letter from Jaymin Patel (May 20, 2022); Letter from Paul K. Sacco (May 21, 2022); Letter from David Navari (May 22, 2022) (“Navari Letter”); Letter from Jim Protsenko (May 24, 2022); Letter from John Hall (May 26, 2022); Letter from Andrew Macafee (May 30, 2022). The Commission also received two anonymous comments on May 19, 2022, both of which stated that credit rating agencies “have become obsolete.”

23

See, e.g.,
Merz Letter; Letter from Robert Long (May 19, 2022); Letter from James R. Brown (May 19, 2022);
see also
Letter from William Desavigny (May 19, 2022); Letter from Kevin Price (May 19, 2022); Letter from Jason MacKenzie (May 19, 2022); Letter from James Zarbock (May 19, 2022); Letter from Carsten Hensch (May 19, 2022); Letter from Thomas Sutton (May 19, 2022); Letter from Harold VanPatten (May 19, 2022); Letter from Aaron Grimshaw (May 19, 2022); Letter from Andre M (May 19, 2022); Letter from Andrew Oshea (May 19, 2022); Letter from Steven Calvino (May 19, 2022);

Letter from Dennis Smith (May 19, 2022); Letter from Devin Dasbach (May 19, 2022); Letter from Mark A. Fritzke (May 19, 2022); Letter from Cameron Beebe (May 19, 2022); Letter from Nick Parasiris (May 19, 2022).

24

See
Letter from Jacob Rajan (May 19, 2022).

25

See, e.g.,
Letter from Joseph Corcoran, Managing Dir. & Assoc. Gen. Counsel, Secs. Indus. & Fin. Mkts. Ass'n, to Vanessa Countryman, Sec'y, SEC (May 23, 2022) (“SIFMA Letter 1”); Better Markets Letter.

II. Discussion of the Final Rule Amendments

The amendments remove the existing Investment Grade Exceptions from both Rule 101 and Rule 102 of Regulation M. For distributions of Nonconvertible Securities, the Commission is adopting two new exceptions—one in 17 CFR 242.101(c)(2)(i) (“Rule 101(c)(2)(i)”), for reliance by distribution participants and their affiliated purchasers, and one in 17 CFR 242.102(d)(2)(i) (“Rule 102(d)(2)(i)”), for reliance by issuers, selling security holders, and their affiliated purchasers. Both exceptions are based on the requirements more fully described in Parts II.A.1 and B.1 that relate to the determination of an issuer's probability of default as derived from a structural credit risk model.
26

As discussed below, in Part II.A.1, final Rule 101(c)(c)(i) differs from the Proposal with regard to the exception's conditions involving who is eligible to make probability of default determinations pursuant to Rule 101(c)(2)(i) and when such probability of default determination must be made to rely on the exception. While the Proposal would have allowed any distribution participant to make the probability of default determination in meeting the conditions of Rule 101(c)(2)(i), the final amendments require the probability of default determination to be made by the distribution participant acting as the lead manager (or in a similar capacity) of a distribution.
27

In addition, final Rule 101(c)(2)(i) will require five additional business days before the price determination date from what was proposed to make the probability of default determination in satisfying the exception's conditions.
28

Finally, the Commission is making some technical, non-substantive changes from the Proposal with regard to the wording of the standard,
29

as well as some clarifying changes to the proposed definition of “structural credit risk model.”
30

26

See
17 CFR 242.101(c)(2)(i), as amended, 242.102(d)(2)(i), as amended (requiring, for reliance by issuers, selling security holders, and their affiliated purchasers, that the distribution participant acting as the lead manager (or in a similar capacity) of a distribution have made the probability of default determination, as applicable to the subject security, pursuant to Rule 101(c)(2)(i), as amended).

27

See infra
Part II.A.1.

28

See infra
Part II.A.1.

29

See infra
note 126.

30

See infra
Part II.A.1.

Because the term “structural credit risk model” is used identically in both Rule 101(c)(2)(i) and Rule 102(d)(2)(i), as amended, the Commission is adding a definition for the term “structural credit risk model” in Rule 100(b) of Regulation M.
31

In addition, the Commission is adopting new paragraph (b)(17) of Rule 17a-4 (“Rule 17a-4(b)(17)”) requiring the preservation of the written probability of default determination, relied upon by a broker-dealer, pursuant to new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i), as applicable, to facilitate Commission staff examinations.
32

31

See
17 CFR 242.100(b).

32

See
17 CFR 240.17a-4(b)(17), as amended.

For distributions of asset-backed securities, the Commission is adopting identical, new exceptions—one in 17 CFR 242.101(c)(2)(ii) (“Rule 101(c)(2)(ii)”), for reliance by distribution participants and their affiliated purchasers, and one in 17 CFR 242.102(d)(2)(ii) (“Rule 102(d)(2)(ii)”), for reliance by issuers, selling security holders, and their affiliated purchasers—requiring that such securities be offered pursuant to an effective shelf registration statement filed on Form SF-3.
33

33

See
17 CFR 242.101(c)(2)(ii), as amended, 242.102(d)(2)(ii), as amended.

A. Rule 101(c)(2) of Regulation M: Implementing Section 939A(b) in Certain Exceptions for Distribution Participants

The application of Rule 101's prohibitions to distributions of Nonconvertible Securities and asset-backed securities generally is limited because, under Regulation M, bids for and purchases of outstanding Nonconvertible Securities are not restricted unless the security being purchased is identical in all of its terms to the security being distributed.
34

For example, Rule 101's restrictions do not apply for a security if there is a single basis point difference in coupon rates or a single day's difference in maturity dates from the security in distribution.
35

In addition, as stated in the Proposal, commenters on the Commission's previously proposed alternatives to the Investment Grade Exception
36

stated that reliance on the Investment Grade Exceptions largely is limited to two situations: re-openings (
e.g.,
when an issuer may want to make a series of offerings of its fixed-income securities via a re-opening to match its funding needs or the desires of its target investor class, or when a foreign sovereign issuer may conduct a re-opening for public financing purposes) and sticky offerings.
37

The securities that meet the

requirements of Rule 101's Investment Grade Exception are less likely to be subject to the type of manipulation that Rule 101 seeks to prevent because these securities trade on the basis of their yield and creditworthiness (traditionally measured by credit ratings), rather than the identity of the particular issuer, and are largely fungible.
38

34
Regulation M Adopting Release, 62 FR 524.

35

See
Regulation M Adopting Release, 62 FR 524. To illustrate with a simple example, absent an exception, a broker-dealer who is participating in a distribution of XYZ Corp.'s 3% bonds maturing 12/31/2029 would be prohibited from making a market in bonds with those terms prior to completing the distribution. The broker-dealer would not, however, be prohibited from making a market in XYZ Corp.'s 3% bonds maturing 12/31/2030 because the date of maturity, a term of the bond, is different from that of the security in distribution.

36

See supra
note 15.

37
Proposal, 61 FR 18316. In addition, the Commission also stated in the Proposal that another example provided by a commenter is a “best-efforts” offering. Proposal, 61 FR 18316. One commenter on the Proposal stated that firms rely on the Investment Grade Exceptions in the context of “sticky deals” and “re-openings” of debt issuances.
See
SIFMA Letter 1, at 4. As discussed below, in Part V.E.5, any offering can become a sticky offering. In such case, it may become challenging for the issue to trade based solely on its yield and maturity, notwithstanding the issuer's creditworthiness. Therefore, a sticky offering does not necessarily indicate a lack of creditworthiness on the part of the issuer. In the Proposal, the Commission asked if sticky offerings of creditworthy issuers disprove the underlying premise for excepting certain Nonconvertible Securities.
See
Proposal, 87 FR 18320. The Commission also asked if the Investment Grade Exception should be removed from Rule 101, without a replacement, because whether an offering will become sticky is unknown at the beginning of the Regulation M restricted period.
See
Proposal, 87 FR 18320. One commenter stated that it is unaware of any manipulative issues associated with reliance on the Investment Grade Exceptions in connection with sticky offerings.
See
SIFMA Letter 1, at 2.

However, no commenter suggested that the Commission should remove the Investment Grade Exception from Rule 101, without a replacement.

38

See
Regulation M Adopting Release, 62 FR 527;
see also
Regulation M Proposing Release, 61 FR 17112. For purposes of Regulation M, securities of issuers of a certain credit quality trade on the basis of their yield and creditworthiness (traditionally measured by credit ratings) and are less susceptible to manipulation because other similar Nonconvertible Securities or asset-backed securities are available to investors as an alternative. If the pricing of an offering is inconsistent with pricing in the overall secondary market for similar Nonconvertible Securities or asset-backed securities, an investor may purchase alternative securities that have a better yield, yet are of comparable creditworthiness, in relation to the security being distributed. Accordingly, the ability to substitute similar Nonconvertible Securities or asset-backed securities for the security in distribution limits the ability of a distribution participant to impact the market and distribution of such security.

1. Rule 101(c)(2)(i): Nonconvertible Securities of Issuers Who Meet a Specified Probability of Default Threshold

The Commission proposed to except the Nonconvertible Securities of issuers for which the probability of default, estimated as of the day of the determination of the offering pricing and over the horizon of 12 calendar months from such day, is less than 0.055%, as determined and documented in writing by the distribution participant as derived from a structural credit risk model.
39

The Commission included a definition for the term “structural credit risk model” as a
proviso
in proposed Rule 101(c)(2)(i) to mean “any commercially or publicly available model that calculates the probability that the value of the issuer may fall below a threshold based on an issuer's balance sheet.”
40

Accordingly, as proposed, a distribution participant's (or its affiliated purchaser's) reliance on proposed Rule 101(c)(2)(i) would have been conditioned on a probability of default determination that was made by use of any commercially or publicly available model that calculates the probability that the value of the issuer may fall below a threshold based on an issuer's balance sheet.

39
Proposal, 87 FR 18338. The Commission stated that, as discussed in that release, based on an analysis of the probability of default and investment grade ratings of a sample of Nonconvertible Securities available on the market as of Oct. 22, 2021, this was an appropriate substitute standard of creditworthiness in place of the reference to credit ratings in the Investment Grade Exception for Nonconvertible Securities.
See
Proposal, 87 FR 18318.

40
Proposal, 87 FR 18338.

As discussed in the Proposal, since 1974, structural credit risk models, such as the model first proposed by Robert C. Merton and its successor models, have become widely relied upon to determine the probability that an issuer will default on its loan obligations.
41

Many commercial data providers, as part of software suites that allow users to analyze securities, employ certain structural credit risk models that are based on the Black-Scholes option pricing model as a way to measure the creditworthiness of companies. These types of structural credit risk models typically use measures from company accounting statements and company-specific and aggregate market prices and require input variables to calculate an estimated probability of default for a specified horizon, including the market value and volatility of the assets, as well as assumptions regarding the threshold for company asset values, below which the equity owner would default on its obligations (“Default Point”).
42

In addition, these structural credit risk models provide the probability that a company's assets will fall below the Default Point at or by the expiration of a defined period.

41

See generally
Proposal, 87 FR 18316-17 (providing a history and overview of structural credit risk models). Generally, these models assume that owners of a company's equity will continue to pay the company's liabilities if the company's value exceeds its liabilities. Equivalently, if the equity owners were considered to own a call option on the value of the company with a strike price equivalent to the liabilities owed, the equity owners would exercise the call on the value of the company. If, however, the company's liabilities exceed the company's value, the models assume that the equity owners will choose to default on the company's liabilities, or equivalently, the equity owners would not exercise the call on the value of the company. Accordingly, these structural credit risk models provide a method, based on the Black-Scholes option pricing model, to estimate the probability that a company might default on its liabilities.
See
Proposal, 87 FR 18317.

42
The Default Point frequently is calculated as all short-term liabilities plus half of the long-term liabilities.
See
Mario Bondioli et al.,
The Bloomberg Corporate Default Risk Model (DRSK) for Public Firms
(Mar. 2021),
available at https://ssrn.com/abstract=3911300.

Generally, the following variables are needed to derive an issuer's probability of default from a typical structural credit risk model: (1) the issuer's value, which can be based on observed market prices of an issuer's equity security or estimated based on an issuer's balance sheet; (2) the volatility of the issuer's equity or assets, which also can be based on market observations or estimated based on an issuer's balance sheet; (3) the risk-free rate; (4) a time horizon; and (5) the Default Point. A structural credit risk model's application may be limited in the absence of a market for an issuer's equity securities if the market price of the issuer's assets, which, as discussed above, is required to calculate the probability of default, is difficult to determine.
43

43
These models calculate the probability of default based on inputs from an issuer's balance sheet. Transactions in equity securities frequently are used as a proxy to determine the value of the firm and the overall volatility of the issuer's assets. Even the absence of a market for an issuer's equities alone does not preclude the ability of a distribution participant to use certain structural credit risk models because the issuer's balance sheet will include the liabilities, assets, and equity, which, with further analysis, can be used to determine the inputs for the models. Distribution participants, based on their activities as an underwriter, broker-dealer, or other person who has agreed to participate in a distribution, can access an issuer's balance sheet to calculate the issuer's probability of default.

Some commenters supported the proposed exception for Nonconvertible Securities that is based on an issuer's probability of default.
44

One commenter stated that the proposed application of a structural credit risk model requirement will provide additional transparency for investors and other market participants.
45

Another commenter agreed with the Commission that the estimated probability of default of a debt security “is and should be a central component of the analysis of the credit risk”
46

and that the “expected probability of default can be independently determined by structural credit risk models based on observable market events and information available on a firm's balance sheet,” without having to rely on an investment grade rating.
47

However, this commenter also stated that balance sheet measures frequently are inaccurate and that comparisons of market values to book values are subject to concerns about “garbage in, garbage out.”
48

While the Commission requested comments regarding whether the exception proposed in Rule 101(c)(2)(i) should require the issuer's balance sheet to be audited,
49

it did not receive any

comments in response to this question. In addition, the Commission considered including in the exception models that may not necessarily rely on an issuer's balance sheet to determine a firm's creditworthiness, such as reduced-form models. Reduced-form models, however, do not necessarily predict future defaults better than structural credit risk models do, and they suffer from a lack of theoretical foundation of the assumed relationships, or the intuitive interpretation of the model dependencies and why the defaults occur.
50

For these reasons, and as discussed throughout this Part, the Commission is adopting a standard that is based on the use of a structural credit risk model as it is appropriately designed to measure creditworthiness of Nonconvertible Securities in new Rule 101(c)(2)(i), in accordance with the requirements of section 939A(b).

44
Letter from Gregory Babyak, Global Head of Reg. Affairs, Bloomberg L.P., to Vanessa A. Countryman, Sec'y, SEC (May 23, 2022) (“Bloomberg L.P. Letter”), at 1; Letter from Robert E. Bishop, Fellow, Ctr. Law & Bus., UC Berkeley School of Law, & Frank Partnoy, Adrian A. Kragen Professor of Law, UC Berkeley School of Law, to Vanessa Countryman, Sec'y, SEC (May 23, 2022) (“IILF Letter”), at 2; Better Markets Letter, at 2.

45
Bloomberg L.P. Letter, at 1.

46
IILF Letter, at 2.

47
IILF Letter, at 5.

48
IILF Letter, at 6.

49
Proposal, 87 FR 18320. Such a requirement could present operational challenges in connection with deriving an issuer's probability of default from

a structural credit risk model. As discussed below, in this Part, the determinations must be “estimated as of the sixth business day immediately preceding the determination of the offering price,” which helps to ensure that timely information regarding the issuer is used as a model input. A lead manager may encounter difficulties in obtaining model input information from an issuer's audited balance sheet each time it needs to determine an issuer's probability of default for purposes of reliance on the exception for Nonconvertible Securities if such a determination were being made in between audits.

50

See infra
Part V.E.3.

One commenter suggested an exception based on alternative standards of creditworthiness that do not utilize structural credit risk models. First, this commenter suggested that the Commission adopt an exception for Nonconvertible Securities that are offered pursuant to an effective registration statement filed on any of the following forms: (1) Form S-3;
51

(2) Form S-4;
52

(3) Form F-3;
53

(4) Form F-4;
54

or (5) Form F-10,
55

provided that, for an offering registered on Form F-10, the offering also meets the transactional requirements of General Instruction I.B.2 of Form F-3.
56

The commenter stated several reasons for which the use of this standard would be desirable,
57

and that allowing some amount of high yield issuers to be eligible for the exception would be an acceptable compromise in light of the benefits the commenter's proposed standard otherwise provides.
58

In addition, this commenter stated that the “consistently very high percentage of registered nonconvertible debt tranches that were investment grade demonstrates that Securities Act registration alone serves as a reliable proxy for identifying offerings of nonconvertible debt securities that trade primarily based upon their yield and creditworthiness.”
59

51
17 CFR 239.13.

52
17 CFR 239.25.

53
17 CFR 239.33.

54
17 CFR 239.34.

55
17 CFR 239.40.

56
SIFMA Letter 1, at 5-8;
see
Letter from Joseph Corcoran, Managing Dir. & Assoc. Gen. Counsel, Secs. Indus. & Fin. Mkts. Ass'n, to Vanessa Countryman, Sec'y, SEC (Oct. 28, 2022) (“SIFMA Letter 2”).

57
SIFMA Letter 1, at 3-4 (stating that this standard would provide a straightforward, uniform standard; align with how the Commission addressed the Dodd-Frank Act-related removal of references to credit ratings from the eligibility criteria for use of certain provisions under the Securities Act and related forms; promote the conduct of offerings on a registered basis by limiting the exception to qualifying registered offerings; afford predictability; avoid complex calculations that could lead to errors or differing results, depending on the particular structural credit risk model used; allow the availability of the exception to be readily and independently verified through a review of the issuer's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database filings, which would minimize additional regulatory burdens and obviate the need for any additional broker-dealer recordkeeping obligations; ease the burden on all involved, including for regulators; and provide greater legal certainty to the affected issuers and any selling shareholders).

58
SIFMA Letter 2, at 1; SIFMA Letter 1, at 5-7.

59
SIFMA Letter 2, at 3.

The Commission acknowledges that the commenter's suggested standard may capture a consistently very high percentage of registered nonconvertible debt tranches that were rated investment grade and may seem operationally easier to determine whether the new exception in Rule 101(c)(2)(i) for Nonconvertible Securities is available, may help to promote the conduct of offerings on a registered basis, and allow for the use of an exception that can be verified with publicly available information, among other things. The commenter's suggested standard, however, would not be appropriate because it does not sufficiently focus on creditworthiness. When the Commission revised the eligibility criteria for use of Forms S-3 and F-3 to remove any references to credit ratings, it specifically stated that the eligibility criteria included in those forms did not distinguish among issuers by the quality of their credit but rather focused exclusively on whether the issuer has a wide following in the marketplace to identify issuers who should be eligible for short-form registration and faster access to capital markets through the shelf registration process.
60

This is distinct from the basis for adopting the Investment Grade Exceptions, including under Rule 101(c)(2), which was that Nonconvertible Securities are appropriate to except from Regulation M's requirements because they are fungible and traded on the basis of their yield and creditworthiness, and therefore are less likely to be manipulated.
61

60

Security Ratings,
Release No. 33-9245 (July 27, 2011) [76 FR 46603 (Aug. 3, 2011)] (“Form S-3 and Form F-3 Release”), 76 FR 46607. When the Commission revised the eligibility criteria for use of Form S-3 and Form F-3 to remove any references to credit ratings, it noted that none of the criteria are a standard of creditworthiness. Form S-3 and Form F-3 Release, 76 FR 46607 n.60. The Commission stated that “any alternative standard for Forms S-3 and F-3 eligibility that does not refer to credit ratings should preserve the forms and access to the shelf registration process for issuers who have a wide following in the marketplace.” Form S-3 and Form F-3 Release, 76 FR 46607. Form SF-3, the shelf registration statement form for asset-backed securities that is discussed below, in Part II.A.2, differs from these other forms raised by the commenter that rely on the eligibility criteria for use of Form S-3 or Form F-3. Whereas the eligibility criteria included in Forms S-3 and F-3 focus exclusively on whether the issuer has a wide following in the marketplace to identify issuers who should be eligible for short-form registration and faster access to capital markets through the shelf registration process, the eligibility criteria and offering requirements included in Form SF-3 help to ensure that asset-backed securities issued in shelf offerings are designed to help ensure that that the securitization is designed to produce expected cash flows that are sufficient to service payments or distributions in accordance with their terms; that obligated parties more carefully consider the characteristics and quality of the assets that are included in the pool; and that asset-backed securities shelf offerings have transactional safeguards and features that make those certain securities appropriate to be issued without prior Commission staff review.
See Asset-Backed Securities Disclosure and Registration,
Release No. 34-72982 (Sept. 4, 2014) [79 FR 57184 (Sept. 24, 2014)] (“Regulation AB II Adopting Release”), 79 FR 57267, 57278, 57283.

61

See
Regulation M Adopting Release, 62 FR 524;
supra
note 13. For these reasons discussed above, as related to the eligibility criteria of Forms S-3 and F-3, the commenter's suggestion of excepting Nonconvertible Securities that are offered pursuant to an effective registration statement filed on Form S-4 or F-4 would not be an appropriate substitute standard of creditworthiness in place of the reference to credit ratings in the Investment Grade Exception pursuant to section 939A(b) because Forms S-4 and F-4 include the Forms S-3 and F-3 eligibility criteria by allowing registrants that meet the registrant eligibility requirements of Form S-3 or F-3 and that are offering investment grade securities to incorporate by reference certain information.
See
Form S-3 and Form F-3 Release, 76 FR 46611 (citing General Instruction B.1 of Forms S-4 and F-4). Similarly, the commenter's suggestion of excepting Nonconvertible Securities that are offered pursuant to an effective registration statement filed on Form F-10, provided that the offering also meets the transactional requirements of General Instruction I.B.2. of Form F-3, would not be an appropriate substitute standard of creditworthiness in place of the reference to credit ratings in the Investment Grade Exception pursuant to section 939A(b) because that measure references transactional requirements that have a distinct purpose from the Commission's original basis for adopting the Investment Grade Exception. As discussed in this Part, the probability of default is an appropriate measure to identify low manipulation risk of Nonconvertible Securities because it allows for the selection of issuers whose securities trade on the basis of yield and creditworthiness.

Specifically, securities of issuers of a certain credit quality trade based on

yield and creditworthiness
62

and are less susceptible to manipulation because other similar Nonconvertible Securities are available to investors as an alternative to the security in distribution. If pricing of a Nonconvertible Security offering is inconsistent with pricing in the overall secondary market for similar Nonconvertible Securities, an investor may purchase alternative Nonconvertible Securities that have a better yield, yet are of comparable creditworthiness, than the security being distributed. Accordingly, the ability to substitute similar Nonconvertible Securities in the market for the security in distribution limits the potential impact that a distribution participant might attempt to exert on the market and distribution of such security. In addition, when debt has a very low probability of default, the cash flows are close to risk-free. Thus, the price of the debt is mainly subject to fluctuations based on aggregate interest rates rather than issuer-specific or security-specific news.

62
Bonds trade among investors and dealers in secondary markets at prices that depend on economy-wide interest rates, as well as on market perceptions regarding the likelihood that the issuing company will make the promised payments. Hendrik Bessembinder & William Maxwell,
Markets: Transparency and the Corporate Bond Market,
22 J. ECON. PERSP. 217, 220 (2008).

The probability of default is an appropriate measure to identify low manipulation risk of such securities, as it allows for the selection of issuers whose securities trade on the basis of yield and creditworthiness (traditionally measured by credit ratings). For issuers with sound creditworthiness, the pricing of securities is unrelated to other risks associated with the identity of the issuer, greatly reducing their uncertainty and manipulation risk. A standard based on a criterion such as being widely followed in the market does not allow for such a clear distinction because such a standard does not differentiate securities that are traded solely on their yield and creditworthiness from securities that trade solely on the issuer's identity and thus could present a high manipulation risk.
63

Accordingly, it is appropriate to implement the section 939A(b) mandate by adopting an exception that is based on a standard that is likewise premised specifically on creditworthiness rather than on whether a particular issuer has a wide following in the marketplace.

63

See infra
Part V.E.3.

Second, the commenter suggested that its recommended standard described above, which is based on the Forms S-3 and F-3 eligibility criteria, could be modified by prohibiting reliance on the exception for Nonconvertible Securities that include both a “limitation on restricted payments covenant” and a “limitation on sales of assets and subsidiary stock covenant,” which the commenter stated are two covenants that typically are associated with non-investment grade debt securities and are almost never used in investment grade debt securities.
64

64
SIFMA Letter 1, at 8.

However, despite the commenter's suggestions, the covenant restrictions are features of current market practices
65

but are not necessarily inherent characteristics of the securities related to their creditworthiness. Conditioning the exception on the absence of certain covenants poses the risk that, should market practice change, the exception would quickly become outdated. Therefore, even with the commenter's two suggested modifications, a standard that is focused on the Form S-3 or Form F-3 eligibility criteria and is premised exclusively on whether an issuer is widely followed,
66

rather than on an issuer's creditworthiness, is not an appropriate substitute standard of creditworthiness in place of the references to credit ratings in Rule 101's Investment Grade Exception for Nonconvertible Securities to sufficiently respond to the requirements of section 939A(b).

65

See, e.g.,
SIFMA Letter 1, at 8.

66
Form S-3 and Form F-3 Release, 76 FR 46607.

Finally, this commenter suggested that the Commission adopt a modified version of the 2008 Proposing Release involving a well-known seasoned issuer (“WKSI”) standard
67

to except: (1) a WKSI that, as of a date within 60 days of the applicable determination date, has a worldwide market value of its outstanding voting and non-voting common equity held by non-affiliates of $700 million or more; and (2) a non-WKSI to the extent it is carved out of the WKSI definition solely by virtue of the application of paragraph (1)(v), (vi), or (ix) of the definition of “ineligible issuer” under Rule 405 under the Securities Act.
68

The Commission recognizes the advantage a WKSI-based standard might have in terms of its simplicity and straightforward calculation. As noted in the Proposal, however, a WKSI-based standard as proposed in 2008 was criticized for allowing many risky, high-yield issues to be excepted and preventing issues by smaller but otherwise credit-worthy issuers from being eligible for the exception.
69

This WKSI-based standard, however, unlike the probability-of-default-based standard, would fail to capture the pricing point where the sound creditworthiness of the issuer eliminates other risks associated with the issuer identity. The Nonconvertible Securities of such issuers trade solely based on their yields and creditworthiness and not on issuer characteristics, where pricing uncertainty and manipulation risk are at their minimum.
70

The WKSI-based standard, therefore, is a less effective measure of manipulation risk as compared to the probability of default measure.

67
In 2008, prior to the enactment of the Dodd-Frank Act, the Commission proposed to substitute credit ratings references in Rules 101 and 102 with a standard for Nonconvertible Securities that was based primarily on the WKSI concept from 17 CFR 230.405 (“Rule 405”), as well as a standard for asset-backed securities that were registered on Form S-3.
See
2008 Proposing Release, 73 FR 40095-97. The WKSI-based approach, consistent with the definition of WKSI under Rule 405, would have excepted the Nonconvertible Securities of companies that have issued at least $1 billion aggregate principal amount of nonconvertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act.
See
17 CFR 230.405, paragraph (1)(i)(B)(
1
) of the definition of WKSI;
see also
2008 Proposing Release, 73 FR 40096.

68

See
SIFMA Letter 1, at 10. This commenter stated that its suggested exception based on Forms S-3 and F-3 is more appropriate than this WKSI-based approach because the Form S-3/F-3-based approach “recognizes several different means of qualifying under the transactional requirement, only one of which is based upon the aggregate principal amount of non-convertible securities issued over the preceding three years.” SIFMA Letter 1, at 9-10. For the reasons discussed in this Part, neither of these approaches is an appropriate standard of creditworthiness in place of the reference to credit ratings in the Investment Grade Exception.

69
Proposal, 87 FR 18334-35.

70

See infra
Part V.E.3.

For these reasons, and pursuant to the requirements of section 939A(b), the probability of default measure is a more appropriate substitute of creditworthiness for the reference to credit ratings in the existing Investment Grade Exception than is the commenter's suggested WKSI-based standard.
71

As discussed above, in this Part, when debt has a very low probability of default, its price fluctuations are mainly based on aggregate interest rates rather than on company-specific or security-specific news. The probability of default measure, in contrast to the commenter's suggested WKSI-based standard, continues to rely on the premise underlying the Investment Grade Exception: Nonconvertible Securities

that trade primarily based on their yield and creditworthiness are less susceptible to the type of manipulation that Rule 101 seeks to prevent.

71

See
Proposal, 87 FR 18317. Similar to how securities covered by the existing Investment Grade Exception are excepted from Rule 101's prohibitions, Nonconvertible Securities that trade based on their yield and creditworthiness would be excepted under Rule 101 as amended to include the probability of default-based standard.

Some commenters stated that the Commission should specify a particular structural credit risk model to be used by all parties in making probability of default calculations.
72

These commenters stated their concerns regarding the potential for inconsistent outcomes resulting from the discretion to choose what structural credit risk models to apply.
73

One commenter stated that the adoption of the proposed model-based standard would create the risk that the new standard would be manipulated because firms would have a wide variety of models from which to select.
74

This commenter stated that, while the proposed probability-of-default-based standard is a reasonable alternative standard of creditworthiness, the use of structural credit risk models would create challenges for the Commission, with regard to implementing the probability of default standard, and for investors, with regard to confidence in the consistency and reliability of determinations made under the new standard.
75

In addition, this commenter stated that setting no minimum standards for the models and allowing market participants the discretion to choose among a wide range of models threatens to create a “race to the bottom” as market participants seek to avoid competitive disadvantages that will arise from having an appropriately rigorous risk of default evaluation.
76

Another commenter, however, stated that it would be “risky” for the Commission to engage in “model preferencing.”
77

72

See
SIFMA Letter 1, at 10; Better Markets Letter, at 5.

73

See
SIFMA Letter 1, at 5; Better Markets Letter, at 4.

74
Better Markets Letter, at 4 (stating, in part, that the use of structural credit risk models will create a lack of uniformity that conflicts with the mandate in section 939A(b) for the Commission to establish, to the extent feasible, uniform standards of creditworthiness).
But see
Bloomberg L.P. Letter, at 2 (stating that, although the application of a particular threshold across multiple models may have some unintended consequences (
e.g.,
different point-in-time probability of default models may produce different results for the same issuance), the proposed exception provides an alternative measure of creditworthiness that is practical, appropriately based on objective factors, and can be consistently applied by market participants). The mandate in section 939A(b) to seek to establish uniform standards of creditworthiness is limited “to the extent [that it is] feasible.” Public Law 111-203, sec. 939A(b). As discussed in this Part, the use of structural credit risk models to derive an issuer's probability of default is an appropriate standard of creditworthiness in accordance with section 939A(b)'s requirements.

75
Better Markets Letter, at 4.

76
Better Markets Letter, at 4.

77

See
IILF Letter, at 6 (stating that requiring a particular type of model could potentially distort the behavior of market participants in their estimations of probability of default and discouraging further and alternative inquiries into the probability of default). The use of structural credit risk models is required only for purposes of deriving an issuer's probability of default pursuant to new Rule 101(c)(2)(i). Distribution participants, as well as other market participants, may use other types of models in evaluating the creditworthiness of an issuer outside of making a Rule 101(c)(2)(i) probability of default determination.

The Commission agrees with the comment against requiring the use of a specific structural credit risk model.
78

On balance, the use of a structural credit risk model to derive an issuer's probability of default pursuant to Rule 101(c)(2)(i), as amended, provides an appropriate degree of flexibility in terms of model selection while also providing certainty to distribution participants as to the standards for the structural credit risk model required for purposes of compliance in making probability of default determinations. The ability to use an unrestricted universe of models for purposes of meeting the conditions of new Rule 101(c)(2)(i) could provide distribution participants with the opportunity to choose model specifications that enable abuse of the exception for Nonconvertible Securities. In this regard, the definition of “structural credit risk model,” as discussed below in this Part, sets minimum standards for the structural credit risk models that may be used to derive an issuer's probability of default to meet the conditions of new Rule 101(c)(2)(i). These minimum standards include that the model be a commercially or publicly available model and that it calculate, based on an issuer's balance sheet, the probability that the value of the issuer will fall below the Default Point, at or by the expiration of a defined period. As discussed below, in Part V.C.3, the standard's use of structural credit risk models could incentivize lead managers to select models and estimation specifics in such a way to ensure the resulted estimates are below the threshold, thus allowing securities of issuers with low creditworthiness and high manipulation risk to be eligible for the exception. The public availability of alternative estimates for investors, however, should mitigate this concern.
79

Specifically, the limitation that the structural credit risk model must be a commercially or publicly available model would limit a distribution participant's ability to develop models for the purpose of abusing the exception.
80

In this regard, use of a structural credit risk model that is not commercially or publicly available, or one that does not calculate, based on an issuer's balance sheet, the probability that the value of the issuer will fall below the Default Point, at or by the expiration of a defined period, would not be permissible in meeting the conditions of the exception.

78

See
IILF Letter, at 6.

79
Also, as discussed below, in Part II.C, because probability of default estimates may be subjective to some extent and not comparable across different issuers or for the same issuer across different issues if estimates are based on different models, or done by different researchers or vendors, the requirement associated with reliance on new Rule 101(c)(2)(i) to preserve written probability of default determinations is designed to facilitate the Commission's examinations of broker-dealers who rely on the exception in new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i).

80

See infra
Part V.C.3.

While a standard that relies on the use of a structural credit risk model retains a certain level of subjectivity,
81

this standard also leaves room for improvement if the market adopts more accurate structural credit risk models in the future. As the Commission stated in the Proposal, the use of any model to estimate creditworthiness necessarily provides an imperfect measure.
82

This flexibility in selection may result in an outcome-oriented selection of structural credit risk models, as one commenter suggested.
83

However, a selection that meets the definition of “structural credit risk model,” as provided in Rule 100(b), as well as the requirements of new Rule 101(c)(2)(i), would be consistent with the aims of section 939A as well as those of Regulation M.
84

In addition, the new record preservation requirement set forth in Rule 17a-4(b)(17), as discussed below in Part II.C, is designed to aid Commission examinations of broker-dealers who rely on the exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i), as amended, and can help deter improper adjusting of the estimation to meet the conditions of either of the exceptions.
85

81

See infra
Part V.C.3;
see also
Proposal, 87 FR 18334.

82
Proposal, 87 FR 18332.

83
SIFMA Letter 1, at 5.

84

See infra
Part V.B (discussing how structural credit risk models, as defined in Rule 100(b), are designed to measure creditworthiness, and creditworthiness itself is considered to be a good measure of manipulation risk).

85

See
17 CFR 240.17a-4(b)(17), as amended;
infra
Part II.C.

The Commission requested comment on whether there are “any reasons why the Rule should not permit a distribution participant to perform its own calculation (subject to recordkeeping requirements, as proposed).”
86

To address concerns that the proposed flexibility in structural

credit risk model selection could lead to different underwriters coming to different conclusions on the availability of an exception from Regulation M based on which structural credit risk model they use, as well that this flexibility could contribute to inefficiencies, confusion, and dissension among distribution participants,
87

the final amendments limit the universe of those who are eligible to determine an issuer's probability of default under new Rule 101(c)(2)(i) to include only the distribution participant who is acting as the lead manager (or in a similar capacity)
88

of a distribution.
89

This limitation will help to ensure consistent reliance on the exception across all distribution participants for the same distribution through use of the same written probability of default determinations and through the new record preservation requirements under Rule 17a-4(b)(17).
90

The lead manager's role and responsibilities in overseeing the distribution process
91

should, for these same reasons, help alleviate concerns regarding the consistency and reliability of the determinations within any particular distribution.
92

86
Proposal, 87 FR 18320.

87
SIFMA Letter 1, at 5.

88
Distribution participants who act as the “lead manager” of a distribution for purposes of the exception in Rule 101 may, as a practical matter, also use or be known by different titles, such as “lead underwriter,” “managing lead underwriter,” “syndicate manager,” “stabilizing manager,” “lead bookrunner,” or “co-managing underwriter.” The parenthetical “(or in a similar capacity)” is included in FINRA's underwriting-related rules, such as FINRA Rule 5110, to recognize this common industry practice, as well as to prevent evasion by persons attempting to avoid regulatory responsibility under a particular provision by using a different title or term to refer to themselves, even though they perform the same or similar function.

89

See
17 CFR 242.101(c)(2)(i), as amended.

90
As discussed below, in Part II.C, broker-dealers who rely on the new exception for Nonconvertible Securities in new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i), as applicable, must preserve certain records pursuant to Rule 17a-4 under the Exchange Act. New paragraph (b)(17) of Rule 17a-4 requires broker-dealers to preserve the written probability of default determination, relied upon pursuant to the exception for Nonconvertible Securities. Accordingly, broker-dealers relying on the exception for Nonconvertible Securities are required 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.

91
The term “lead manager” under new Rule 101(c)(2)(i) is consistent with how the term “manager” is applied, for recordkeeping purposes, in 17 CFR 240.17a-2(b)(1) with respect to any person who acts as a manager of a distribution for its sole account or for the account of a syndicate or group in which it is a participant with respect to keeping records of any syndicate covering transactions, penalty bids, and all related stabilizing activity, all three of which are governed under 17 CFR 242.104, which cross-references the recordkeeping requirement in 17 CFR 240.17a-2, as well as the “managing underwriter” in connection with TRACE-reporting of eligible fixed-income securities, or FINRA Rule 5131's requirement that the lead managing underwriter of a distribution disclose indications of interest and final allocation information to the issuer's pricing committee, or notify the issuer of any impending release or waiver of lock-ups. Thus, similar to the traditional role played by the lead or managing underwriter in firm commitment offerings—which generally include overseeing the offering process to ensure that the marketing, pricing, and allocation processes all go smoothly; providing critical advice on the structure, size, timing, and price of the offering; and advising on how to best present the issuer's business in the prospectus or other offering documents—the distribution participant acting as the lead manager (or in a similar capacity) of a distribution is the only market participant who is eligible to derive the issuer's probability of default for purposes of meeting the conditions of new Rule 101(c)(2)(i), in recognition that it is in the best position to do so. There may be distributions with more than one distribution participant acting as the lead manager (or in a similar capacity). In such a distribution, because the rule text refers to “the distribution participant acting as the lead manager,” only one of the distribution participants acting as the lead manager would be permitted to make the probability of default determination for the particular distribution.

92

See, e.g., infra
Part V.C.3 (discussing that the requirement related to the lead manager's probability of default determination should mitigate the subjectivity (of the analysis involved in probability of default estimation, as well as of the selection of the model and data sample specifics) and the concerns regarding non-uniform probability of default estimates for the same issue—and to some degree across issues for the same issuer to the extent the same parties are engaged by the issuer for different issues).

The lead-manager requirement is intended to broadly reflect current market practices.
93

Lead managers will be incentivized to share their probability of default determinations with other distribution participants and their affiliated purchasers (as well as with the issuer, selling security holders, and their affiliated purchasers) in order to rely on the exception for Nonconvertible Securities given their primary role and responsibilities in overseeing the distribution process, which can include providing liquidity and facilitating an orderly distribution and aftermarket in connection with the offering.
94

While Regulation M does not require the lead manager to coordinate the activities of the other syndicate members, lead managers are, as a practical matter, concerned that the other underwriters in the syndicate are, among other things, complying with Regulation M's trading prohibitions
95

so as not to extend the Regulation M restricted period.
96

However, Rule 101(c)(2)(i), as amended, does not require that the lead manager making the probability of default determination share the determination with other distribution participants or their affiliated purchasers in order for those parties to rely on the exception.
97

Therefore, non-lead manager distribution participants and their affiliated purchasers (as well as issuers, selling security holders, and their affiliated purchasers, as discussed below, in Part II.B.1) may not be able to rely on the exception for Nonconvertible Securities if the lead manager does not share the probability of default determination or there is no distribution participant to act as the lead manager for the distribution, such as with self-underwritten offerings, at-the-market offerings, or other shelf offerings, to the extent such an offering meets the definition of a “distribution” under Rule 100(b) of Regulation M.
98

93

See, e.g., supra
notes 88, 91.

94

See, e.g.,
Regulation M Adopting Release, 62 FR 534-35.

95

See, e.g., supra
notes 88, 91; SIFMA,
Model Form of Master Agreement Among Underwriters
(Dec. 10, 2018),
https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf https://www.sifma.org/wp-content/uploads/2017/08/SIFMA-Model-MAAU.pdf.

96

See
Regulation M Adopting Release, 62 FR 522-23 (discussing Rule 100's definition of “completion of participation in a distribution” when underwriters in a syndicate are involved).

97
The Commission asked in the Proposal whether distribution participants should be required to post or make the probability of default public on their website to rely on the exception.
See
Proposal, 87 FR 18320. As discussed below, in Part II.C, one commenter stated that the Commission also could publish, or require publication of, default probability estimates that market participants derive from various models, along with default probabilities implied by both market prices and credit default swap spreads.
See
IILF Letter, at 8. However, the Commission did not receive any comment suggesting that distribution participants making probability of default determinations should be required to post or make the probability of default determinations public on their website in order to rely on the exception. Nor did the Commission receive any comment suggesting that the sharing of probability of default determinations among other covered persons should be included as a condition to the exception.

98
Rule 100 of Regulation M defines the term “distribution” as “an offering of securities, whether or not subject to registration under the Securities Act that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.” With regard to shelf offerings, each takedown of a shelf is to be individually examined to determine whether such offering constitutes a “distribution” (
i.e.,
whether it satisfies the “magnitude” of the offering and “special selling efforts and selling methods” criteria of a distribution). Regulation M Adopting Release, 62 FR 526. In those situations where a broker-dealer sells shares on behalf of an issuer or selling security holder in ordinary trading transactions into an independent market (
i.e.,
without any special selling efforts), the offering will not be considered a distribution, and the broker-dealer will not be subject to Rule 101. Regulation M Adopting Release, 62 FR 526.

This potential impact is mitigated, however, if the syndicate adjusts the way it interacts with lead managers. For example, the syndicate could decide, by contract (
e.g.,
in an agreement among underwriters) and for the same reason of consistency as discussed above, to specifically authorize the lead manager

to share its probability of default determination with other distribution participants. The syndicate could also make the decision not to allow the lead manager to share its probability of default determination with unrelated distribution participants in order to keep a tighter control of the distribution. Because the facts and circumstances vary across issues, it is reasonable to let the syndicate decide how widely the probability of distribution determination is shared by the lead manager. If such information is shared, it must be used consistently across the syndicate to rely on the new exception in Rule 101(c)(2)(i) because such reliance is conditioned on the lead manager's probability of default determination.

The lead-manager requirement, however, could affect current market practices by resulting in fewer Nonconvertible Securities being excepted under the new standard in comparison to those currently excepted under the Investment Grade Exception if, as a practical matter, only Nonconvertible Securities that are subject to underwritten offerings become eligible for the new exception in Rule 101(c)(2)(i). With regard to the types of distributions covered, as a result of the condition requiring that the lead manager perform the probability of default determinations in order for reliance on the exception, this exception will be available to a subset of distributions of Nonconvertible Securities covered under the existing Investment Grade Exception and to a subset of the distributions that would have been captured under the Proposal.
99

Accordingly, any potential challenges, as a commenter suggested,
100

are likely to be faced in carrying out obligations in order to rely on the new exception in Rule 101(c)(2)(i). The estimated costs associated with the requirement related to the lead manager making the probability of default determination are included below, in Part V.C.1.
101

99

See
Proposal, 87 FR 18330.

100

See
Better Markets Letter, at 4.

101
However, as discussed below, in Parts V.C.1 and VI.C.1, some lead managers may rely on third party vendors rather than internally calculate the probability of default.

The bright-line requirements of Rule 101(c)(2)(i), as amended, and the corresponding record preservation requirements of new Rule 17a-4(b)(17) also help to promote confidence in the consistency and reliability of the lead manager's determinations by limiting the degree to which there are variances between probability of default calculations within any one distribution as well as by deterring any improper tweaking of model inputs.
102

The bright-line threshold of 0.055%, as well as the pre-determined time horizon, are model inputs that are uniform and predictable and, thus, should provide the necessary clarity as to what is expected in evaluation and documentation. In addition, the bright-line threshold of 0.055% will help to ensure that only those Nonconvertible Securities that trade on the basis of yield and creditworthiness, and are fungible,
103

will meet the exception, regardless of the model picked. Accordingly, the probability-of-default-based standard articulates an appropriate alternative measure of creditworthiness that is practical and is appropriately based on objective factors.

102
As discussed below, in Part II.C, the record preservation requirements provided in new Rule 17a-4(b)(17) are sufficient to help the Commission's examinations of broker-dealers relying on the new probability-of-default-based standard.

103

See, e.g., supra
notes 13, 38.

One commenter stated that commercially or publicly available structural credit risk models are not used by all firms in the context of evaluating whether to underwrite a security and that such a decision, instead, is focused on the adequacy and accuracy of disclosures.
104

The Commission acknowledges that, when a firm evaluates whether to underwrite a distribution of securities, it typically focuses on the adequacy and accuracy of an issuer's disclosures. However, the adequacy and accuracy of disclosures are a separate question from the creditworthiness of securities for purposes of the exception for Nonconvertible Securities. It is possible that an accurate disclosure statement did not reveal the issuer's low creditworthiness, making the offered securities inappropriate to be eligible for the exception for Nonconvertible Securities that trade on the basis of their yield and creditworthiness.

104
SIFMA Letter 1, at 5.

One commenter stated that the proposed probability of default calculations would create a heightened risk for errors.
105

Another commenter stated that market participants can reliably estimate the probability of default, not only by using the proposed “structural credit risk models” but also by using other statistical models,
106

market measures of credit risk, and other credit risk measures.
107

This commenter encouraged the Commission to adopt a final rule that references market measures of credit risk as part of the estimation of, or as an alternative to, the probability of default.
108

105
SIFMA Letter 1, at 5.

106
IILF Letter, at 2 (stating that the inability to reliably estimate the probability of default on a debt security using any of a variety of statistical models and market measures is strong evidence that the security should not fall within an exception to Regulation M and could also be evidence that the market participant is not in a position to trade or hold that specific security). As discussed in this Part, new Rule 101(c)(2)(i) requires that the probability of default determination be derived from a structural credit risk model. Distribution participants and their affiliated purchasers may not avail themselves of the exception in new Rule 101(c)(2)(i) with regard to any security that does not meet the requirements of that exception.

107
IILF Letter, at 2.

108
IILF Letter, at 2, 6-8 (stating its concerns about the use of balance sheets and suggested that the Commission reference more flexible alternatives, such as the probability of default threshold could vary annually on an ongoing basis depending on a similar analysis of more recent data going forward or peg the annual probability of default threshold based on an analysis of a sample of securities from the previous year). The Commission has considered this comment and, on balance, concerns about the use of an issuer's balance sheet should be addressed by the rigorous theoretical justification as well as by the economic interpretation of the resulting relationships between the inputs that are embedded in such structural credit risk models.
See, e.g., infra
note 243. However, allowing a more flexible threshold, as would be done under the commenter's suggestion, would result in increased subjectivity and non-uniformity of the application of the exception.

The Commission agrees with the comments that market participants can reliably estimate the probability of default derived from a structural credit risk model.
109

The Commission also acknowledges that probability of default estimates are not free of subjectivity and can vary across structural credit risk models, researchers, or vendors.
110

The use of any model or market measure to estimate issuer creditworthiness is imperfect.
111

The new exception's bright-line probability of default threshold and time horizon, however, provides predictability and allows for the exception to be applied consistently by distribution participants who are eligible to make probability of default determinations.
112

As discussed below, in Part V.E.3, the Commission has considered other types of models, such as reduced-form models, which would generally provide less stable predictions than structural credit risk models do because they can be so flexible that they suffer from a lack of theoretical foundation and a lack of intuitive interpretation of why the defaults occur. Also, unrestricted use of these models might also provide more opportunity to choose a reduced-form model specification to enable use of the exception for Nonconvertible Securities. The Commission therefore is adopting

an exception that is based on the use of a structural credit risk model as this model is appropriately designed to measure creditworthiness of Nonconvertible Securities in Rule 101(c)(2)(i), as amended, in accordance with the requirements of section 939A(b).

109
IILF Letter, at 2.

110

See
Proposal, 87 FR 18332.

111

See
Proposal, 87 FR 18332.

112
Bloomberg L.P. Letter, at 2.

One commenter recommended that the proposed probability of default threshold should be increased to 0.5% in order to capture the maximum amount of issuers who, currently, are eligible under the existing exception (
i.e.,
the proposed threshold of 0.055% is too restrictive with regard to scoping in securities that currently are excepted).
113

Other commenters supported the proposed probability of default threshold of 0.055% as reasonable.
114

One commenter stated that the bright-line threshold of 0.055% will provide clarity as to what is expected in evaluation and documentation.
115

113
SIFMA Letter 1, at 10. The Commission estimated in the Proposal that, while the proposed threshold of 0.055% would capture approximately 90% of the investment grade securities in its sample of nonconvertible fixed income securities, a threshold of 0.5% would capture about 98.6% of investment grade securities.
See
Proposal, 87 FR 18330, 18334.

114

See
Bloomberg L.P. Letter, at 2; IILF Letter, at 6.

115
Bloomberg L.P. Letter, at 2. Another commenter stated that it is not necessary to state a precise bright-line measure. IILF Letter, at 6. The exception's use of a bright-line threshold, by imposing specific and clear requirements, helps to ensure that the exception captures only those Nonconvertible Securities that trade on the basis of yield and creditworthiness. It also helps to ensure that the exception is based on objective factors and can be consistently applied by market participants.
See
Bloomberg L.P. Letter, at 2.

The Commission has considered these comments and concluded that the 0.055% threshold appropriately calibrates the probability of default to determine the creditworthiness of an issuer whose Nonconvertible Securities trade based on their yield and creditworthiness.
116

While the higher threshold of 0.5% captures a larger set of securities of creditworthy issuers whose securities are eligible for the existing Investment Grade Exception, it also allows for an exception that captures a larger set of securities that could be prone to manipulation risk in comparison to the 0.055% threshold (
i.e.,
non-investment grade securities).
117

Because the commenter's suggested 0.5% threshold, in comparison to the 0.055% threshold, risks capturing a majority of the securities that are not traded on the basis of their yield and creditworthiness in the same way that Nonconvertible Securities excepted under the existing Investment Grade Exception are traded, too many distributions of these types of securities would be included, which reflects that a 0.5% threshold may not be an appropriate replacement standard of creditworthiness, in accordance with of section 939A(b).

116

See infra
Part V.B; Proposal, 87 FR 18319, 18330.

117

See also
Proposal, 87 FR 18334. Based on an analysis of the available data as of Mar. 2023, a 0.5% threshold would make the new exception less restrictive and would result in 124 additional non-investment grade securities being captured by the standard, from 64 non-investment grade issues under the 0.055% threshold to 188 issues under the 0.5% threshold.
See infra
Part V.B. These figures differ from those included in the Proposal because they are based on an analysis of the available data as of Mar. 2023, whereas the Proposal's figures were based on an analysis of the data available as of Oct. 2021.
See infra
Part V.B.

Further, even if the 0.055% threshold does not capture the exact same set of Nonconvertible Securities captured by the Investment Grade Exception, the 0.055% threshold nevertheless identifies Nonconvertible Securities that are less susceptible to the manipulation that Rule 101 is designed to prevent because they trade based on their yield and creditworthiness, As discussed above, Regulation M seeks to protect the offering price of a security during a distribution, when there are heightened incentives on the part of those who are involved in the offering process to influence the subject security's price. Because these Nonconvertible Securities are traded on the basis of their yield and creditworthiness, and are largely fungible, they are less susceptible to manipulation.
118

118

See
Regulation M Adopting Release, 62 FR 527;
supra
note 38.

In other words, the ability of distribution participants and their affiliated purchasers to bid up the price of a Nonconvertible Security of an issuer that meets the 0.055% probability of default threshold is limited by investors' ability to substitute the security with other securities that are similar and of comparable creditworthiness. In contrast, a non-investment grade security that has a much higher probability of default tends to have idiosyncratic risks that make them less substitutable and hence more susceptible to manipulation. The threshold of 0.5% would capture more than the majority of non-investment grade securities (approximately 69.9% of non-investment grade securities),
119

which indicates that it may not be an appropriate measure of creditworthiness to replace the reference to credit ratings in Rule 101's Investment Grade Exception. Accordingly, the 0.055% threshold appropriately calibrates the probability of default to determine the creditworthiness of an issuer whose Nonconvertible Securities should trade based on yield and creditworthiness and is an appropriate substitute standard of creditworthiness to replace the credit ratings reference in the Investment Grade Exception pursuant to section 939A(b).

119

See infra
Part V.E.1.

While the probability of default measure uses a threshold of 0.055%, as was proposed, the final rule text is changed from the proposed rule text of “less than 0.055%” to state “0.055% or less.” The Commission is clarifying that a determination of a 0.055% probability of default is eligible for the exception, so long as all other conditions of the exception are met. This change is consistent with the estimates included in the Proposal, including with how the Commission calibrated the probability of default threshold in the Proposal.
120

120

See
Proposal, 87 FR 18330;
see also
Proposal, 87 FR 18319, 18332.

The same commenter also suggested that the probability of default calculations should be permitted to be made within a specified duration of time in advance of pricing (rather than as of the day of determining the offering price), for example, within 10 calendar days prior to pricing of the offering, similar to the approach taken with respect to average daily trading volume (“ADTV”) calculations, to afford distribution participants adequate time to adjust their market activities as necessary.
121

The Commission acknowledges that lead managers who make probability of default determinations pursuant to Rule 101(c)(2)(i) may need additional time prior to the pricing of an offering to make the required calculations. However, in light of the comments received, the 10-calendar-day period suggested by the commenter would be unnecessarily long for the lead manager to determine and document in writing the issuer's probability of default because the determination is likely to be highly automated.
122

In addition, the suggested 10-calendar-day period may not encourage as timely of information about the issuer as possible if the model inputs are taken farther away from the day of the determination of the offering price, as proposed.

121
SIFMA Letter 1, at 10.

122

See infra
Part VI.C.1. For example, because commonly available spreadsheet software can be used to calculate the probability of default, lead managers would not need 10 calendar days to derive an issuer's probability of default.
See, e.g.,
Proposal, 87 FR 18319.

The Commission is, therefore, modifying the proposed time horizon of “the day of the determination of the

offering pricing” to allow the lead manager to make its probability of default determination as of “the sixth business day immediately preceding the determination of the offering price” for purposes of the new exception. This change from the proposed time horizon of “the day of the determination of the offering price” is being made in response to comment that additional time is needed because “[i]t would be very damaging to the issuer to launch a re-opening, subsequently determine that there is no exception under the probability of default calculation, and then have to extend the pricing of the offering by at least one (or five) business days.”
123

The Commission agrees with the commenter that more time would be useful to address the potential of an offering by at least one to five business days but is concerned that the model inputs supporting the probability of default determination may become stale with additional time beyond that.
124

Accordingly, the Commission is extending the time horizon to allow for the potential of an offering being extended up to five business days. Further, this will allow the determination to be made before Regulation M's otherwise applicable five-business-day restricted period (
i.e.,
preceding the determination of the offering price) and should provide a sufficient amount of additional time for the lead manager to account for any relevant market activities and timely information regarding the issuer as a model input in determining the probability of default.
125

This essentially allows these distribution participants, in relation to the proposed “day of the determination of the offering price” requirement, five additional business days, as defined in Rule 100(b), before the actual pricing and launch of the offering to make the probability of default determination.

123
SIFMA Letter 1, at 11.

124

See, e.g., infra
Part V.B (discussing how probabilities of default implied by structural credit risk models generally use current estimates of equity valuation and volatility based on the recent trading activity, and hence incorporate more recent news affecting the valuation and perceived volatility of the firm).

125

See, e.g.,
Proposal, 87 FR 18330.

In view of the nature and trading characteristics of Nonconvertible Securities, the impact, if any, of a corporate or market event in the intervening five business days would be unlikely to result in the manipulation that Regulation M seeks to prevent. Nonconvertible Securities are priced and traded differently than equity securities in that the focus (with Nonconvertible Securities) is placed on receiving periodic interest payments during the life of the instrument rather than on any potential equity upside or increase in the current trading or offering price. Therefore, trading activity in Nonconvertible Securities at or around the time of the distribution is unlikely to influence the pricing or trading of such securities, particularly during Regulation M's (otherwise applicable) restricted period.

Accordingly, the Commission is adopting, with targeted modifications in consideration of the comments received, as discussed in this Part, as well as certain technical changes,
126

a new exception in Rule 101(c)(2)(i) for 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 the horizon of 12 full calendar months from such day, is 0.055% or less, as determined and documented, in writing, by the distribution participant acting as the lead manager (or in a similar capacity) of a distribution, as derived from a structural credit risk model. For the reasons discussed above, in this Part, and as supported by an analysis of the probability of default and investment grade credit ratings of a sample of Nonconvertible Securities available on the market,
127

the standard used in the new exception is an appropriate substitute standard of creditworthiness to replace the credit ratings reference in the Investment Grade Exception for Nonconvertible Securities.

126
The final amendments make the technical change of deleting the word “the” from the beginning of the exception in order to mirror the beginning of new Rule 101(c)(2)(ii). The final rule amendments also make an edit to use the words “as derived from” instead of “by using,” as proposed, to clarify that a structural credit risk model must be the only method of determining an issuer's probability of default, as opposed to one method among others. This change also conforms the standard to how it was discussed in the Proposal.
See, e.g.,
Proposal, 87 FR 18318-19. The final amendments also make a conforming edit from the proposed rule text to add the word “full” preceding the time horizon of 12 calendar months to make the phrasing of the exception's time horizon consistent with Regulation M's other time horizons.
See, e.g.,
17 CFR 242.100(b) (defining the terms “ADTV,” which uses a time horizon of “two full calendar months,” and “principal market,” which uses the time horizon of “12 full calendar months”).

127

See infra
Parts V.A through E.

Finally, the Commission is adopting, substantially as proposed, with certain clarifying
128

and technical
129

changes, a definition under Rule 100(b) of Regulation M for the term “structural credit risk model” that means “any commercially or publicly available model that calculates, based on an issuer's balance sheet, the probability that the value of the issuer will fall below the threshold at which the issuer would fail to make scheduled debt payments, at or by the expiration of a defined period.”
130

Accordingly, a covered person's reliance on Rule 101(c)(2)(i) or Rule 102(d)(2)(i), as amended, is conditioned on a probability of default determination that was derived from any commercially or publicly available structural credit risk model that calculates, based on an issuer's balance sheet, the probability that the value of the issuer will fall below the threshold at which the issuer would fail to make scheduled debt payments, at or by the expiration of a defined period.

128
The Commission is making clarifying changes to the proposed definition of the term “structural credit risk model” that conform it to its description in the Proposal. As discussed above, in Part II.A.1, the Proposal stated that a structural credit risk model “provide[s] a probability that a firm's assets will fall below the Default Point at or by the expiration of a defined period of time.” Proposal, 87 FR 18317. The final rule amendments conform the proposed definition to that description and clarify that the “threshold” referenced in the proposed definition is the Default Point.

129
The Commission is also making a non-substantive, technical change from the proposed definition of the term “structural credit risk model.” As discussed below, because the final rule amendments include the term “structural credit risk model” in both new Rule 101(c)(2)(i) and new Rule 102(d)(2)(i), the Commission is adding to Rule 100(b) a definition for the term “structural credit risk model.” The addition of this definition in Rule 100(b) does not change the definition of the term “structural credit risk model” but rather simplifies the final text of new Rules 101(c)(2)(i) and 102(d)(2)(i) by obviating the need for a
proviso
containing a definition in each of those rules. Accordingly, use of the term “structural credit risk model” is identical across new Rules 101(c)(2)(i) and 102(d)(2)(i).

130
17 CFR 242.100(b).

2. Rule 101(c)(2)(ii): Asset-Backed Securities Offered Pursuant to an Effective Shelf Registration Statement Filed on Form SF-3

The Commission proposed an amendment to add a new exception in Rule 101(c)(2)(ii) for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3.

In 2014, the Commission adopted shelf eligibility criteria for asset-backed securities offerings registered on new Form SF-3 in part to implement section 939A(b) of the Dodd-Frank Act.
131

The Commission designed the shelf eligibility requirements to help ensure a

certain “quality and character” in light of the requirement to reduce regulatory reliance on credit ratings.
132

The shelf eligibility requirements included in Form SF-3 are designed to help ensure that the securitization is designed to produce expected cash flows that are sufficient to service payments or distributions in accordance with their terms;
133

that obligated parties more carefully consider the characteristics and quality of the assets that are included in the pool;
134

that asset-backed securities shelf offerings have transactional safeguards and features that make those certain securities appropriate to be issued without prior Commission staff review;
135

and that issuers design and prepare asset-backed securities offerings with greater oversight and care.
136

The asset-backed securities offered pursuant to an effective shelf registration statement filed on Form SF-3 should trade primarily on the basis of yield and creditworthiness, rather than on the identity of a particular issuer and its idiosyncratic risk.

131

See
Regulation AB II Adopting Release.

132

See
Regulation AB II Adopting Release, 79 FR 57189.

133

See
Regulation AB II Adopting Release, 79 FR 57267.

134

See
Regulation AB II Adopting Release, 79 FR 57278.

135

See
Regulation AB II Adopting Release, 79 FR 57283.

136
Regulation AB II Adopting Release, 79 FR 57265, 57285.

One commenter supported the adoption of the proposed exception for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on FormSF-3 and stated that it appreciated the straightforward nature of the standard, which allows all interested parties to easily determine whether the exception is available.
137

137

See
SIFMA Letter 1, at 11.

Another commenter disagreed with the Commission's statement that an exception for asset-backed securities that is based on a probability of default threshold may be unfeasible.
138

This commenter stated that market participants are able to estimate the probability of default for these securities, not only using statistical models but also based on market measures such as credit spreads.
139

In response to Request for Comment (“RFC”) 29,
140

this commenter stated that a probability of default standard based on market measures would have indicated that the exception to Regulation M no longer applied for certain debt securities during the months leading up to the collapse of Lehman Brothers, and available data shows that, if such a market measure-based standard had been implemented, the exceptions for Regulation M would not have been available for debt securities as early as fall 2007.
141

Despite this example, the Commission has considered this comment and determined that an exception for asset-backed securities that is based on a structural credit risk model to derive an issuer's probability of default would be unfeasible because distribution participants (including those acting as the lead managers) may not be able to collect all of the information required to calculate the probability of default, such as the value and volatility of the equity.
142

In other words, practical challenges of obtaining reliable fundamental information about the equity would make a probability of default measure unfeasible for an exception for asset-backed securities that trade on the basis of their yield and creditworthiness. The Commission has also determined that a measure based on credit spreads or the use of other models, such as reduced-form models, would not be appropriate to use due to their flexible or unstructured nature, which could result in a standard that can be used to abuse the exception.
143

138
IILF Letter, at 6.

139
IILF Letter, at 6-7 (stating that asset-backed securities are widely traded and have frequently quoted prices and credit spreads and that it is straightforward to calculate the probability of default based on these market measures). For the reasons discussed above, in Part II.A.1, the Commission is requiring that an issuer's probability of default be derived from a structural credit risk model, and not from other market measures.

140
Proposal, 87 FR 18323 (requesting comment on whether a probability-of-default-based standard would be appropriate for the exception for asset-backed securities; whether there are models that are used to calculate a probability of default threshold for asset-backed securities that would be relevant to consider based on the type of security involved and, if so, what the threshold should be; what benefits this approach would provide; what other concerns this approach could raise; and how this approach would address potential conflicts of interest involving the distribution participant or affiliated purchaser making the determination).

141
IILF Letter, at 7 (citing Flannery, Houston & Partnoy,
Credit Default Swap Spreads,
158 U. PA. L. REV. 2085, 2087 (2010)). The available data referenced in the commenter's statement, as well as the article the commenter cited, pertains to debt and credit default swaps. It does not appear from the cited article that the analysis performed related to credit default swaps was performed with regard to asset-backed securities. Further, this commenter did not provide similar information about asset-backed securities.

142

See infra
Part VI.B (discussing model inputs).

143

See infra
Part V.E.6.

The same commenter stated that “any final rules governing asset-backed securities also could reference expected recovery in the event of default and default correlation.”
144

The commenter suggested to require under the exception that the applicable market participant determine and document a conclusion that the credit risk associated with a security was “minimal” (or some other similar standard) based on these variables, without any requirement that they use a particular model.
145

The commenter's suggested exception, by conditioning reliance on a list of variables and a judgment of “minimal” credit risk, without any bright-line requirements to help deter abuse of the exception through self-serving conclusions, would not be sufficiently objective.

144
IILF Letter, at 8.

145
IILF Letter, at 8.

The Commission continues to believe that its original basis for excepting securities of a certain quality and character is appropriate and that such securities are less at risk of the manipulation that Regulation M addresses.
146

As discussed above, the Commission excepted investment grade asset-backed securities from Rule 101 because such securities trade primarily on the basis of yield and creditworthiness (traditionally measured by credit ratings).
147

In providing this rationale, the Commission stated that the principal focus of investors in the asset-backed securities market is on the structure of a class of securities and the nature of the assets pooled to serve as collateral for those securities rather than on the identity of a particular issuer.
148

The Commission also stated that Rule 101(c)(2) excepts investment grade securities that are “primarily serviced by the cashflows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holders.”
149

146

See
Regulation M Adopting Release, 62 FR 527;
see also Prohibitions Against Trading by Persons Interested in a Distribution,
Release No. 34-19565 (Mar. 4, 1983) [48 FR 10628, 10631 (Mar. 14, 1983)] (stating that the “fungibility” of certain types of securities makes manipulation of their price very difficult).

147

See
Regulation M Adopting Release, 62 FR 527.

148

See
Regulation M Adopting Release, 62 FR 527.

149

See
Regulation M Adopting Release, 62 FR 527 (citations omitted). The Commission stated that such rationale also applies to the existing identical exception in Rule 102(d)(2) of Regulation M. Regulation M Adopting Release, 62 FR 531.

As discussed above, in this Part, the practical challenge of obtaining reliable fundamental information about the equity makes a probability of default determination difficult or infeasible. The Commission believes that an appropriate and pragmatic approach is

to add an exception based on FormSF-3, as proposed, because it sufficiently focuses on creditworthiness.
150

In addition, as stated in the Proposal, a standard that relies on Form SF-3 with respect to Nonconvertible Securities would not be appropriate because the transaction requirements included in Form SF-3 are relevant only to asset-backed securities and thus would not be a sufficient measure of creditworthiness for securities that are not subject to the Form SF-3 transaction requirements.
151

150

See, e.g., supra
notes 60-61 (contrasting the focus of creditworthiness in the eligibility criteria and offering requirements included in Form SF-3 with that of other Commission Forms, such as Form S-3 and Form F-3).

151

See
Proposal, 87 FR 18321.

The transaction requirements included in Form SF-3 allow for shelf offerings of only those asset-backed securities that share the qualities and characteristics of the investment grade asset-backed securities currently excepted in Rule 101(c)(2): with respect to either set of securities, the principal focus of investors is the structure of a class of securities and the nature of the assets pooled to serve as collateral for those securities, rather than on the identity of a particular issuer.
152

First, eligibility for offering securities pursuant to a Form SF-3 is limited, in part, by the percentage of delinquent assets and, for certain lease-backed securitizations, by the portion of the pool attributable to the residual value of the physical property underlying the leases.
153

For an asset-backed securities offering with an effective Form SF-3, delinquent assets cannot constitute 20% or more of the asset pool. Delinquent assets may not convert into cash within a finite period of time, as required by the definition of “asset-backed security,” because they are not performing in accordance with their terms and management or that other action may be needed to convert the assets into cash. However, as the Commission stated at the time it adopted the 20% delinquency limitation for shelf eligibility, in principle, asset-backed securities should be primarily dependent on the pool of assets self-liquidating instead of on the ability of the entity performing collection services.
154

The application of the limitation on delinquent assets was designed to ensure that attention is focused on the ability of collateral of the underlying asset pool to generate cash flow rather than on the identity of the issuer and its ability to convert those assets into cash,
155

consistent with the Commission's original basis for excepting investment grade asset-backed securities from Rule 101.
156

152

See supra
note 149.

153

See
17 CFR 239.45(b)(v), (vi); Form SF-3, General Instruction I.B.1(e) and (f).

154

Asset-Backed Securities,
Release No. 33-8518 (Dec. 22, 2004) [70 FR 1506, 1517 (Jan. 7, 2005)] (“Regulation AB Release”). In adopting the 20% delinquency concentration level, the Commission codified a staff position that an asset-backed security will not fail to meet the definition of “asset-backed security” solely because such a security is supported by assets having total delinquencies of up to 20% at the time of the proposed offering.
See
Regulation AB Release, 70 FR 1517 (citing Bond Mkt. Ass'n, SEC Staff No-Action Letter, 1997 WL 634124 (Oct. 8, 1997) (“BMA NAL”)). This threshold was the same threshold that was applied to certain other matters affecting registration and disclosure requirements for asset-backed securities (
e.g.,
non-recourse commercial mortgage securitizations, pooling of corporate debt securities, and securitizations involving third-party credit enhancement).
See
BMA NAL, 1997 WL 634124, at * 3. The staff position was based on the premise that such a threshold for total delinquency concentration would, by itself, not present a materially greater risk of asset non-performance or default at the security level.
See
BMA NAL, 1997 WL 634124, at * 4.

155

See
Regulation AB Release, 70 FR 1517.

156

See
Regulation M Adopting Release, 62 FR 527.

Second, Form SF-3 includes certain transaction requirements with respect to the structure of the asset-backed security being offered. Such structural requirements include: (1) a certification by the depositor's chief executive officer that, among other things, the securitization structure provides a reasonable basis to conclude that the expected cash flows are sufficient to service payments or distributions in accordance with their terms; (2) a review of the asset-backed security's pool of assets upon the occurrence of certain triggering events, including delinquencies, by a person that is unaffiliated with certain transaction parties, such as the sponsor, depositor, servicer, trustee, or any of their affiliates; and (3) a dispute resolution provision, contained in the underlying transaction documents, for any repurchase request.
157

When adopting the transaction requirements included in Form SF-3, the Commission stated that sponsors may have an increased incentive to carefully consider the characteristics of the assets underlying the securitization and accurately disclose these characteristics at the time of offering.
158

The Commission also stated that investors should benefit from the reduced losses associated with nonperforming assets because, as a result of this new shelf requirement, sponsors will have less of an incentive to include nonperforming assets in the pool.
159

Because the transactional safeguards included in Form SF-3 provide incentives for obligated parties to, among other things,
160

more carefully consider the characteristics and quality of the assets that are included in the pool,
161

asset-backed securities that are offered pursuant to an effective Form SF-3 should trade based on their yield and creditworthiness rather than on the identity of a particular issuer.
162

157
Form SF-3, General Instruction I.B.1(a)-(c).

158

See
Regulation AB II Adopting Release, 79 FR 57283.

159

See
Regulation AB II Adopting Release, 79 FR 57283.

160

See supra
notes 132-136.

161

See
Regulation AB II Adopting Release, 79 FR 57278.

162

See, e.g.,
Regulation AB II Adopting Release, 79 FR 57277-78.

The requirement regarding an effective shelf registration statement filed on Form SF-3 is an appropriate substitute for the reference to credit ratings in the Investment Grade Exception because the standard is designed to limit eligibility for that exception to only those asset-backed securities that should trade based on their yield and creditworthiness due to their particular qualities and characteristics. Because the ability of distribution participants and their affiliated purchasers to bid up the price of an asset-backed security offered pursuant to an effective Form SF-3, during a distribution, is limited by a market participant's ability to substitute the security with other securities that are similar and of comparable creditworthiness,
163

such a security is less susceptible to the types of manipulation that Regulation M seeks to prevent. The application of the transaction requirements included in the Commission's Form SF-3, therefore, should result in the offering of asset-backed securities that have similar qualities and characteristics to the investment grade asset-backed securities currently excepted under the existing provision in Rule 101(c)(2). In addition, the exception for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3 carries over the standard of creditworthiness included in the Commission's Form SF-3 and helps to implement the mandate that, to the extent feasible, uniform standards of creditworthiness be used.
164

163

See
Regulation M Adopting Release, 62 FR 527.

164
Public Law 111-203, sec. 939A(b) (requiring agencies to “seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness”).

Accordingly, the Commission is adopting, substantially as proposed, with a technical change,
165

an amendment to add a new exception in Rule 101(c)(2)(ii) for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3.

165
The final rule amendments make a non-substantive, technical change that replaces the proposed reference to “17 CFR 239.45” with a reference to “§ 239.45 of this chapter” when referencing Form SF-3.

B. Rule 102(d)(2) of Regulation M: Implementing Section 939A(b) in Certain Exceptions for Issuers and Selling Security Holders

The Commission proposed to remove, without replacing, the Investment Grade Exception in Rule 102(d)(2) of Regulation M. The Commission stated in the Proposal that this removal without replacement was appropriate given that the retention of an exception for creditworthy Nonconvertible Securities and asset-backed securities would not likely be necessary to facilitate orderly distributions or limit disruptions in the trading market in light of issuers' limited market access needs and the apparent limited reliance on Rule 102's Investment Grade Exception, coupled with the incentive for issuers, selling security holders, and their affiliated purchasers to manipulate the market for the distributed security, regardless of the security's credit quality.
166

166

See
Proposal, 87 FR 18323-24.

Two commenters supported the proposed elimination, without replacement, of Rule 102(d)(2)'s Investment Grade Exception.
167

One commenter stated that it is “appropriate in contexts where deference arguably should be made to independent decisions and judgment by market participants, without the crutch of reliance on credit ratings.”
168

167

See
Better Markets Letter, at 3-4 (stating that the proposal to eliminate, without replacing, the exception in Rule 102 for certain investment grade securities is appropriate because issuers and selling security holders have comparatively strong incentives to manipulate the price of the distributed security); IILF Letter, at 7. As discussed below, in Part II.B.1, the new exception for Nonconvertible Securities takes account of this consideration.

168
IILF Letter, at 7.

One commenter objected to the proposed elimination, without replacement, of the Investment Grade Exception in Rule 102(d)(2) and stated that the “continued availability of such an exception would be important to broker-dealers who are affiliated with an issuer but are not, for whatever reasons, serving as an underwriter or other participant in connection with the distribution.”
169

This commenter stated that the Commission, instead, should substitute the existing standard in Rule 102(d)(2) with “the same standards as used for purposes of the exceptions under Rule 101(c)(2).”
170

For reasons explained below, the Commission agrees with this commenter and is replacing the Investment Grade Exception in Rule 102, rather than eliminating the exception, without replacement, as proposed. The Commission continues to believe that its original basis for excepting Nonconvertible Securities and asset-backed securities of a certain quality and character from Rule 102's prophylactic prohibitions is appropriate and that the substitute standards discussed below are appropriate to ensure that those securities are less at risk of the manipulation that Regulation M addresses.
171

169
SIFMA Letter 1, at 12-13. This commenter stated that the Investment Grade Exception in Rule 102 is relied upon in the context of sticky offerings and re-openings of debt issuances.
See
SIFMA Letter 1, at 4.

170

See
SIFMA Letter 1, at 12. With regard to replacing the Investment Grade Exception in Rule 102 pursuant to section 939A(b)'s requirements, the Commission requested comment on whether it should adopt an exception based on either the probability-of-default-based standard for Nonconvertible Securities or the standard for asset-backed securities that are offered pursuant to an effective shelf registration statement filed on Form SF-3 instead of removing the Investment Grade Exception, without substituting an alternative, and whether it should adopt an exception in Rule 102 if a distribution participant determines that a security is an excepted security pursuant to Rule 101(c)(2). Proposal, 87 FR 18324 (request for comment (RFC) 35). One commenter replied, in response to RFC 35, that, to the extent the Commission receives comments that market participants on their own cannot make decisions and judgments about credit risk related to Rule 102, an exception based on probability of default would be a viable alternative.
See
IILF Letter, at 7. The Commission did not receive any such comment in response to the Proposal.

171

See
Regulation M Adopting Release, 62 FR 527;
see also Prohibitions Against Trading by Persons Interested in a Distribution,
Release, No. 34-19565 (Mar. 4, 1983) [48 FR 10628, 10631 (Mar. 14, 1983)].

The Commission is adopting rule amendments that remove the Investment Grade Exception from Rule 102 of Regulation M and substitute in its place exceptions based on alternative standards of creditworthiness to except Nonconvertible Securities. The reasons for adding these new exceptions are discussed below with regard to Nonconvertible Securities, in Part II.B.1, and asset-backed securities, in Part II.B.2.

1. Rule 102(d)(2)(i): Nonconvertible Securities of Issuers Who Meet a Specified Probability of Default Threshold

The Commission acknowledges that eliminating the exception, without replacement, may impact entities, such as broker-dealers who are not distribution participants (and are not eligible to quality for an exception under Rule 101) but may qualify for a comparable exception under Rule 102 as a result of being an affiliate of an issuer or selling security holder and meeting the exception's conditions. The continued availability of an exception for the Nonconvertible Securities will also provide issuers and selling security holders with more flexibility during distributions as compared to the Proposal. The elimination, without replacement, of the Investment Grade Exception from Rule 102 for issuers and selling security holders could increase issuance costs or deter market participants from issuing Nonconvertible Securities with low manipulation risk.
172

172

See
Proposal, 87 FR 18333.

In adopting the Investment Grade Exception, the Commission stated that it determined to include the Investment Grade Exception in Rule 102 based, in part, on the rationales indicated for an identical exception to Rule 101.
173

The Commission excepted investment grade Nonconvertible Securities from Rule 101 “based on the premise that these securities traded on the basis of their yield and credit ratings, are largely fungible and, therefore, are less likely to be subject to manipulation.”
174

As discussed above, in Part II.A.1, the new exception in Rule 101(c)(2)(i) for 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 the horizon of 12 full calendar months from such day, is 0.055% or less, as determined and documented, in writing, by the distribution participant acting as the lead manager (or in a similar capacity) of a distribution, as derived from a structural credit risk model, is an appropriate substitute standard of creditworthiness in place of the reference to credit ratings in the Investment Grade Exception for Nonconvertible Securities.

173
Regulation M Adopting Release, 62 FR 531.

174
Regulation M Adopting Release, 62 FR 527.

The standard of creditworthiness, which was the basis of the Investment Grade Exception for Nonconvertible Securities in Rule 102, is still appropriate to use as the basis of an

exception to Rule 102 for Nonconvertible Securities.
175

In addition, the standard of creditworthiness used in the exception in Rule 101(c)(2)(i), as amended, is an appropriate standard of creditworthiness to use in place of the reference to credit ratings in the Investment Grade Exception in Rule 102 pursuant to the requirements of section 939A(b). That standard, which is based on an issuer's probability of default, is designed to identify Nonconvertible Securities that are less susceptible to the manipulation that Regulation M is designed to prevent because they trade based on their yield and creditworthiness, as determi

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2023-12591. Public record. Not legal advice.