1. Rule 101
    Under the proposed amendment to Rule 101, respondents wishing to
rely on the exception for a distribution of Nonconvertible Securities
would be required 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.\129\ This requirement would result in respondents
incurring recordkeeping burden. The Commission preliminarily believes
that this process would likely be highly automated, and that
respondents would initially comply with this requirement by
reprograming systems to create a means to calculate electronically the
probability of default based on manually gathered and entered inputs
for financial modeling. The Commission preliminarily believes that all
respondents would be broker-dealers who have experience using their own
proprietary version of a publicly available Structural Credit Risk
Model so the initial configuration of systems will be handled
internally and take 3 hours per respondent. The Commission also
preliminarily believes that broker-dealers already have the software
and systems in place that would be required to make the
calculations.\130\

Accordingly, the Commission estimates that the total industry-wide
initial burden for the proposed amendment to Rule 101 would be 711
hours.\131\
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    \129\ The Commission recognizes that some respondents may choose
to utilize the probability of default estimates calculated and made
available by a third-party vendor rather than perform the
calculations themselves. The Commission's burden estimate for the
proposed amendment to Rule 101 is based upon respondents gathering
the required data and calculating the probability of default
internally without the use of third-party vendors, because the
Commission lacks granular information from which to base an estimate
of the proportion of respondents that would use vendors. The
Commission welcomes comments on this approach, including regarding
the likelihood and cost of using third-party vendors, including any
time burden associated with using such services.
    \130\ Further, the Commission preliminarily believes that
respondents that choose to utilize the probability of default
estimates calculated and made available by a third-party vendor
would already have access to the vendor's software and systems
containing these estimates, typically as part of an existing
subscription, so they would not need to procure further services or
subscriptions from these vendors. The Commission welcomes comments
on this preliminary belief and on any related costs and burdens.
    \131\ 237 respondents x 3 hours = 711 hours.
---------------------------------------------------------------------------

    An issuer's probability of default is forward-looking and changes
over time, so the Commission preliminarily believes that respondents
would manually gather the inputs required to calculate probability of
default each time it participates in a distribution of debt securities.
There were 19,076 offerings of Nonconvertible Securities in 2020.\132\
Because financial modeling generally, and the probability of default
calculation more specifically, is well-known by industry participants,
the Commission preliminarily believes that respondents would have
employees that are familiar with how to gather the required inputs. The
Commission, therefore, estimates that would take respondents roughly 1
hour per distribution of Nonconvertible Securities on this requirement.
Accordingly, the Commission estimates that the amendment to Rule 101
will result in an aggregate annual ongoing industry-wide burden of
19,076 hours. The Commission, therefore, estimates that the total PRA
burden resulting from the proposed amendment to Rule 101 would be
19,787 hours in the first year \133\ and 19,076 hours thereafter.
---------------------------------------------------------------------------

    \132\ This number was obtained from Mergent, a financial data
provider. Data for 2021 is not yet available in Mergent.
    \133\ 711 hours (initial burden) + 19,076 hours (ongoing annual
burden) = 19,787 hours.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed amendments
would not result in respondents incurring PRA burden when participating
in distributions of asset-backed securities because whether an asset-
backed security has an effective registration statement on Form SF-3 is
an objective, observable fact.\134\ Further, under the proposed
amendments, there is no requirement for distribution participants or
their affiliated purchasers to keep records documenting its reliance on
the exception for distributions of asset-backed securities.
---------------------------------------------------------------------------

    \134\ See 17 CFR 239.45.
---------------------------------------------------------------------------

2. Rule 17a-4
    The proposed amendment to Rule 17a-4 would require broker-dealers
relying on the exception in proposed paragraph (c)(2)(i) 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. Because the burden to make these records is accounted
for in the PRA estimates for the amendment to Rule 101, the burden
imposed by these proposed new requirements under Rule 17a-4 is limited
to the maintenance and preservation of the written records.\135\ The
Commission estimates that this recordkeeping requirement would impose
an initial burden of 25 hours per respondent for updating the
applicable policies and systems required to account for capturing the
records made pursuant to proposed paragraph (c)(2)(i). Accordingly, the
Commission estimates that the total industry-wide initial burden for
this requirement would be 5,925 hours.\136\ The Commission also
estimates that respondents would incur an ongoing annual burden of 10
hours per firm for maintaining such records as well as to make
additional updates to the applicable recordkeeping policies and systems
to account for the proposed rules, leading to a total ongoing industry-
wide burden of 2,370 hours.\137\ The Commission, therefore, estimates
that the total PRA burden resulting from the proposed amendment to Rule
17a-4 would be 8,295 hours in the first year \138\ and 2,370 hours
thereafter.
---------------------------------------------------------------------------

    \135\ As noted above, for the purposes of these estimates, the
Commission assumes that no registrants are using vendors to rely on
the proposed exceptions, however, the Commission also preliminarily
believes that the burden associated with the proposed amendment to
Rule 17a-4 would not differ between respondents that rely on a
third-party vendor and those that do not.
    \136\ 237 respondents x 25 hours = 5,925 hours.
    \137\ 237 respondents x 10 hours = 2,370 hours.
    \138\ 5,925 hours (initial burden) + 2,370 hours (ongoing annual
burden) = 8,295 hours.

                                                PRA Summary Table
----------------------------------------------------------------------------------------------------------------
                                                                                Ongoing annual
                                                                                burden hours      Total PRA
                                                                  Initial burden     per year      burden hours
                                                                       hours       (after first    in first year
                                                                                year)
----------------------------------------------------------------------------------------------------------------
Industry-Wide Burden due to Proposed Amendment to Rule 101......             711          19,076          19,787
Industry-Wide Burden due to Proposed Amendment to Rule 17a-4....           5,925           2,370           8,295
----------------------------------------------------------------------------------------------------------------

D. Collection of Information Is Mandatory

    Each collection of information discussed above would be a mandatory
collection of information.

E. Confidentiality

    The Commission would not typically receive confidential information
as a result of this collection of information. To the extent that the
Commission receives--through its examination and oversight program,
through an investigation, or by some other means--records or
disclosures from a distribution participant regarding the probability
of default determination, such information would be kept confidential,
subject to the provisions of applicable law.

F. Retention Period of Recordkeeping Requirement

    Pursuant to proposed Rule 17a-4(b)(17) a broker-dealer who is a
distribution participant or affiliated purchaser would be required to
retain information for a period of not less than three years, the first
two years in an easily accessible place.

G. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to (1) evaluate whether the proposed collections of
information are necessary for the proper performance of the functions
of the Commission, including whether the information would have
practical utility; (2) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collections of information and
assumptions used therein; (3) determine whether there are ways to
enhance the quality, utility, and clarity of the information to be
collected; (4) determine whether there are ways to minimize the burden
of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology; and (5) evaluate whether the proposed
amendments would have any effects on any other collection of
information not

previously identified in this section. The Commission also requests
that commenters provide data to support their discussion of the burden
estimates.
    While the Commission welcomes any public input on this topic, the
Commission asks commenters to consider the following questions:
    42. Is the Commission adequately capturing the respondents that
would be subject to burdens under the proposed amendments?
Specifically, would more or fewer than the 237 respondents determine
the probability of default?
    43. Is the Commission accurately estimating the amount of time it
would take to program systems and gather the data required to perform
the probability of default calculations?
    44. Would any aspects of the proposed amendments that are not
discussed in this PRA Analysis affect the burden associated with the
collection of information?
    45. Do commenters agree with the Commission's preliminary belief
that the proposed amendment to Rule 102 would not change PRA burdens?
    46. Do commenters agree with the Commission's preliminary belief
that the proposed amendments would not result in respondents incurring
PRA burden when participating in distributions of asset-backed
securities?
    Any member of the public may direct to us any comments concerning
the accuracy of these burden estimates and any suggestions for reducing
the burdens. Persons submitting comments on the collection of
information requirements should direct the comments to the Office of
Management and Budget, Attention: Desk Officer for the Securities and
Exchange Commission, Office of Information and Regulatory Affairs,
[email protected], and send a copy to Vanessa
Countryman, Secretary, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549-1090, with reference to File No. S7-11-22. OMB
is required to make a decision concerning the collection of information
between 30 and 60 days after publication of this release. Consequently,
a comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publication. Requests for materials
submitted to OMB by the Commission with regard to these collections of
information should be in writing, refer to File No. S7-11-22, and be
submitted to the Securities and Exchange Commission, Office of FOIA
Services, 100 F Street NE, Washington, DC 20549-2736.

VIII. 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 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.\139\ Additionally,
Section 23(a)(2) of the Exchange Act 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.
---------------------------------------------------------------------------

    \139\ See 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    The analysis below addresses the likely economic effects of the
proposed 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
difficult 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 proposed 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 Security and asset-
backed security (collectively ``fixed-income securities'') \140\
distribution and 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 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 nine credit rating agencies registered with
the Commission as NRSROs.\141\ Three large NRSROs (S&P Global Ratings,
Moody's Investors Services, Inc., and Fitch Ratings, Inc.) have
historically accounted for most of the market share in this market. As
of December 31, 2020, these three market participants accounted for
94.7% of all of the NRSRO credit ratings outstanding.\142\
---------------------------------------------------------------------------

    \140\ The term ``fixed-income'' in the Economic Analysis section
refers to nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities.
    \141\ U.S. Sec. and Exch. Comm'n, Annual Report on Nationally
Recognized Statistical Rating Organizations 2 (2022), available at
https://www.sec.gov/files/2022-ocr-staff-report.pdf.
    \142\ Id. at 24.
---------------------------------------------------------------------------

    The affected securities are nonconvertible debt, nonconvertible
preferred, and asset-backed securities. In 2020, there were 19,076
issues of nonconvertible debt, with 694 issuers and 237 participating
underwriters involved.\143\ Additionally, in 2020, there were 152,069
issues of mortgage-backed securities with 195 underwriters involved and
7,255 issues of other asset-backed securities with 155
underwriters.\144\
---------------------------------------------------------------------------

    \143\ The statistics are based on the data from Mergent.
    \144\ The data for the asset-backed securities (including
mortgage-backed securities) comes from Bloomberg.
---------------------------------------------------------------------------

2. The Investment Grade Exception to Regulation M
    Regulation M is designed to prevent manipulative activities that
could artificially influence the demand and pricing of covered
securities.\145\ In particular, Rules 101 and 102 of Regulation M
prohibit distribution and market participants from bidding for or
purchasing a covered security, unless an exception, such as the
Investment Grade Exception, applies.\146\ At the time the exception was
included, the investment grade securities, that is securities
characterized by sound credit-worthiness, were considered to be

traded primarily on yield and maturity, rather than the factors that
determine credit-worthiness of the issuer and add uncertainty to the
pricing of the issue.\147\ Thus sound credit-worthiness was considered
to be a good proxy for manipulation risk. Such 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. The Commission continues to believe that sound
credit-worthiness is a good proxy for manipulation risk since
securities issued by firms with sound credit-worthiness trade primarily
on yield and maturity and not on issuer-specific characteristics that
may increase pricing uncertainty.
---------------------------------------------------------------------------

    \145\ See supra Part 0.
    \146\ See 17 CFR 242.101(a), 102(a); see, e.g., 17 CFR
242.101(c)(2), 102(d)(2).
    \147\ See Regulation M Adopting Release, 62 FR 527.
---------------------------------------------------------------------------

    The Commission believes that the application of the Investment
Grade Exception to Rules 101 and 102 is primarily limited to two
cases:\148\ Reopenings (an offering of an additional principal amount
of securities that are identical to the securities already outstanding)
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). Reopenings are used infrequently and constitute about 3%
of the relevant securities' markets' issuance volume.\149\ Sticky
offerings are not identified in the relevant databases, making it
difficult to assess their relative magnitude.
---------------------------------------------------------------------------

    \148\ Some commenters note that best efforts offerings (see
supra note 59) and foreign sovereign offerings (see supra note 62)
could also be affected by the exceptions in Rules 101 and 102.
    \149\ The estimate is obtained using Mergent data for the
relevant fixed income securities during the past five years as of
Oct. 2021.
---------------------------------------------------------------------------

    Reopenings 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 reopening 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.\150\
---------------------------------------------------------------------------

    \150\ See SIFMA Letter 3 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 Arnold & Porter Letter at 3.
---------------------------------------------------------------------------

    Sticky offerings typically result when a large investor fails to
fulfill its expressed purchase interest in the issue,\151\ which could
be due to a negative factor that transpired in regard to the issue or
issuer. 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 to a heightened risk of manipulation even if the security is rated
as investment grade.
---------------------------------------------------------------------------

    \151\ Sullivan & Cromwell Letter at 4.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the exception based on
investment grade rating is rarely used in practice in Rule 102. Rule
102 prohibits trading of the securities fungible with the securities
being issued by issuers, selling security holders, and their affiliated
purchasers.\152\ However, 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.\153\
---------------------------------------------------------------------------

    \152\ See supra Part IV.A.1.c. for a relevant discussion.
    \153\ See supra Part IV.B.
---------------------------------------------------------------------------

    The Investment Grade Exception was included in the regulation as it
was considered a good proxy for the likelihood of manipulation
risk.\154\ However, the reference to NRSRO ratings in the Commission's
rules may encourage investors to place undue reliance on the NRSRO
ratings. Additionally, even though credit-worthiness has been
historically considered a good proxy for manipulation risk, it is still
not a precise measure of such risk and therefore there are costs
associated with using such a proxy that currently exist in the relevant
markets. Specifically, in some instances distribution participants may
choose to engage in manipulative activities of the securities of
issuers with sound credit-worthiness. As a result, under the existing
rules, situations may arise in which securities with high manipulation
risk are excepted from Regulation M.
---------------------------------------------------------------------------

    \154\ See supra Part III (discussing the history of the
Investment Grade Exceptions).
---------------------------------------------------------------------------

B. Benefits of the Proposed Amendment

    As mentioned above, Section 939A 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
credit-worthiness as the Commission determines to be appropriate.''
\155\ In this proposed rule, the Commission proposes to rely upon the
Structural Credit Risk Models to measure credit-worthiness.\156\ These
models have become widely used to estimate the probability of default
of an issuer.\157\
---------------------------------------------------------------------------

    \155\ 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)].
    \156\ See for example 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.
    \157\ See supra note 67.
---------------------------------------------------------------------------

    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 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.\158\ The key

assumption of a Structural Credit Risk Model is that default occurs
when the value of the company falls below the book value of the debt.
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.
---------------------------------------------------------------------------

    \158\ 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.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the probability of
default based on the Structural Credit Risk Models is an appropriate
proxy for credit-worthiness. As discussed previously, the Commission
continues to believe that credit-worthiness is an appropriate standard
to reflect manipulation risk since securities issued by firms with
sound credit-worthiness trade primarily on yield and maturity and have
low pricing uncertainty. Thus, the probability of default based on
Structural Credit Risk Models is a reasonable proxy for manipulation
risk.
    The Commission calibrated the 0.055% threshold in the sample of
nonconvertible fixed income securities so as to capture approximately
90% of the investment grade securities in our sample of nonconvertible
fixed income securities (2436 distinct investment grade issues with
probability of default below 0.055% out of 2710 total investment grade
rated issues in the sample). This threshold also captures 125 distinct
non-investment grade issues with probability of default below 0.055%.
Overall, 2561 issues meet the proposed exception as compared with the
2710 issues under the current exception.\159\ The securities with
probability of defaults within the first 12 months, as estimated based
on a widely accepted Structural Credit Risk Model, below the 0.055%
threshold are proposed to be excepted from Rule 101.
---------------------------------------------------------------------------

    \159\ The most recent available investment grade status (as of
the last available Mergent update through Dec. 2020) for
nonconvertible securities issued between 2016 and 2020 was obtained
from Mergent while the probability of default estimates were
obtained for a cross-section of securities available in Bloomberg as
of Oct. 22, 2021, which represents an average trading day with
respect to the relevant market metrics. Since the cross-section of
the relevant securities does not change considerably from day to day
and the relevant metrics are typically calculated based on the data
over a several months period or longer, it is unlikely that the
results of the analysis are considerably affected by the specific
day selected for the analysis. Please refer to Mario Bondioli,
Martin Goldberg, Nan Hu, Chngrui Li, Olfa Maalaoui, & Harvey J.
Stein, The Bloomberg Corporate Default Risk Model (DRSK) for Private
Firms (working paper Aug. 27, 2021), available at https://ssrn.com/abstract=3911330 (retrieved from SSRN Elsevier database), for
methodology description of Bloomberg probability of default measure.
---------------------------------------------------------------------------

    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, and hence incorporate
most 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.\160\ \161\
---------------------------------------------------------------------------

    \160\ This is consistent with the following SEC staff statement
in 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.
    \161\ 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).
---------------------------------------------------------------------------

    Distribution participants should be able to calculate the
probability of default internally using Structural Credit Risk Models.
One of the benefits of the proposed amendment is that the distribution
participants will have the flexibility of selecting the model they find
most convenient to assess the credit-worthiness of issuers for the
purposes of using the exception. This means the distribution
participants will no longer have to rely on an NRSRO rating for the
issue for purposes of the Regulation M exception and will no longer
have to rely on an NRSRO's choice of the model for such purposes.
Furthermore, the Commission preliminarily believes that 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.\162\
---------------------------------------------------------------------------

    \162\ See a relevant discussion in supra Part IV.A.1.c).
---------------------------------------------------------------------------

    Removing the reference to credit ratings from Rules 101 and 102 of
Regulation M may also have a benefit of expanded options available to
distribution participants compared to the Regulation M Investment Grade
Exception requirement, as the proposed 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 credit-worthiness 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 participants 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 proposed amendments, the Structural Credit Risk Models
cannot, as a practical matter, apply to asset-backed securities due to
the complexity of the structure of such instruments. In the case of
asset-backed securities, the Commission preliminarily believes that
securities that are offered pursuant to an effective shelf registration
statement filed on Form SF-3 should also be excepted from Rule 101.
Form SF-3 requirements provide objective criteria that also ensure that
the securities with the least amount of manipulation risk are allowed
to rely on the Regulation M exception. Specifically, Form SF-3
requirements limit the number of nonperforming assets in the asset-
backed security pool, require review of the pool assets, and require
certification by the chief executive officer, among other things. The
Commission continues to believe, as noted when it adopted these
requirements, that use of Form SF-3 incentivizes sponsors to carefully
review and disclose the underlying assets' characteristics, reducing
the overall uncertainty about the asset-backed security and therefore
the risk of manipulation. Accordingly, 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 from Rule 101(c)(2).
Further, an analysis of a merged sample of Form SF-3 filers and
Bloomberg credit ratings

for year 2021 asset-backed securities issuances demonstrates that 78%
of Form SF-3 filers' issuances have investment grade status (362 out of
464 rated issuances), while the remaining 22% of issuances have non-
investment grade status (102 issuances).\163\ To the extent that asset-
backed securities for which a Form SF-3 is filed includes securities
that have low manipulation risk but lack an investment grade rating,
the additional benefit of the proposed amendments is allowing such low
manipulation risk issues to rely on the exception and encouraging
participation in the relevant market.
---------------------------------------------------------------------------

    \163\ We note that 770 investment grade asset-backed security
issuances (by 191 issuers) from the 2021 Bloomberg sample did not
merge with the sample of Form SF-3 filers in part due to necessarily
present imperfections in issuer name matching and in part due to a
much smaller number of Form SF-3 filers (62 issuers). This may imply
a possibility that a fairly large number of issuances that are able
to rely on the exception currently will be excluded under the
proposed standard. The asset-backed securities eligible for Rule
144A were excluded from the analysis as they are able to rely on a
different exception.
---------------------------------------------------------------------------

    The Commission is proposing to eliminate the exception entirely
from Rule 102, as discussed above, given the heightened risk of
manipulation that exists for issuers and selling security holders and
absence of a need to facilitate an orderly distribution or to limit
potential disruptions in the trading market, coupled with our
understanding that the Investment Grade Exception is generally not
relied upon in practice, as issuers and selling security holders who
are subject to Rule 102, unlike broker-dealers, typically do not trade
outstanding issues of their own securities that are identical to the
issue being distributed in the secondary market.\164\ The economic
benefit of the proposed amendment is that it may contribute to the
Dodd-Frank Act goals of reducing perceived government endorsement of
NRSROs and over-reliance on credit ratings by market participants in
Regulation M by removing the relevant reference to credit ratings.
---------------------------------------------------------------------------

    \164\ See also a relevant discussion in supra note 120.
Eliminating the Investment Grade Exception, however, could affect
the ability of foreign sovereign issuers to purchase any of such
issuer's securities. See discussion in infra Part VIII.C.5 and
Arnold & Porter Letter at 3.
---------------------------------------------------------------------------

C. Costs of the Proposed Amendment

    The Commission recognizes that some of the affected distribution
participants may bear costs from the proposed amendments. The proposed
amendments may alter the universe of securities that can rely on the
exception and additionally may prevent issuers from using the exception
in some cases potentially leading to fewer issues of the affected
securities. If some distribution participants decide not to participate
in certain issues as a result of the proposed amendments, the costs of
the affected issues may increase. For example, when fewer banks or
broker-dealers are available, these distribution participants may be
able to charge higher fees. Additionally, as the result of the proposed
amendments fewer issues may take place, potentially limiting issuers'
ability to raise capital and affecting investors in the relevant
securities as the available security selection and liquidity may be
reduced.
    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 maintaining records related to the
probability of default estimation; (3) costs due to the probability of
default being an imperfect proxy for credit-worthiness, (4) asset-
backed securities' costs associated with the proposed amendments, (5)
costs related to Rule 102 amendments (6) 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
    Distribution participants may incur costs related to determining
the probability of default. Consistent with the PRA section,\165\ the
Commission estimates that it would take a distribution participant 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 $240,318.\166\ Consistent with
the PRA section,\167\ the Commission also estimates that it would take
a distribution participant one hour to gather the inputs required to
calculate probability of default each time it participates in a
distribution of Nonconvertible Securities. There were 19,076 offerings
of Nonconvertible Securities in 2020. Therefore, it is estimated that
annually distribution participants would spend $6,447,688 \168\ in the
aggregate complying with this requirement.
---------------------------------------------------------------------------

    \165\ See supra Part VII.C.1.
    \166\ 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), available at https://www.sifma.org/resources/research/management-and-professional-earnings-in-the-securities-industry-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 the end of 2021 using data published by the Bureau
of Labor Statistics. 237 distribution participants x 3 hours x $338
hour for a compliance manager = $240,318.00.
    \167\ See supra Part V.C.1.
    \168\ 19,076 offerings x 1 hour x $338 hour for a compliance
manager = $6,447,688.
---------------------------------------------------------------------------

    Any costs associated with using a vendor to obtain probability of
default estimate should be minimal, as the Commission preliminarily
believes that distribution participants engaged in the offering of
Nonconvertible Securities would typically already have subscriptions to
vendors that provide calculations regarding the probability of default
based on Structural Credit Risk Models.\169\ Furthermore, we believe
that distribution participants, in particular those that choose to
determine the probability of default estimate internally, would already
have the computational resources necessary to conduct such analysis
internally.\170\
---------------------------------------------------------------------------

    \169\ See supra note 84.
    \170\ See supra Part IV.A.1.c).
---------------------------------------------------------------------------

2. Costs Associated With Maintaining Records Related to the Probability
of Default Estimation
    Distribution participants would also incur costs related to
capturing and maintaining records regarding the probability of default
determination. Consistent with the PRA section,\171\ the Commission
estimates that it would take a distribution participant 25 hours to
update the applicable policies and systems required to account for
capturing the records made pursuant to proposed Rule 101(c)(2)(i), for
an aggregate cost of $2,002,650.\172\ Consistent with the PRA
section,\173\ the Commission also estimates that it would take a
distribution participant 10 hours to maintain such records as well as
to make additional updates to the applicable recordkeeping policies and
systems to account for the proposed rules. Therefore, it is estimated
that annually broker-dealers would spend $801,060 \174\ in the
aggregate complying with this requirement.
---------------------------------------------------------------------------

    \171\ See supra Part VII.C.2.
    \172\ 237 distribution participants x 25 hours x $338 hour for a
compliance manager = $2,002,650.
    \173\ See supra Part V.C.1.
    \174\ 237 distribution participants x 10 hours x $338 for a
compliance manager = $801,060.
---------------------------------------------------------------------------

3. Costs Associated With Structural Credit Risk Model Based Probability
of Default Being an Imperfect Proxy for Credit-Worthiness
    As discussed previously, the proposed Structural Credit Risk Models
are designed to measure credit-worthiness, and credit-worthiness itself

is considered to be a good measure of manipulation risk. There are
costs that are currently present in the relevant markets associated
with credit-worthiness being an imperfect proxy for manipulation risk.
However, in the absence of a better proxy for manipulation risk,
credit-worthiness has continued to successfully serve the purpose of
measuring such risk for many years. This is also supported by the
comments stating that investment grade standard has been successfully
used in Rules 101 and 102 exception.\175\ The proposed amendments are
not expected to alter those costs and the discussion that follows
focuses instead on the costs associated with the proposed Structural
Credit Risk Models as a proxy for credit-worthiness.
---------------------------------------------------------------------------

    \175\ See, for example, Rothwell at 2 and ABA at 15 -17.
---------------------------------------------------------------------------

    The use of any model to estimate credit-worthiness necessarily
provides an imperfect measure. Structural credit risk models are no
exception. We note, however, that NRSROs similarly may rely on
imperfect models of estimating issuer credit-worthiness. Moreover,
models such as Structural Credit Risk Models often are a part of the
analysis involved in obtaining a credit rating.\176\
---------------------------------------------------------------------------

    \176\ 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 would 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 counter cyclical,
they tend to be slow in incorporating updates \177\ and relatively
fewer firms will have an investment grade credit rating during
downturns, the impact of the counter cyclicality of default
probabilities implied by Structural Credit Risk Models would 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. Distribution participants would, however, be able to adjust
the required estimated model parameters and inputs frequently as market
conditions change, mitigating the costs discussed above.
---------------------------------------------------------------------------

    \177\ See COVID-19 Market Monitoring Group, supra note 160
(``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.'').
---------------------------------------------------------------------------

    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 proposed
amendments relative to the market baseline.
    In addition, as discussed previously in reference to the selected
threshold, the amendment may expand slightly the universe of firms that
qualify for the exception and include firms 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 less sensitive to aggregate interest rate
changes.
    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 the issuer may
lead to potential conflicts of interest since the vendor is
incentivized in this case to produce an estimate which would allow the
issuer 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
Rule 101 exception. Therefore, given the reputational concerns it is
unlikely that these vendors would produce a slightly different product
to cater specifically to the use of these estimates for purposes of
relying on the Rule 101 exception. Additionally, the model input
estimates or assumptions may be tweaked by the distribution
participants in such a way as to produce the desired estimation result
if the model is estimated internally and may result in market
participants' adjusting the models so as to be able to rely on the
exception.\178\ 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.
---------------------------------------------------------------------------

    \178\ The definition of Structural Credit Risk Models for
purposes of 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 proposed threshold of 0.055% for the exception is
based on model assumptions and historical data. 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 safe
issues from using it. This 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, fewer investment
grade firms would fall below the threshold. Credit rating by NRSROs are
also countercyclical but tend to be slow moving, since credit rating
changes often lag updates to firm conditions that would impact cost of
capital.\179\
---------------------------------------------------------------------------

    \179\ COVID-19 Market Monitoring Group, supra note 160 (``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.'').

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

4. Costs Associated With Asset-Backed Securities' Amendments
    The proposed amendments may render some asset-backed securities
ineligible to rely on the exception from the Regulation M. This may
increase issuance costs for the distribution participants. For
instance, broker-dealers may reduce an offering's size or increase fees
if required to comply with Regulation M. Additionally, distribution
participants may need to establish new business relationships due to
Regulation M restrictions. Furthermore, some issuers may decide not to
issue the affected securities if required to comply with Regulation M
restrictions. 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.
5. Costs Associated With Amendments to Rule 102
    As discussed previously, the effect of eliminating the exception
from Rule 102 is expected to be minimal since the exception is likely
not useful from a practical standpoint, because the issuers and selling
security holders who are subject to Rule 102 typically do not trade
their own securities that are being issued. However, as was identified
previously in a comment letter, an Investment Grade Exception from Rule
102 could affect the ability of foreign sovereign issuers or their
affiliates to purchase any of such issuer's securities.\180\ In the
past the Commission has issued exemptive relief for some foreign
sovereign issuers because they trade, as represented in incoming
letters, based on a yield spread to US treasuries.\181\ This might mean
that bonds of foreign sovereign issuers are less susceptible to
manipulation risk since there is less uncertainty in regards to their
valuation. Eliminating the exception from Rule 102 may increase
issuance costs or deter market participants from issuing such
securities with low manipulation risk.
---------------------------------------------------------------------------

    \180\ Arnold & Porter Letter at 3.
    \181\ See supra note 121.
---------------------------------------------------------------------------

6. Indirect and Other Costs of the Amendments
    Besides the direct effects on the distribution participants and
affected securities discussed above the proposed amendment may also
generate indirect effects on investors in these securities and NRSROs.
For instance, if issuer participation in the relevant security issues
becomes limited, some issues may not take place that otherwise would.
Investors may face a more limited choice of investment instruments as a
result, for example in the case of reopenings. This may further affect
liquidity of their portfolios since reopenings can offer additional
liquidity benefits as the securities offered in reopenings are
interchangeable with the existing issues. However, as already
discussed, these costs are expected to be minimal as reopenings are
used infrequently.
    The proposed amendment does not rely on an NRSRO rating in order to
determine if an issue can rely on 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 distribution participants 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
would be provided through the distribution participant.

D. Efficiency, Competition, and Capital Formation

    As discussed previously, distribution participants will have
flexibility to select the best Structural Credit Risk Model to access
credit-worthiness as a measure of manipulation risk for their business.
This may encourage market participation in affected security issues
and, as a result, could improve competition between issuers for the
investors as well as between other distribution participants. 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 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. We note however that these
effects are not expected to be significant because the exceptions in
Rules 101 and 102 affect only a small portion of the relevant market as
discussed previously.
    However, while unlikely, 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,
distribution participants 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 issuer pays
for the supplied estimate and where vendors may be incentivized to
produce an estimate designed to fit the desired estimation result. Thus
issues that otherwise would 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.
    Further, the positive effects discussed above could be offset by
the fact that some issuers may face higher costs or no longer be able
to use the exception, for example, due to imperfect model estimates as
a result 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 impact the
competition and capital formation in the relevant markets. Further,
potential negative effects of non-uniform estimates and subjectivity
additionally reduce these benefits. 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 proposed threshold, 2-
4 propose alternative approaches to using Structural Credit Risk Models
as a standard of credit-worthiness to measure manipulation risk.
Alternative 5 discusses elimination of the exception, alternative 6
deals with asset-backed securities, while alternative 7 discusses Rule
102 options.
1. Alternative Threshold for Probability of Default
    The proposed threshold of 0.055% was chosen so as to capture most
of the investment grade securities while at the same time capturing the
fewest of the non-investment grade securities. However, a different
threshold could be used in the proposed exception, which would capture
different proportions of investment and non-investment grade
securities. For example, a higher

threshold of 0.5% is estimated to capture about 98.6% of investment
grade securities (2673 out of 2710 investment grade issues), overall
resulting in 2883 issues that can rely on the exception under the
proposed standard.\182\ A lower threshold of 0.01% is estimated to
capture about 65% of investment grade securities (1760 out of 2710
investment grade issues) and overall results in 1811 issues that can
rely on the exception under the proposed standard.\183\ The advantage
of a higher threshold is that it captures a larger set of investment
grade securities, but at the expense of also capturing a small set of
non-investment grade securities, which could be more prone to
manipulation risk. As alternatives, the Commission could increase the
threshold, which would allow more investment grade securities to rely
on the exception at expense of potentially a higher manipulation risk;
or decrease the threshold, which would limit the ability of some of the
investment grade securities to use the exception, but would potentially
also limit the number of non-investment grade securities allowed to
rely on the exception and, as a result, also limit manipulation risk.
---------------------------------------------------------------------------

    \182\ 2883 issues captured by the new proposed standard (with
probability of default below 0.5%) consist of 2673 investment grade
issues and 210 non-investment grade rated issues.
    \183\ 1811 issues captured by the new proposed standard (with
probability of default below 0.01%) consist of 1760 investment grade
issues and 51 non-investment grade rated issues.
---------------------------------------------------------------------------

    As an alternative to providing a specific number as a threshold,
the Commission could specify a method for distribution participants to
use in calculating such a threshold. For example, such method could
involve calculating probability of default for a sample of
nonconvertible securities similar to the distribution participant's
securities issued over a specified time interval and comparing it to
investment grade status or another specified standard of credit-
worthiness. A longer time interval would capture more issues and
improve statistical accuracy at expense of having market conditions
potentially changing and generating incorrect estimates. A shorter time
interval ensures the market conditions have not changed but includes
fewer issues resulting in a smaller sample and lower statistical
accuracy.
    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 exception across issues or issuers; or lead to market
participants adjusting the estimation to be able to rely on the
exception.
2. Exception Based on Security Characteristics
    As an alternative replacement for the reference to investment grade
securities, the Commission has 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.\184\ Other
relevant security characteristics that could be used are outlined in
the 2011 Proposal.\185\ Such analysis could be performed internally or
externally and could be additionally verified by a third party. Below
we discuss public float, yield to maturity and empirical duration
criteria in more detail.
---------------------------------------------------------------------------

    \184\ 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.
    \185\ 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.\186\
---------------------------------------------------------------------------

    \186\ See also a related discussion in supra note 70.
---------------------------------------------------------------------------

     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.
     Exception Based on Empirical Duration.
    Empirical duration is another alternative proxy that can 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 credit-worthiness. A
Nonconvertible Security with negative empirical duration is less
impacted by changes in interest rates than Nonconvertible Securities of
credit-worthy issuers and trades similar to equity securities. Although
negative empirical duration may demonstrate that a particular issuer or
security is not credit-worthy, it has some limitations that impact the
viability of negative empirical duration as a substitute for 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 has also considered an exception based on issuer
characteristics, for example, the interest coverage ratio, the WKSI
standard, as suggested in the 2008 Proposal,\187\ 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.
---------------------------------------------------------------------------

    \187\ 2008 Proposing Release, 73 FR 40095-97.
---------------------------------------------------------------------------

     Exception Based on the WKSI Standard.
    The Commission could adopt the WKSI standard as a criterion to
determine eligibility for the exception. The issuers that fall under
the WKSI definition are large and established firms that typically have
sound credit-worthiness. The advantage of this characteristic is its
simplicity and straightforward calculations. However, the WKSI standard
as discussed in the 2008 Proposal was heavily criticized, for instance
for allowing risky high-yield issues to be eligible for the exception
and preventing issues by smaller but

otherwise credit-worthy issuers from relying on the exception.\188\
---------------------------------------------------------------------------

    \188\ ABA Letter at 15-17 and SIFMA Letter 1 at 13.
---------------------------------------------------------------------------

     Exception Based on the Interest Coverage Ratio.
    Another possible issuer-based criterion for exception eligibility
is the interest coverage ratio. A high interest coverage ratio
typically indicates the issuer's ability to repay debt and can be used
as a criterion to reflect credit-worthiness. 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. The proposed 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.\189\ The latter models could be a good measure
of credit-worthiness and of manipulation risk to the extent that
credit-worthiness is a good proxy for manipulation risk. 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. 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.
---------------------------------------------------------------------------

    \189\ 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).
---------------------------------------------------------------------------

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. 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.\190\ Some of
these factors, such as default statistics or credit assessments,
measure issuer credit-worthiness, 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.
---------------------------------------------------------------------------

    \190\ 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)].
---------------------------------------------------------------------------

    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.
    However, the scope and objectives of the 15c3-1 standard and the
exception in Rules 101 and 102 of Regulation M are different: The 15c3-
1 standard applies only to broker-dealers, which already have the
necessary arrangements in place to apply 15c3-1 standard, whereas the
Regulation M exceptions affect a broader range of market participants.
For example, banks involved in the relevant security issues will also
be affected. 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,\191\ possibly deterring some market
participants.
---------------------------------------------------------------------------

    \191\ 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.
---------------------------------------------------------------------------

5. Elimination of the Exception
    The Commission also considered eliminating the exception for fixed-
income securities. The advantage of this alternative is a more uniform
application of Regulation M, which eliminates 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 broker-dealers
from the need to spend time or costs to implement, understand, and
calibrate any proposed standard such as a Structural Credit Risk Model.
The Commission preliminarily believes that most broker-dealers already
have the capability to undertake those calculations themselves or
procure them from a data vendor and would benefit from the continued
availability of an exception despite the costs.
    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
reopenings, broker-dealers who might otherwise elect to reopen a bond
offering may determine not to do so to avoid restrictions of Regulation
M that could arise during such a reopening 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 participants, potentially
increasing fees faced by the issuers. Further, if certain

issues do not take place under the proposed 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 Rules 101 or 102 could structure its buying
activity before or after the applicable restricted period so as not to
incur any costs associated with relying on the exceptions.
    The above arguments apply to all currently excepted investment
grade securities because any such issue can become a sticky offering
and the distribution participants 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 Regulation M (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 of the exception could also affect the liquidity of the
fixed-income issues if reopenings of issues already in circulation are
more costly, potentially reducing issuers' reliance on this financing
structure, which negatively impacts 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, the issuer
may need to seek a different broker-dealer to comply with the
Regulation M requirements. 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 could
use a standard based on the value at risk. 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 securities' pool and determining the cash flows
available to the asset-backed security in each scenario. A number of
commercially available options can be used to perform this analysis.
Value at risk can be a good indicator of manipulation risk since low
value at risk indicates that the majority of the cash flows are
sufficiently assured. The price of the asset-backed security in this
case is more certain and is less subject to manipulation risk.
    However, value at risk is by construction estimated for a specified
time period and thus only accounts for the potential losses during such
period, while losses may also occur after this time period. In this
case the price of the asset-backed security may depend on issue-
specific factors and be prone to manipulation despite the estimated
value at risk over the specified time period being low. This may allow
securities with high manipulation risk to rely on the exception.
7. Alternatives for Rule 102 Exception
    The Commission considered exempting all bonds issued by a foreign
government or political subdivision thereof from Rule 102 of Regulation
M. This would allow such issuers to avoid compliance costs associated
with Regulation M requirements as discussed above. However, this
alternative implies excepting non-investment grade foreign sovereign
securities along with investment grade foreign sovereign securities.
This may introduce considerable risk that some foreign sovereign
issuers with low credit-worthiness and which are subject to a
considerable geopolitical risk are allowed to rely on Regulation M
exception. This could potentially result in a high pricing uncertainty
and a high manipulation risk introduced into the relevant markets.
    The Commission also considered excepting asset-backed securities
from Rule 102 that are offered pursuant to an effective shelf
registration statement filed on Form SF-3. However, this alternative
might introduce risk regarding issuers, selling shareholders, or their
affiliated purchasers engaging in activity to favorably affect the
distribution based on their interest in an offering's outcome, without
any benefit to facilitating orderly distributions or to limiting
potential disruptions in the trading market.\192\ These market
participants, unlike distribution participants, may have an interest in
the specific pricing of the issue and could benefit from engaging in
activity that impacts the market. Thus, excepting such asset-backed
securities from requirements of Regulation M could introduce
manipulation risk in the relevant markets.
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    \192\ See supra note 120.
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F. Request for Comment

    We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support
alternative recommendations. Please provide empirical data, when
possible, and cite to economic studies, if any, to support alternative
approaches.
    47. Are commenters aware of any additional examples of situations
when Structural Credit Risk Models cannot be applied or are difficult
to apply? Please explain why these situations occur.
    48. Are there any assumptions or inputs of Structural Credit Risk
Models that may be relevant to the estimation of the probability of
default and may require additional clarification?
    49. Do commenters agree with the Commission's assessment of the
availability and associated costs of the estimates for probability of
default based on Structural Credit Risk Models? Similarly, do
commenters agree with the Commission's assessment of availability and
associated costs of the necessary software or other resources necessary
to obtain the estimates internally? Are there any factors that the
Commission failed to consider?
    50. Do commenters agree with the Commission's assessment of the
proposed method of threshold measurements? Would a different method of
threshold have greater benefits or fewer costs than the proposed method
of threshold measurements? It is difficult to select a threshold that
would capture all of the investment grade securities and none of the
non-investment grade securities due to the imperfect correlation of
credit ratings and probability of default. Should the current method
used to calculating the threshold aim at capturing a larger set of
investments grade securities, such as a set above 90%, or aimed at
capturing a smaller set of non-investment grade securities, such as
fewer than 125 issues? Should a different date other than October 22,
2021, for the analysis be selected? Should the Commission propose a
method for calculating the threshold instead of proposing a number?
Should the Commission provide guidance on the sample of securities,
time interval, standard of credit-worthiness as a basis for comparison,
or other specifications that should be used in this method?

    51. Are commenters aware of any available data that may help
identify how many issuances of asset-backed securities with investment
grade rating might be excluded under the proposed standard?
    52. Are commenters aware of cases when incorrect estimates of
Structural Credit Risk Models' parameters result in inaccurate
probability of default estimates? For example, cases when the estimated
probability of default is high for an issuer with sound credit-
worthiness and vice versa. Please provide the supporting data and
calculations if available.
    53. Are there cases where probability of default is not a
reasonable proxy for credit-worthiness and therefore manipulation risk?
If so, why is it a poor proxy in those cases?
    54. What concerns, if any, do commenters have regarding the counter
cyclicality of probabilities of default implied by Structural Credit
Risk Models?

IX. Regulatory Flexibility Act Certification

    Section 3(a) of the Regulatory Flexibility Act of 1980 \193\
(``RFA'') requires the Commission to undertake an initial regulatory
flexibility analysis of the proposed rule on small entities unless the
Commission certifies that the rule, if adopted, would not have a
significant economic impact on a substantial number of small
entities.\194\ Pursuant to Section 605(b) of the RFA, the Commission
hereby certifies that the proposed amendments to the rule, would not,
if adopted, have a significant economic impact on a substantial number
of small entities. For purposes of Commission rulemaking in connection
with the RFA, small entities include broker-dealers with total capital
(net worth plus subordinated liabilities) of less than $500,000 on the
date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Rule 17a-5(d) under the Exchange
Act,\195\ or, if not required to file such statements, a broker or
dealer that had total capital (net worth plus subordinated liabilities)
of less than $500,000 on the last day of the preceding fiscal year (or
in the time that it has been in business, if shorter); and is not
affiliated with any person (other than a natural person) that is not a
small business or small organization.\196\
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    \193\ 5 U.S.C. 603(a).
    \194\ 5 U.S.C. 605(b).
    \195\ See 17 CFR 240.17a-5(d).
    \196\ See 17 CFR 240.0-10(c).
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    With respect to the amendments to Rules 101 and 102, it is unlikely
that any broker-dealer who is defined as a ``small business'' or
``small organization'' as defined in Rule 0-10 \197\ could be an
underwriter or other distribution participant as it would not have
sufficient capital to participate in underwriting activities. Small
business or small organization for purposes of ``issuers'' or
``person'' other than an investment company is defined as a person who,
on the last day of its most recent fiscal year, had total assets of $5
million or less.\198\ We believe that none of the various persons that
would be affected by this proposal would qualify as a small entity
under this definition as it is unlikely that any issuer of that size
had investment grade securities that could rely on the existing
exception. Therefore, we believe that these amendments would not impose
a significant economic impact on a substantial number of small
entities.
---------------------------------------------------------------------------

    \197\ 17 CFR 240.0-10.
    \198\ 17 CFR 240.0-10(a).
---------------------------------------------------------------------------

    We encourage written comments regarding this certification. The
Commission solicits comment as to whether the proposed amendments to
Rules 101 and 102, and Rule 17a-4 could have an effect on small
entities that has not been considered. We request that commenters
describe the nature of any impact on small entities and provide
empirical data to support the extent of such impact.

X. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996,\199\ the Commission is also requesting information
regarding the potential impact of the proposed amendments on the
economy on an annual basis. In particular, comments should address
whether the proposed changes, if adopted, would have a $100,000,000
annual effect on the economy, cause a major increase in costs or
prices, or have a significant adverse effect on competition,
investment, or innovations. Commenters are requested to provide
empirical data and other factual support for their views to the extent
possible.
---------------------------------------------------------------------------

    \199\ Public Law 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

Statutory Basis and Text of Proposed Amendments

    Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly Sections 3(b), 15, 23(a), and 36 (15 U.S.C. 78c(b), 78o,
78w(a), and 78mm) thereof, and Sections 939 and 939A of the Dodd-Frank
Act, the Commission is proposing to amend Exchange Act Rules 101 and
102.

List of Subjects in 17 CFR Part 240 and 242

    Broker-dealers, Fraud, Issuers, Reporting and recordkeeping
requirements, Securities.

Text of Rule Amendments

    For the reasons in the preamble, title 17, chapter II of the Code
of Federal Regulations is proposed to be amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934

0
1. The authority citation for part 240 continues to read, in part, as
follows:

    Authority:  15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
    Section 240.17a-4 also issued under secs. 2, 17, 23(a), 48 Stat.
897, as amended; 15 U.S.C. 78a, 78d-1, 78d-2; sec. 14, Pub. L. 94-
29, 89 Stat. 137 (15 U.S.C. 78a); sec. 18, Pub. L. 94-29, 89 Stat.
155 (15 U.S.C. 78w);
* * * * *
0
2. Amend Sec.  240.17a-4 by adding paragraph (b)(17) to read as
follows:

Sec.  240.17a-4   Records to be preserved by certain exchange members,
brokers and dealers.

* * * * *
    (b) * * *
    (17) The written probability of default determination pursuant to
Sec.  242.101(c)(2)(i) of this chapter (Rule 101 of Regulation M).
* * * * *

PART 242--REGULATIONS M, SHO, ATS, AC, NMS, AND SBSR AND CUSTOMER
MARGIN REQUIREMENTS FOR SECURITY FUTURES

0
3. The authority citation for part 242 continues to read as follows:

    Authority:  15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.

0
4. Amend Sec.  242.101 by revising paragraph (c)(2) to read as follows:

Sec.  242.101   Activities by distribution participants.

* * * * *
    (c) * * *
    (2) Certain nonconvertible and asset-backed securities. (i) The
nonconvertible debt securities and nonconvertible preferred securities
of issuers for which the probability of default, estimated as of the
day of the determination of the offering pricing and over the horizon
of 12 calendar months from such day, is less than 0.055%, as determined
and documented in writing by the distribution participant using a
structural credit risk model; provided, however, that, for purposes of
this paragraph, the term ``structural credit risk model'' shall mean
any commercially or publicly available model that calculates the
probability that the value of the issuer may fall below a threshold
based on an issuer's balance sheet; or
    (ii) Asset-backed securities that are offered pursuant to an
effective shelf registration statement filed on Form SF-3 (17 CFR
239.45).
* * * * *

Sec.  242.102   [Amended]

0
5. Amend Sec.  242.102 by removing and reserving paragraph (d)(2).

    By the Commission.

    Dated: March 23, 2022.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2022-06583 Filed 3-29-22; 8:45 am]
BILLING CODE 8011-01-P