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)].
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    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.
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    \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 determined by the current financial
condition of the issuer. However, given that issuers and selling
security holders have the greatest interest in an offering's
outcome,\176\ regardless of the credit quality of the security,\177\ it
would not be appropriate for the exception to permit those parties to
make their own probability of default determinations (by their own or a
third party calculation) in order to meet the conditions of the
exception.
---------------------------------------------------------------------------

    \175\ See supra note 13 and accompanying text.
    \176\ See Regulation M Adopting Release, 62 FR 530.
    \177\ See Proposal, 87 FR 18323.
---------------------------------------------------------------------------

    Therefore, Rule 102(d)(2)(i), as amended, uses the same bright-line
test for excepting Nonconvertible Securities. For issuers, selling
security holders, and their affiliated purchasers to use the exception
in Rule 102(d)(2)(i), as amended, however, they must rely on the
probability of default determination made by the distribution
participant acting as the lead manager (or in a similar capacity) \178\
of the distribution and documented in writing pursuant to Rule
101(c)(2)(i), as amended. Rule 102(d)(2)(i), as amended, does not
permit reliance on the exception if issuers, selling security holders,
or their affiliated purchasers make the required probability of default
determinations themselves, or rely on a determination made by a non-
lead manager or any other third party. This condition to the exception
means that issuers, selling security holders, and their affiliated
purchasers would not be able to rely on the new Rule 102(d)(2)(i)
exception when selling securities directly, unless a lead manager is
involved in the distribution and had made (and documented) the
qualifying probability of default determination. This condition
provides for the continued availability of an exception under Rule 102
for creditworthy Nonconvertible Securities for broker-dealers who are
affiliated with an issuer but are not serving as an underwriter or
other participant in connection with the distribution. At the same
time, this condition is designed to prevent abuse of the exception by
issuers, selling security holders, and their affiliated purchasers by
taking into account that these market participants have the greatest
interest in an offering's outcome and generally do not have the same
market access needs as underwriters.\179\ In addition, the condition
regarding lead-manager probability of default determinations in new
Rule 102(d)(2)(i) is consistent with the condition regarding lead-
manager probability of default determinations in new Rule 101(c)(2)(i).
---------------------------------------------------------------------------

    \178\ See supra note 88.
    \179\ See Regulation M Adopting Release, 62 FR 530.
---------------------------------------------------------------------------

    Even though probability of default determinations made by or
directly for issuers or selling security holders or affiliated
purchasers cannot be used in order for such parties to rely on the new
exception in Rule 102(d)(2)(i) for Nonconvertible Securities, these
parties would, however, be able to avail themselves of the exception in
reliance on a probability of default determination made by the
distribution participant acting as the lead manager (or in a similar
capacity) of the distribution pursuant to Rule 101(c)(2)(i), as
amended. Similar to how the lead or managing underwriter in a firm
commitment offering communicates certain pricing, allocation, and other
distribution-related information to the issuer or selling security
holder in connection with that particular distribution, the lead
managing underwriter's communications regarding its probability of
default determination may vary based on the parties and their prior
course of conduct as to the frequency and manner or mode of such
communication.
    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 the issuer, selling security holders, or their
affiliated purchasers in order for those parties to rely on the
exception. Therefore, issuers, selling security holders, and their
affiliated purchasers will 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. With
regard to the types of distributions covered, as a result of the
condition related to lead-manager probability of default
determinations, the exception for Nonconvertible Securities is
available to a subset of distributions covered under the existing
Investment Grade Exception \180\ but more distributions than what was
covered under the Proposal given that the Proposal would have removed,
and not replaced, the Investment Grade Exception in Rule 102.\181\ The
estimated costs associated with the condition related to the lead
manager making the probability of default determination are included
below, in Part V.C.1.
---------------------------------------------------------------------------

    \180\ See, e.g., Proposal, 87 FR 18330. As discussed above, in
Part II.A.1, this may be the case in, for example, 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. With regard to shelf offerings,
each takedown is to be individually examined to determine whether
such offering constitutes a ``distribution.'' Regulation M Adopting
Release, 62 FR 526. If, as a result of the amendments, the exception
for Nonconvertible Securities is no longer available in connection
with a distribution, and if no other exception is available, Rule
102's prohibitions would apply. Accordingly, an issuer and all of
its affiliated purchasers would be subject to the applicable
restricted period of Rule 102 when sales off a shelf by an issuer,
or by any affiliated purchaser, constitute a distribution of
securities. Similarly, when a selling security holder sells off the
shelf and such sales constitute a distribution, all other shelf
security holders who are affiliated purchasers of the selling
security holder would be subject to the applicable restricted period
of Rule 102. See Regulation M Adopting Release, 62 FR 531.
    \181\ See Proposal, 87 FR 18333.
---------------------------------------------------------------------------

    As discussed below, in Part II.C, broker-dealers who rely on the
new exception in Rule 102(d)(2)(i) are required to preserve the written
probability of default determination made pursuant to Rule
101(c)(2)(i), as amended. This record preservation requirement could
help facilitate Commission examinations of broker-dealers who rely on
Rule 102(d)(2)(ii), as amended, and could deter their misuse of the
exception through relying on determinations that do not meet the
conditions of the exception or through relying on the exception when no
determination has been made.
2. Rule 102(d)(2)(ii): Asset-Backed Securities Offered Pursuant to an
Effective Shelf Registration Statement Filed on Form SF-3
    The Commission is adopting in new Rule 102(d)(2)(ii) an exception
for asset-backed securities that are offered pursuant to an effective
shelf registration statement filed on Form SF-3. The Commission stated
in the Proposal that the incentive for issuers, selling shareholders,
and their affiliated purchasers to manipulate the market of a
distributed security exists regardless of the credit quality of the
security.\182\

While this incentive may exist, 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 that meet the Investment Grade
Exception \183\ and thus are less likely to be subject to the type of
manipulation that Regulation M seeks to address.
---------------------------------------------------------------------------

    \182\ See Proposal, 87 FR 18323.
    \183\ See supra notes 153-161 and accompanying text.
---------------------------------------------------------------------------

    In addition, in contrast to how Nonconvertible Securities would be
excepted, whether an asset-backed security is rated investment grade is
an objective, observable fact, as is whether an asset-backed security
is offered pursuant to an effective shelf registration statement filed
on Form SF-3. Reliance on the new exception in Rule 102(d)(2)(i) does
not require issuers, selling security holders, or their affiliated
purchasers to make a calculation in determining whether the subject
asset-backed security meets the conditions of that exception (i.e.,
that the asset-backed security is offered pursuant to an effective
shelf registration statement filed on Form SF-3), in contrast to how
reliance on the new exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i)
for Nonconvertible Securities is conditioned on a calculation
determining whether the issuer's probability of default meets the
specified threshold. Because the Investment Grade Exception for asset-
backed securities does not focus on the potential interests of those
covered persons seeking to rely on the exception but rather the
particular qualities of the securities themselves (i.e., that the
asset-backed securities are appropriate to except from Regulation M
because they trade on the basis of their yield and creditworthiness,
traditionally measured by credit ratings, and are largely fungible),
the measure based on the Form SF-3 shelf eligibility requirements,
which similarly focuses on the particular qualities of the asset-backed
securities, is an appropriate substitute standard of creditworthiness
to replace the reference to credit ratings in the existing Investment
Grade Exception in accordance with section 939A(b)'s requirements,
without having to restrict or place any further conditions on who may
rely on the exception under Rule 102(d)(2)(ii), as amended.
    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.\184\ As discussed above, in
Part II.A.2, the Commission excepted investment grade asset-backed
securities from Rule 101 because such securities trade primarily on the
basis of yield and credit rating.\185\ When the Commission adopted the
Investment Grade Exception in Rule 101, it 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.\186\ The Commission also stated that the
Investment Grade Exception is for 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.'' \187\
---------------------------------------------------------------------------

    \184\ Regulation M Adopting Release, 62 FR 531.
    \185\ See Regulation M Adopting Release, 62 FR 527.
    \186\ See Regulation M Adopting Release, 62 FR 527.
    \187\ See Regulation M Adopting Release, 62 FR 527 (citations
omitted).
---------------------------------------------------------------------------

    The standard in new Rule 102(d)(2)(i) that relies on the Form SF-3
eligibility requirements continues to be derived from the premise that
certain asset-backed securities are traded based on factors such as
their yield and creditworthiness.\188\ As discussed above, in Part
II.A.2, 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 that meet the Investment Grade Exception: 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.\189\
---------------------------------------------------------------------------

    \188\ See Regulation M Adopting Release, 62 FR 527.
    \189\ See supra note 149.
---------------------------------------------------------------------------

    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 asset-backed securities currently excepted under Rule 102's
Investment Grade Exception. Because the ability of issuers, selling
security holders, 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,\190\ such a security is less susceptible
to the types of manipulation that Regulation M seeks to prevent. In
accordance with section 939A(b), it is appropriate to continue to
except in Rule 102(d)(2) asset-backed securities that trade on the
basis of their yield and creditworthiness.
---------------------------------------------------------------------------

    \190\ See Regulation M Adopting Release, 62 FR 527.
---------------------------------------------------------------------------

    For these reasons, the Commission is adopting in new Rule
102(d)(2)(ii) an exception for asset-backed securities that are offered
pursuant to an effective shelf registration statement filed on Form SF-
3. The new exception in Rule 102(d)(2)(i) may be relied upon by
issuers, selling security holders, and their affiliated purchasers if
all conditions of the exception are met.

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

    The Commission proposed a new record preservation \191\ requirement
that broker-dealers who are distribution participants or affiliated
purchasers must preserve certain records pursuant to Rule 17a-4 under
the Exchange Act, the Commission's broker-dealer record retention rule.
Proposed paragraph (b)(17) of Rule 17a-4 would have required broker-
dealers relying on the exception for Nonconvertible Securities to
preserve the written probability of default determination made pursuant
to proposed paragraph (c)(2)(i) of Rule 101. Accordingly, those broker-
dealers would be 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 made pursuant to proposed
paragraph (c)(2)(i) of Rule 101.\192\
---------------------------------------------------------------------------

    \191\ In the Proposal, this requirement was described as a
``recordkeeping'' requirement. For clarity and consistency with the
title of Rule 17a-4 (``Records to be preserved by certain exchange
members, brokers, and dealers''), this requirement is referred to
throughout this release as a record preservation requirement.
    \192\ Proposal, 87 FR 18324.
---------------------------------------------------------------------------

    One commenter stated that the proposed record preservation
requirement for certain broker-dealers is ``plainly appropriate as a
means of facilitating the Commission in its examination and oversight
of broker-dealers who rely on the exception in Rule 101 and would be
required to

conduct the new probability of default determination.'' \193\
---------------------------------------------------------------------------

    \193\ Better Markets Letter, at 4.
---------------------------------------------------------------------------

    Another commenter stated that the Commission should not adopt the
proposed record preservation requirement for broker-dealers relying on
new Rule 101(c)(2)(i)'s exception for Nonconvertible Securities because
``firms are already subject to extensive recordkeeping requirements
[and] should continue to have flexibility in determining the precise
nature and types of records they make and retain for such purpose, just
as they do for purposes of the various other exceptions to Rule 101 of
Regulation M.'' \194\
---------------------------------------------------------------------------

    \194\ SIFMA Letter 1, at 12; see also SIFMA Letter 2, at 2.
---------------------------------------------------------------------------

    However, unlike the other securities-based exceptions in Rule 101,
which apply to ``actively-traded securities,'' \195\ ``exempted
securities,'' \196\ and ``face-amount certificates or securities issued
by an open-end management investment company or unit investment
trust,'' \197\ and which are based on standards that rely on the use of
publicly available information that can be verified, this exception is
subject to the specific requirements in section 939A(b) to use
``standards of credit-worthiness.'' As discussed above, in Parts II.A.1
and B.1, the probability of default, as derived from structural credit
risk models, is an appropriate substitute standard of creditworthiness
to replace the reference to credit ratings in the existing Investment
Grade Exceptions in accordance with section 939A(b)'s requirements. Due
to the number of variations among structural credit risk models and
their estimated inputs, the probability of default estimates may be
subjective to some extent.\198\ As discussed below, in Part V.A.2,
creditworthiness is an appropriate standard to reflect manipulation
risk because securities issued by firms with sound creditworthiness
trade primarily on yield and creditworthiness (traditionally measured
by credit ratings) and have low pricing uncertainty and manipulation
risk. Reliance on the new exception in Rule 101(c)(2)(i) or Rule
102(d)(2)(i) for issuers of Nonconvertible Securities is conditioned on
the use of a written probability of default calculation that has been
determined and documented, in writing, by the distribution participant
acting as the lead manager. This exception is in contrast to the other
Regulation M exceptions that require the use of publicly available
information that can be verified. Accordingly, requiring a record of
the written probability of default determination to be preserved will
help facilitate the Commission's examinations of broker-dealers relying
on the new exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i). The
record preservation requirement, therefore, is appropriate to help
deter improper adjusting of the estimation to meet the conditions of
either of the exceptions. Further, 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.
---------------------------------------------------------------------------

    \195\ 17 CFR 242.101(c)(1).
    \196\ 17 CFR 242.101(c)(3).
    \197\ 17 CFR 242.101(c)(4).
    \198\ See infra Part V.C.3; see also Proposal, 87 FR 18334.
---------------------------------------------------------------------------

    Another commenter stated that the Commission could publish, or
require publication of, point estimates at a particular time and as
rolling averages of default probabilities during a specified period,
default probability estimates that market participants derive from
various models, along with default probabilities implied by both market
prices and credit default swap spreads (to the extent those are traded
for a particular issuance).\199\ While access to such information could
be informative for certain market participants and investors, the
record preservation requirement set forth in new Rule 17a-4(b)(17), as
stated in the Proposal, was designed to aid the Commission in its
examinations of broker-dealers relying on the exception in Rule
101(c)(2)(i), as amended, by requiring such broker-dealers to retain
the written probability of default determination supporting their
reliance on the exception.\200\ As such, a requirement for these
entities to publish the information from the commenter's suggestion
would not serve this purpose because such a requirement may not
necessarily involve the type of information needed to meet the
conditions new Rule 101(c)(2)(i) or new Rule 102(d)(2)(i) \201\ and,
therefore, would not facilitate the Commission's examinations of
broker-dealers relying on those exceptions. In addition, the cost
burden of doing so on a regular basis could be disproportionate to the
infrequent usage of the exception, as these entities could incur other
burdens associated with disclosing such information.\202\ Accordingly,
it could discourage some entities from participating in certain issues,
which could increase the costs of the affected issues.\203\ Similarly,
for the Commission to publish this information, such that parties could
rely on the information, would also not be appropriate because this
approach would not facilitate its examinations of broker-dealers
relying on the exception.
---------------------------------------------------------------------------

    \199\ IILF Letter, at 8.
    \200\ Proposal, 87 FR 18324.
    \201\ See, e.g., 17 CFR 242.101(c)(2)(i), as amended,
242.102(d)(2)(i), as amended. Both of the new exceptions for
Nonconvertible Securities in Rules 101 and 102 require that the
issuer's probability of default be documented and determined, in
writing, without necessarily requiring the other information
included in the commenter's suggestion.
    \202\ See Proposal, 87 FR 18329; infra Part V.A.2.
    \203\ See, e.g., infra Part V.C.
---------------------------------------------------------------------------

    After reviewing the comments, the Commission is adopting Rule 17a-
4(b) under the Exchange Act largely as proposed, by adding new
paragraph (17), which requires broker-dealers to preserve the written
probability of default determination, relied upon pursuant to the new
exception in Rule 101(c)(2)(i) or Rule 102(d)(2)(i), as applicable. As
discussed above in Part II.B.1, the new exception in Rule 102(d)(2)(i)
was not originally proposed. However, proposed Rule 17a-4(b)(17) was
intended to capture ``broker-dealers relying on the exception for
Nonconvertible Securities'' \204\ and, therefore, the Commission
believes it is appropriate to apply it to both exceptions for
Nonconvertible Securities that are being adopted. Moreover, broker-
dealers relying on either exception should be in a position to comply
with the requirements of new Rule 17a-4(b)(17) because both exceptions
require that the lead manager of a distribution make and document in
writing the probability of default determination pursuant to Rule
101(c)(2)(i), as amended.\205\ Accordingly, the final rule adds ``or
Sec.  242.102(d)(2)(i) . . . or Rule 102 . . . as applicable'' in light
of the addition of the new exception for Nonconvertible Securities in
Rule 102(d)(2)(i) and that broker-dealers may be relying on the new
exception either in Rule 101(c)(2)(i) or in Rule 102(d)(2)(i),
depending on whether they are a covered person under Rule 101 or Rule
102. In addition, the final rule adds the text ``, relied upon by such
broker-dealer,'' to clarify that the written probability of default
determination must be preserved in connection with a broker-dealer's

reliance on the new exception in Rule 101(c)(2)(i) or in Rule
102(d)(2)(i), as applicable.
---------------------------------------------------------------------------

    \204\ Proposal, 87 FR 18324.
    \205\ New Rule 17a-4(b)(17) requires broker-dealers to preserve
the written probability of default determination, relied upon by
such broker-dealer, pursuant to Sec.  242.101(c)(2)(i) or Sec.
242.102(d)(2)(i) (Rule 101 or Rule 102 of Regulation M), as
applicable.
---------------------------------------------------------------------------

    New paragraph (b)(17) of Rule 17a-4 would affect the existing
practices of broker-dealers by imposing new record preservation
requirements when relying on the exception in new Rule 101(c)(2)(i) or
new Rule 102(d)(2)(i). A broker-dealer who is a distribution
participant acting as the lead manager (or in a similar capacity) of a
distribution and uses a vendor to determine the probability of default
could satisfy this record preservation requirement by maintaining
documentation of the assumptions used in the vendor model, as well as
the output provided by the vendor supporting the probability of default
determination. Such a broker-dealer calculating the probability of
default on its own could satisfy the record preservation requirement by
maintaining documentation of the value of each variable in deriving the
probability of default, along with a record identifying the specific
source(s) of such information for each variable. Other broker-dealers,
namely those that rely on the written probability of default
determination of another broker-dealer acting as the lead manager (or
in a similar capacity), could satisfy the record preservation
requirement by maintaining a copy of the documentation described above,
or by retaining a written notice it received of the probability of
default determination.
    The requirement to preserve, pursuant to Rule 17a-4(b), the written
probability of default determination is consistent with other record
retention obligations that Exchange Act rules impose on broker-
dealers.\206\ Exchange members and broker-dealers currently are
required to comply with the three-year preservation period in Rule 17a-
4(b) for other records and should have in place procedures to satisfy
such preservation requirements.\207\
---------------------------------------------------------------------------

    \206\ See Proposal, 87 FR 18325.
    \207\ 17 CFR 240.17a-4(b).
---------------------------------------------------------------------------

III. Other Issues

    Certain commenters urged the Commission to take additional or
different regulatory and non-regulatory actions than the approaches
that were proposed, including actions that the Commission did not
propose. These suggestions covered a variety of areas, including use of
the term ``investors,'' \208\ SEC enforcement actions,\209\ other
provisions of Regulation M,\210\ insurance company ratings,\211\
individual securities,\212\ credit ratings industry reforms,\213\
agency operations,\214\ and nondisclosures.\215\ These issues are
outside the scope of the Proposal and that the final amendments to
Rules 100(b), 101(c)(2), 102(d)(2), and 17a-4(b) appropriately further
the Commission's objectives of promoting investor protection, enhancing
market efficiency, and facilitating capital formation by implementing
the requirements of section 939A(b) of the Dodd-Frank Act and
facilitating the Commission during examinations of broker-dealers.
---------------------------------------------------------------------------

    \208\ Letter from Brian (Mar. 25, 2022).
    \209\ Letter from Patrick Lawson (Mar. 26, 2022).
    \210\ SIFMA Letter 2, at 4-5.
    \211\ Letter from Jason Wallace (May 19, 2022).
    \212\ See, e.g., Letter from Anthony Frattin (May 19, 2022);
Kern Letter; Wang Letter; Ferguson Letter; Navari Letter.
    \213\ See Better Markets Letter, at 2.
    \214\ See Letter from Senator Thom Tillis to Vanessa Countryman,
Sec'y, SEC (Nov. 4, 2022).
    \215\ Letter from The Delois Albert Brassell Estate and the
Robert James Brassell Estate (June 1, 2022).
---------------------------------------------------------------------------

IV. Other Matters

    If any of the provisions of these rules, or the application thereof
to any person or circumstance, is held to be invalid, such invalidity
shall not affect other provisions or application of such provisions to
other persons or circumstances that can be given effect without the
invalid provision or application.
    Pursuant to the Congressional Review Act,\216\ the Office of
Information and Regulatory Affairs has designated these rules as not a
``major'' rule as defined by 5 U.S.C. 804(2).
---------------------------------------------------------------------------

    \216\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------

V. Economic Analysis

    The Commission is sensitive to the economic consequences and
effects, including costs and benefits, of its rules. Some of these
costs and benefits stem from statutory mandates, while others are
affected by the discretion exercised in implementing the mandates.
Section 3(f) of the Exchange Act \217\ provides that whenever the
Commission is engaged in rulemaking pursuant to the Exchange Act and is
required to consider or determine whether an action is necessary or
appropriate in the public interest, the Commission shall also consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. Additionally,
section 23(a)(2) of the Exchange Act \218\ requires the Commission,
when making rules under the Exchange Act, to consider the impact such
rules would have on competition. Section 23(a)(2) also provides that
the Commission shall not adopt any rule which would impose a burden on
competition that is not necessary or appropriate in furtherance of the
purposes of the Exchange Act.
---------------------------------------------------------------------------

    \217\ 15 U.S.C. 78c(f).
    \218\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The analysis below addresses the likely economic effects of the
amendments, including the anticipated benefits and costs of the
amendments, and their likely effects on efficiency, competition, and
capital formation. The Commission also discusses the potential economic
effects of certain alternatives to the approach taken by these
amendments. Some of the benefits and costs discussed below are
impracticable to quantify. For example, sticky offerings are generally
not identified in the available data and may be difficult to trace in
the appropriate records of the distribution participants. Therefore,
much of the discussion of economic effects is qualitative.

A. Baseline

1. The Investment Grade Fixed Income Market
    To assess the economic effects of the amendments, the Commission is
using as the baseline the nonconvertible debt, nonconvertible
preferred, and asset-backed securities markets as they exist at the
time of this release, including applicable rules that the Commission
has already adopted.
    The affected parties include Nonconvertible Securities and asset-
backed securities (collectively ``fixed-income securities'') \219\
distribution and other market participants, such as issuers, selling
security holders, underwriters, banks, broker-dealers, and their
affiliated purchasers; fixed-income security investors, such as retail
investors, mutual funds, exchange traded funds, and separate investment
accounts; vendors of the relevant market data; and nationally
recognized statistical rating organizations (``NRSROs''). Currently a
majority of the distribution participants in the relevant markets are
subscribed to a major vendor of the market data necessary to evaluate
various aspects of the distribution. Further, a rating by an NRSRO is
necessary in order for distribution participants to rely on the
Investment Grade Exception. Today there are ten credit rating agencies
registered with the Commission as

NRSROs.\220\ Three large NRSROs (S&P Global Ratings, Moody's Investors
Service, Inc., and Fitch Ratings, Inc.) have historically accounted for
most of the market share in this market. As of December 31, 2021, these
three market participants accounted for 94.4% of all of the NRSRO
credit ratings outstanding.\221\
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    \219\ The term ``fixed-income securities'' in the Economic
Analysis section refers to nonconvertible debt securities,
nonconvertible preferred securities, and asset-backed securities.
    \220\ See Current NRSROs, U.S. Sec. & Exch. Comm'n, available at
https://www.sec.gov/about/divisions-offices/office-credit-ratings/current-nrsros.
    \221\ See Staff Report on Nationally Recognized Statistical
Rating Organizations (Feb. 2023) at 23, available at https://www.sec.gov/files/2023-ocr-staff-report.pdf.
---------------------------------------------------------------------------

    The affected securities are nonconvertible debt, nonconvertible
preferred, and asset-backed securities. In 2021, there were 33,798
issues of nonconvertible debt securities,\222\ with 687 issuers and 301
agents involved (266 reported as participating underwriters, of which
201 were the lead underwriters; 39--as trustees, and 10--as fiscal
agents).\223\ Additionally, in 2021, there were 114 filed prospectuses
for public offerings of asset-backed securities.\224\
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    \222\ The nonconvertible debt securities also include preferred
securities.
    \223\ The statistics are based on the data from Mergent. Some
agents were reported as performing two or more functions, for
example as an underwriter and as a lead underwriter.
    \224\ The information is based on EDGAR data for public
offerings of asset-backed securities. It should be noted that
prospectuses may contain multiple tranches, including non-offered
tranches excluded from the public offering of asset-backed
securities.
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2. The Investment Grade Exception
    Regulation M is designed to prevent manipulative activities that
could artificially influence the demand and pricing of covered
securities.\225\ In particular, Rules 101 and 102 of Regulation M
prohibit distribution and certain other market participants from
bidding for or purchasing a covered security, in connection with a
distribution of securities unless an exception, such as the Investment
Grade Exception, applies.\226\ At the time the exception was included,
the investment grade securities, that is securities characterized by
sound creditworthiness, as measured by credit rating, were considered
to be traded primarily on yield and credit ratings, and to be largely
fungible.\227\ Therefore, sound creditworthiness was considered to be a
good proxy for low manipulation risk. Investment Grade issues were
presumed to have low probability of default and were thus considered to
have low pricing uncertainty and low manipulation risk, which formed
the basis for the exception. For purposes of these amendments sound
creditworthiness is a good proxy for low manipulation risk since
securities issued by firms with sound creditworthiness trade primarily
on yield and creditworthiness (traditionally measured by credit
ratings).\228\ Further, none of the commenters on the Proposal raised
concern that creditworthiness would not be an adequate proxy for
manipulation risk.
---------------------------------------------------------------------------

    \225\ See supra Part I.
    \226\ See 17 CFR 242.101(a), 242.102(a); see, e.g., 17 CFR
242.101(c)(2), 242.102(d)(2).
    \227\ See Regulation M Adopting Release, 62 FR 527.
    \228\ There are other metrics that could serve as a proxy for
manipulation risk in Rules 101 and 102, such as security public
float or visibility to other market participants. One commenter for
instance proposed Form S-3 and F-3 standard and a WKSI-based
standard to measure manipulation risk (SIFMA Letter 1). However,
unlike measures of creditworthiness, such criteria fail to capture
the pricing point where the security is trading solely based on its
yield and maturity and thus has low pricing uncertainty and low
manipulation risk. Therefore, measures of creditworthiness are a
better proxy for manipulation risk.
---------------------------------------------------------------------------

    The application of the Investment Grade Exception to Rules 101 and
102 is primarily limited to two cases: re-openings (an offering of an
additional principal amount of securities that are identical to the
securities already outstanding, for example, when an issuer wishes to
make a series of offerings via a re-opening to match its funding needs
or when some foreign sovereign issuers conduct a re-opening for public
finance purposes \229\) and sticky offerings (an offering where a lack
of demand results in an underwriter being unable to sell all of the
securities in a distribution, for example, when an investor failed to
honor a previously expressed indication of interest; also, as stated in
the Proposal, another example a commenter provided is in a best-efforts
offering \230\).\231\ Re-openings are used infrequently and constitute
about 0.3% of the relevant securities' markets' issuance volume.\232\
Sticky offerings are not identified in the relevant databases, making
it difficult to assess their relative magnitude.
---------------------------------------------------------------------------

    \229\ See Proposal, 87 FR 18316. Note, however, that not every
foreign sovereign issue is conducted in the form of re-opening.
    \230\ See Proposal, 87 FR 18316. In a `best-effort' offering,
the underwriters are not required to sell any specific number or
dollar amount of securities but will use their best efforts to sell
the securities offered. See Plain English Disclosure, Release No.
34-38164, (Jan. 14, 1997) [62 FR 3152 (Jan. 21, 1997)]. Note,
however, that not every best-effort offering will become sticky,
where the underwriter is unable to sell all of the securities in the
distribution.
    \231\ See Proposal, 87 FR 18329. Note that the Commission
received no comments on the types of issues that typically rely on
the exception.
    \232\ The estimate is obtained using Mergent data for relevant
securities during 2021.
---------------------------------------------------------------------------

    Re-openings are used in situations when such financing method
offers the benefit of cost-effectiveness. For example, it may be
cheaper for an issuer to offer a series of small offerings as opposed
to one large offering, as the latter could result in a lower offering
price due to the supply pressure. Further, since a re-opening issue is
fungible with securities already in circulation and can be traded
interchangeably with these securities in the secondary market, it
provides additional liquidity benefits to the investors.\233\
---------------------------------------------------------------------------

    \233\ See Letter from Kenneth E. Bensten, Jr., Executive Vice
President, Public Policy and Advocacy, SIFMA to Elizabeth M. Murphy,
Secretary (July 5, 2011) at 6; John Berkery & Remmelt Reigersman,
Re-openings: Issuing Additional Debt Securities of an Outstanding
Series, Mayer Brown 1-2 (2020), available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/05/reopenings_-issuing-additional-debt-securities-of-an-outstanding-series.pdf. See also Proposal, 87 FR 18329.
---------------------------------------------------------------------------

    As discussed above, sticky offerings typically result when a large
investor fails to fulfill its expressed purchase interest in the issue,
which could be due to a negative factor that transpired about the issue
or issuer.\234\ Any offering of the relevant security thus can become a
sticky offering. In such cases it may become challenging to trade the
issue based solely on the yield and maturity (otherwise it would have
become possible to find another purchaser in a timely manner). This may
give rise in some cases to a heightened risk of manipulation in
connection with a distribution of securities even if the security is
rated as investment grade.\235\
---------------------------------------------------------------------------

    \234\ See Proposal, 87 FR 18329.
    \235\ We note, however, that not all sticky offerings are issued
by an issuer with a low creditworthiness and have a high
manipulation risk. It is thus important to have a standard of
creditworthiness that is able to capture most recent available
information on issuer creditworthiness, such as probability of
default, and account for the cases of possible sudden declines in
creditworthiness.
---------------------------------------------------------------------------

    Rule 102 provides that, in connection with a distribution of
securities effected by or on behalf of an issuer or selling security
holder, it shall be unlawful for such person, or any affiliated
purchaser of such person, directly or indirectly, to bid for, purchase,
or attempt to induce any person to bid for or purchase, a covered
security during the applicable restricted period.\236\ Issuers and
selling security holders generally do not have the same market access
needs as underwriters and are not expected to buy the securities they
are issuing. However, as pointed out by one of the commenters, their
affiliated broker-dealers, which do not serve as an underwriter, may
seek to rely on Rule 102 exception.\237\
---------------------------------------------------------------------------

    \236\ See supra Part I for a relevant discussion.
    \237\ SIFMA Letter 1, at 12-13.

---------------------------------------------------------------------------

    The Investment Grade Exception was included in Regulation M as it
was considered a good proxy for the likelihood of manipulation
risk.\238\ However, the reference to credit ratings in the Commission's
rules may encourage investors to place undue reliance on the credit
ratings. Credit ratings themselves are potentially imprecise and often
lagging indicators of creditworthiness.\239\
---------------------------------------------------------------------------

    \238\ See supra Part I.
    \239\ We note that the SEC staff took a similar position in the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC Staff
(July 15, 2020) (``Cost of debt capital is driven by a wide range of
financial and non-financial factors and forces; ratings downgrades
are generally lagging indicators of cost of debt capital.''),
available at https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15.
---------------------------------------------------------------------------

B. Benefits of the Amendments

    As mentioned above, section 939A(b) of the Dodd-Frank Act requires
the Commission to ``remove any reference to or requirement of reliance
on credit ratings, and to substitute in such regulations such standard
of creditworthiness as the Commission determines to be appropriate.''
\240\ In this amendment, the Commission will require distribution
participants, issuers, selling security holders and affiliated
purchasers, in order to avail themselves of these exceptions from
Regulation M, to rely upon the structural credit risk models as a
measure of creditworthiness.\241\ These models have been used to
estimate the probability of default of an issuer.\242\
---------------------------------------------------------------------------

    \240\ Public Law 111-203, sec. 939A(a). The Commission has
issued several releases concerning the removal of references to
credit ratings: Security Ratings, Release No. 34-64975 (July 27,
2011) [76 FR 46603 (Aug. 3, 2011)]; Removal of Certain References to
Credit Ratings Under the Securities Exchange Act of 1934, Release
No. 34-71194 (Dec. 27, 2013) [79 FR 1522 (Jan. 8, 2014)]; Removal of
Certain References to Credit Ratings under the Investment Company
Act, Release No. IC-30847 (Dec. 27, 2013) [79 FR 1316 (Jan. 8,
2014)]; Asset-Backed Securities Disclosure and Registration, Release
No. 34-72982 (Sept. 4, 2014) [79 FR 57184 (Sept. 24, 2014)]; Removal
of Certain References to Credit Ratings and Amendment to the Issuer
Diversification Requirement in the Money Market Fund Rule, Release
No. IC-31828 (Sept. 16, 2015) [80 FR 58124 (Sept. 25, 2015)].
    \241\ See, e.g., the seminal model by Robert C. Merton, On the
Pricing of Corporate Debt: The Risk Structure of Interest Rates, 29
Journal of Finance 449, 449-70 (1974), along with related successive
refinement models such as Fischer Black & John C. Cox, Valuing
Corporate Securities: Some Effects of Bond Indenture Provisions, 31
J. Fin. 351, 351-67 (1976); Robert Geske, The Valuation of Corporate
Liabilities as Compound Options, 12 J. Fin. & Quantitative Analysis
541, 541-52 (1977); and Oldrich A. Vasicek, Credit Valuation, KMV
(Mar. 22, 1984), among others.
    \242\ For example, the Merton (1974) Model and the Successor
Models are included in the curriculum for such credentials as the
Chartered Financial Analyst. See, e.g., Credit Analysis Models, >CFA
Inst. (2022), available at https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/credit-analysis-models. One commenter, however, suggested that ``most of
our member firms do not use them [the credit risk models] for other
purposes either, to the extent such models are used at all, they
serve merely as a supplement to member firms' own proprietary credit
analysis as part of their decision making on whether to extend a
loan or other credit.'' (SIFMA Letter 1 at 5). See also Part II.A.1
for a relevant discussion.
---------------------------------------------------------------------------

    Structural credit risk models typically take the issuer balance
sheet measures of debt obligations as given and estimate a probability
of default based on the market value and volatility of the firm's
equity. The value of equity is viewed in these models as the value of a
call option on firm assets where the strike price is the total notional
value of debt. Since the market value of equity, the volatility of
equity, and the notional value of debt can be calculated from the
market trading and balance sheet data, under the structural credit risk
models the volatility of the value of the assets and the market value
of assets, which are not observable, can be estimated. The probability
of default can be calculated as the probability that the call option
will expire out-of-the-money, which occurs when the value of the
company falls below the book value of the debt.
    As discussed above, structural credit risk models are based on the
structure of the balance sheet.\243\ Since the future value of the firm
is unknown, a structural credit risk model must make assumptions about
the probability distribution of possible firm values in different
scenarios, some of which may trigger default. These assumptions include
the current firm value and the volatility of firm value, for which the
observed market value of equity and the volatility of equity is often
an input. Some models include assumptions over the firm's dividend
policy.
---------------------------------------------------------------------------

    \243\ An alternative set of models used to derive probability of
default are `reduced-form models'. The reduced-form models rely on
statistical analysis rather than the balance sheet to determine a
firm's creditworthiness. However, compared to structural credit risk
models, they lack in rigorous theoretical justification as well as
economic interpretation of the resulted relationships between the
model inputs. See, e.g., Edward Altman, Andrea Resti, & Andrea
Sironi, Default Recovery Rates in Credit Risk Modeling: A Review of
the Literature and Empirical Evidence, 33 Econ. Notes 183 (2004)
(discussing the competing models), available at https://onlinelibrary.wiley.com/doi/10.1111/j.0391-5026.2004.00129.x.
---------------------------------------------------------------------------

    For purposes of these amendments, the probability of default
derived from the structural credit risk models is an appropriate proxy
for creditworthiness. As discussed previously in Part V.A.2,
creditworthiness is an appropriate standard to reflect manipulation
risk since securities issued by firms with sound creditworthiness trade
primarily on yield and creditworthiness (traditionally measured by
credit ratings) and have low pricing uncertainty and manipulation risk.
The Commission received several comments supporting the probability of
default as a standard for Rules 101 and 102 exception.\244\ However,
one commenter opposed this option and suggested a standard based on
Forms S-3 and F-3 or on WKSI standard.\245\ However, these alternatives
are not good measures of sound creditworthiness as compared to
probability of default because they fail to reflect the pricing point
where a security is traded solely on its yield and maturity. Thus, the
probability of default based on structural credit risk models is a more
appropriate proxy for creditworthiness, and thereby for manipulation
risk.
---------------------------------------------------------------------------

    \244\ See, e.g., IILF Letter, Bloomberg L.P. Letter, and Better
Markets Letter.
    \245\ See SIFMA Letters 1 and 2 and the relevant discussion in
Part II.A.1.
---------------------------------------------------------------------------

    Consistent with the Proposal, the Commission is adopting a 0.055%
probability of default threshold. The Commission requested and received
comments on this proposed threshold level. Specifically, one commenter
expressed support of the proposed threshold and also noted that at any
given date, the composition and population of any selected sample
meeting the threshold could change; \246\ as such some variation of the
estimated percentages of the captured universe of securities eligible
for the existing Investment Grade Exception is to be expected. Another
commenter expressed that the threshold should be increased to 0.5%
because it believes the exceptions as amended should be crafted to
capture as many of the securities covered under the existing investment
grade exceptions as possible; this commenter did not address the
corresponding increase in the percentage of currently ineligible
securities or the costs of that increase.\247\ No other commenters
suggested a different or lower threshold and, overall, the commenters
did not identify any economic effects of the proposed threshold level
that were not considered in the Proposal.
---------------------------------------------------------------------------

    \246\ See Bloomberg L.P. Letter, at 2.
    \247\ See SIFMA Letter, at 10.
---------------------------------------------------------------------------

    The Commission acknowledges that the percentage of investment grade
securities that would be captured under a specific threshold fluctuates
over time and as conditions change that affects the various inputs into
the models. As of March 2023, the 0.055% probability of default
threshold captured

approximately 76% of the investment grade securities in the final
sample of nonconvertible Fixed-Income Securities used (1996 distinct
investment grade issues with probability of default below 0.055% out of
2637 total investment grade rated issues in the sample).\248\ This
threshold also captured approximately 24% of non-investment grade
issues (64 out of 269 non-investment grade issues in the sample).
---------------------------------------------------------------------------

    \248\ The investment grade status for nonconvertible securities
issued between 2018 and 2023 was obtained from Mergent (as of the
last available Mergent update through Mar. 2023) while the
probability of default estimates were obtained for a cross-section
of securities available in Bloomberg (as of Mar. 28, 2023). Please
refer to Mario Bondioli, Martin Goldberg, Nan Hu, Chengrui Li, Olfa
Maalaoui Chun, & Harvey J. Stein, The Bloomberg Corporate Default
Risk Model (DRSK) for Public Firms (working paper Aug. 28, 2021),
available at https://ssrn.com/abstract=3911300 (retrieved from SSRN
Elsevier database), for methodology description of Bloomberg
probability of default measure.
---------------------------------------------------------------------------

    This estimation differs from that in the Proposal. In the Proposal,
we observed, using data from October 2021, that the 0.055% threshold
captured about 90% of investment grade securities (2436 out of 2710
issues) and about 37% of non-investment grade issues (125 of 341 non-
investment grade issues).\249\ Overall, at the time of the analysis of
data as of March 2023, 2060 issues met the proposed exception as
compared with the 2637 issues under the current exception.
---------------------------------------------------------------------------

    \249\ See Proposal, 87 FR 18330.
---------------------------------------------------------------------------

    Given the reaction of commenters to the proposed 0.055% threshold
\250\ and that there is an unavoidable trade-off between capturing
securities that are ineligible for the existing Investment Grade
Exception and leaving out some securities that are currently eligible,
the proposed threshold is intended to strike a reasonable balance
between these two statistical realities over time.\251\
---------------------------------------------------------------------------

    \250\ As discussed above, one commenter expressed general
support of the proposed 0.055% threshold (see Bloomberg L.P. Letter,
at 2) while another commenter suggested increasing the level to 0.5%
(See SIFMA Letter 1, at 10).
    \251\ As pointed out by one commenter, some variation of the
estimates is unavoidable, and ``this highlights the importance of
selecting an objective, data driven model that is consistently
applied over time and documented by the distribution participant.''
See Bloomberg Letter, at 2.
---------------------------------------------------------------------------

    Nonconvertible debt securities and nonconvertible preferred
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 are to be excepted from Rules 101 and 102.
    An advantage of using probabilities of default implied by
structural credit risk models instead of NRSRO credit ratings is that
these model-implied probabilities of default 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. In contrast, credit
rating agencies are generally slower than the market in updating credit
ratings and outlooks and thus may reflect less up-to-date
information.\252\
---------------------------------------------------------------------------

    \252\ We note that the SEC staff took a similar position in the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC Staff
(July 15, 2020) (``Cost of debt capital is driven by a wide range of
financial and non-financial factors and forces; ratings downgrades
are generally lagging indicators of cost of debt capital.''),
available at https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15. Some academic studies find evidence
that structural credit risk models may be able to respond to
aggregate and firm specific news faster than credit ratings. Also,
such models are able pick up on differences in default risk within a
credit rating bucket. However, credit ratings do not necessarily
imply probabilities of default and thus may not be directly
comparable to probability of default estimated using a structural
credit risk model. See Jing-zhi Huang & Hao Zhou, Specification
Analysis of Structural Credit Risk Models (Fed. Res. Bd., Fin. &
Econ. Discussion Series, 2008-552008), available at https://www.federalreserve.gov/pubs/feds/2008/200855/200855pap.pdf; Moody's
Analytics, EDF Overview (2011) (outlining the approach by Moody's
KMV), available at https://www.moodysanalytics.com/-/media/products/EDF-Expected-Default-Frequency-Overview.pdf; Giuseppe Montesi &
Giovanni Papiro, Risk Analysis Probability of Default: A Stochastic
Simulation Model, 10 J. Credit Risk 29 (2014).
---------------------------------------------------------------------------

    The Proposal did not limit which distribution participants are
allowed to produce probability of default estimations for the purposes
of the exception. In order to ensure consistency and reliability of the
estimates within any particular distribution and reduce the potential
subjectivity and non-uniformity of the estimates the amendments specify
that only lead managers are responsible for estimating the probability
of default for a given distribution.\253\ Lead managers would have
flexibility of either calculating the probability of default internally
using structural credit risk models, given the wide availability of
software products available on the market that perform such
calculations, or obtaining an estimate from a vendor. One of the
benefits of the amendment is that the lead managers will have the
flexibility of selecting the model they find most appropriate to assess
the creditworthiness of issuers for the purposes of using the
exception.\254\ This means the lead managers will not have to rely on a
credit rating for the issue in order to determine its eligibility for
Rules 101 and 102 exception and will no longer have to rely on an
NRSRO's choice of the model for such purposes.\255\ Furthermore,
multiple vendors currently provide estimates of the probability of
default based upon structural credit risk models as a part of default
packages that include various market data and metrics.\256\
---------------------------------------------------------------------------

    \253\ Some of the costs associated with this option are
discussed in the Costs Section of the Economic Analysis.
    \254\ However, this will not be the case for other distribution
participants who are not considered the lead manager of the
distribution, which may deter such participants from relying on the
exception. Further, this may result in lead managers' selecting a
model that allows them to rely on the exception but is not
necessarily the best model of the securities' creditworthiness and
manipulation risk. These issues are discussed in more detail in
infra Part V.C.
    \255\ Even though the lead manager would have to use a
structural credit risk model, there are many versions of such models
available, and the specific model parameters can be selected as
well, providing considerable flexibility of the estimates as
compared to the specific choices used in the assessments by NRSROs.
    \256\ Vendors offer a number of commercial applications based on
structural credit risk models. The probability of default calculated
by structural credit risk models, such as the Merton (1974) Model
and the Successor Models, can also be calculated by lead managers
without the use of a vendor. One commenter, however, suggested that
currently firms seldom use probability of default models in
connection with issuances of the relevant securities. See SIFMA
Letter 1 at 5.
---------------------------------------------------------------------------

    Removing and replacing the references to credit ratings from Rules
101 and 102 of Regulation M may also have a benefit of expanding the
number of options available to lead managers compared to what they
would have under the requirements of the Investment Grade Exception.
Specifically, the exceptions' requirement will no longer rely on a
limited number of vendors providing credit ratings, which may reduce
possible negative consequences from limited competition. Structural
credit risk models as a measure for creditworthiness could therefore
serve as a better proxy for manipulation risk than credit ratings
because, by prescribing a methodology rather than a metric generated by
only a certain category of regulated vendors (that is, NRSROs),
distribution lead managers may have more options for either using a
vendor-supplied structural credit risk model or using their own
proprietary version of a publicly available structural credit risk
model.
    Under the final rule amendments, the structural credit risk models
cannot be applied to asset-backed securities due to

the complexity of the structure of such instruments.\257\ Even though
one commenter suggested that probability of default can be estimated
for asset-backed securities \258\ such estimation based on structural
credit risk models is not routinely used due to the complexity of the
structure of these securities and the corresponding complex application
of such models. Further, another commenter supported proposed Form SF-3
standard for the Investment Grade Exception with respect to asset-
backed securities.\259\ The final amendments provide that securities
that are offered pursuant to an effective shelf registration statement
filed on Form SF-3 should also be excepted from Rules 101 and 102. The
Form SF-3 shelf eligibility requirements provide objective criteria
that can also ensure that the securities are consistent with the
Commission's original basis for the Investment Grade Exceptions. Asset-
backed securities that are offered pursuant to an effective shelf
registration statement filed on Form SF-3 are less at risk of the
manipulation that Regulation M addresses. Specifically, the Form SF-3
shelf eligibility requirements limit the number of nonperforming assets
in the asset-backed security pool, require review of the pool assets if
certain conditions are met, and require certification by the chief
executive officer, among other things.
---------------------------------------------------------------------------

    \257\ See a relevant discussion in supra Part II.B.2.
    \258\ See IILF Letter, at 6.
    \259\ SIFMA Letter 1, at 11.
---------------------------------------------------------------------------

    As the Commission noted when adopting Form SF-3, the Form
incentivizes sponsors to carefully review and disclose the underlying
assets' characteristics, reducing the overall uncertainty about the
asset-backed security \260\ and, with respect to these final
amendments, the risk of manipulation. The Commission received no
comments that suggest otherwise. Asset-backed securities that are
offered pursuant to an effective shelf registration statement filed on
Form SF-3 have similar qualities and characteristics to the investment-
grade asset-backed securities currently excepted in Rule
101(c)(2).\261\ A review of recent EDGAR database filings confirms that
almost all asset-backed securities issued pursuant to an effective
shelf registration statement filed on Form SF-3 have investment grade
ratings.\262\
---------------------------------------------------------------------------

    \260\ See supra notes 121-125 and accompanying text.
    \261\ One commenter opposed use of SF-3 standard for asset-
backed securities and suggested relying on the probability of
default instead (IILF Letter, at 7). However, probability of default
calculations based on a structural credit risk model are complex for
this type of securities due to their complex structure and are not
routinely used. Another commenter in fact expressed support of using
SF-3 standard for asset-backed securities (SIFMA Letter 1, at 11).
    \262\ Based on EDGAR database filings from 2022.
---------------------------------------------------------------------------

C. Costs of the Amendments

    The Commission recognizes that some of the affected underwriters,
their affiliates, as well as issuers, selling security holders and
affiliated purchasers may bear costs from the amendments. The
amendments may alter the universe of securities that are eligible for
the new exceptions. If some distribution participants decide not to
participate in certain issues because of the rule amendments, the costs
of the affected issues may increase. For example, when fewer banks or
broker-dealers are available, the underwriters may be able to charge
higher fees. Additionally, as the result of the amendments, fewer
issues may take place or issuers may rely more on private markets,\263\
potentially limiting issuers' ability to raise capital and affecting
investors in the relevant securities as the available security
selection and liquidity may be reduced.
---------------------------------------------------------------------------

    \263\ See SIFMA letter 1, at 5.
---------------------------------------------------------------------------

    There are several types of costs that could arise: (1) costs
associated with calculations or obtaining the probability of default
estimate; (2) costs associated with preserving records related to the
probability of default estimation; (3) costs due to the probability of
default being an imperfect proxy for creditworthiness, (4) asset-backed
securities' costs associated with the amendments, (5) indirect and
other costs of the amendments. We discuss these costs in detail below.
1. Costs Associated With Obtaining the Estimate of the Probability of
Default
    Lead managers may incur costs related to determining the
probability of default. Consistent with the Paperwork Reduction Act
(``PRA'') section,\264\ the Commission estimates that it will take a
lead manager 3 hours to establish a system to gather the data serving
as the inputs and then perform the analysis necessary to calculate the
probability of default of the issuer whose securities are the subject
of the distribution, for an aggregate cost of $218,889 \265\ Consistent
with the PRA section,\266\ the Commission also estimates that it will
take a lead manager one hour to gather the inputs required to calculate
probability of default each time it participates in a distribution of
Nonconvertible Securities. There were 33,798 offerings of
Nonconvertible Securities in 2021. Therefore, it is estimated that
annually lead managers will spend maximum of $12,268,674 \267\ in the
aggregate complying with this requirement if all lead managers choose
to estimate the probability of default internally.
---------------------------------------------------------------------------

    \264\ See infra Part VI.
    \265\ The Commission estimates the wage rate based on salary
information for the securities industry compiled by SIFMA. See
Management & Professional Earnings in the Securities Industry--2013,
SIFMA (Oct. 7, 2013). These estimates are modified by the Commission
staff to account for an 1800 hour work-year and multiplied by 5.35
(professionals) or 2.93 (office) to account for bonuses, firm size,
employee benefits and overhead. These figures have been adjusted for
inflation through Jan. 2023 using data published by the Bureau of
Labor Statistics' Consumer Price Index inflation calculator,
available at https://www.bls.gov/data/inflation_calculator.htm. 201
lead managers x 3 hours x $363 hour for a compliance manager =
$218,889.
    \266\ See infra Part VI.C.1.
    \267\ Cost estimated is based on the sum of 33,798 offerings
multiplied by 1 burden hour multiplied by $363, for a compliance
manager. See Management & Professional Earnings in the Securities
Industry--2013, SIFMA (Oct. 7, 2013). These estimates are modified
by the Commission staff to account for an 1800 hour work-year and
multiplied by 5.35 (professionals) or 2.93 (office) to account for
bonuses, firm size, employee benefits and overhead. These figures
have been adjusted for inflation through Jan. 2023 using data
published by the Bureau of Labor Statistics' Consumer Price Index
inflation calculator, available at https://www.bls.gov/data/inflation_calculator.htm.
---------------------------------------------------------------------------

    However, some lead managers may rely on third party vendors rather
than internally calculate the probability of default. Any costs
associated with using a vendor to obtain probability of default
estimate, however, should be small, as the vendors typically already
have subscriptions available to provide calculations regarding the
probability of default based on structural credit risk models.\268\
Furthermore, lead managers, in particular those that choose to
determine the probability of default estimate internally, are likely to
already have the computational resources necessary to conduct such
analysis internally. Therefore, the total costs for the lead managers
of complying with the requirement should be below $12,268,674.
---------------------------------------------------------------------------

    \268\ See infra note 256. One commenter suggested that firms
rarely use probability of default models in connection with
issuances of the relevant securities. However, probability of
default estimates are typically provided by the vendors in a package
with other data firms are often subscribed to.
---------------------------------------------------------------------------

    Further, since the rule amendments specify that only the lead
manager can supply the estimate of the probability of default for the
purposes of relying on the exception, some issues where 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, may not be able to rely on the

exception. These issues may therefore be subject to Regulation M
restrictions and may have to rely on private markets and may face
potentially higher issuing costs or not take place.\269\
---------------------------------------------------------------------------

    \269\ Such costs, however, cannot be quantified due to lack of
available data.
---------------------------------------------------------------------------

2. Costs Associated With Maintaining Records Related to the Probability
of Default Estimation
    Broker-dealers relying on the new exception in Rule 101(c)(2)(i) or
Rule 102(d)(2)(i) must preserve the written probability of default
determination made pursuant to Rule 101(c)(2)(i), as amended.
Consistent with the PRA section,\270\ the Commission estimates that it
will take a distribution participant 25 hours to update the applicable
policies and systems required to account for capturing the records made
pursuant to new Rule 101(c)(2)(i), for an aggregate cost of
$2,731,575.\271\ Consistent with the PRA section,\272\ the Commission
also estimates that it will take a distribution participant 10 hours to
maintain such records as well as to make additional updates to the
applicable record preservation policies and systems to account for the
rules. Therefore, it is estimated that annually broker-dealers will
spend $1,092,630 \273\ in the aggregate complying with this
requirement.
---------------------------------------------------------------------------

    \270\ See supra Part VI.C.2.
    \271\ 301 distribution participants x 25 hours x $363 hour for a
compliance manager = $2,731,575. See Management & Professional
Earnings in the Securities Industry--2013, SIFMA (Oct. 7, 2013).
These estimates are modified by the Commission staff to account for
an 1800 hour work-year and multiplied by 5.35 (professionals) or
2.93 (office) to account for bonuses, firm size, employee benefits
and overhead. These figures have been adjusted for inflation through
Jan. 2023 using data published by the Bureau of Labor Statistics'
Consumer Price Index inflation calculator, available at https://www.bls.gov/data/inflation_calculator.htm.
    \272\ See supra Part VI.C.2.
    \273\ Cost estimated based on the sum of 301 distribution
participants multiplied by 10 burden hours multiplied by $363, for a
compliance manager. See Management & Professional Earnings in the
Securities Industry--2013, SIFMA (Oct. 7, 2013). These estimates are
modified by the Commission staff to account for an 1800-hour work-
year and multiplied by 5.35 (professionals) or 2.93 (office) to
account for bonuses, firm size, employee benefits and overhead.
These figures have been adjusted for inflation through Jan. 2023
using data published by the Bureau of Labor Statistics' Consumer
Price Index inflation calculator, available at https://www.bls.gov/data/inflation_calculator.htm.
---------------------------------------------------------------------------

3. Costs Associated With Structural Credit Risk Model Based Probability
of Default Being an Imperfect Proxy for Creditworthiness
    As discussed previously, the structural credit risk models are
designed to measure creditworthiness, and creditworthiness itself is
considered a good measure of manipulation risk. There are costs that
are currently present in the relevant markets associated with
creditworthiness being an imperfect proxy for manipulation risk.
However, in the absence of a better proxy for manipulation risk,
creditworthiness has continued to successfully serve the purpose of
measuring such risk for many years. This is also supported by the
comments stating that the investment grade standard has been
successfully used in Rules 101 and 102 exception.\274\ The final rule
amendments are not expected to alter those costs and the discussion
that follows focuses instead on the costs associated with the
structural credit risk models as a proxy for creditworthiness.
---------------------------------------------------------------------------

    \274\ See, e.g., Rothwell, at 2 and ABA Letter, at 15 -17.
---------------------------------------------------------------------------

    The use of any model to estimate creditworthiness necessarily
provides an imperfect measure. Structural credit risk models are no
exception. We note, however, that models such as structural credit risk
models often are a part of the analysis involved in obtaining a credit
rating.\275\
---------------------------------------------------------------------------

    \275\ See, e.g., John Y. Campbell, Jens Hilscher, & Jan
Szilagyi, In Search of Distress Risk, 63 J. Fin. 2899 (2008),
available at https://scholar.harvard.edu/files/campbell/files/campbellhilscherszilagyi_jf2008.pdf.
---------------------------------------------------------------------------

    Some ways to implement structural credit risk models make use of
historical trading data to produce a reliable estimate of the model
input parameters. These data may not be available for certain
infrequently traded securities. In some circumstances, the market for a
security has not yet been established and sufficient trading data are
unavailable, making it difficult to apply the exception.
    Additionally, structural credit risk models rely on a number of
parameter estimates such as firm market value and volatility, which
could be difficult to assess as these values change with market
conditions and business fluctuations. A changing term structure of
interest rates and noise trading in the market can further distort the
probability of default estimates. Incorrect parameter estimates may
result in the incorrect estimates of default probability and allow
distribution participants to rely on the exception for risky issues or
prevent distribution participants from relying on the exception for
safe issues. Implied probabilities of default are sensitive to market
prices and estimates of market volatility and consequently tend to be
counter cyclical, increasing during market downturns, which are often
also periods of increased uncertainty. A constant threshold which is
not time-varying will potentially result in fewer firms qualifying for
the exception during market downturns, which may result in more
issuances during this period not qualifying or firms choosing not to
issue, hence increasing their cost of capital or limiting their access
to capital.
    While credit rating downgrades are also countercyclical occurring
more frequently during market downturns, they tend to be slow in
incorporating updates.\276\ Thus, the impact of the counter cyclicality
of default probabilities implied by structural credit risk models could
be stronger relative to using credit ratings: during periods of
distress, using these probabilities of default will likely result in
fewer firms with an investment grade credit rating falling below the
threshold, and thus fewer firms qualifying for the exception relative
to using credit ratings. Lead managers who make probability of default
determinations pursuant to new Rule 101(c)(2)(i) could make reasonable
adjustments to model parameters and inputs to recalculate the
probability of default as market conditions change, mitigating the
costs discussed above.
---------------------------------------------------------------------------

    \276\ We note that the SEC staff took a similar position the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC (July
15, 2020) (``Cost of debt capital is driven by a wide range of
financial and non-financial factors and forces; ratings downgrades
are generally lagging indicators of cost of debt capital.''),
available at https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15.
---------------------------------------------------------------------------

    Due to the number of variations among structural credit risk models
and their estimated inputs, the 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
latter may affect market participants' ability to effectively rely on
the estimates to make comparative assessments across multiple
securities. However, this is also true of the credit ratings that often
rely on similar models, which mitigates these costs of the amendments
relative to the market baseline.
    Further, as a result of the Rules 101 and 102 amendments, all
underwriters as well as issuers, selling security holders and
affiliated purchasers will rely on the lead manager's assessment of the
probability of default in order to use the exception.\277\ This should
mitigate the subjectivity and non-uniformity of the estimation concerns
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.
This requirement allows the lead manager to perform estimations which
determine if the resulted probability of default falls below the
threshold for all the distribution participants and their affiliates
and thus the availability of the exception. Some of these participants
may decide to withdraw if the exception is not available. However, the
lead manager is interested in the best outcome of the distribution and
therefore has strong incentives to encourage the participation of these
entities in the distribution, mitigating the above concern. This may,
on the other hand, incentivize lead managers to select models and
estimation specifics in such a way to ensure the resulted estimates are
below the threshold, potentially allowing issues of issuers with low
creditworthiness and high manipulation risk to rely on the exception.
The public availability of alternative probability of default estimates
available for the investors through multiple vendors, however, should
mitigate this concern.
---------------------------------------------------------------------------

    \277\ See supra Part II.B.1.
---------------------------------------------------------------------------

    In addition, as discussed above in reference to the selected
threshold, the proposed amendment may expand the universe of issuers of
nonconvertible securities that qualify for the exception and include
issuers that did not receive an investment grade credit rating, but
have a structural credit model implied probability of default that
falls below the threshold. The debt prices of these firms may be prone
to manipulation if the price of their debt is relatively more sensitive
to the idiosyncratic risks of the issuers.
    Additionally, this amendment may create potential opportunities for
new products offered by the vendors designed specifically for a given
issue or issuer. A custom designed estimate paid for by a party with an
interest in the outcome of the distribution may lead to potential
conflicts of interest since the vendor is incentivized in this case to
produce an estimate which will allow the issuer, their affiliates and
selling security holders, and other distribution participants to rely
on the exception. However, the existing major vendors supplying
probability of default estimates have numerous clients currently using
this information for business purposes other than the Rules 101 and 102
exception. Therefore, given the reputational concerns it is unlikely
that these vendors will produce a product to cater specifically to the
use of these estimates for purposes of relying on the Rules 101 and 102
exception.
    Additionally, the model input estimates or assumptions may be
selected by the lead manager in such a way as to produce the desired
estimation result if the model is estimated internally and may result
in lead managers' selecting the models so as to be able to rely on the
exception.\278\ This may result in an additional cost of adding some
manipulation risk to the relevant markets if manipulation prone issues
are allowed to rely on the exception as a result.
---------------------------------------------------------------------------

    \278\ The definition of structural credit risk models for
purposes of new Rule 101(c)(2)(i) is limited to commercially or
publicly available models, which would limit a distribution
participant's ability to develop its own models to achieve favorable
results.
---------------------------------------------------------------------------

    Finally, the threshold of 0.055% for the exception is based on
model assumptions and available data. Some commenters expressed support
for the proposed threshold level selection,\279\ while one commenter
suggested a higher level.\280\ Future market evolution may result in
this threshold becoming either too large or too small, allowing risky
issues to rely on the exception or preventing less risky issues from
using it. One commenter expressed a similar concern about a set-level
threshold specification in the rules.\281\ The threshold may vary by
industry, with the threshold being more restrictive in some industries
relative to the original NRSRO investment grade designation. Moreover,
probabilities of default as implied by structural credit risk models
tend to be counter-cyclical and can spike in periods of crisis due to
decreases in market valuation and increases in equity volatility.
Consequently, during such periods, fewer investment grade firms
generally fall below the threshold. Credit ratings by NRSROs are also
countercyclical but tend to be slow-moving, since credit rating changes
often lag updates to firm conditions that will impact cost of
capital.\282\
---------------------------------------------------------------------------

    \279\ See Bloomberg L.P. Letter. at 2, which provides analysis
supporting the proposed probability of default threshold.
Additionally, IILF Letter, at 6 suggests that the proposed threshold
is in a reasonable range.
    \280\ See SIFMA Letter 1 at 10.
    \281\ See IILF Letter, at 6.
    \282\ We note that the SEC staff took a similar position in the
COVID-19 Market Monitoring Group, Credit Ratings, Procyclicality and
Related Financial Stability Issues: Select Observations, SEC Staff
(July 15, 2020) (``Cost of debt capital is driven by a wide range of
financial and non-financial factors and forces; ratings downgrades
are generally lagging indicators of cost of debt capital.''),
available at https://www.sec.gov/news/public-statement/covid-19-monitoring-group-2020-07-15.
---------------------------------------------------------------------------

4. Costs Associated With Asset-Backed Securities' Amendments
    The amendments may render some asset-backed securities ineligible
to rely on the exception from the Regulation M. This may increase
issuance costs for the underwriters as well as issuers, selling
security holders and affiliated purchasers. For instance, broker-
dealers may reduce an offering's size or increase fees if the exception
to Regulation M is no longer available.\283\ Additionally, issuers may
need to establish new business relationships due to Regulation M
restrictions. Furthermore, some issuers may decide not to issue the
affected securities if the exceptions to Regulation M are no longer
available. As a result, some asset-backed securities' issues may not
take place, which could affect issuers' ability to raise capital and
could affect investors in the relevant markets by potentially reducing
the selection of the available asset-backed securities.
---------------------------------------------------------------------------

    \283\ Such changes in fees or changes in size cannot be
reasonably quantified due to lack of available data on the
respective changes (before and after an occurrence) in the relevant
values.
---------------------------------------------------------------------------

5. Indirect and Other Costs of the Amendments
    Besides the direct effects on the distribution participants and
affected securities discussed above the final rule amendments may also
generate indirect effects including on investors in these securities
and NRSROs. For instance, distribution participants other than lead
managers may want to verify the estimates provided by the lead manager
by either obtaining the estimate from a vendor or making the
calculations internally, which will result in additional costs for
these participants.\284\
---------------------------------------------------------------------------

    \284\ These costs are estimated as $363 per participant per
distribution if estimates are obtained internally. Consistent with
the PRA, the Commission estimates that it would take one hour per
issue to calculate probability of default. Cost estimated is based
on 1 burden hour multiplied by $363, for a compliance manager. See
Management & Professional Earnings in the Securities Industry--2013,
SIFMA (Oct. 7, 2013). These estimates are modified by the Commission
staff to account for an 1800 hour work-year and multiplied by 5.35
(professionals) or 2.93 (office) to account for bonuses, firm size,
employee benefits and overhead. These figures have been adjusted for
inflation through Jan. 2023 using data published by the Bureau of
Labor Statistics' Consumer Price Index inflation calculator,
available at https://www.bls.gov/data/inflation_calculator.htm.
---------------------------------------------------------------------------

    Additionally, the lead managers, although not required, may need to
expend resources in terms of their staff time and resources in order to
notify other distribution participants, their affiliated purchasers,
issuers, selling security holders, and their affiliated purchasers of
their probability of default

determinations that were estimated pursuant to Rule 101(c)(2)(i).
    The Commission estimates that it will take 0.25 hours per lead
manager per issue (8,450 hours annually) \285\ to notify other
distribution participants of the probability of default estimates.
Therefore, the total estimated cost for the lead managers associated
with notifying other distribution participants is estimated as
$1,732,250.\286\
---------------------------------------------------------------------------

    \285\ 33,798 issues times 0.25 hours.
    \286\ 8,450 hours * $205 hour for a junior business analyst wage
= $1,732,250 See Management & Professional Earnings in the
Securities Industry--2013, SIFMA (Oct. 7, 2013). These estimates are
modified by the Commission staff to account for an 1800 hour work-
year and multiplied by 5.35 (professionals) or 2.93 (office) to
account for bonuses, firm size, employee benefits and overhead.
These figures have been adjusted for inflation through January 2023
using data published by the Bureau of Labor Statistics' Consumer
Price Index inflation calculator, available at https://www.bls.gov/data/inflation_calculator.htm.
---------------------------------------------------------------------------

    Further, if issuer participation in the relevant security issues,
for example in the case of re-openings or issues that are more likely
to become sticky offerings, becomes limited, some issues may not take
place that otherwise would. Investors may additionally face a more
limited choice of investment instruments as a result. This may also
affect liquidity of their portfolios in the case of re-openings, since
re-openings can offer additional liquidity benefits as the securities
offered in re-openings are interchangeable with the existing issues.
However, as already discussed in the case of re-openings, these costs
are expected to be minimal as re-openings are used infrequently.
    The rule amendments do not rely on an NRSRO rating in order to
determine if an issue is eligible for the exception. This may diminish
NRSROs' clientele to the extent NRSROs choose not to provide structural
credit risk model-based estimates of the probability of default for
their existing clients opting to rely on the exception. However, the
amendment may increase the clientele of the vendors that supply
relevant data and metrics to the lead managers or other distribution
participants who wish to verify the lead manager estimates, if such
vendors already supply probability of default estimates or choose to
offer this estimate as a part of their services. In addition, if firms
do not solicit credit rating services from NRSROs beyond the estimate
of a probability of default implied by a structural credit risk model,
investors will not be able to benefit from the information provided by
a credit rating report and ongoing coverage of the firm that otherwise
will be provided through the distribution participant.

D. Efficiency, Competition, and Capital Formation

    As discussed previously, lead managers will have flexibility in
selecting the structural credit risk model to access creditworthiness
as a measure of manipulation risk for the business. This may encourage
issuers to issue securities in relevant markets, as well as
participation of other distribution participants, such as selling
security holders and affiliated purchasers. As a result, this could
improve competition between issuers for investors as well as
competition between lead managers for underwriting business.
    Further, widely available estimates of the probability of default
as well as an option of internal model estimation could lead to a more
competitive environment in the provision of models as the requirement
to rely on proprietary credit risk models of a small number of NRSROs
is removed. The improved competition, market participation and
efficiency ultimately should lead to more efficient capital formation
as the access to and functioning of the relevant fixed income markets
improves.
    However, it is possible that a new business model could emerge in
the relevant markets that leads to conflicts of interest and
neutralizes the effects discussed above. For instance, lead managers
could contract with a vendor or a credit rating agency directly to
create a custom estimate of the probability of default. This could
result in a business model where an interested party pays for the
supplied estimate and where vendors may be incentivized to produce an
estimate designed to fit the desired estimation result. Thus issuers
that otherwise will not be able to rely on the exception could end up
being excepted potentially increasing the manipulation risk in the
relevant markets, which in turn could negatively affect competition and
capital formation. The reputational concerns, however, would generally
prevent vendors from generating estimates specifically designed for the
needs of a small number or a single customer.
    Additionally, the positive effects discussed above could be offset
by the fact that only lead managers can obtain an estimate of the
probability of default for the distribution. Some issues where 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'' may not have the exceptions
available.\287\ This may deter participants from such distributions and
in some cases result in securities being issued in private markets or
issues not taking place. This may negatively affect the competition and
capital formation in the relevant market.
---------------------------------------------------------------------------

    \287\ See supra Part V.C.1.
---------------------------------------------------------------------------

    Some issuers may also face higher costs or no longer be able to use
the exception, for example, due to imperfect model estimates because of
market fluctuations or changing market. High costs of issuance or
inability to rely on the exception may deter participants from issuing
the affected securities, which could affect competition and capital
formation in the relevant markets. Further, potential negative effects
of non-uniform estimates and subjectivity additionally reduce these
benefits. As discussed previously, variations in model assumptions,
parameters, or data sample used necessarily introduce an element of
subjectivity in the final estimates and leads to differences in the
estimates across different issues or issuers. Finally, potentially
increased issuance costs due to some asset-backed securities being
ineligible for the exception may also negatively affect market
participation and competition of the relevant markets.

E. Reasonable Alternatives

    Alternative 1 discussed below deals with the probability of default
threshold, alternatives 2-4 discuss alternative approaches to using
structural credit risk models as a standard of creditworthiness to
measure manipulation risk. Alternative 5 discusses elimination of the
exception from Rule 101, alternative 6 deals with asset-backed
securities, alternative 7 discusses Rule 102 options, while the last
alternative discussed the record preservation requirement.
1. Alternative Threshold for Probability of Default
    The Probability of Default threshold of 0.055% was chosen in an
effort to maximize investment grade securities captured and minimize
the non-investment grade securities captured. However, a different
threshold could be used in the Rule exception, which would capture
different proportions of investment and non-investment grade
securities. For example, based on data as of March 2023, a higher
threshold of 0.5% is estimated to capture about 97% of investment grade
securities (2550 out of 2637 investment grade issues) and about 70% of
non-investment grade issues (188 out of 269 non-investment grade
issues). A lower threshold of 0.03% is estimated to capture about 64%
of investment grade securities (1675 out of 2637 investment grade

issues) and 11% of non-investment grade issues (29 out of 269 non-
investment grade issues).
    The advantage of a higher threshold is that it captures a larger
set of investment grade securities, but at the expense of also
capturing an additional set of non-investment grade securities, which
could be prone to manipulation risk. Increasing the threshold would
allow more investment grade securities to rely on the exception at
expense of a potentially higher manipulation risk; on the other hand,
decreasing the threshold would limit the ability of some of the
investment grade securities to use the exception, but would also limit
the number of non-investment grade securities allowed to rely on the
exception and, as a result, also limit manipulation risk.
    The Commission proposed 0.055% threshold level, which scoped in
about 90% of investment grade issues and about 37% of non-investment
grade issues.\288\ One of the commenters suggested increasing the
threshold in order to capture a larger percentage of the previously
eligible investment grade issues,\289\ another commenter suggested that
the proposed threshold level is appropriate,\290\ while none of the
commenters suggested decreasing the threshold. Furthermore, at any
given date, the proportion of currently eligible securities that would
be captured varies. Manipulation risk remains the primary concern of
Regulation M. Because the originally proposed threshold of 0.055%
remains appropriate for these purposes, and acknowledging the variation
in eligible securities that would be captured over time, increasing (or
decreasing) this threshold for the primary aim of capturing more (or
fewer) of currently eligible securities does not justify changing this
threshold.
---------------------------------------------------------------------------

    \288\ Based on the data as of Oct. 2021. Based on Mar. 2023
data, 0.055% threshold scopes in about 76% of investment grade
issues (1996 out of 2637 issues) and about 24% or non-investment
grade issues (64 out of 269 issues).
    \289\ SIFMA Letter 1, at 7 and 10, see also a relevant
discussion in Part II.B.1.
    \290\ See Bloomberg L.P. Letter, at 2.
---------------------------------------------------------------------------

    Rather than providing a specific number as a threshold, a method
for distribution participants to use in calculating such a threshold
could be specified instead. For example, such method could involve
calculating a set of probability of default estimates for a sample of
Nonconvertible Securities with characteristics such as yield and
maturity similar to the distribution participant's securities issued
over a specified time interval and comparing it to a specified standard
of creditworthiness. A longer time interval of the data sample would
capture more issues and improve statistical accuracy at expense of
having market conditions potentially changing and generating incorrect
estimates. A shorter time interval of the sample ensures the market
conditions have not changed but includes fewer issues resulting in a
smaller sample and lower statistical accuracy. One of the commenters
expressed similar ideas advocating for an estimation method rather a
fixed threshold level, which would result in a more flexible threshold
level.\291\
---------------------------------------------------------------------------

    \291\ See IILF Letter, at 7.
---------------------------------------------------------------------------

    The main advantage of specifying a method as opposed to a number
for the threshold is its flexibility with respect to changing market
conditions. The main disadvantage of this alternative is subjectivity
of the analysis involved, which may lead to non-uniform application of
the Regulation M exceptions across issues or issuers if the estimated
threshold differs considerably across issues or issuers; or incentivize
market participants to adjust the threshold estimation to be able to
rely on the exception. Some commenters expressed a concern for the
estimates' subjectivity and non-uniformity as discussed previously.
This alternative could introduce additional subjectivity and non-
uniformity and thus is sub-par to the originally proposed option.\292\
---------------------------------------------------------------------------

    \292\ See SIFMA Letter 1, at 5, Better Markets Letter, at 4, and
the relevant discussion in Part II.D.
---------------------------------------------------------------------------

2. Exception Based on Security Characteristics
    As an alternative replacement for the reference to investment grade
securities, the Commission considered analysis that could be based on
security characteristics, such as (1) total amount of issue outstanding
(public float); (2) yield to maturity of the security during a past
trading period; or (3) empirical duration.\293\ Other relevant security
characteristics that could be used are outlined in the 2011
Proposal.\294\ Such analysis could be performed internally or
externally and could be additionally verified by a third party. All of
these alternatives were included in the Proposal and the Commission
received no comments in regards to these alternatives. Below we discuss
public float, yield to maturity and empirical duration criteria in more
detail.
---------------------------------------------------------------------------

    \293\ Empirical duration is bond duration calculated based on
historical data rather than a formula. Typically, it is estimated
using a regression analysis of the relationship between market bond
prices and Treasury yields.
    \294\ 2011 Proposing Release, 76 FR 26557-64.
---------------------------------------------------------------------------

     Exception Based on the Total Amount of Issue Outstanding
(Public Float).
    To the extent that it is more difficult to manipulate price of a
larger issue, public float could be used as an alternative criterion to
reflect manipulation risk. This criterion has the advantage of being
straightforward and easy to evaluate. Due to its simplicity, it lacks
the estimation issues associated with other measures such as the
probability of default. However, determination of a threshold for
public float to select securities for the exception is complicated due
to its considerable variation across issuers or industries. A specific
threshold selection could potentially disadvantage smaller issuers--
especially during periods of market downturns when valuations are low.
Additionally, public float is not inherently an indication of low
credit risk since a distressed firm can have a large amount of debt.
     Exception Based on Yield to Maturity.
    Securities that are traded primarily on yield and maturity have low
manipulation risk, as discussed before, since their pricing does not
reflect issuer specific risks. Yield to maturity, therefore, can be
used as an alternative criterion to evaluate manipulation risk.
However, using yield to maturity as a criterion for securities eligible
for the exception is also problematic. Even though this criterion is
similarly easy to obtain and lacks any major estimation issues,
selecting a threshold is not straightforward. For instance, yield to
maturity differs considerably by industry. Selecting a fixed threshold
may result in some industries being under-represented and others over-
represented in the pool of eligible issues. Moreover, yield to maturity
often moves with risk-free rates; thus fewer firms would be excepted
during periods of high interest rates. The default-free component of
yield to maturity makes this measure a very noisy proxy of credit
worthiness.
     Exception Based on Empirical Duration.
    Empirical duration is another alternative proxy that could be used
to evaluate Nonconvertible Securities for an exception from Regulation
M. Negative empirical duration might be an indication that a
Nonconvertible Security or its issuer is of low creditworthiness. A
Nonconvertible Security with negative empirical duration is less
affected by changes in interest rates than Nonconvertible Securities of
creditworthy issuers and trades similar to equity securities. Although
negative empirical duration may demonstrate that a particular issuer or
security is not creditworthy, it has some limitations that affect the
viability

of negative empirical duration as a substitute for the reference to
credit ratings in the Investment Grade Exception. In particular, this
measure relies heavily on statistical analysis, requires the
Nonconvertible Security to be traded, and may lack intuitive
interpretation, which renders empirical duration a poor proxy for the
type of manipulation that Regulation M is designed to prevent.
3. Exception Based on Issuer Characteristics
    The Commission also considered an exception based on issuer
characteristics, for example, the interest coverage ratio, the WKSI
standard, as suggested in the 2008 Proposing Release,\295\ a Form S-3/
F-3-based standard, or a criterion based on a reduced-form credit risk
model, as an alternative to the structural credit risk models. We
discuss these alternatives below.
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    \295\ 2008 Proposing Release, 73 FR 40095-97.
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     Exception Based on the WKSI Standard.
    The Commission could adopt a standard based on the amount of the
issuer's total securities outstanding or based on the WKSI standard as
a criterion to determine eligibility for the exception. The issuers
that fall under the WKSI definition or with sufficient amounts of total
securities issued or outstanding are large and established firms that
typically have sound creditworthiness. The Commission included this
alternative in the Proposal. One commenter expressed some support for
this alternative.\296\ The advantage of this characteristic is its
simplicity, uniformity, and the lack of subjectivity of the analysis.
However, the WKSI standard as discussed in the 2008 Proposing Release,
for example, was heavily criticized for allowing risky high-yield
issues to be eligible for the exception and preventing issues by
smaller but otherwise creditworthy issuers from relying on the
exception, which remains a considerable concern.\297\ Even though one
of the commenters suggested a standard based on the WKSI standard due
to its simplicity, uniformity and lack of subjectivity,\298\ such a
standard would fail to capture the pricing point where securities trade
solely based on their yields and maturity and not on the issuer
characteristics, where pricing uncertainty and manipulation risk are at
their minimum. Thus, such a standard would be a sub-par measure of
manipulation risk as compared to the probability of default.
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    \296\ See SIFMA Letter 1 at 9.
    \297\ ABA Letter, at 15-17 and Letter from Deborah A. Cunningham
and Boyce I. Greer, Co-chairs, Securities Industry and Financial
Markets Association (``SIFMA'') Credit Rating Agency Task Force, to
Florence E. Harmon, Acting Secretary (Sep. 4, 2008) at 13.
    \298\ See SIFMA Letter 1 at 9.
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     Exception Based on Forms S-3 and F-3.
    One commenter stated that the complexity of the proposed
probability of default calculations would impose additional regulatory
burdens that could be avoided if the exception, instead, relied on a
standard based on readily verifiable and publicly available
information.\299\ This commenter proposed using Form S-3 or Form F-3 as
a standard for the exception given the uniformity, simplicity and a
lack of subjectivity of such a standard.\300\ The Form S-3 or Form F-3
eligibility criteria are intended to access whether an issuer is widely
followed,\301\ rather than an issuer's creditworthiness. A widely
followed issuer may be more likely to have a low manipulations risk,
making this a reasonable alternative criterion to consider for the
Investment Grade Exception. However, such a standard does not
differentiate securities that are traded solely on their yield and
creditworthiness from securities that trade also on the issuer identity
and thus have a high manipulation risk. Therefore, probability of
default is a preferred standard to rely upon in the assessment of
manipulation risk for the purposes of the Investment Grade Exception.
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    \299\ See SIFMA Letter 1 at 5.
    \300\ See SIFMA Letter 1, at 5-8 as well as the related
discussion in Part II.B.1.
    \301\ Form S-3 and Form F-3 Release, 76 FR 46607.
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     Exception Based on the Interest Coverage Ratio.
    Another possible issuer-based criterion for exception eligibility
is the interest coverage ratio. This alternative was included in the
Proposing Release and no commenters expressed a view on this option. A
high interest coverage ratio typically indicates the issuer's ability
to repay debt and can be used as a criterion to reflect
creditworthiness. It has the advantage of being a simple and easy to
calculate value. However, the interest coverage ratio is an accounting
measure that can result in inconsistent outcomes as it is based on the
reported earnings rather than cash flows. Reported earnings may differ
based on accounting practices of the firm. Structural credit risk
models have an advantage over interest coverage ratio since they are
not dependent on reported earnings, which are heavily influenced by
accounting practices.
     Exception Based on Reduced-Form Credit Risk Model.
    An alternative to using structural credit risk models is reduced-
form credit risk models.\302\ The latter models could be a good measure
of creditworthiness and of manipulation risk to the extent that
creditworthiness is a good proxy for manipulation risk. This
alternative was discussed in the Proposal. One of the commenters
proposed a similar alternative relying on debt security prices, yields,
or credit spreads instead of using a structural credit risk model for
the probability of default estimation.\303\ Unlike structural models,
reduced-form models do not assume default occurs when firm value falls
below a threshold. The default is instead assumed to follow an
unobserved process and the default model can be fitted to the market
data. The advantage of these models is they do away with some of the
unrealistic requirements of structural credit risk models, for example
when the firm value, its volatility or other required parameters are
unobserved.
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    \302\ The reduced-form credit risk models are discussed, for
example, in Robert Litterman & Thomas Iben, Corporate Bond Valuation
and the Term Structure of Credit Spreads, 17 (3) Fin. Analysts J.
52, 52-64 (1991); Robert A. Jarrow & Stuart M. Turnbull, Pricing
Derivatives on Financial Securities Subject to Default Risk, 50 J.
Fin. 53, 53-86 (1995); Robert A. Jarrow, David Lando, & Stuart M.
Turnbull, A Markov Model for the Term Structure of Credit Risk
Spreads, 10 Rev. Fin. Stud. 481, 481-523 (1997); Darrell Duffie &
Kenneth J. Singleton, Modeling the Term Structures of Defaultable
Bonds, 12 Rev. Fin. Stud. 687, 687-720 (1999).
    \303\ IILF Letter, at 2.
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    Even though such models can be considered more flexible and may
provide better fit for the observed default events, their ability to
predict future defaults may not necessarily exceed that of the
structural models. In addition, unlike structural models, they suffer
from a lack of theoretical background of the assumed relationships, or
the intuitive interpretation of the model dependencies and why the
defaults occur. Unrestricted use of these models might also provide
more opportunity to choose a reduced-form model specification which
enables use of the exception. Further, some commenters expressed a
concern for a lack of consistency and uniformity across issues or
issuers in using probability of default standard for the
exception.\304\ Since reduced-form models are more flexible and less
structured than structural credit risk models, such concerns would be
more pronounced in

a standard that is based on the reduced-form models.
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    \304\ See SIFMA Letter 1, at 5, Better Markets Letter, at 4.
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4. Exception Based on Issuer and Issue Characteristics
    The Commission considered, as another alternative, an analysis
based on both security and issuer characteristics; for example,
characteristics outlined in Exchange Act Rule 15c3-1. This alternative
was discussed in the Proposal and the Commission received no comments
in regard to this option. Rule 15c3-1 specifies a set of factors to
determine a minimum amount of credit risk broker-dealers can use to
determine if a security can qualify for lower haircuts: (1) credit
spreads; (2) securities-related research; (3) internal or external
credit assessments; (4) default statistics; (5) inclusion in an index;
(6) enhancements and priorities; (7) price, yield and/or volume; or (8)
asset-class specific factors.\305\ Some of these factors, such as
default statistics or credit assessments, measure issuer
creditworthiness, while others, such as price, yield, or volume,
measure the manipulation risk present in each specific issue, providing
a good overall assessment of manipulation risk.
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    \305\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, Release No. 34-71194 (Dec. 27,
2013) [79 FR 1522, 1527-28 (Jan. 8, 2014)].
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    The advantage of this alternative is that it would align the
exception with already existing standards that broker-dealers might
apply to determine whether a security has a minimal amount of credit
risk. The standard in Rule 15c3-1 was adopted in 2013 as a replacement
for a reference to investment grade securities pursuant to section 939A
of the Dodd-Frank Act. Such test could have minimum additional costs
for broker-dealers who already have all the necessary procedures in
place for its application.
    The Rule 15c3-1 standard is commonly used for seasoned securities
and, therefore, includes a longer time period to obtain information
about issues that may not be available for the new issuances and for
seasoned (actively traded) distributions that may have only a one-day
restricted period also subject to Regulation M. Moreover, the Rule
15c3-1's minimal credit risk standard is based on a set of eight
different factors, some of which include price or volume, with respect
to each specific issue. Depending on these other participants' systems
and regulatory obligations, it may be costly for them to replace the
investment grade standard with the minimal credit risk standard. This
could result in a situation where different distribution participants
are facing different costs,\306\ possibly deterring some market
participants.
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    \306\ This is unlike the structural credit risk model based
probability of default that would imply the same costs for all the
participants who obtain the estimated values.
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5. Elimination of the Investment Grade Exception From Rule 101
    The Commission also considered eliminating the Investment Grade
Exception for Fixed-Income Securities from Rule 101. Elimination of the
exception was discussed as an alternative in the Proposal and the
Commission did not receive any direct comments on this option. However,
as discussed in Part II, commenters broadly supported the Commission's
efforts to find an alternative standard of creditworthiness in place of
the references to credit ratings in Rule 101's Investment Grade
Exception (as opposed to removing the Investment Grade Exception,
without a replacement).\307\ The advantage of this alternative is
eliminating the situations when manipulation-prone securities fall
under the exception due to limitations of proxies used to select the
securities to be excepted. For instance, as discussed above, there are
various limitations of the structural credit risk models' applications,
which may limit the ability of certain issuers to rely on the exception
or allow issuers with a higher risk of having their securities
manipulated to avoid Regulation M. If the exception is eliminated, any
limitations of such a proxy for manipulation risk are eliminated as
well. In addition, this approach could ultimately relieve lead managers
from the need to spend time or costs to implement, understand, and
calibrate any standard such as a structural credit risk model.
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    \307\ See, e.g., SIFMA Letter 1, at 2; Bloomberg L.P. Letter, at
1.
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    However, this approach raises a number of concerns. Specifically,
eliminating the exception could make some offerings in the excepted
securities considerably more costly. For example, with respect to re-
openings, broker-dealers who might otherwise elect to re-open a bond
offering may determine not to do so to avoid restrictions of Regulation
M that could arise during such a re-opening if it becomes a sticky
offering. This could increase the cost of the issue that has to rely on
the next-best alternative structure. Further, an alternative
transaction structure, if selected, may decrease the liquidity of the
securities being issued because they would not be fungible with the
previously issued securities. This may also result in some distribution
participants, such as broker-dealers, deciding not to participate. This
could limit the number of available broker-dealers, potentially
increasing fees faced by the issuers. Further, if certain issues do not
take place under the amendments, it could reduce the selection of
available securities for the investors in the relevant markets and may
limit issuers' ability to raise capital.
    However, these costs might be mitigated because a party subject to
the prohibitions of Rule 101 could structure its buying activity before
or after the applicable restricted period so as not to incur any costs
associated with relying on the exception.
    The above arguments apply to all currently excepted investment
grade securities because any such issue can become a sticky offering
and the underwriters have to account and adjust for this possibility
ex-ante. In a scenario where an underwriter is unable to sell its
allotted securities to the public on or promptly after the pricing
date, there is no exception on which to rely, the underwriter/broker-
dealer would likely ex-ante adjust the cost of issuance to reflect this
added risk. Broker-dealers could be more cautious in structuring
potentially sticky offerings if they know they will be required to
comply with Rule 101 (and have no exceptions available), by reducing an
offering's size or increasing fees as a risk premium. This could
potentially raise the cost of investment grade offerings. However, this
could also decrease the probability of an offering to become sticky,
potentially reducing manipulation risk in the relevant markets.
    The removal, without replacement, of the Investment Grade Exception
could also affect the liquidity of the Fixed-Income Securities if re-
openings of issues already in circulation are more costly, potentially
reducing issuers' reliance on this financing structure, which
negatively affects the investors in the relevant markets.
    This alternative could also disrupt some established business
relationships. In certain circumstances new relationships may need to
be established. For example, if an offering becomes sticky, absent
Investment Grade Exception to rely on some broker-dealers may be
limited in their ability to trade relevant securities and decide to
withdraw, in which case the issuer may need to seek a different broker-
dealer. This would increase costs of the affected security offerings,
including the new broker dealer fees or the search costs, especially
when the market has a limited number of available broker-dealers.

6. Alternative for Asset-Backed Securities
    As an alternative for asset-backed securities the Commission
considered using a standard based on the value at risk. This
alternative was included in the Proposal and no commenter expressed any
view on this standard. Value at risk measures the percentage loss of
the security in the worst case scenarios over a specified time period.
It can be estimated by performing a simulation over the underlying