Thursday, July 3, 2008

The Rule 144A

Since passage of the Securities Exchange Act of 1933, firms seeking to raise external capital and avoid the registration requirements and oversight of the U. S. Securities and Exchange Commission (SEC) have done so through private placements. The Securities Act of 1933 makes a fundamental distinction between distributions of securities (primary offerings) and transactions in securities. Offerings that involve the distribution and underwriting of securities are viewed as public offerings and require registration. To qualify for an exemption from registration, issuers and purchasers of private placements must meet certain conditions.5 Under Section 4(2) and its safe harbor of SEC Regulation D, issuers can qualify for an exemption from registration if they place securities with accredited investors and a limited number of individual investors who intend to hold the securities for investment purposes.

Less recognized, however, is that the exemption granted to the issuer does not extend to the purchasers of private placements. Because the SEC recognized that financial intermediaries could effectively distribute securities through resales of private placements, prior to Rule 144A purchasers of private placements were restricted in their ability to resell them. An institution purchasing private placements could resell them if they subsequently registered the securities or if they could establish that the purchase was motivated for investment purposes. One guide that the SEC has traditionally relied upon to establish “investment intent” is the length of time a purchaser holds a security. Typically, resales of private placements could be sold without registration, if the purchaser held the securities for at least two years.6 The net effect of these rules was to significantly inhibit resale opportunities and liquidity for purchasers of private placements.

Rule 144A lifts registration requirements for resales of private placements as long as the security is sold to qualified institutional buyers (QIB). Under the initiative, the SEC recognized that certain buyers were able to “fend for themselves” in obtaining and processing information about an issuer. As a consequence, the QIB market is limited to large financial institutions and other accredited investors. The requirements to qualify as a QIB are as follows:
1. An institution (e.g., an insurance or investment company, or pension plan) that owns or invests at least $100 million in securities of non-affiliates,
2. A bank or savings and loan (S&L) association that meets condition 1a. and also has an audited net worth of at least $25 million,
3. A broker or dealer registered under the Exchange Act, acting for its own account or for that of QIBs that own and invest at least $10 million in securities of non-affiliates, or
4. An entity whose equity holders are all QIBs.

Post enactment of Rule 144A, registration applied only to “public offers,” which were defined to concern individual investors rather than QIBs. Under this interpretation, resale’s of private placements under Rule 144A no longer involve a public offering, and thus do not require registration. Instead Rule 144A resales to QIBs now constitute transactions which fall outside of the reach of the 1933 Act. The easing of resale restrictions was motivated by a belief that institutional investors were able to independently obtain and process information about 144A securities.

However, while Rule 144A eliminates certain disclosure requirements, it would be incorrect to say that it requires no disclosure. Generally speaking, Rule 144A requires issuers to provide a brief statement of the issuer’s business, its products and services, and financial statements (balance sheet, profit and loss, and retained earnings statements) for the preceding two years.

The financial statements must be audited to the extent possible, although formal reconciliation to Generally Accepted Accounting Principles (GAAP) is not required. This information requirement does not apply to companies reporting under the Exchange Act of 1934 (as these firms are already subject to SEC disclosure), foreign government issuers, and foreign private issuers that have applied for a home country exemption (Rule 12g3-2(b)) on a voluntary basis.

A home country exemption allows an international firm to fulfill the Rule 144A information requirement by providing an English translation of the financial statements used in its own country. Companies with home market exemptions often are subject to on-going disclosure in their home markets but the level of disclosure is not typically as strict as that required by the U.S. The remainder of firms, not subject to on-going disclosure in their home market or the U.S., must meet the general Rule 144A information requirements outlined above. This latter group is likely to have the least available information and present the greatest challenge to QIBs in judging their quality. International 144A issues differ in another important respect from domestic 144A issues. Fenn (2000) and Livingston and Zhou (2002) find that over 97 percent of domestic 144A issues are accompanied by simultaneous application for registration rights.

This procedure allows debt to be placed immediately in the 144A market and within 60 days the issuer must exchange the Rule 144A security with a registered security. Registration of the security permits debt to be subsequently resold to individual investors in addition to QIBs. Registration rights also subject the issuer to on-going SEC disclosure. As a result, Livingston and Zhou (2002) suggest registration rights significantly improve the liquidity of Rule 144A issues by expanding the pool of buyers.11 For international issuers, registration rights involve increased disclosure and the costs of preparing U.S. GAAP financial statements. These costs are likely to be substantially higher for international issuers than for domestic issuers whose financial statements must already comply with U.S. GAAP. Consequently, few international issuers apply for registration rights.

The foregoing discussion leads to several hypotheses about the potential differences in offering yields between 144A and public debt issues. The SEC has argued that full disclosure is in the public’s interest and, consistent with this, studies have shown that investors pay higher prices for securities that provide greater information and transparency (e.g., Amihud and Mendelson 1986). Since more 144A debt is exempt from public disclosure, the offering yield could be higher due to a lack of transparency relative to public debt issues. Alternatively, market participants in the 144A market could be able to achieve a satisfactory level of disclosure irrespective of government regulations.

The 144A market involves institutional investors, and if QIBs are able to extract equivalent information or possess the capability to adequately judge credit quality on the available information, ceteris paribus, there should be no difference in the costs of borrowing between the markets. Finally, the debt contracting literature suggests that private lenders can possess an informational advantage over participants in the public debt market. The information advantage a lender enjoys typically stems from its ability to observe inside information about the borrower, (e.g., see Carey et al. 1993; and James 1987). This advantage is less likely to occur in the 144A market due to the overlap of buyers for 144A and public debt. Anecdotal evidence suggests that investment banks market both types of debt to a similar list of institutional clients. Thus the purchasing institutions appear to have similar capacities to evaluate 144A and public debt.

Even without an information advantage, some elements of the debt contracting literature could hold in the 144A market. Information intensive claims that typify the private placement market can impose high monitoring costs on a lender, and for such claims private debt can be less costly than public debt. To the extent 144A debt reflects more uncertainty, information intensity, or other elements of complexity, it can be more cost effective to market these issues to a smaller group of buyers and, hence, lower yields could be associated with Rule 144A debt.

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