US SEC updates regulatory strategic plan – global capital markets impact

October 2022  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

October 2022 Issue

The US Securities and Exchange Commission (SEC) released for public comment an updated ‘Strategic Plan for Fiscal Years 2022-2026’ that includes three principal goals, notably, to develop and implement a robust regulatory framework that keeps pace with evolving markets, business models and technologies.

Current regulatory activity by the SEC has been described by some as using enforcement cases as an expression of regulatory policy, and, by others, as lacking clear policy direction. The global impact of the SEC’s regulatory actions can have an effect on the international capital markets. Thus, the Strategic Plan, and related public comment, presents welcome news for industry professionals seeking to conduct business.

Rule 15c2-11 reinterpretation

The SEC implemented Rule 15c2-11 under the Securities Exchange Act of 1934 over 50 years ago to address improprieties and potential avenues for fraud and manipulation in the penny stock market. The rule requires broker-dealers to collect and review specified issuer information before making their interest in buying or selling covered over-the-counter securities known to others, barring an exception. Historically, the SEC has only applied this rule to equity securities.

Recently, the SEC amended Rule 15c2-11 to provide for additional disclosure by broker-dealers to potential investors, which took effect on 28 September 2021. Four days prior to this effective date, the SEC issued a surprising no-action letter response to the Financial Industry Regulatory Authority (FINRA) indicating that the rule has applied to all securities, including fixed income, since its inception.

Consistent with the historic treatment of this rule as applying solely to equity securities, the 297-page final rule release made little mention of fixed income securities, including through the SEC’s economic analysis, which estimated that only 9998 securities would be impacted by the amendments, a figure that is highly inaccurate if quotes on fixed income securities were meant to be included.

This new interpretation has had significant ramifications for the industry. According to the ‘SIFMA 2022 Capital Markets Fact Book’, global fixed income security market cap exceeded that of equity securities, totalling approximately $126.9 trillion, $49.1 trillion of which were US fixed income markets.

In a 16 December 2021 no action letter to FINRA, the SEC affirmed its position that the rule would also apply to fixed income securities, including high-yield debt securities issued for resale to sophisticated investors pursuant to Rule 144A. This newly affirmed SEC interpretation of Rule 15c2-11 comes into direct conflict with the longstanding practices in the Rule 144A market for high-yield bonds, and the requirements of those issuers under Rule 144A to publicly disclose and share information with potential investors. Historically, and for good reason, this information has previously been kept confidential. The interplay between the Rule 144A and the SEC’s newly affirmed Rule 15c2-11 practice leads to numerous challenges.

Most importantly, Rule 144A provides for the holder of the 144A securities and any prospective purchaser of those securities to be given the right to obtain from the issuer – “upon request” – specified information about the issuer. The “upon request” aspect of Rule 144A offerings and the “publicly available” requirement under Rule 15c2-11 has created regulatory complexities for issuers and broker-dealers alike.

In response to concerns expressed regarding the application of Rule 15c2-11 to fixed-income securities, the 16 December 2021 no-action letter indicated that SEC staff would not recommend enforcement action under the amendments to Rule 15c2-11 for broker-dealers that publish or submit quotations in a quotation medium for fixed income securities if such broker-dealer qualifies under one of the “phases” enumerated in the letter.

The first phase, which provides relief to fixed income securities sold pursuant to Rule 144A, expires soon, on 3 January 2023. After this date, broker-dealers will be unable to issue public quotations in Rule 144A securities unless the issuer has published current and publicly available information. Beyond the confidentiality concerns, issuers will have to grapple with determining how to comply with the numerous information requirements, many of which are not readily applicable to fixed income, as the rules and related guidance were clearly written with equities in mind.

SEC staff declines extension of global investment research relief

On 18 February 2022, the SEC issued its ‘Staff Report on the Issues Affecting the Provision of and Reliance Upon Investment Research Into Small Issuers’. Without determining causation, the report noted that, after the recast Markets in Financial Instruments Directive (MiFID II) was implemented, “many asset managers decreased their research budgets and the number of their research providers…”. The report also found that post-MiFID II, research pricing competition “has disadvantaged small research providers more so than large research providers”.

MiFID II requires, among other things, the unbundling of research costs from execution costs with the goal of preventing the use of trading commissions to pay for research – a practice viewed by European Union (EU) regulatory authorities as a potential conflict of interest and an “unlawful inducement”. Asset managers in the EU must therefore pay for research either: (i) directly from their own funds, i.e., hard dollar payments; or (ii) from a research payment account (RPA) funded by clients (and subject to strict operational requirements).

For US broker-dealers, complying with requests to unbundle research costs is problematic because the receipt of ‘special compensation’ for research by a broker-dealer potentially subjects the broker-dealer to additional regulation and oversight by the SEC as an investment adviser if the research is deemed investment advice.

In response to these concerns, the SEC issued a no-action letter on 26 October 2017, providing US broker-dealers the ability (albeit still only on a temporary basis) to accept hard dollar payments or payment through an RPA from EU asset managers (or their contractually-bound sub-advisers) without being deemed investment advisers subject to the Advisers Act. However, on 26 July 2022, William Birdthistle, director of the Division of Investment Management of the SEC, announced that “the Division does not intend to extend the temporary position beyond its current expiration”, on 3 July 2023, “and does not expect to issue further assurances with respect to the adviser status of broker-dealers accepting compensation under MiFID II arrangements”.

In light of this looming no-action expiration, broker-dealers providing research that receive hard dollar payments for such research will need to carefully examine their operations to determine whether such activities would qualify under a separate exemption or whether investment adviser registration is required. Without regulatory action from the SEC, in coordination with regulators around the world, the provision of investment research will experience challenges, particularly – as the SEC report itself notes – for medium and smaller issuers and US brokers.

 

Marlon Q. Paz is a partner at Latham & Watkins LLP. He can be contacted on +1 (202) 654 7101 or by email: marlon.paz@lw.com.

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Marlon Q. Paz

Latham & Watkins LLP

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