On April 30, 1990, the Securities and Exchange Commission implemented Rule 144A, which it viewed as “the first step toward achieving a more liquid and efficient institutional resale market for unregistered securities.”1 The rule enabled less-than-investment grade companies to issue, without prior SEC review, both straight and convertible debt as well as preferred stock. All the parties involved in the markets — investors, underwriters, issuers and regulators — viewed Rule 144A as a tremendous step forward for financial markets. It would enable companies to come to market faster, which would allow them to time the market to obtain the best terms; in turn, investors would have a greater universe of investments from which to choose. Regulators believed that requiring companies to obtain approval of their prospectuses within a six-month period would be sufficient to insure that the information in the original prospectus was accurate. Of course, regulators did retain the right to take action against companies whose filings turned out to be materially false.

While the rule has generally been a success, market growth and other factors have rendered certain parts of the rule outmoded. While in 1990 the entire size of the market was about $200 billion, the last few years have routinely seen more than $100 billion of new issuance. As of the end of 2003, the total market size was approximately $750 billion.

Rule 144A also seems to have caused some confusion among investors. Based on my discussions with participants in the market (including regulators) and other anecdotal evidence, it appears that many investors are violating this rule. They are probably not harmed by such violations — after all, most investors in the high yield market are large institutions that are presumably sophisticated enough to evaluate the risks of buying non-registered securities.

Lack of prior SEC review occasionally hurts even sophisticated investors, who must rely on the information provided in the prospectus. Moreover, a rule that was intended to protect the unsophisticated now prevents whole categories of sophisticated investors from participating where they should be able to. Truth be told, the SEC is not enforcing Rule 144A with any rigor. If it did, market liquidity would be significantly impaired because the number of investors able to participate in such offerings would be restricted. This could raise the cost and limit the availability of capital for less-than-investment grade companies, which would be directly contrary to the spirit of the rule.

The SEC, when adopting Rule 144A, promised “to monitor the evolution of this market and to revisit the Rule with a view to making any appropriate changes. Among the issues that the Commission would expect to consider would be the nature and number of regular participants in the market, the types of securities traded, the liquidity of the market, the extent of foreign issuer participation in the private market, the effect of the Rule 144A market on the public market, and any perceived abuses of the safe harbor.”2

Clearly, it's time the Commission took a hard look at the market and updated the rule.

EXCEPTIONS

Rule 144A provides a non-exclusive safe harbor exemption from the registration requirements of the Securities Act of 1933 for specified resales of restricted (that is to say, privately placed and non-registered) securities to institutional investors. The rule generally exempts from registration resales of restricted securities to “qualified institutional buyers” (QIBs). With certain important exceptions, a QIB is an institution that has in excess of $100 million of investable assets (it may not be a natural person, which creates certain anomalies). One important exception to the $100 million threshold is that a registered broker-dealer qualifies with $10 million of investable assets. A qualified broker-dealer can act as a riskless principal for an institution that is itself a QIB, or as an agent on a non-discretionary basis in a sale to a QIB. Another important exception covers banks or savings-and-loan associations that have at least $25 million in assets. Institutions meeting these asset thresholds are deemed sophisticated enough to make investment decisions without relying on the SEC's gate-keeping function.

It is perhaps ironic that a rule designed to make it easier for high-risk companies to sell securities was issued during the first collapse of the high yield bond market in 1990, when those who invested in such companies suffered large losses. From 1990 to 1991, the high yield bond market entered one of its worst periods on record, with new issuance drying up and bond prices dropping so low that the spread between high yield bonds and Treasury securities exceeded 1,000 basis points for the first time in history.

High yield bond issuers have been the biggest beneficiaries of this relaxed regulatory regime. For more than a decade, corporate bond issuers have not been required to subject their bond deals to SEC review before bringing them to market. The market has evolved to the point that the SEC does not review more than 90 percent of all new bond issues before they come to market. With annual Rule 144A issues approaching or exceeding $100 billion in recent years, much of the secondary trading activity in the high yield bond market involves restricted or non-registered securities. For all intents and purposes, the high yield bond market is a private placement market. As a result, investors are subject to the additional risk that subsequent SEC review will lead to significant changes in disclosures upon which investment decisions were based.

Issuers are required to tell investors that their prospetuses may be materially false. Disclosure from Polypore, Inc.'s bond issue in May 13, 2004 baldly states that a final prospectus may be dramatically different from a prospectus issued when bonds are sold under Rule 144A. The same language is found in every Rule 144A prospectus. Polypore said: “Comments by the SEC on the description of or business, the financial data or the other information in the registration statement may require modification, reformulation or deletion of some of the data or information we present in this offering memorandum or additional disclosure compared to that in the offering memorandum. Any such modification, reformulation, deletion or additional disclosure could be significant.”3

Since the advent of Rule 144A and, to a lesser extent, general market growth, the high yield bond market has grown significantly larger and more liquid. It has only occasionally been marred by egregious failures in due diigence. But market participants continue to stretch the private placement envelope. For example, underwriters and issuers have been peppered with “drive-by under-writings” that are announced in the morning and sold in the afternoon. Investment bankers would have to be supermen to perform adequate due diligence on such deals.

In another development, several companies in the controversial energy industry have issued bonds that will be permanent 144As. These are generally secured bonds that cannot be registered for technical, legal reasons. As a result, large bond issuers with multiple bond issues, including Williams Cos. Inc. and Calpine Corp., have some registered and some unregistered bonds; this has created confusion for buyers who have assumed that bonds outstanding more than six months had been registered when in fact they were not. Because disclosure by these companies is timely and complete as a result of having other registered issues (as well as public stock), little purpose is served by limiting the universe of possible buyers for the unregistered issues.

Rule 144A is being honored in the breach, so to speak. Despite the fact that investors are required to sign “QIB letters” affirming their ability to purchase these securities, many investors believe themselves to be QIBs when a technical reading of the rule demonstrates that they are not. As the rule merely requires that the seller of the security have a reasonable belief that the purchaser is a QIB, innocent mistakes are understandable. Two examples illustrate some of the anomalies to which Rule 144A gives rise. Any individual, even a multibillionaire, can't be a QIB. Instead, individuals, no matter how wealthy, can invest only if they do so through a qualified entity — one that has at least $100 million in assets. In other words, an individual may own a QIB, but may not himself be a QIB. Talk about a distinction without a difference!

The same rule applies to hedge funds. Even a $10 billion hedge fund can't make such an investment if it has a single limited partner who isn't a QIB, because someone who would otherwise be a QIB is prohibited from purchasing restricted securities on behalf of somebody who is not. The $10 billion hedge fund could create a separate fund to segregate out any investors who are not QIBs, but otherwise could invest only in such securities if it were doing so on behalf of partners or shareholders who are themselves QIBs.

A third example is instructive: Rule 144A as originally proposed provided that investment advisors, but no other types of institutions holding securities in discretionary or fiduciary accounts (such as banks), could include assets under management in determining eligibility as a QIB. In response to comments questioning this provision, the SEC decided to expand the types of entities that could count assets under management to include other institutions in the business of investing money for clients, provided they meet a specified dollar threshold and are purchasing the securities for a client that is itself a QIB. But the law was not drafted to permit the professionals making the investment decisions at these institutions to own these securities for their own account unless they did so through entities that they owned that were QIBs. That would require these professionals to themselves have enormous net worth, something that is often not the case in view of the high thresholds required by the law. In other words, what's good for the goose here is not good enough for the gander. This has an unintended effect. In today's hedge fund business, many investors insist that their managers eat their own cooking by investing in their funds themselves. Yet such an investment by managers who are not QIBs would disqualify the hedge fund from being able to invest in these issues.

POSSIBLE REFORMS

The SEC needs to make amending Rule 144A a priority. I respectfully suggest the following changes as a starting point for helping the rule better achieve its goals in the current market environment:

  • Investors with a minimum net worth of much less than $100 million should be permitted to buy under Rule 144A. There is no reason accredited investors shouldn't be allowed to invest in these securities when they're permitted to make much riskier investments directly into hedge funds, futures and other sophisticated strategies.

  • Natural persons who are accredited investors should be permitted to invest in Rule 144A securities. There is no good reason why such investments must be made through legal entities such as corporations, partnerships, etc.

  • Investment professionals who are qualified to purchase Rule 144A bonds on behalf of their investors should be permitted to invest in them for their own accounts.

These modifications would go a long way toward insuring that Rule 144A does not prevent those who are fully qualified by reason of financial wherewithal and investment experience and acumen to buy restricted securities without violating the rule.

Endnotes

  1. Release No. 33-6862, April 30, 1990.
  2. Ibid.
  3. Polypore, Inc., May 13, 2004.