The SEC has adopted rule amendments to federal Regulation M that replace credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities with a default probability for nonconvertible debt securities and nonconvertible preferred securities. Additionally, the Commission has adopted a record preservation provision for broker-dealers who rely on the new amendments. The final rule satisfies a Dodd-Frank Act Section 939A(b) requirement.
Regulation M credit rating removal and replacement. Federal Regulation M is a set of rules that preserve the pricing integrity of the securities trading markets by prohibiting issuers, selling security holders, distribution participants, and their affiliated purchasers from conducting activities that could artificially influence the market for an offered security. Regulation M’s Rules 101(c)(2) and 102(d)(2) currently except nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated investment grade by at least one nationally recognized statistical rating organization.
What Dodd-Frank mandated in 2010 and what the SEC has just accomplished with the amendments is:
- Remove from Regulation M Rule 101 and 102 certain exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-back securities;
- Replace those exceptions with—for nonconvertible debt securities and nonconvertible preferred securities—a probability of default of 0.055 percent or less, estimated as of the sixth business day immediately preceding the determination of the offering price, over the horizon of 12 full calendar months from that day; a distribution participant acting as lead manager would make that determination in writing using a “structural credit risk model” that Regulation M Rule 100 has newly defined. Also, new Rules 101(c)(2)(ii) and 102(d)(2)(ii) except asset-backed securities offered in accordance with an effective shelf registration statement filed on Commission Form SF-3; and
- Require broker-dealers relying on the new exception for certain nonconvertible debt securities and nonconvertible preferred securities to abide by new Rule 17a-4 paragraph (b)(17), which mandates the broker-dealers to preserve the written probability of default determination for not less than three years, the first two years in an easily accessible place.