The Collision of Rule 15c2-11 and Rule 144A

The Consequences for Capital Formation

The U.S. Securities and Exchange Commission’s novel decision to apply Rule 15c2-11 to fixed income securities has the potential to upend parts of the $5 trillion Rule 144A market, which is currently relied upon by thousands of American companies, financial institutions and other issuers – and which securities are held by pension plans, mutual funds and other institutional investors throughout the United States and globally.

In Part I of this two-part blog series, we provided a history of Rule 15c2-11, often referred to as the Penny Stock Quote Rule, its intent, and its sudden and unexpected application to the fixed income markets that reversed 50 years of regulatory policy. In this Part II, we discuss how this new interpretation could upend portions of the Rule 144A markets.

Rule 144A offerings: A key tool for raising debt capital

The SEC established Rule 144A in 1990 to provide a safe harbor from Securities Act registration for resales of securities to highly sophisticated institutions that are “qualified institutional buyers” (“QIBs”). To be eligible as a QIB, an entity generally must be one of an enumerated categories of institutions and own and invest at least $100M of securities of unaffiliated issuers. Individuals cannot be QIBs, no matter how wealthy or sophisticated they are. In short, Rule 144A was promulgated by the SEC to codify a non-public alternative to registered offerings.

Currently, there are over $5 trillion of 144A securities outstanding, including $898 billion in sovereigns and approximately $4.2 trillion in corporates—with the most significant corporate issuers in the energy, consumer discretionary, communications, materials and utilities sectors. Total 144A issuances (across issuer types) in 2020 were approximately $1.15 trillion and in 2021 were approximately $1.36 trillion. Average daily trading volume in 144A securities (across issuer types) in 2020 was over $9 billion and in 2021 was over $10 billion.

First, some background on the nuts and bolts of a 144A security and its eligible buyers.

How 144A works in practice for issuers and investors

Typically, an issuer seeking to raise capital in the 144A market first sells restricted securities directly to a broker-dealer through a private placement that is exempt from registration. The broker-dealer then uses the Rule 144A exemption to offer and resell those securities to QIBs such as pension plans and mutual funds. A QIB must also satisfy a $100 million in securities owned and invested threshold – not the retail investor the SEC aimed to protect with its Penny Stok Rule.

When a broker-dealer engages in a Rule 144A offering, the QIB is typically provided with an offering memorandum that is subject to the antifraud provisions of the federal securities laws and that contains the same general type of information contemplated by Rule 15c2-11, including a detailed description of the issuer, its financial statements, and the securities to be offered. The broker-dealer participating in the offering receives legal opinions and a comfort letter from the issuer’s auditing firm as assurance as to the accuracy of the information in the offering memorandum.  Securities acquired in a Rule 144A transaction are “restricted securities” and may only be resold by the QIB pursuant to an exemption from registration under the Securities Act. That exemption is typically either Rule 144A for sales inside the Unites States or Regulation S for sales outside the United States.

Speaking more broadly, Rule 144A facilitates the ability of companies, financial institutions and other issuers to raise trillions of dollars annually, particularly through issuance of fixed income securities. At the same time, the rule facilitates a marketplace that provides an efficient and effective investment option for sophisticated institutions seeking fixed income exposure.

Issuer information is available to current and prospective holders of the securities. Rule 144A requires that the holder of the 144A securities and any prospective purchaser of those securities be given the right to obtain from the issuer—upon request—specified information about the issuer (e.g., a brief description of the issuer’s operations and certain financial information). In many cases, issuers make this information available on a website where any qualified investor can request access to the information.

The careful crafting of Rule 144A

In the lead-up to the SEC’s 1990 adoption of Rule 144A, the Commission carefully considered and calibrated the rule’s architecture and mechanics, including through a 1988 proposal and 1989 re-proposal. The SEC’s deliberation included consideration of the concept that issuer information be “available upon request,” as described above. The SEC evaluated, for example, whether there should be no such information condition “on the theory that [QIBs] are sophisticated investors that are able to adequately assess their need for information and to determine when to proceed with an investment” and whether an issuer information condition would “unnecessarily impair the efficiency of resale transactions” under the rule.

Ultimately, the SEC determined – after considering public comments – that the “available upon request” approach appropriately balanced investor protection and capital formation policy goals. The highly sophisticated nature of the institutions eligible to purchase these securities was central to the Commission’s determination, as those institutions have the ability to make their own assessments of what information they need in order to protect themselves.

SEC Rule 15c2-11: An old rule applied in a new way

As discussed in Part I of this series, SEC Rule 15c2-11 requires broker-dealers to collect and review specified issuer information – and confirm that such information is publicly available – before making their interest in buying/selling covered over-the-counter securities known to others, unless an exception applies. The SEC first implemented the rule in 1971 primarily for the purpose of reducing fraud and manipulation in the penny stock market (i.e., requiring a broker-dealer to diligence a penny stock issuer, to ensure the issuer is a real company and not a fraud, before publicly quoting the issuer’s securities).

In 2021, in discussions with the industry concerning 2020 amendments to Rule 15c2-11, the SEC staff expressed the view that Rule 15c2-11 has always applied to other types of OTC securities – including fixed income. This surprised the broker-dealer and investment community as well as even some SEC Commissioners. To our knowledge, in the 50 years of the rule’s existence, the SEC has never enforced compliance with the rule for fixed income or questioned firms’ fixed income activities under the rule.

The plain words of Rule 15c2-11 clearly contemplate that the Commission crafted Rule 15c2-11 with the equities – not fixed income – markets in mind. Additionally, the 297 pages of the SEC’s 2020 release that made unrelated amendments to the rule (all of which were reviewed and approved by the SEC’s Commissioners, Office of General Counsel and Chief Economist) discusses the Rule and its costs and impacts exclusively in terms of applying only to equities.

SEC Commissioner Hester Peirce summarized this unusual and awkward dynamic when she noted the following in a September 2021 statement concerning the SEC staff’s recent actions in this area: “Nothing in the [SEC’s 2020 rulemaking] release suggests that the Commission considered the application of [Rule 15c2-11] to the fixed-income markets. The policy analysis [in the rulemaking release] focuses entirely on the need for additional disclosure in the OTC equity markets to deter fraud in those markets, and the justification rests on the need to protect retail shareholders. The economic analysis focuses on the effects and incentives the rule creates in the OTC equity markets… Consequently, nobody seems to have contemplated that this rule would affect the fixed-income markets in a way different from the pre-amendment version of the rule, much less that its requirements potentially would render unviable certain recent technological innovations in trading – innovations that have benefited investors and improved market quality.”

If the Commission believed that Rule 15c2-11 applied to fixed income securities at the time of its 2020 rulemaking, it seems obvious that it would have needed to address how those rule amendments (which included requiring issuer information for covered securities to be publicly available) applied in respect of Rule 144A.

The SEC Staff establishes a new compliance regime

In response to industry concerns about the SEC staff’s new interpretation, on September 24, 2021, the staff published a letter that provided broker-dealers with “no-action relief” until January 3, 2022 to comply with Rule 15c2-11 for fixed income. Then on December 16, 2021, the SEC staff issued a second letter, establishing a prescriptive and intricate compliance regime that firms must follow for fixed income securities:

  • “Phase 1” for Rule 15c2-11 fixed income compliance applies from Jan. 3, 2022 to Jan. 3, 2023, but excludes fixed income offered pursuant to Rule 144A, as well as seven other categories of fixed income securities (e.g., issuers that also have a class of securities listed on an SEC-registered exchange).
  • “Phase 2” for Rule 15c2-11 fixed income compliance applies from January 4, 2023 until January 4, 2024 and applies to the same categories of fixed income securities as Phase 1, except the rule begins to apply to 144A fixed income securities.
  • “Phase 3” for Rule 15c2-11 fixed income compliance commences on January 5, 2024 (with no end date) and applies to the same categories of fixed income securities covered in Phase 2 where either (a) the security is foreign sovereign debt or guaranteed by a foreign government or (b) there is a website link on the medium on which the security is quoted that directly to the current and publicly available information about the issuer.

The negative implications for investors and issuers

Under the new regime established by the SEC staff, beginning on January 4, 2023, in order to publish quotations for 144A securities to the market through quotation mediums, broker-dealers will be required to confirm that the issuer’s information is publicly available. Thus, the SEC staff is requiring 144A issuer information to be made available to non-QIBs in the general public who are not eligible to invest in these 144A securities. This conflicts with the construct that the Commission developed when it designed and adopted Rule 144A (where issuer information is not publicly available, but instead provided “upon request” by holders and prospective holders who are QIBs).

When the Commission adopted amendments to Rule 15c2-11 in 2020, the Commission did not contemplate or anticipate that the rule (and accompanying amendments) would apply to fixed income securities, and therefore did not consider the conflicting implications for 144A securities. Importantly, many Rule 144A issuers are private companies that do not issue registered debt or have listed equity securities, and are not required to make their financials public.

Investors that currently hold Rule 144A debt securities face an unfortunate and unfair reality: starting January 4, 2023, broker-dealers might no longer be able to efficiently advertise their interest in and ability to buy/sell some Rule 144A securities because the issuer information is not publicly available and Rule 15c2-11 is not satisfied, thus reducing investors’ ability to exit such investments at the best possible price. Furthermore, investors’ appetite to purchase and hold some Rule 144A debt securities could be reduced in the future, for the same reason: their ability to sell those securities in an efficient and effective manner through broker-dealer intermediaries will be compromised.

The efficacy of utilizing Rule 144A for debt financing is now in question for private issuers. First, the reduced desirability of their Rule 144A securities to investors (as explained above) may affect pricing, potentially making Rule 144A a less viable pathway for capital raising for private issuers. And in terms of potentially adjusting issuer behavior to reflect the new interpretation of Rule 15c2-11, it seems unlikely that these issuers—which have grown accustomed to providing their sensitive financial and other information only “upon request” and privately to holders and prospective holders, consistent with Rule 144A—would find it desirable, or in some cases, even practicable to change course and make their sensitive information publicly available.

There is still time to fix the problem

The SEC should suspend the imposition of requirements in the No-Action letter for private issuers to publish their financial information.  If they don’t, there will be material disruptions to these issuers’ access to capital markets, and investors could see the value of their investments decline significantly, with no appreciable public policy goal.

If the Commission would like to consider applying Rule 15c2-11 to 144A fixed income securities, or revisit Rule 144A under the Securities Act more generally, then the Commission should at a minimum provide the opportunity for issuers, investors, broker-dealers, other market participants and the public generally to provide input, in accordance with the requirements and spirit of the Administrative Procedures Act, through a transparent rulemaking process.

Without meaningful public input into the rulemaking process, this threatens to be yet another example of the consequences that issuers, investors and the marketplace will suffer under one of the SEC’s most ambitious rulemaking agendas in its history.

Joe Corcoran is a Managing Director and Associate General Counsel for SIFMA. His work focuses on regulatory and legislative proposals that impact corporate finance or capital market activities of member firms, including underwriting, syndication, mergers and acquisitions and research.

Chris Killian is a Managing Director for SIFMA. He is responsible for SIFMA’s advocacy related to fixed income market structure, including corporate credit, securitized products and GSE/housing finance reform, as well as the transition from LIBOR.