After U.S. regulators finalized an amendment to a 50-year-old rule designed to limit penny stock fraud, WilmerHale attorney Bruce Newman did what the lawyers do and combed it through .
In a note to his clients in October last year, he detailed the relevant parts of the rule for those seeking to comply with it, primarily around the information brokers should check before quoting the prices of a title. Then he noticed something that would eventually shake Wall Street trading desks.
“While market participants may think the 15c2-11 rule is limited to stocks, it is actually not so limited and covers all securities other than municipal securities.” he wrote.
Bank compliance officials began seeking clarification from the regulator, the Securities and Exchange Commission, calling on trade associations to understand how five decades could have gone by without anyone – bankers or regulators – apparently knowing the rule encompassed debt markets. .
When the amendment was passed in September 2020, there was no mention of the bond market. There was no due diligence – a legal requirement for the SEC when proposing regulation – on how this could affect the bond market. Even the commissioners responsible for passing the rule said they only thought of the amendment in the context of the stock market.
The regulation requires that brokers posting prices for securities that are not publicly traded must ensure that certain financial information of the issuer is up to date, in an attempt to limit bogus companies that attract investment. The non-contentious amendment proposed last year required that this same information also be publicly available for investors to see.
“The amended rule represents another important step in our tireless and proactive efforts to protect retail investors from micro-capitalization fraud,” said Stephanie Avakian, director of the enforcement division, at the time. It certainly doesn’t sound much like the corporate bond market.
Nonetheless, this year a new administration took over the leadership of the SEC, not involved in the amendment when it was proposed in September 2020 and without any assumptions that could have been made as to its applicability in the markets.
The current SEC has approached the issue much like Newman did; there is no exemption, therefore, regardless of what has happened before or what has been understood by market participants, the rule applies to the corporate bond market.
Bond bankers and investors have cried foul.
When the rule was first written in 1972, most of the companies with marketable bonds were also public companies, already reflected in the rule’s application to stock markets. The high yield bond market was in its infancy. And the predominant medium of exchange – between the parties by telephone – would not be covered by this rule. The need for an exemption was less pressing.
Even in 1998, when a proposed exemption for fixed income securities was considered but not adopted, the majority of transactions in the corporate bond market were still done bilaterally.
Fast forward to the present day and the way debt is traded has changed and the size of the corporate bond market has inflated. Many issuers, especially in the high yield bond market, are private companies, generally required to disclose their debt to investors, but not required to make such disclosures.
As a result, for this part of the bond market, collecting the data required by rule 15c2-11 is not possible, bankers say.
This means that either the SEC grants the market an exemption, or private companies begin to publish their financial information, or trading in part of the corporate bond market could be reduced.
The problem came to a head in late September, when the amendment was due to go into effect, until the SEC granted a last-minute extension to the new year.
Bankers say it’s still not enough time, complaining about the SEC’s lack of advice on how to implement the rule in the bond market when it’s so clearly written for stocks.
The SEC is for the moment impassive. Even accidentally, the rule encourages greater transparency on the part of companies. Also, it’s not as if the bond market is actually going to stop; for SOEs, this rule already applies to their stock trading, and for companies that do not wish to publicly disclose their debt, their debt will still be traded as before – over the phone.
But for bankers, the rule brawl is indicative of a less sympathetic agency under President Gary Gensler, less willing to listen to the industry and more determined to impose regulation on it.
“It’s a lot more for regulators to tell the market what to do,” said a banker familiar with the rule. Another said: “We rushed internally. . . It’s definitely a hard line.
Bruce Newman and WilmerHale declined to comment.