After US regulators finalised an amendment to a 50-year-old rule designed to limit fraud in penny stocks, lawyer Bruce Newman at WilmerHale did what lawyers do and went through it with a fine tooth comb.
In a note to his clients in October last year, he detailed the pertinent parts of the rule for those looking to comply with it, mostly around disclosures that dealers must check before quoting prices on a security. Then he noted something that would eventually send tremors through Wall Street trading desks.
“Although market participants may think of Rule 15c2-11 as limited to stocks, it is not, in fact, so limited, and covers all securities other than municipal securities,” he wrote.
Bank compliance officers began asking for clarification from the regulator, the Securities and Exchange Commission, roping in trade associations to get to the bottom of how five decades could have gone by without anyone — bankers or regulators — seemingly being aware that 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 it proposes regulation — on how it might affect the bond market. Even commissioners responsible for passing the rule have said they only thought of the amendment in the context of the equity market.
The regulation requires that dealers publishing prices for securities that are not listed on an exchange must ensure certain financial information from the issuer is up to date, with the intention of limiting bogus companies luring investment. The uncontentious amendment proposed last year required 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 being victimised by microcap fraud,” said Stephanie Avakian, director of the division of enforcement, at the time. That certainly doesn’t sound much like the corporate bond market.
Nonetheless, this year a new administration took the helm at the SEC, uninvolved in the amendment when it was proposed in September 2020 and untethered to any assumptions that may have been made about its applicability across 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 was 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 companies with tradable bonds were also public companies, already captured by the rule’s application to stock markets. The high-yield bond market was in its nascency. And the predominant means of trading — between parties over the phone — would not be captured by this rule. The need for an exemption was less pressing.
Even in 1998, when a proposed exemption for fixed income was considered but not passed, the majority of trading in the corporate bond market still took place bilaterally.
Fast forward to the present day and the way debt is traded has changed and the sheer size of the corporate bond market has swelled. Many issuers, especially in the high-yield bond market, are private companies, typically required to make disclosures to investors in their debt but not required to publish these disclosures publicly.
As a result, for this part of the bond market, gathering the data required under rule 15c2-11 is not possible, the bankers say.
That means either the SEC gives the market an exemption or private companies start publishing their financial information, or trading in a chunk of the corporate bond market could be curtailed.
The issue came to a head at the end of September when the amendment was due to come into effect, until the SEC gave a last-minute extension to the new year.
Bankers say that is still not enough time, complaining about a lack of guidance from the SEC on how to implement the rule in the bond market when it is so clearly written for stocks.
The SEC is so far unmoved. However accidental, the rule encourages greater transparency from companies. What’s more, it’s not as if the bond market will actually grind to a halt; for public companies, this rule already applies to trading in their shares, and for companies unwilling to give up the information publicly, their debt will still trade as it once did — over the phone.
But for bankers, the scuffle over the rule is indicative of a less sympathetic agency under the leadership of chair Gary Gensler, less willing to listen to the industry and more intent of forcing regulation upon it.
“He is much more about regulators telling the market what to do,” said one banker familiar with the rule. Another said: “We have been scrambling internally . . . It’s definitely a hard line.”
Bruce Newman and WilmerHale declined to comment.