Industry warns SEC bond disclosure plan may backfire

Extending rules for OTC equities to 144A bond issues could result in less price transparency

US broker-dealers are warning the Securities and Exchange Commission (SEC) that extending the scope of a disclosure rule, which was originally designed for over-the-counter stocks, could harm liquidity in the private placement market for large corporate bonds.

Dealers warn that the application of Rule 15c2-11 to bonds whose issuers have been granted safe harbour from Securities Act registration under Rule 144A would drive trading into darker channels.

“It is a massive step backwards in terms of transparency. Communication of interest in trading non-public Rule 144A issuances will return to one-on-one formats, basically email or phone calls.” says Chris Killian, a managing director of securitisation and credit at the Securities Industry and Financial Markets Association (Sifma).

“That means liquidity in those securities is going to be worse, price discovery is going to be worse, and pricing is going to be worse.”

Previously, Rule 15c2-11 was implemented and enforced only in relation to investor trading of OTC equities, popularly known as penny stocks. Updates to the rule were approved by the SEC in December 2020, under former chair Jay Clayton. These included prohibiting broker-dealers from publishing quotes for an issuer’s security when issuer information is not current and publicly available, subject to certain exceptions.

The purpose of this prohibition was to protect retail investors who might otherwise be at risk of fraud if they bought stocks based on stale information. The unimplemented rule was then inherited by new SEC chair Gary Gensler, who subsequently decided to apply it to OTC bonds issued under Rule 144A as well, even though this market is accessible only to qualified institutional buyers (QIBs).

The broader application caught the industry by surprise, and the SEC therefore issued a no-action letter in December 2021, delaying compliance by a year to January 2023.

On June 10, 2022, Sifma wrote to the SEC requesting an indefinite extension of that relief for Rule 144A debt. The relief requires only that issuer financial information is disclosed to investors upon request.

Liquidity in those securities is going to be worse, price discovery is going to be worse, and pricing is going to be worse

Chris Killian, Sifma

Sifma warns that without the relief, secondary market liquidity will suffer as dealers stop publishing quotes, deterring institutional investors.

“In the end, it’s the investors who hold their outstanding securities who are going to be in a tough spot,” says Joe Corcoran, associate general counsel at Sifma.

Lower liquidity and reluctant investors will also force issuers to pay higher yields for new issuance, thereby increasing funding costs for US companies. Ultimately, the 144A market could become a less attractive route for corporate and asset-backed securities issuers.

A former SEC staffer who wrote an economic analysis for Rule 15c2-11 agrees that the commission’s decision to extend the rules to capture fixed income “could potentially backfire”.

Joshua White, now an assistant professor of finance at Vanderbilt University, says that “we never discussed fixed income or 144A” because staff did not think it was meant to be covered by the rule.

This confirms the concerns of Republican SEC commissioner Hester Peirce and market participants that the new expanded scope was not subject to an appropriate economic analysis of the costs and benefits, nor an accompanying notice and comment process.

Private for a reason

Fixed income dealers say the new interpretation of Rule 15c2-11 conflicts with Rule 144A requirements that financial information be made available only privately when requested by QIBs. Issuers are not required to make their financial information public under Rule 144A.

“Nor do I think some of these companies intend to make their information public next year,” says Sifma’s Corcoran.

There is usually a good reason why some firms or asset-backed vehicles choose to issue debt under Rule 144A. They “tend to be a little riskier”, White says, and a private placement allows them to convey that information confidentially to the investors in a more nuanced way.

The SEC’s new interpretation of Rule 15c2-11 puts dealers in a bind because they cannot force a bond issuer to publish financial information. White suggests they might apply collective leverage to prospective 144A issuers, advising that future debt offerings will only be placed if the issuer follows certain requirements. For instance, industry governors of the Financial Industry Regulatory Authority could recommend that Finra adopts such guidance. But that could deter 144A offerings altogether.

“Some will seek debt financing in more obscure areas, and that could impede capital formation,” says White. “Broker-dealers have a profit motive, they want to issue these securities.”

Indirect regulation

White does think there is a case for the SEC to improve the information available on 144A issues for secondary market trading. When the bond is first issued, QIBs that are eligible to purchase must be furnished with company financial information, but the same level of detail “may not be available or provided to the next buyer”, White says.

Commissioner Peirce, who objected to the extension of the penny-stocks rule to include 144A offerings, acknowledged to Risk.net earlier this year that there may be a case for more disclosure in the market, but argued that the SEC should find a more suitable way of achieving it.

However, White sympathises with the idea that transparency cannot be improved through obligations on the issuers themselves, as they are exempt from Securities Act registration.

“All [the SEC] can do is indirectly regulate them, through gatekeepers: accountants, attorneys and broker-dealers,” he says.

He suggests the best approach for the industry would be to carry out its own analysis of historical 144A offerings and present this to the SEC. That study should compare the level of financial information available to investors in the primary and secondary markets for private placements against the information available on public issues. The aim would be to tease out whether there is any correlation between the quality and quantity of information on the one hand, and bad outcomes for investors – such as enforcement action or default – on the other hand.

Editing by Philip Alexander