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Bond Market Regulation
By Elizabeth H. Baird & Micah S. Green, Steptoe & Johnson LLP

Unintended Consequences: How Expanding SEC Rule 15c2-11 to Fixed Income Will Result in Less Transparency, Reduced Liquidity, and Limited Price Discovery

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The key prerequisites to a broker-dealer initiating a quotation in any quotation medium are found in the definitions of the terms “current” and “publicly available” information. “Current” means that the issuer information is filed, published, or is “as of” a date within the timeframes specified in the Amended Rule. “Publicly available” means that the required information is available on one or more specified venues where the public can freely access it. Prior to the amendments, the requirement of “reasonably current” financial information in the Rule was broadly interpreted and there was no requirement of public availability.
There are a number of vendors that have risen to the challenge of providing services to make compliance with the new requirements easier. This includes making information available to market participants that can be evaluated to determine if an issuer qualifies for an Appendix A exemption (things like the parent issuer has an equity traded on a U.S. exchange, and other indicators), and to satisfy the paragraph (b) requirements (such as is the specified information actually out there, is it readily available, etc.).
Quotations Published in a Quotation Medium
SEC Rule 15c2-11, amended in September 2020, provides that a broker-dealer may not initiate quotations for a security in a "quotation medium," other than a national securities exchange, unless the broker-dealer is able to satisfy specified information requirements regarding the issuer. The Staff published two No Action letters, in September 2021 and December 2021, which extended the time for compliance for fixed income securities under certain conditions. They also provided citations to defend the fragile proclamation that 15c2-11 has always been applied to fixed income securities. The truth is, in practice, this Rule has really never been applied to bonds. In fact, the companion FINRA rule, 6432, is in the OTC Equity section of their manual and does not mention fixed income at all.
As Commissioner Peirce has stated, as the amendments evolved through the drafting process at the Commission, at no time was the application of the updated rule to fixed income raised. The term “fixed income” does not even appear in the Rule proposal. Indeed, one needs to go no further than the economic analysis accompanying the proposed Rule to see that the Division of Economic Research and Analysis (“DERA”) limited its review of the economic impact of the proposal to the equity markets. DERA and the rule writing division would have met on a number of occasions to discuss the breadth of the market impact and the define the scope of the accompanying analysis. Dozens of reviewers throughout the Commission would have reviewed this analysis, along with the draft rule, prior to its publication. Curiously, it was only after adoption that anyone, SEC included, focused on a possible application to bonds. Upon hearing the unanticipated appeals from the securities industry to exempt fixed income, we respectfully submit that the Commissioners saw an opportunity to materially and expeditiously extend the scope of this rule through the simple provision of time limited no action relief, which upon expiration will fundamentally limit the price discovery process for certain fixed income securities.
Applying a rule that was not either overtly or subtly intended for debt securities without full discussion, consideration, and subject to the open process prescribed under the Administrative Procedures Act, will have unintended consequences. The No Action letters changed nothing substantive about the application of the Rule, they just temporarily provided relief from immediate implementation that had heretofore not been applied to fixed income securities. They addressed none of the obstacles to or impacts of applying the Rule to the bond market. If the SEC indeed believes that bondholders would benefit from the application of 15c2-11, it should present its reasoning through the regular rule-writing process, including public comment, before imposing these new requirements.
Current and Publicly Available
The No Action Letter reads that “fixed income securities are often quoted on quotation mediums rather than on interdealer quotation systems,” and that “the Rule applies to any broker-dealer that publishes or submits quotations in a quotation medium.” “Quotation medium” is broadly defined as “any device that is used by brokers or dealers to make known to others their interest in any security.” “Quotation,” in this rule, includes any indication by a broker-dealer that it wishes to advertise its interest in buying or selling a particular security.
First, a platform that merely hosts other broker-dealers’ quotes, rather than displaying its own quotes, would likely not be in violation of the Rule if it displays the bids and asks of others without conducting a 15c2-11 analysis.
Second, the term “quotation” is very broadly defined in this Rule seemingly to encompass just about any sort of market activity. The way that the Staff has traditionally viewed this can be best described as the difference between communicating and advertising.
In the past, the Staff would not view a “communication” as sufficient to satisfy the definition of quoting. A communication can be made in a number of ways. It could be a bilateral interaction with another market participant, when a broker-dealer sends its daily inventory to other broker-dealers or institutions, responses to requests for bids and offerings, or an internal offering screen reflecting bonds available in inventory.
Advertising or publishing, by contrast, is putting out interest to buy or sell on a medium where the broker-dealer can update the price and quantity, as it sees fit, throughout the day. It is a live executable quote. This would trigger the obligations of 15c2-11.
There are a number of exemptions from the requirements for current financial information about the issuer. The most notable of the exemptions is where the transaction is unsolicited and the customer is not an insider or affiliate of the issuer. A number of other exemptions to the disclosure requirements include: the large cap exemption, exchange delist exemption, and the municipal securities exemption.
For securities that are not within the scope of the No Action Letter, broker-dealers will have to presently comply with the information gathering and review the requirements of the amended Rule. These are primarily found in paragraph (b)(5) or (f)(2) for an exemption. Some fixed income securities will obviously go dark.
The widely reported rationale for these changes was that they would further prevent fraud on retail investors. Where issuers with publicly available securities do not publish financial information, the availability of bids and asks on those securities and reports of daily trading volume extend an undeserved imprimatur of legitimacy to the company when, in fact, not enough is known to support such a conclusion. No one has been able to identify any regulatory enforcement action in the fixed income context which is based upon a fact pattern resembling this potential equity market misconduct that the Rule is intended to avoid. Indeed, the difference in these markets leaves one wondering how such a fact pattern could even arise with bonds.
This dilemma highlights the gap in appreciation of the difference between equity and fixed income markets and products, and the tendency to simply force equity market solutions onto bonds. If there is no financial information about an equity issuer there is no way to evaluate a company’s fundamentals or measure the stock’s relative value at a particular dollar price. By contrast, the entire purpose of the bond market is to price risk. Bonds trade on yield, a metric for relative value. The yield of a bond at any bid or ask can be determined whether the financial information of the issuer is available or not. That yield can then be compared to bonds of other issuers with equivalent characteristics, such as to bonds of other issuers without publicly available financial information. The bond market is efficiently tiered into segments of equivalent securities based upon the categories of risk that the issuers’ debt presents.
Ultimately, there is a significant likelihood that the changes that Rule 15c2-11 will force onto the fixed income market will be counterproductive to the stated goal of market transparency; more trading will be conducted bilaterally, over the phone, as broker-dealers become reluctant to provide certain information if doing so would implicate the obligations of this Rule. The unavoidable consequence will be reduced liquidity and limited price discovery for the impacted bonds.