Considerations for Foreign Banks Financing in the United States, 2016 … · 2016-09-13 · largest...

Authors

Bradley Berman

Ze’-ev D Eiger

Lloyd S Harmetz

Jerry R Marlatt

Anna T Pinedo

IFLRinternational Financial Law Review

Considerations for Foreign Banks Financing in the United States2016 Update

Financial institutions, including foreign banks, regularly access the capital markets and seek to diversifytheir funding alternatives. Foreign banks may seek to access the US capital markets without subjectingthemselves to registration with, and oversight by, the US Securities and Exchange Commission (SEC).

This brief summary is intended to outline the most common capital raising approaches used by foreignbanks, and the issues that foreign banks should consider in structuring offerings of securities, certificates ofdeposit, or commercial paper in the United States.

We also discuss continuous offering programmes, such as bank note and medium-term noteprogrammes, since these are used by foreign banks that are frequent issuers. Finally, we address issuancesof covered bonds and structured products into the United States. We hope that this overview provides ahelpful guide.

Considerations for Foreign Banks Financing in the United States 2016 update 1

Introduction

Introduction 1About the authors 5About the firm 7

CHAPTER 1

General overview of securities registration and disclosure requirements 9

CHAPTER 2

Overview of financing through exempt offerings 14

CHAPTER 3

Overview of continuous issuance programmes 22

CHAPTER 4

Mechanics of a Section 4(a)(2) offering 28

CHAPTER 5

Mechanics of a Rule 144A/Regulation S offering 35

CHAPTER 6

Section 3(a)(2) and considerations for foreign banks financing in the United States 42

CHAPTER 7

Bank deposit products versus securities 49

Contents

2 Considerations for Foreign Banks Financing in the United States 2016 update

CHAPTER 8

Considerations related to commercial paper 53

CHAPTER 9

Exchange Act Registration 60

CHAPTER 10

Foreign banks and the Investment Company Act 69

CHAPTER 11

Blue sky laws 74

CHAPTER 12

Regulation by the Financial Industry Regulatory Authority 77

CHAPTER 13

Special considerations related to structured products 85

CHAPTER 14

Covered bond basics 92

CHAPTER 15

Schedule B filers 98


AuthorsBradley Berman is of counsel in the Capital Markets Group of the New York office of Morrison &Foerster. His work previously involved capital-raising debt and equity transactions for large bank holdingcompanies, including several common stock issuances. Mr Berman also advises domestic and non-USissuers on domestic and international securities offerings of structured products linked to equities,commodities and currencies. He has extensive experience with exchange traded notes and advised a non-US frequent issuer on all of their exchange traded notes over a period of three years. Mr Berman also advisesissuers on shelf registration statements, medium term note programmes and exempt transactions, and hasworked on many bank note issuances by state and national banks.

Ze’-ev D. Eiger is a partner in the Capital Markets Group of the New York office of Morrison & Foerster.He also serves as Co-Head of Morrison & Foerster’s Israel Desk. Mr Eiger’s practice focuses on securitiesand other corporate transactions for both foreign and domestic companies. He represents issuers,investment banks/financial intermediaries, and investors in financing transactions, including publicofferings and private placements of equity and debt securities. He also represents foreign private issuers inconnection with securities offerings in the United States and the Euro markets, and financial institutionsin connection with domestic and international offerings of debt securities and medium-term noteprogrammes.

Lloyd S. Harmetz is a partner in the Capital Markets Group of the New York office of Morrison &Foerster. He focuses on securities offerings and other corporate transactions for US and non-US companies.Mr Harmetz’s experience includes public offerings, private placements and Pipe offerings of equity anddebt securities, in which he represents both issuers and underwriters. His practice focuses on securitiesofferings by financial institutions, including investment grade securities and structured products linked toequities, commodities, interest rates and other underlying assets. Mr Harmetz’s practice also specialises instructuring continuous offering programmes that are registered under the Securities Act, or that are exemptfrom registration under Regulation S, Rule 144A and Section 3(a)(2) of the Securities Act.


About the authors

Jerry R. Marlatt is senior of counsel in the Capital Markets Group of the New York office of Morrison &Foerster. He represents issuers, underwriters and placement agents in public and private offerings of debt,covered bonds, surplus notes, securities of structured investment and specialised operating vehicles, andsecurities repackagings. Representative transactions involve the first covered bond by a US financialinstitution, the first covered bond programme for a Canadian bank, surplus notes and common stock fora US monoline insurance company, eurobond offerings by US issuers and securities offerings for a varietyof structured vehicles. Mr Marlatt is a contributor to Covered Bonds Handbook, published by PractisingLaw Institute (2010) and a charter member of the United States Covered Bonds Council. He was named“Dealmaker of the Year” by The American Lawyer for his work as issuer’s counsel on the first covered bonddeal ever registered with the Securities and Exchange Commission.

Anna T. Pinedo is a partner in the Capital Markets Group of the New York office of Morrison & Foerster.She has concentrated her practice on securities and derivatives. Ms Pinedo represents issuers, investmentbanks/financial intermediaries, and investors in financing transactions, including public offerings andprivate placements of equity and debt securities, as well as structured notes and other structured products.She works closely with financial institutions to create and structure innovative financing techniques,including new securities distribution methodologies and financial products. Ms Pinedo has particularfinancing expertise in certain industries, including working with technology-based companies,telecommunications companies, healthcare companies, financial institutions, Reits and consumer financecompanies. She has worked closely with foreign private issuers in their securities offerings in the UnitedStates and in the Euro markets. Ms Pinedo also has worked with financial institutions in connection withinternational offerings of equity and debt securities, equity- and credit-linked notes, and hybrid andstructured products, as well as medium-term note and commercial paper programmes.



We are Morrison & Foerster — a global firm of exceptional credentials. Our clients include some of thelargest financial institutions, investment banks, Fortune 100, technology and life science companies. Wehave been included on The American Lawyer’s A-List for thirteen straight years, and Fortune named us oneof the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative andbusiness minded results for our clients, while preserving the differences that make us stronger.

We are a leading capital markets law firm, advising issuers, agents and underwriters in a broad range ofdomestic and international private and public financings. Our team of over 220 capital markets lawyers in16 offices worldwide is consistently ranked as one of the most active securities firms in the United Statesand Asia, representing issuers and underwriters in hundreds of securities offerings raising over $100 billioneach year. Morrison & Foerster has one of the most well-regarded financial services regulatory practices inthe world. Our knowledge of the regulatory and business environment, practice before regulatory agencies,and frequent interaction with regulators combine to enhance our clients’ ability to execute their businessgoals effectively.

This is MoFo. Visit us at www.mofo.com. For more updates, follow @Thinkingcapmkts on Twitter:www.twitter.com/thinkingcapmkts.

About the firm

Foreign issuers, including foreign banks, which areconsidering accessing the US capital markets havea number of financing alternatives. As apreliminary matter, a foreign (non-US domiciled)

issuer must choose between undertaking a public offeringin the United States, which would have the result ofsubjecting the issuer to ongoing securities reporting anddisclosure requirements, or undertaking a limited offeringthat will not subject the issuer to US reporting obligations.

Registration requirementsAn issuer may conduct a public offering in the UnitedStates by registering the offer and sale of its securitiespursuant to the Securities Act of 1933, as amended(Securities Act), and also registering its securities for listingor trading on a US securities exchange pursuant to theSecurities Exchange Act of 1934, as amended (ExchangeAct). Section 5 of the Securities Act sets forth theregistration and prospectus delivery requirements forpublic offerings of securities.In connection with any offer or sale of securities in

interstate commerce or through the use of the mails,Section 5 requires that a registration statement must be ineffect and a prospectus meeting the prospectusrequirements of Section 10 of the Securities Act must bedelivered prior to sale. As we discuss further below, theSecurities Act is a disclosure statute. The purpose of theSecurities Act is to ensure that an issuer provides investorswith complete disclosure about the securities that it isoffering. The registration and prospectus deliveryrequirements of Section 5 require filings with theSecurities and Exchange Commission (SEC) and areintended to protect investors by providing them withsufficient information about the issuer and its business andoperations, as well as about the offering, in order that theymay make informed investment decisions.As a result, in connection with a public offering of

securities, an issuer must provide extensive informationabout its business and financial results. The preparation ofthe principal disclosure document (the registrationstatement) is a time-consuming and expensive process. Wedo not discuss the factors to be considered in connectionwith preparing a registration statement, nor do we discussthe steps required in connection with the preparation ofthe document. Once filed with the SEC, the SEC willreview the document closely and provide the issuer with

detailed comments. The comment process may take aslong as 60 to 90 days once a document has been filed withthe SEC.Once all of the comments have been addressed and the

SEC staff is satisfied that the registration statement isproperly responsive, the registration statement may beused in connection with the solicitation of offers topurchase the issuer’s securities. Depending upon the natureof the issuer (whether it is a domestic or foreign privateissuer) and the nature of the securities being offered by theissuer, the issuer may use one of various forms ofregistration statement.Once an issuer has determined to register its securities

under the Securities Act, the issuer usually also will applyto have that class of its securities listed or quoted on asecurities exchange and, in connection with doing so, willregister its securities under the Exchange Act. TheExchange Act requires registration of securities for thebenefit of investors that purchase securities in thesecondary market. The Exchange Act imposes two separatebut related obligations on issuers: registration obligationsand reporting obligations. Section 12 of the Exchange Actsets forth the requirements for registration of securitiesunder the Exchange Act and requires that an issuer registera class of its securities with the SEC under twocircumstances, pursuant to either Section 12(b) or 12(g).Pursuant to Section 12(b) of the Exchange Act, an issuermust register a class of its equity or debt securities underthe Exchange Act prior to the listing of those securities ona national securities exchange.The Section 12(b) registration requirement is applicable

regardless of whether the securities previously have beenregistered under the Securities Act. Section 12(g) of theExchange Act requires registration when the issuer hastotal assets exceeding $10 million and a class of equitysecurity held of record by 2,000 or more persons or 500 ormore persons who are not accredited investors (as definedin Securities Act Rule 501(a)). Section 13(a) of theExchange Act imposes reporting obligations on an issuerthat has registered a class of securities under Section 12 ofthe Exchange Act. Section 15(d) of the Exchange Actrequires registration when the issuer has filed a registrationstatement that has become effective pursuant to theSecurities Act. Registration under either Act will subjectthe issuer to the periodic reporting requirements and otherrequirements under the Exchange Act.


CHAPTER 1

General overview of securities registration and disclosure requirements

The federal securities laws are intended to protectinvestors by ensuring that adequate information isavailable to them prior to their making an investmentdecision. The Securities Act and the rules and regulationspromulgated under the act set forth detailed disclosurerequirements applicable to public offerings. Reportingissuers must adhere to the disclosure requirements of theExchange Act in relation to their periodic filings.Disclosures required pursuant to the Securities Act, whichrelate to specific offerings, are integrated with thoserequired under the Exchange Act. For foreign privateissuers, the SEC has provided a separate integrateddisclosure system, which provides a number ofaccommodations for foreign practices and policies.

What is a foreign private issuer?A foreign private issuer (FPI) is any issuer (other than aforeign government) incorporated or organised under thelaws of a jurisdiction outside of the United States, unlessmore than 50% of the issuer’s outstanding voting securitiesare held directly or indirectly by residents of the UnitedStates, and any of the following applies: (1) the majority ofthe issuer’s executive officers or directors are US citizens orresidents; (2) the majority of the issuer’s assets are locatedin the United States; or (3) the issuer’s business isprincipally administered in the United States.1Current SEC rules ease the disclosure burdens imposed

upon FPIs and reduce the ongoing costs of securitiesreporting obligations for FPIs. Below we list some of themain benefits available to FPIs:• Annual report filing. Foreign private issuers are required

to file annual reports on Form 20-F within four monthsfrom the issuer’s fiscal year-end.2 In contrast, USdomestic issuers generally must file their annual reportson Form 10-K within 60 to 90 days following the endof their fiscal year.3

• Quarterly financial reports. A FPI has no legal obligationto file quarterly reports. By contrast, US domesticissuers must file a quarterly report on Form 10-Q. AFPI may choose to furnish quarterly financialinformation on a voluntary basis under cover of Form6-K.

• Proxy solicitation statements. Unlike a US domesticissuer, a FPI has no legal obligation to file proxysolicitation materials on Schedule 14A or 14C inconnection with annual or special meetings of itssecurity holders.4

• Audit committee. A FPI also has no legal obligation toestablish an audit committee. However, in the absenceof such a committee, for certain US federal securitieslaw purposes, issuer’s entire board of directors may actas the audit committee.5

• Internal control reporting. A FPI only has to file annuallyregarding its financial reporting internal controls whilea US domestic issuer must do so on a quarterly basis.6

• Executive compensation. A FPI is exempt from the SEC’s

disclosure rules for executive compensation on anindividual basis, but is required to provide certaininformation on an aggregate basis. In addition,individual management contracts and compensatoryplans must be filed as exhibits unless the issuer’s homecountry does not require such filings to be made and arenot otherwise publicly disclosed by the issuer.7

• Directors/officers, equity holdings. Directors and officersof a FPI (in other words, insiders) do not have to reporttheir equity holdings and transactions in such holdingsunder Section 16 of the Exchange Act (Forms 3 and 4)8.However, some directors and officers may have toreport their holdings under Section 13 of the ExchangeAct, if applicable, and a FPI must provide shareownership information regarding directors and officersas of the most recent practicable date in its annualreport on Form 20-F and in other filings.

• IFRS – No US Gaap reconciliation. A FPI may prepareits financial statements in accordance with InternationalFinancial Reporting Standards (Ifrs) as issued by theInternational Accounting Standards Board withoutreconciliation to US generally accepted accountingprinciples (US GAAP). In addition, a FPI using theIFRS standard is only required to file two years offinancial statements for its first reporting year, ratherthan the previously required three years.

• Exiting the reporting system. Rule 12h-6 under theExchange Act allows a US-listed FPI to exit the UScapital markets with relative ease and terminate theregistration of a class of securities under Section 12(g)of the Exchange Act or terminate its reporting dutiesunder Section 15(d) of the Exchange Act. A FPI mayterminate its registration or reporting duties withrespect to a class of equity securities after certifying that:• The FPI has had reporting obligations under Section

13(a) or Section 15(d) for at least the last 12 months,has filed or furnished all reports required for thatperiod, and has filed at least one annual report;

• The FPI’s securities have not been sold in the UnitedStates in a registered offering under the SecuritiesAct during the last 12 months other than certainexceptions;

• The FPI has maintained a listing of the subject classof securities for at least the last 12 months on one ormore exchanges in a foreign jurisdiction, whichconstitutes the primary trading market for thosesecurities; and

• The average daily trading volume of the subject classof securities in the United States has been no greaterthan 5% of its worldwide average daily tradingvolume of the securities for the most recent 12-month period, or on a date within the last 120 days,the subject class of securities is either held of recordby fewer than 300 persons on a worldwide basis orfewer than 300 persons resident in the United States.

A FPI may terminate its registration or reporting


duties with respect to a class of debt securities aftercertifying that:

• The FPI has had reporting obligations under Section13(a) or Section 15(d) for at least the last 12 months,has filed or furnished all reports required for thatperiod, and has filed at least one annual report; or

• On a date within the last 120 days, the subject classof securities is either held of record by fewer than300 persons on a worldwide basis or fewer than 300persons resident in the United States.

• Exchange Act registration. Rule 12g3-2(b) under theExchange Act allows a FPI to exceed the registrationthresholds of Section 12(g) of the Exchange Act andeffectively have its equity securities traded on a limitedbasis in the over-the-counter market in the UnitedStates. This may be useful for FPIs that wish toaccommodate a limited number of US investorswithout triggering ongoing registration and disclosureobligations. Rule 12g3-2(b) under the Exchange Actautomatically exempts a FPI from Exchange Actregistration requirements and SEC reportingobligations if:• its primary trading market is in a foreign

jurisdiction;• it publishes, in English, the required disclosure

documents on its website or through a generallyavailable electronic information delivery system; and

• it does not otherwise have any Section 13(a) or 15(d)Exchange Act reporting obligations.

Despite these important benefits, conducting a publicoffering in the United States, and becoming subject toongoing registration requirements is expensive. Foreignissuers considering whether to register their securities inthe United States under the Securities Act or the ExchangeAct also should consider carefully the securities liabilitiesto which they and their directors and officers and othercontrol persons may become subject. Similarly, issuersshould consider the securities law liabilities to which theymay become subject in connection with offerings exemptfrom the US registration requirements. As we discuss inthis book, these are considerably more limited.

Exemptions from registrationGiven the onerous registration requirements that areapplicable to issuers that register their securities with theSEC, many issuers choose to access the US capital marketsthrough targeted financings exempt from the registrationrequirements of the securities laws. Foreign bank holdingcompanies or foreign banks may avail themselves of theseexemptions to raise capital from US investors.A number of exemptions from the Section 5 registration

requirements are available, based either on the type ofsecurity being offered and sold (described in Section 3 ofthe Securities Act), or on the type of transaction in whichthe security is being offered and sold (described in Section4 of the Securities Act), including the following:

• Section 3(a)(2) of the Securities Act (Section 3(a)(2)) is anexemption from registration under the Securities Actavailable for securities issued or guaranteed by banks. Aforeign bank may rely on this exemption to offer itssecurities in the United States, guaranteed by its USbranch or agency, or for securities issued by its USbranch or agency. See Chapter 6 (Section 3(a)(2) andconsiderations for foreign banks financing in theUnited States).

• Section 3(a)(3) of the Securities Act (Section 3(a)(3)) is anexemption from the registration requirements under theSecurities Act for short-term commercial paper withcertain characteristics, provided the proceeds are usedfor current transactions. See Chapter 8 (Considerationsrelated to commercial paper).

• Section 4(a)(2) of the Securities Act (Section 4(a)(2)) is anexemption from registration for “transactions by anissuer not involving any public offering,” or privateplacements. Often issuers will rely on the safe harborprovided by Regulation D under the Securities Act(Regulation D), which provides greater certaintyregarding the types of offerings that would beconsidered private placements. A foreign bank holdingcompany may rely on Section 4(a)(2) to issue equity ordebt securities to accredited or institutional investors inthe United States. See Chapter 2 (Overview offinancing through exempt offerings).

• Rule 144A under the Securities Act (Rule 144A) is a safeharbor available for the resale of certain securities toqualified institutional buyers, or QIBs, by certainpersons other than the issuer of the securities. SeeChapter 2 (Overview of financing through exemptofferings).

• Regulation S under the Securities Act (Regulation S) is anexclusion from the registration requirements of Section5 of the Securities Act for “offers and sales of securitiesoutside the United States” by both US and foreignissuers, which can be used by foreign bank holdingcompanies or foreign banks in combination with aprivate placement or Rule 144A offering to reach abroader universe of potential investors. See Chapter 2(Overview of financing through exempt offerings).Foreign bank holding companies may issue and sell

equity, debt, hybrid (Tier 1) or structured securities inreliance on Section 4(a)(2) and Rule 144A, and may add aRegulation S component to an offering. Usually, foreignbank holding companies that do not want to list a class ofsecurities on a securities exchange in the United States willissue non-voting preferred securities or debt securities. Aforeign bank generally will rely on the Section 3(a)(2)exemption to offer its securities in the United States,guaranteed by its US branch or agency, or for securitiesissued by its US branch or agency. Foreign banks also mayoffer commercial paper in reliance on the Section 3(a)(3)exemption.A foreign bank that anticipates that it will offer securities


regularly in the United States may choose to establish acontinuous issuance program, like a medium-term noteprogramme, bank note programme or commercial paperprogramme, as opposed to relying on standalone offeringsof securities. An issuer will be able to realise certainefficiencies and improve its access to the capital markets byestablishing a programme. Foreign banks also may issueand offer covered bonds to US investors, either on astandalone basis, or through an issuance programme. Inaddition, foreign issuers may issue other instruments,which are not considered securities, including, forexample, certificates of deposit, to US investors. Theregistration requirements are not applicable to bankdeposits, or other instruments that are not consideredsecurities.In this book, we provide an overview of the exemptions

from registration that may be available to foreign bankholding companies or foreign banks that seek to access theUS capital markets. We also discuss the types of productsthat may be offered by foreign banks. Foreign banks mayoffer various types of debt securities, including, but notlimited to, senior unsecured debt, senior secured debt (likecovered bonds), subordinated debt, structured debt (likeequity-linked, currency-linked, or commodity-linkednotes), hybrid debt intended to obtain favorable regulatorycapital treatment, including contingent capital (or CoCo)debt securities, and deposit liabilities. We also discuss theentities that may offer such products, such as the homeoffices or US branches of foreign banks or special purposefinance vehicles sponsored by foreign banks.



1. Exchange Act Rule 3b-4(c). A FPI is permitted toassess its status as a FPI once a year on the last businessday of its second fiscal quarter, rather than on acontinuous basis, and may avail itself of the FPIaccommodations, including use of the FPI forms andreporting requirements, beginning on thedetermination date on which it establishes itseligibility as a FPI. If a FPI determines that it nolonger qualifies as a FPI, it must comply with thereporting requirements and use the forms prescribedby US domestic companies beginning on the first dayof the fiscal year following the determination date.SEC Release No. 33-8959. Note that if a FPI loses itsstatus as a FPI, it will be subject to the reportingrequirements for a US domestic issuer, and whileprevious SEC filings do not have to be amended uponthe loss of such status, all future filings would berequired to comply with the requirements for a USdomestic issuer. Financial Reporting Manual, Divisionof Corporate Finance, Topic 6120.2, available athttp://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.shtml.

2. Form 20-F, General Instruction A.(b)(2).

3. Form 10-K, General Instruction A.(2)(a)-(c).

4. Rule 3a12-3(b) under the Exchange Act.

5. Form 20-F Instruction to Item 6.C and SEC ReleaseNo. 33-8220 (April 9 2003).

6. SEC Release No. 33-8238 (June 5 2003).

7. Item 6.B of Form 20-F.

8. Rule 3a12-3(b) under the Exchange Act.

ENDNOTES


Foreign issuers often find that they would like toaccess investors in the United States withoutsubjecting themselves to the ongoing registrationand reporting requirements applicable to public

companies in the United States. As a result, many foreignissuers consider offering securities to investors in theUnited States in reliance on one of the exemptions fromregistration. In this chapter we provide a brief overview ofthe most commonly relied upon exemptions.

Section 4(a)(2)Section 4(a)(2) provides that the Section 5 registrationrequirements do not apply to “transactions by an issuer notinvolving any public offering”. This is often referred to asthe private placement exemption. The breadth of thisexemption makes it useful for issuers attempting toconduct a variety of financing transactions. The rationalefor this exemption from registration is that the extensiveregulation applicable to public offerings is not requiredwhen offerings are made by an issuer to a limited numberof offerees who can protect themselves. These exemptionsare available to US and non-US public and privatecompanies. In 1982, the SEC adopted Regulation D toprovide issuers with a safe harbour for conducting Section4(a)(2) private placements.

Securities acquired pursuant to a Section 4(a)(2) offeringmay be immediately resold under Rule 144A, even thoughthey are “restricted securities,” as defined in Rule 144(a)(3)under the Securities Act. The intent to resell under Rule144A is not inconsistent with Section 4(a)(2) and does notaffect the availability of the exemption.

Regulation D provides issuers with three safe harboursfor issuing securities without registration. The first, Rule504, provides an exemption pursuant to Section 3(b) ofthe Securities Act for offerings of up to $1 million. Thesecond, Rule 505, provides an exemption pursuant toSection 3(b) for offerings of up to $5 million. The third,Rule 506(b), which is the most popular, provides anexemption pursuant to Section 4(a)(2) for limitedofferings and sales without regard to dollar amount, butonly to 35 purchasers and an unlimited number of“accredited investors”, who are typically institutionalinvestors or high net-worth individuals. Until recently,general solicitation was not permitted in privateplacements in accordance with Rule 506. However, in July2013, pursuant to Section 201 of the Jumpstart Our

Business Startups Act (112 P.L. 106) (the “JOBS Act”), theSEC revised Rule 506 by adding a new exemption, Rule506(c), which permits general solicitation if the issuertakes “reasonable steps to verify” that purchasers areaccredited investors, all purchasers are accredited investors,or the issuer reasonably believes that they are, immediatelyprior to the sale, and if certain other requirements are met.As part of the amendments, the SEC established fouroptional methods that would satisfy the accredited investorverification requirements. In addition, newdisqualification provisions were added to Rule 506,prohibiting the use of the exemption by certain bad actorsand felons, whether or not general solicitation is used.

Section 4(a)(2) private placements are attractive toforeign issuers considering offering securities in the UnitedStates because they permit them to raise large amounts ofcapital without the cost and delays of registration underthe Securities Act and SEC review of offering documents.Section 4(a)(2) private placements for foreign issuers arealmost always for debt securities, given that most foreignissuers want to avoid having too many US holders ofequity securities if the foreign issuers intend not to becomesubject to US reporting requirements.

Rule 144ARule 144A is a resale safe harbour exemption from theregistration requirements of Section 5 of the Securities Actfor certain offers and sales of qualifying securities bycertain persons other than the issuer of the securities. Theexemption applies to resales of securities to qualifiedinstitutional buyers (QIBs) (or to other purchasers that theinitial purchasers and any persons acting on their behalfreasonably believe to be QIBs). Issuers must find anotherexemption for the initial offer and sale of unregisteredsecurities, typically Section 4(a)(2) (often in reliance onRegulation D) or Regulation S. Resales to QIBs, which arelarge institutional investors with securities portfolios inexcess of $100 million, in compliance with Rule 144A arenot public “distributions” and, consequently, the reseller ofthe securities is not an “underwriter” within the meaningof section 2(a)(11) of the Securities Act. The securitieseligible for resale under Rule 144A are securities of US andforeign issuers that are not listed on a US securitiesexchange or quoted on a US automated inter-dealerquotation system.

There are four main conditions to reliance on Rule

CHAPTER 2

Overview of financing through exemptofferings


144A, including two procedural requirements (a noticeand information requirement). These requirements aresignificantly less burdensome than those associated with anSEC registered public offering.

Why should a foreign bank consider a Rule144A offering?Rule 144A permits issuers to raise large amounts of capitalwithout the cost and delay of registration under theSecurities Act and SEC review of the offering documents.In addition to these benefits, Rule 144A:• Does not require extensive ongoing registration or

disclosure in the United States;• Provides a clear safe harbour for offerings to

institutional investors; and• Provides greater liquidity for foreign issuers.

Rule 144A provides increased liquidity in several waysfor foreign issuers. A foreign issuer may avail itself ofRegulation S for offers and sales of securities outside theUnited States. Purchasers of such securities may then resellthe securities to US persons (as defined in Regulation S) inreliance on Rule 144A. A foreign issuer may also sell itssecurities to a financial intermediary that acts as an initialpurchaser and immediately resells the securities to QIBs inreliance on Rule 144A. The availability of Rule 144A thusprovides greater liquidity for otherwise restricted securities.

How are Rule 144A transactions structured?The following types of transactions are often conducted inreliance on Rule 144A:• Offerings of debt or preferred securities by public

companies;• Offerings by foreign issuers that do not want to become

subject to US reporting requirements; and• Offerings of common securities by non-reporting

issuers (in other words, “private” initial public offerings(IPOs)).Most Rule 144A offerings by FPIs that are not otherwise

US reporting companies are offerings of debt securities, inlarge measure because the issuer wants to avoid having aclass of equity securities held of record by 2,000 or morepersons or 500 or more persons who are not accreditedinvestors (as defined in Rule 501(a) under the SecuritiesAct), which could trigger the obligation to become a USreporting company. Such offerings may be conducted on astandalone basis or as a continuous offering programme.An issuer that intends to engage in multiple offerings mayhave a Rule 144A programme or a Rule 144A/RegulationS programme. Rule 144A offerings often are structured asglobal offerings, with a side-by-side offering targeted atforeign holders in reliance on Regulation S. Doing sopermits an issuer to broaden its potential pool of investors.

Understanding Rule 144ARule 144A provides a non-exclusive safe harbour from theregistration and prospectus delivery requirements of

Section 5 of the Securities Act for certain offers and salesof qualifying securities by certain persons other than theissuer of the securities. The safe harbour is based on twostatutory exemptions from registration under Section 5,Section 4(a)(1) and Section 4(a)(3) of the Securities Act. Insummary, Rule 144A provides that:• For sales made under Rule 144A by a reseller, other

than the issuer, an underwriter, or a broker-dealer, thereseller is deemed not to be engaged in a public“distribution” of those securities and, therefore, not tobe an “underwriter” of those securities within themeaning of Section 2(a)(11) and Section 4(a)(1) of theSecurities Act; and

• For sales made under Rule 144A by a reseller that is adealer, the dealer is deemed not to be a participant in a“distribution” of those securities within the meaning ofSection 4(a)(3)(C) of the Securities Act and not to be an“underwriter” of those securities within the meaning ofSection 2(a)(11) of the Securities Act, and thosesecurities are deemed not to have been “offered to thepublic” within the meaning of Section 4(a)(3)(A) of theSecurities Act.A Rule 144A offering usually is structured so that the

issuer first sells the newly-issued restricted securities to an“initial purchaser”, typically a broker-dealer, in a privateplacement exempt from registration under Section 4(a)(2)or Regulation D. Rule 144A then permits the broker-dealer to immediately resell the restricted securities toQIBs (or to purchasers that the broker-dealer and anypersons acting on its behalf reasonably to be QIBs).

In July 2013, pursuant to Section 201 of the JOBS Act,the SEC revised Rule 144A to permit general solicitationand advertising of Rule 144A offerings, provided thatactual sales are only made to persons reasonably believed tobe QIBs. This revision was designed in part to address thecriticism that prior SEC rules were overly broad in limitingcommunications to QIBs. The amendments to Rule 144Atook effect on September 23 2013.

Rule 144A requirementsThere are four conditions to reliance on Rule 144A:• The resale is made only to a QIB (or to other purchasers

that the initial purchasers and any persons acting ontheir behalf reasonably believe to be QIBs);

• The securities resold: (a) when issued were not of thesame class as securities listed on a US national securitiesexchange or quoted on a US automated inter-dealerquotation system; and (b) are not securities of an open-end investment company, unit investment trust, orface-amount certificate company that is, or is requiredto be, registered under the Investment Company Act of1940, as amended (Investment Company Act);

• The reseller (or any person acting on its behalf ) musttake reasonable steps to ensure that the buyer is awarethat the reseller may rely on Rule 144A in connectionwith the resale; and


• Where securities of an issuer are involved that is neitheran Exchange Act reporting company, or a foreign issuerexempt from reporting pursuant to Rule 12g3-2(b)under the Exchange Act, or a foreign government, theholder and a prospective buyer designated by the holdermust have the right to obtain from the issuer and mustreceive, upon request, certain reasonably currentinformation about the issuer.

QIBsRule 144A identifies certain institutions that may beconsidered QIBs. In order to be considered a QIB, thefollowing entities must own and invest on a discretionarybasis at least $100 million in securities of non-affiliates: (1)insurance companies; (2) investment companies registeredunder the Investment Company Act or businessdevelopment companies, as defined in the InvestmentCompany Act; (3) licensed small business investmentcompanies; (4) certain pension plans, benefit plans andtrust funds; (5) business development companies, asdefined in the Investment Advisers Act of 1940, asamended; and (5) registered investment advisers. Banksand thrifts may be considered QIBs if they own and investon a discretionary basis at least $100 million in securitiesof non-affiliates and have an audited net worth of at least$25 million. Registered securities dealers need only ownand invest on a discretionary basis $10 million in securitiesof non-affiliates to be considered QIBs, and they mayexecute no-risk principal transactions for QIBs withoutregard to the amount owned and invested. Any entity ofwhich all of the equity owners are QIBs is deemed to be aQIB.

A seller must reasonably believe that the purchaser is aQIB. Rule 144A provides several non-exclusive alternativesfor ascertaining QIB status, including reliance on apurchaser’s annual financial statements, filings by thepurchaser with the SEC or another US or foreigngovernmental agency or self-regulatory organisation, or acertification by an executive officer of the purchaser as tosatisfaction of the financial tests. Many financialintermediaries provide QIB questionnaires to theircustomers in order to pre-qualify them for offerings.

Eligible securitiesRule 144A is not available for transactions in: (1) securitiesthat, when issued, were of the same class as securities listedon a national securities exchange or quoted on anautomated interdealer quotation system (for example,Nasdaq); or (2) securities of an open-end investment trustor face amount certificate company (in other words, aninvestment company, such as a mutual fund). Preferredequity securities and debt securities commonly viewed asdifferent series generally will be viewed as different, non-fungible classes for purposes of Rule 144A. Convertible orexchangeable securities are treated as the underlyingsecurity unless subject to an effective conversion premium

of at least 10%. The SEC staff ’s position is that securitiesthat are convertible or exchangeable at the issuer’s optionare “fungible” if the underlying security is fungible,regardless of the “effective conversion premium”. Warrantsand options are treated as the underlying security unlessthe warrant or option has a term of at least three years andan effective exercise premium of at least 10%.

Notice requirementA seller and anyone acting on its behalf must take“reasonable steps” to ensure that the purchaser is awarethat the seller may rely on the Rule 144A exemption. Thisrequirement is typically satisfied by placing a legend on thesecurity and including appropriate statements in theoffering memorandum for the securities.

Information requirements for non-reportingissuersIn order for the Rule 144A safe harbour to be available, ifthe issuer is not: (1) a reporting company under theExchange Act; (2) a foreign company exempt fromreporting under Rule 12g3-2(b) under the Exchange Act;or (3) a foreign government, then the holder of thesecurities and any prospective purchaser designated by theholder has the right to obtain from the issuer, upon theholder’s request, the following information:• A brief description of the issuer’s business, products,

and services;• The issuer’s most recent balance sheet, profit and loss

statement, and retained earnings statement; and• Similar financial statements for the two preceding fiscal

years.This obligation to provide information pursuant to Rule

144A continues so long as the issuer is neither a reportingcompany nor a foreign issuer providing home countryinformation under the Rule 12g3-2(b) exemption. In someRule 144A offerings, especially debt offerings, the issuermay agree, in the indenture or other operative document,to provide disclosure similar to public company disclosurefor as long as the security is outstanding. A FPI exemptfrom reporting pursuant to Rule 12g3-2(b) under theExchange Act will satisfy the reasonably currentinformation requirement by continuing to publish thespecified Rule 12g3-2(b) information in English on itswebsite in accordance with the requirements of the issuer’shome country or principal trading markets.1

A foreign issuer exempt from reporting under Rule12g3-2(b) under the Exchange Act is not subject to theinformation requirements under Rule 144A. Rule 12g3-2(b) under the Exchange Act exempts from registrationunder the Exchange Act most non-US companies that arelisted in their home markets (but not on a US securitiesexchange) and that publish certain English languagefinancial and business information on their websites. Therule also allows non-US companies (even those with morethan 300 US shareholders) to benefit automatically from


an exemption from Exchange Act reporting obligation. Asa result, it is easier for security holders to resell thesecurities of exempt foreign issuers to QIBs pursuant toRule 144A.

Rule 144A does not provide how the security holder’s“right to obtain” the required information must beestablished. However, the SEC has confirmed that such aright can be created in the terms of the security, bycontract, by operation of law or by the rules of a self-regulatory organisation.2

Restricted securities and resales by investorsSecurities acquired in a Rule 144A transaction are“restricted securities” within the meaning of Rule144(a)(3) under the Securities Act. As a result, thesesecurities remain restricted until the applicable holdingperiod expires and may only be publicly resold under Rule144 under the Securities Act (Rule 144), pursuant to aneffective registration statement, or in reliance on any otheravailable exemption under the Securities Act. Often,investors will negotiate with the FPI to obtain resaleregistration rights in connection with a Rule 144Aoffering. However, a FPI that would like to avoid USreporting requirements will typically not grant registrationrights. Consequently, in order to resell the securities, aninvestor either will need to hold the securities for a one-year holding period (assuming the FPI is not a reportingcompany), or dribble the securities out in compliance withRule 144, or resell the securities pursuant to anotherexemption—including selling to another QIB. Exemptresales of restricted securities may be made in compliancewith Rule 144A itself, Regulation S, the “Section4(a)(1½)” exemption or the section 4(a)(7) exemption.

Rule 144Rule 144 has been called the dribble-out rule since itpermits investors (often affiliates) to sell limited quantitiesof securities acquired in private transactions over aprotracted period of time. The SEC adopted amendmentsto Rule 144 in 2007 that, among other things, shortenedthe holding periods for restricted securities, making iteasier for Rule 144A securities to be acquired by non-QIBsonce the restricted period has expired.

For non-affiliate holders of restricted securities, Rule144 provides a safe harbour for the resale of such securitieswithout limitation after six months in the case of issuersthat are reporting companies that comply with the currentinformation requirements of Rule 144(c), and after oneyear in the case of non-reporting issuers, such as manyFPIs.3 In each case, after a one-year holding period, resalesof these securities by non-affiliates will no longer besubject to any other conditions under Rule 144.

For affiliate holders of restricted securities, Rule 144provides a safe harbour permitting resales, subject to thesame six-month and one year holding periods for non-affiliates and to other resale conditions of Rule 144. These

other resale conditions include, to the extent applicable:(a) adequate current public information about the issuer;(b) volume limitations; (c) manner of sale requirements forequity securities; and (d) notice filings on Form 144.

The Section 4(a)(1½) exemptionThe Section 4(a)(1½) exemption is a case law-derivedexemption that allows the resale of privately placedsecurities in a subsequent private placement.4 Thisexemption typically is relied on in connection with theresale of restricted securities to accredited investors whomake appropriate representations. Generally, if anaccredited investor cannot qualify as a QIB under Rule144A, the seller will seek to use the Section 4(a)(1½)exemption for secondary sales of privately-held securities.Section 4(a)(1½) also is sometimes used to extend a Rule144A offering to institutional accredited investors.

The Section 4(a)(7)Section 4(a)(7) became effective immediately after theFixing America’s Surface Transportation Act was signedinto law on December 4 2015. Section 4(a)(7) provides aresale exemption for certain transactions involvingunregistered resales and partially resembles the Section4(a)(1½) exemption for private resales of restrictedsecurities, although it is more limited in scope. TheSection 4(a)(7) resale exemption requires, among otherthings, that (1) each purchaser is an accredited investor, (2)neither the seller nor any person acting on the seller’sbehalf engages in any form of general solicitation and (3)in the case of an issuer that is not a reporting company,exempt from the reporting requirements pursuant to Rule12g3-2(b) under the Exchange Act, or a foreigngovernment eligible to register securities on Schedule B, atthe request of the seller, the seller and a prospectivepurchaser obtain from the issuer reasonably currentinformation.

Regulation SRegulation S represents the SEC’s position that securitiesoffered and sold outside of the United States need not beregistered with the SEC and specifies two safe harbours, anissuer safe harbour (Rule 903) and a resale safe harbour(Rule 904), which provide that offers and sales made incompliance with certain requirements are deemed to haveoccurred outside the United States and are, therefore,excluded from the application of Section 5. Regulation S isattractive for foreign issuers that may have operations inthe United States or who choose to do a global offeringbecause they can rely on the Regulation S “minimumjurisdictional contacts” concept for reasonable assurancethat they will not inadvertently become subject to federalsecurities laws merely because of a Regulation S tranche.Additionally, the Regulation S resale safe harbour providesa means for non-US employees of foreign companies toresell company securities acquired through their employee


benefit plans.

What types of Regulation S offerings may aforeign issuer consider?There are several types of Regulation S offerings that US orforeign issuers may conduct:• A standalone Regulation S offering, in which the issuer

conducts an offering of debt or equity securities solelyin one or more non-US countries;

• A combined Regulation S offering outside the UnitedStates and Rule 144A offering inside the United States,which, from the US perspective, is more common andusually involves debt securities; and

• Regulation S continuous offering programmes for debtsecurities, including various types of medium term noteprogrammes; these programmes may be combined withan issuance of securities to QIBs (or to other purchasersthat the initial purchasers and any persons acting ontheir behalf reasonably believe to be QIBs) in theUnited States under Rule 144A.Accordingly, issuers may use Regulation S alone as well

as in combination with other offerings. A Regulation S-compliant offering can be combined with a registeredpublic offering in the United States or an offering exemptfrom registration in the United States, such as a Rule 144Aoffering, as well as be structured as a public or privateoffering in one or more non-US jurisdictions.

Understanding Regulation SRegulation S, which is comprised of Rules 901 to 905under the Securities Act) is available only for “offers andsales of securities outside the United States” made in goodfaith and not as a means of circumventing the registrationprovisions of the Securities Act. The below parties may relyon Regulation S:• Offering participants, including:

• US issuers—both reporting and non-reportingissuers may rely on the Rule 901 general statementor the Rule 903 issuer safe harbour;

• Foreign issuers—both reporting and non-reportingforeign issuers may rely on the Rule 901 generalstatement or the Rule 903 issuer safe harbour;

• Distributors (underwriters and broker-dealers)—both US and foreign financial intermediaries mayrely on the Rule 901 general statement or the Rule903 issuer safe harbour;

• Affiliates of the issuer—both US and foreign;• Any persons acting on the behalf of the

aforementioned persons;• Non-US resident purchasers (including dealers) who

are not offering participants may rely on the Rule 901general statement or the Rule 904 resale safe harbour totransfer securities purchased in a Regulation S offering;and

• US residents (including dealers) who are not offeringparticipants may rely on the Rule 901 general statement

or the Rule 904 resale safe harbours in connection withpurchases of securities on the trading floor of anestablished foreign securities exchange that is locatedoutside the United States or through the facilities of adesignated offshore securities market.

Regulation S requirementsThe availability of the issuer and the resale safe harbours iscontingent on two general conditions:• The offer or sale must be made in an offshore

transaction; and• No “directed selling efforts” may be made by the issuer,

a distributor, any of their respective affiliates, or anyperson acting on their behalf.Regulation S provides that any offer, sale, and resale is

part of an “offshore transaction” if:5• No offer is made to a person in the United States; and• Either: (1) at the time the buy order is originated, the

buyer is (or is reasonably believed to be by the seller)physically outside the United States; or (2) thetransaction is for purposes of Rule 903, executed on aphysical trading floor of an established foreign securitiesexchange, or for purposes of Rule 904, executed on a“designated offshore securities market” and the seller isnot aware that the transaction has been pre-arrangedwith a US purchaser.A buyer is generally deemed to be outside the United

States if the buyer (as opposed to the buyer’s agent) isphysically located outside the United States. However, ifthe buyer is a corporation or investment company, thebuyer is deemed to be outside the United States when anauthorised agent places the buy order while physicallysituated outside the United States. In addition, offers andsales of securities made to persons excluded from thedefinition of “US person”, even if physically present in theUnited States, are deemed to be made in offshoretransactions.

Directed selling efforts“Directed selling efforts” is defined by Regulation S as “anyactivity undertaken for the purpose of, or that could bereasonably expected to result in, conditioning the USmarket for the relevant securities”.6 This applies during theoffering period as well as during the distributioncompliance period. Violation of the prohibition againstdirected selling efforts precludes reliance on the safeharbour.

Additional restrictionsOfferings made in reliance on Rule 903 are subject toadditional restrictions that are calibrated to the level of riskthat securities in a particular type of transaction will flowback into the United States. Rule 903 distinguishes threecategories of transactions based on: (1) the type ofsecurities being offered and sold; (2) whether the issuer isdomestic or foreign; (3) whether the issuer is a reporting


issuer under the Exchange Act; and (4) whether there is a“substantial US market interest”.• “Category 1” transactions are those in which the

securities are least likely to flow back into the UnitedStates. Therefore, the only restrictions on suchtransactions are that they must be “offshoretransactions” and that there be no “directed sellingefforts” in the United States.

• “Category 2” and “Category 3” transactions are subjectto an increasing number of offering and transactionalrestrictions for the duration of the applicable“distribution compliance period.”“Distribution compliance period” is defined in

Regulation S7 generally as the period following the offeringwhen any offer or sales of Category 2 or 3 securities mustbe made in compliance with the requirements ofRegulation S in order to prevent the flow back of theoffered securities into the United States. The period rangesfrom 40 days to six months for reporting issuers or oneyear for equity securities of non-reporting issuers.

Resale limitations and transfer restrictionsIn terms of liquidity, a FPI should carefully consider thetransfer restrictions that are imposed on securities soldpursuant to Regulation S. Securities cannot be offered orsold to a US person during the distribution complianceperiod unless the transaction is registered under theSecurities Act or exempt from registration. The relevantdistribution compliance periods in connection withsecurities sold in a Category 1, Category 2 and Category 3offerings, respectively, are set forth above. The distributioncompliance period begins on the later of: (1) the date whenthe securities were first offered to persons other thandistributors; or (2) the date of the closing of the offering,and continues until the end of the time period specified inthe relevant provision of Rule 903.8

Rule 144A/Regulation SA FPI that would like to offer its securities to USinstitutional investors may not be able to accomplish thisobjective if it were to structure a financing transactionsolely as a Regulation S offering. Rule 144A offerings areoften structured as global offerings, with a side-by-sideoffering targeted at foreign holders in reliance onRegulation S. This dual structure permits an issuer tobroaden its potential pool of investors. The issuer may sellto an initial purchaser outside the United States in relianceon Regulation S, even if the initial purchaser contemplatesimmediate resales to QIBs in the United States.

Compliance with both Rule 144A andRegulation SIn a global offering, the Rule 144A portion must complywith the Rule 144A requirements. Similarly, the offering ofthe Regulation S portion must comply with Regulation Sdiscussed above. It should be emphasised that the

Regulation S portion of any offering refers only to theportion of the offering that requires the offeringparticipants to comply with Regulation S in order tobenefit from the safe harbour. The offering itself must alsocomply with the requirements of applicable non-USjurisdictions and the requirements of any foreign securitiesexchange or other listing authority.

As we have seen, an issuer may rely on both Rule 144Aand Regulation S. For example, an issuer may sell itssecurities in a private placement to an initial purchaser thatwill rely on Rule 144A for resales and contemporaneouslyoffer its securities offshore in reliance on Regulation S.Although Regulation S imposes a distribution complianceperiod during which time purchasers cannot resell theirsecurities to US persons, Rule 144A provides a non-exclusive safe harbour for resales of Regulation S securities.US broker-dealers may purchase unregistered securitiesoffered outside the United States under Regulation S andresell them in the United States to QIBs pursuant to Rule144A during the distribution compliance period.9 Inaddition, a QIB that acquired securities in a Rule 144Atransaction can rely on Regulation S to resell the securitiesto any purchaser in an offshore transaction, provided suchresales do not involve any US-directed selling efforts.

In its adopting release for the revised Rule 144A, theSEC confirmed its view that concurrent offshore offeringsthat are conducted in compliance with Regulation S willnot be integrated with domestic unregistered offerings thatare conducted in compliance with Rule 506 of RegulationD or Rule 144A10 (i.e., general solicitation in a Rule 144Aoffering will not automatically constitute “directed sellingefforts” in respect of a related Regulation S offering).Therefore, engaging in a solicitation in the United Statesin connection with a Rule 144A offering will not result ina loss of the Regulation S exemption. However, the generalsolicitation must still be analyzed to ensure that it does notconstitute directed selling efforts under Regulation S.11

Exempt securitiesThe prior discussions focus on transactions that are exemptfrom the registration requirements of Section 5 of theSecurities Act. The Securities Act also provides exemptionsfrom the registration requirements for certain types ofinstruments. These exemptions are contained in Section 3of the Securities Act. There are exemptions under Section3 for securities issued by certain types of entities. Forexample, there are exemptions available for securitiesissued by, among others: certain governmental entities,including municipalities; by certain not for profitorganisations under Rule 501(c)(3) under the InternalRevenue Code of 1986, as amended; and for banks. Inaddition, there are exemptions available for certain types ofinstruments.


Section 3(a)(2)Section 3(a)(2) exempts from registration under theSecurities Act any security issued or guaranteed by a bank.This exemption is based on the notion that, whetherchartered under state or federal law, banks are highly andrelatively uniformly regulated, and as a result will provideadequate disclosure to investors about their business andoperations in the absence of federal securities registrationrequirements. In addition, banks are also subject to variouscapital requirements that may help increase the likelihoodthat holders of their debt securities will receive timelyprincipal and interest payments. Commercial paperbacked by letters of credit of domestic banks are exemptunder Section 3(a)(2). The SEC view is that letters ofcredit, in effect, are guarantees, and the commercial paperthey support are therefore exempt as securities guaranteedby a bank.12

Section 3(a)(3)Most commercial paper is issued in reliance on Section3(a)(3). Section 3(a)(3) exempts from the registration andprospectus delivery requirements “any note, draft, bill ofexchange, or banker’s acceptance which arises out of acurrent transaction or the proceeds of which have been orare to be used for current transactions, and which has amaturity at the time of issuance of not exceeding ninemonths, exclusive of days of grace, or any renewal thereofthe maturity of which is likewise limited.”13 Thisexemption, like that for bank securities, is not transactionbased.

The SEC has construed Section 3(a)(3) to apply only to“prime quality negotiable commercial paper of a type notordinarily purchased by the general public, that is, paperissued to facilitate well-recognized types of currentoperational business requirements and of a type eligible fordiscounting by US Federal Reserve banks”.14 In ReleaseNo. 33-4412, the SEC stated that negotiable notes thathad been issued, or the proceeds of which will be used in

“producing, purchasing, carrying or marketinggoods or in meeting current operating expenses of acommercial, agricultural or industrial business, andwhich is not to be used for permanent for fixedinvestment, such as land, buildings, or machinery, norfor speculative transactions or transactions insecurities (except direct obligations of the UnitedStates government)”

are eligible for discounting under the regulations of theBoard of Governors of the US Federal Reserve System.15Although the SEC no longer requires that commercialpaper be eligible for discounting, the rest of this statementhas been construed to mean that the commercial papermust be used for “current transactions”.

The current transaction requirement is not satisfiedwhere the proceeds of the commercial paper are used to:(1) discharge existing debt (unless the existing debt is alsoexempt under Section 3(a)(3)); (2) purchase or construct a

plant; (3) purchase durable machinery or equipment; (4)fund commercial real estate development or financing; (5)purchase real estate mortgages or other securities; (6)finance mobile homes or home improvements; or (7)purchase or establish a business enterprise.16

The SEC has established through several no-actionletters17 that an issuer is not required to trace the proceedsof issued commercial paper into identifiable currenttransactions. Instead, as long as the amount of outstandingcommercial paper at any time is not greater than theamount of current transactions eligible to be financed (thecommercial paper capacity), the current transactionrequirement will be deemed satisfied. The SEC’s Divisionof Corporation Finance has stated that an issuer should usea balance sheet test for determining commercial papercapacity.18 This test involves determining the capital anissuer has committed to current assets and the expenses ofoperating its business over the preceding 12-monthperiod.19

1. Rule 144A(d)(4)(ii)(C) under the Securities Act. Seealso Rule 12g3-2(b) under the Exchange Act.

2. Securities Act Release No. 33-6862, 46 S.E.C. Docket26 (April 23 1990).

3. For a non-reporting issuer, compliance with theadequate current public information conditionrequires the public availability of basic informationabout the issuer, including certain financialstatements.

4. The seminal case involving the so-called Section4(a)(1½) exemption was the Second Circuit Court ofAppeals decision in Gilligan, Will & Co. v. SEC, 267F.2d 461 (2d Cir. 1959).

5. Rule 902(h).

6. Rule 902(c).

7. Rule 902(f ).

8. Id.

9. See Rules 144(a)(3)(iii) and 144A(b)–(c) under theSecurities Act; Preliminary Note 2 to Rule 144A;Preliminary Note 5 to Regulation S; Securities ActRelease No. 33-7505, 66 S.E.C. Docket 1069(February 17 1998); Securities Act Release No. 33-6863, 46 S.E.C. Docket 52 (April 24 1990).

10. Securities Act Release No. 33-9415 at 57 (July 102013).

11. SEC Compliance and Disclosure Interpretation(C&DI) Rule 144A 138.04 (November 13 2013).

12. See Chapter 6 (Section 3(a)(2) and considerations forforeign banks financing in the United States).

13. Section 3(a)(3) of the Securities Act, 15 USC. §77c(a)(3) (2009).

14. Securities Act Release No. 33-4412 (September 201961).

15. Id.

16. Id.

17. Westinghouse Credit Corporation, SEC No-ActionLetter, 1986 WL 66748 (May 5 1986); LyondellPetrochemical Co., SEC No-Action Letter, 1989 WL246100 (July 19 1989).

18. Id.; C&DI Securities Act Sections 219.02 (November26 2008).

19. See Chapter 8 (Considerations relating to commercialpaper).

ENDNOTES



OverviewA larger, more established issuer with regular fundingneeds may want to maximise its capital raisingopportunities by establishing a continuous issuanceprogramme. A continuous issuance programme enables anissuer to offer securities at any time, from time to time,over the term of the programme, with a modicum ofdocumentation required for each issuance. Many foreignissuers may already be familiar with, or have established,global medium-term note programmes, Euro medium-term note programmes or commercial paper programmes.These programmes permit the issuer to offer debtsecurities (in the case of an MTN programme) or short-term debt (in the case of a commercial paper programme)regularly in response to inquiries from investors (reverseinquiry transactions) or in transactions initiated by theissuer to or through a financial intermediary that acts onan agency or principal basis. An issuer may also establish acontinuous offering programme pursuant to which it sellsother types of securities, including covered bonds. Aforeign issuer may want to consider setting up acontinuous issuance programme that permits the issuer tooffer securities to US investors.

Medium-term note programmesAn MTN programme enables an issuer to offer a variety ofdebt securities on a regular or continuous basis, in astreamlined manner. Traditionally, issuers have used theirMTN programmes to fill the financing gap between short-term commercial paper, which has a maturity of ninemonths or less, and long-term debt, which has a maturityof one year or more. Although MTNs typically havematurities of between two and five years, they are notrequired to have any particular tenor. An issuer may specifythe overall amount of debt it will offer from its MTNprogramme. It is important that the issuer work with itsarranger to determine an appropriate size for theprogramme.An MTN programme relies on a master set of disclosuredocuments, agreements with dealers, and issuing andpaying agency agreements to help minimise the newdocumentation (and associated costs) required for eachoffering of notes. This approach enables an issuer tocomplete each issuance quickly and efficiently. If an MTNprogramme is conducted as a private placement, the issuergenerally relies on the exemptions from registrationafforded by Section 4(a)(2) of the Securities Act,

Regulation D, Rule 144A, Regulation S or a combinationthereof. An issuer may have more than one MTNprogramme, and may use each programme to target aspecific market. For example, an issuer may have a Rule144A MTN programme to access the debt markets in theUnited States on a private basis as well as a bank noteprogramme (at the bank level), that is exempt fromregistration under Section 3(a)(2).

MTN programme structuresRule 144A programmesAs discussed in Chapter 1, Rule 144A is a resale safe harborexemption from the registration requirements of Section 5of the Securities Act for certain offers and sales ofqualifying securities by certain persons other than theissuer. The exemption applies to resales of securities toQIBs. Rule 144A permits persons other than the issuer toresell, in a transaction not involving a public offering,restricted securities. Typically, a financial intermediary,such as an investment bank, facilitates the resale ofsecurities in a Rule 144A offering. The sale of the securitiesto the initial purchaser is conducted pursuant to theexemption from registration under Section 4(a)(2).

Bank note programmesA bank issuer may choose to structure its MTNprogramme as a bank note programme. These programmesare similar to other types of MTN programmes, exceptthat the securities of banks are exempt from registrationpursuant to Section 3(a)(2). Instead of relying on atransactional exemption from registration, theseprogrammes rely on a securities-based exemption.However, unlike other issuers, banks are subject toregulation (that is, by the Office of the Comptroller of theCurrency, if a national bank; or by individual stateregulators, if a state bank). These regulators may subjectbank issuers to offering restrictions and limitations thatmay not apply to other issuers.1

Posting and settlementIssuances of notes under an MTN programme settledifferently than underwritten offerings of notes issued ona stand-alone basis. Through programme dealers, an issuerof MTNs typically posts offering rates over a range ofpossible maturities: for example, nine months to one year;one year to 18 months; 18 months to two years; andannually thereafter. An issuer may post rates as a yield

CHAPTER 3

Overview of continuous issuance programmes


spread over US Treasury securities having the same or asimilar maturity. The dealers provide this rate informationto investors or to other dealers. When an investor expressesinterest in an MTN offering, the dealer contacts the issuerto obtain a confirmation of the terms of the transaction.Within a range, the investor may have the option ofselecting the actual maturity of the notes, subject to finalagreement with the issuer. DTC, Euroclear andClearstream have established procedures for the deposit ofglobal securities and the transfers of interests within eachof the securities and between the securities held by each ofthem, subject to compliance with applicable legalrequirements.

Arranger and dealersAn issuer looking to establish an MTN programme willengage an investment bank to assist with that process. Anissuer also might engage additional investment banks toserve as dealers (or selling agents) under the programme.An arranger for an MTN programme performs many ofthe same functions as a lead underwriter in a traditional,public underwritten offering. The arranger assists theissuer in establishing the programme, advising on the formand content of the offering documents, including the sizeof the programme and the types of securities that may beoffered under the programme. The arranger also assists indrafting the offering documents and related programmeagreements. As part of the drafting process, the arrangernegotiates the terms of the programme documents,including the distribution or programme agreement, on itsown behalf and on behalf of the other dealers named in theprogramme.In addition, the arranger also serves an advisory role withrespect to the MTN programme. It advises the issuer ofpotential financing opportunities and communicates tothe issuer any offers from potential investors. For eachissuance, the arranger will coordinate the offering, servingas principal dealer for the programme. The arranger alsocoordinates settlement of the MTN issuances with theissuer and the paying agent. Lastly, the arranger typicallymakes a market in the securities issued under theprogramme (ensuring greater liquidity for investors).However, an arranger has no obligation to purchase anysecurities issued under the programme. An arranger mayparticipate in a particular takedown, but has no obligationto do so.

Programme dealersAt the time a programme is established, the issuer willselect both an arranger and a number of other investmentbanks to serve as dealers. Dealers engaged at the start of theprogramme typically are named in the offering materials asdealers. The dealers for an MTN programme act as sellingagents for the programme, and are responsible for placingthe securities sold under the programme. The dealers, likethe arranger, often make a market in the issuer’s securities.

It is prudent for an issuer to engage multiple dealers,because an increase in dealer price quotations may lead tomore reverse enquiry transactions.Because an issuer’s needs may change, and because thevalue of an MTN programme lies in its flexibility, theagreement may also contain the procedures for adding newdealers, either for a particular tranche or for the MTNprogramme. These procedures typically include arequirement that the new dealer delivers an accession letterin which it becomes a party to the programme agreement,and agrees to perform and comply with all of the dutiesand obligations of a dealer under the programmeagreement. The issuer then sends a letter to the dealer (orcountersigns the dealer’s letter) confirming itsappointment to the programme.The issuer may appoint one or more new dealers for aparticular tranche. The procedures to become a dealer fora particular note issue include a requirement that the newdealer delivers an accession letter in which it becomes aparty to the programme agreement, agrees to perform andcomply with all of the duties and obligations of a dealer,with respect to that issue of notes, under the programmeagreement. The issuer then sends a letter to the dealer (orcountersigns the dealer’s letter) confirming itsappointment, solely with respect to that issue of notes, asa dealer under the programme agreement.

Due diligence concernsBecause takedowns from an MTN programme may befrequent, and often occur on short notice, the dealers arenot likely to be able to initiate and complete a full duediligence review at the time of each offering. In order toaccommodate these timing considerations, the issuer andthe dealers should establish an ongoing due diligencereview process. The dealers (coordinated by the arranger)and their counsel will periodically, at least once a quarter(if not more often) update their prior due diligence. Thiswill ensure that their review is up-to-date at the time ofeach takedown. To facilitate this process, the issuer willdesignate, under the MTN programme, a law firm(designated dealers’ counsel) to represent the dealers andconduct ongoing legal due diligence on their behalf. If thedealers relied on different counsel for each issuance, itwould be difficult to complete takedowns quickly.

DocumentationAn MTN programme makes use of a standard, or master,set of documents that are agreed when the programme isestablished. The programme then relies on a streamlinedset of documents for each particular issuance. For eachtype of MTN programme, these documents have anumber of common features.


DisclosureMarket practice is to include substantial disclosure aboutthe issuer (or its parent), although generally less than thatrequired for a registered offering (for instance, for afinancial institution, unregistered programmes may notinclude the SEC’s Industry Guide 3 disclosure). Issuersand arrangers rely on the SEC disclosure rules inRegulations S-K and S-X as a guide. In addition, thenature of the issuer’s business and its credit ratings mayinfluence the level of disclosure.

Offering memorandumThe primary disclosure document is referred to as an“offering memorandum” or an “offering circular”. Theoffering memorandum contains: (1) information aboutthe issuer and its business (or incorporates this informationby reference); and (2) information about the securities thatwill be offered under the programme and the manner inwhich the securities will be distributed. If the offering isconducted under Rule 144A, the offering memorandummust include a legend regarding re-sale and transferrestrictions applicable to Rule 144A offerings. In addition,the offering memorandum often states that the issuer isavailable to respond to questions and provide additionaldocuments (to the extent it can do so withoutunreasonable effort or expense).The offering memorandum will provide investors with abrief discussion of the issuer and its business. If the issueris a foreign issuer, the financial statements it prepares in itshome country may be incorporated by reference. If theoffering memorandum will be used for offerings to USinvestors, the financial statements should be compliantwith US Gaap or Ifrs. If the offering memorandumcontains non-US Gaap financial statements, considerationshould be given to including a reconciliation footnoteexplaining the differences between the non-US Gaapnumbers and US Gaap equivalents. Risk factors includedin the offering memorandum may be limited in scope andfocus on risks relating to the notes, including particularrisks surrounding the various structured notes included inthe programme, risks associated with the transferrestrictions on the notes (as discussed above), risks relatedto the anticipated uses of proceeds, and any new businessrisks. If the issuer does not file Exchange Act reportscontaining its business and industry risks, the risk factorsmay be more fulsome.The offering memorandum will describe the generalterms of the notes applicable to all series of notes, or tocertain types of notes in a section usually referred to as the‘description of the notes’. This section will describe thevarious types of notes to be offered under the programme— fixed rate notes, floating rate notes, equity-or credit-linked notes, or other types of structured notes. Thissection also contains all of the provisions that may beapplicable to the notes offered under the programme,including their status, where the notes may be presented

for payment and whether they may be redeemed, amongothers. An issuer may issue any type of note under itsMTN programme, provided that the terms are genericallydescribed in this section (although it may be possible toissue another type of note, if the issuer, dealers and counselare comfortable with the disclosure, which would besignificantly updated in the pricing supplement).The offering memorandum will contain a plan ofdistribution section describing the manner in which thenotes will be sold and by whom. This section describes therelationship between the issuer and the dealers, andinforms investors that notes may be sold on a principal oragency basis, among other things. In addition, this sectionmay contain legends containing selling restrictions in thevarious jurisdictions in which the notes will be sold. It isessential that the issuer and arranger discuss in advance therelevant jurisdictions in which the issuer would like toissue notes, and the types of debt securities the issuerwould like to issue in each jurisdiction.The offering memorandum may also include adiscussion of the tax consequences of investing in thenotes, at least on a generic level. The tax discussion mayneed to be supplemented in connection with specificissuances of notes.

Pricing supplement/final termsPricing supplements are intended to supplement thedisclosure about the issuer and the notes contained in theoffering memorandum. The pricing supplement typicallyis used to disclose the specific terms of the series ofsecurities and the manner in which they will be offered. Inaddition, from time to time, additional or updatedinformation about the issuer may be included in thisdocument. An issuer may use a pricing supplement or thefinal terms to provide investors with the specific terms ofthe notes being issued.

Programme agreementA programme agreement (also referred to as a distributionagreement or a sales agency agreement) is a contractbetween the issuer and the dealers. A programmeagreement serves the same purpose as an underwritingagreement for an underwritten public offering, but isdesigned to apply to multiple offerings, as opposed to asingle offering, during the life of the programme. Eachoffering under the programme is governed by theprogramme agreement, eliminating the need to draft,negotiate and execute a new agreement at the time of eachtakedown.An administrative procedures memorandum is typicallyattached as an exhibit to the programme agreement and/orthe fiscal and paying agency agreement. Thismemorandum details the procedures for offering notesunder the programme, including the exchange ofinformation, settlement procedures, and responsibility forpreparing documents (among the issuer, the dealers, the


paying agent, and the applicable clearing system) for eachissuance under the programme. Although counsel draftsthis document, it is critical that it be reviewed by the issuer,the dealers, and the fiscal and paying agent’s back officepersonnel to ensure that it accurately reflects thesettlement procedures for the programme.

Fiscal and paying agency agreementsA fiscal and paying agency agreement governs therelationship between the issuer and the fiscal and payingagent. The agreement sets forth their arrangements forissuing notes, making payment of principal and interest,and other related matters. The fiscal and paying agent isresponsible for the following:• Authenticating notes at the time of issuance and, insome cases, serving as ‘custodian’ or ‘safekeeper’ for theexecuted notes;

• Processing payments of interest, principal, and otheramounts on the securities from the issuer to theinvestors;

• Communicating notices from the issuer to theinvestors;

• Coordinating settlement of the MTNs with the issuerand the dealers; and

• Processing certain tax forms that may be required underthe programme.Unlike an indenture trustee in a US registered offering,the fiscal and paying agent solely performs ministerialfunctions and has no fiduciary duty to note holders anddoes not act on their behalf. For example, if an event ofdefault occurs under the terms of the notes, each noteholder is individually responsible for accelerating paymenton its own note, whereas an indenture trustee wouldaccelerate payment on all defaulted notes on behalf of thenote holders. As in the case of a programme agreement,this agreement applies to all issuances of securities underthe programme, so that a new agreement is not needed atthe time of each takedown.

Calculation agentThe fiscal and paying agent is also often engaged to act asthe calculation agent for an MTN programme. Thisengagement may be pursuant to a separate calculationagency agreement, or pursuant to the fiscal and payingagency agreement. The calculation agent calculates theinterest payments due in respect of floating rate notes, asto each relevant interest period. The calculation agent alsomay calculate the returns payable on a structured note.However, in the case of structured notes, given the type ofinformation needed to calculate the payments(information regarding equity securities or indices, forexample), a broker-dealer (usually, the arranger or a dealer)is more likely to serve as calculation agent.

Exchange rate agentOften, another function of the fiscal and paying agent is toserve as an exchange rate agent for the programme. In thiscapacity, the fiscal and paying agent will convert thepayments made by the issuer on foreign currency-denominated MTNs into US dollars amounts for thebenefit of US investors.

Closing deliverablesIn connection with the programme signing, the issuer isobligated to deliver to the arranger and the other dealerscertain documents. Many of these deliverables are alsorequired in connection with a large, syndicatedprogramme takedown. The issuer will deliver to the dealersan officers’ certificate as to the accuracy of the informationcontained in the offering documents, an opinion ofcounsel and a comfort letter.

Commercial paperCommercial paper generally consists of short-termunsecured promissory notes issued by US financial andnon-financial companies. Many companies issuecommercial paper to raise capital in order to fund theirday-to-day operations, because it can be a lower-costalternative to bank loans or other debt securities.Commercial paper maturities can range up to 270 days,but average approximately 30 days. Issuers also establishcommercial paper programmes, usually naming one ormore dealers, to sell commercial paper on a continuousbasis. We discuss the exemptions applicable to commercialpaper in Chapter 8 (Considerations related to commercialpaper) and also discuss the documentation requirementsassociated with the establishment of a commercial paperprogramme.

Integration issuesContinuous private placements and Regulation DofferingsIn a 1962 release, the SEC stated that, when determiningwhether an offering is public or private, it will considerwhether the offering was part of a larger offering. The SECset forth a number of factors that it would consider inmaking this determination—these are the same factors setforth in Rule 502(a) under Regulation D. However, it isunlikely that a private placement made pursuant toRegulation D will be integrated with an issuance off of anunregistered MTN programme, because most RegulationD offerings are of common stock and MTN programmesare for non-convertible debt (or non-convertible preferredstock).

Continuous private placements and the Section3(a)(3) commercial paper programmeAnother integration issue that arises in connection withcontinuous private placements is whether the SEC wouldview as integrated an issuance off of an unregistered MTN


programme or Section 4(a)(2) commercial paperprogramme with a concurrent Section 3(a)(3) commercialpaper programme.The SEC has addressed the simultaneous privateplacement of notes and Section 3(a)(3) commercial paperofferings in a series of no-action letters. It permits theofferings, even where the maturities of the securitiesoverlap and the same dealers are used. In these cases,however, the issuers represented to the SEC that theproceeds of the two offerings would be used appropriately(for current transactions only, in the case of thecommercial paper proceeds, and for non-currenttransactions, in the case of the privately placed notes).Integration issues can also arise if an issuer decides toconvert a commercial paper programme from a Section3(a)(3) programme to a Section 4(a)(2) programme orconduct a concurrent registered continuous MTNprogramme and a Section 3(a)(3) commercial paperprogramme.In a commercial paper programme, dealer agreementsusually address integration by requiring that the issuerrepresent that the proceeds of the commercial paperprogramme under Section 3(a)(3) will be segregated andthat it will implement appropriate corporate controls toprevent integration. The overlapping maturities aloneshould not result in integration, provided the programmescan be distinguished by their use of the proceeds, or theissuer can establish a reasonable distinction regarding theMTNs issued under the continuous programme and theSection 3(a)(3) commercial paper programme.

1. For more information on bank note programmes, seeChapter 6 (Section 3(a)(2) and considerations forforeign banks financing in the United States).

ENDNOTE



Section 4(a)(2) provides that the registrationrequirements of Section 5 do not apply to“transactions by an issuer not involving any publicoffering”. This is often referred to as the private

placement exemption for issuers. The breadth of thisexemption makes it useful for issuers attempting toconduct a variety of financing transactions. The rationalefor this exemption from registration is that the extensiveregulation applicable to public offerings is not requiredwhen offerings are made to a limited number of offereeswho can protect themselves. These exemptions areavailable to US and non-US public and private companies.In 1982, the SEC adopted Regulation D to provide issuerswith safe harbours for conducting Section 4(a)(2) privateplacements.A Section 4(a)(2) private placement provides an

attractive capital-raising alternative for a foreign issuerconsidering offering securities in the United States. Aprivate placement permits a foreign issuer to raisesignificant capital without the cost and delays ofregistration under the Securities Act and SEC review ofoffering documents. In addition, Section 4(a)(2) privateplacements also have the advantage of providing greaterliquidity for foreign issuers and not requiring or triggeringextensive ongoing registration or disclosure for foreignissuers. Section 4(a)(2) private placements for foreignissuers almost always involve the sale of debt securitiesgiven that many foreign issuers seek to avoid having a baseof equity holders in the United States.

Section 4(a)(2) private placementsThere are a number of ways FPIs can raise capital in theUnited States, including private placements underSection 4(a)(2) and Rule 144A offerings. Foreigncompanies that have a class of their securities registeredin the United States may also raise capital through publicofferings. Under Section 4(a)(2), the registration andrelated prospectus delivery requirements under Section 5of the Securities Act are not applicable; however, statuteitself provides little guidance as to the types oftransactions that fall within the scope of Section 4(a)(2).Judicial and regulatory interpretations have produced afact-specific analysis of the types of transactions thatcould be deemed a private offering, based on thefollowing factors.1 The factors are flexible, and no singlefactor is determinative.

• The number of offerees and their relationship to each otherand to the issuer: This factor is significant. There is nomaximum permitted number of offerees; however, thelarger the number of offerees, the greater the difficultysustaining the evidentiary burden. Offering to a largeand diverse group with no preexisting relationship tothe issuer suggests a public offering.

• The number of securities offered: The smaller the number,the less likely the offering will be deemed a publicoffering.

• The size of the offering: The smaller the size of theoffering, the less likely the offering will be deemed apublic offering.

• The manner of offering: There are two generalconditions: (1) the offering should be made throughdirect communication with eligible offerees by eitherthe issuer or the issuer’s agent; and (2) the offeringcannot include any general advertising or generalsolicitation.2

• The sophistication and experience of the offerees: Generalbusiness knowledge and experience usually aresufficient. Important factors to consider are education,occupation, business and investment experience and networth. An investor having a sophisticated representativeprobably (but not always) satisfies this test. Alternativesto sophistication are the financial ability to bear risks (inother words, the investor’s wealth) and the existence ofa special relationship to the issuer (for example, insideror privileged status, or personal relationship).

• The nature and kind of information provided to offerees orto which offerees have ready access: The disclosure neednot be as extensive as that in a registered offering, butmust be factually equivalent. Disclosing basicinformation regarding the issuer’s financial condition,business, results of operations, and management issatisfactory. All information must be made availableprior to sale.

• Actions taken by the issuer to prevent the resale of securities:Securities must come to rest in the hands of immediateinvestors. Premature re-sales of securities may bedeemed a public distribution and considered part of theoriginal offering. Failure to satisfy the conditions ofSection 4(a)(2) with respect to the entire transactionwill result in failure to qualify for the Section 4(a)(2)exemption. Investors who do not purchase with therequisite investment intent and who resell the securities

CHAPTER 4

Mechanics of a Section 4(a)(2) offering


may be deemed statutory underwriters and may beunable to rely on the Section 4(a)(1) resale exemption.Issuers generally take certain precautions to prevent theresale of their securities, including obtaining a writtenrepresentation from each investor that it is acquiring thesecurities for investment and not with a view todistribution, placing restrictive legends on thesecurities, and issuing stop transfer orders with respectto the securities. The nature of the securities (in otherwords, debt or equity) is irrelevant to the availability ofthe Section 4(a)(2) exemption.These factors, while helpful, do not provide certainty for

an issuer that seeks to conduct a private placement. Inresponse, the SEC adopted Regulation D in 1982 toprovide issuers with safe harbours for conducting Section4(a)(2) private placements.The Section 4(a)(2) exemption is available only to the

issuer of the securities. This exemption is not available forthe resale of securities purchased by investors in a privateplacement. The issuer claiming the Section 4(a)(2)exemption has the burden of establishing that theexemption is available for the particular transaction. Ifsecurities are sold without a valid exemption fromregistration, Section 12(a)(1) of the Securities Act gives thepurchaser the right to rescind the transaction for a periodof one year after the sale. The rescissionary right may beexercised against anyone who was involved in the sale ofthe security, including issuer and any broker-dealer thatmay have acted as a financial intermediary or placementagent in connection with the offering. Further,transactions that are not deemed exempt under Section4(a)(2) will be treated as an unregistered public offering,and the issuer may be subject to liability under US federalsecurities laws.

Regulation DRegulation D is a non-exclusive safe harbour, which meansan issuer that fails to satisfy the objective criteria ofRegulation D still may rely on Section 4(a)(2). RegulationD is available only to issuers, and applies only to aparticular transaction. Therefore, resales of securities mustbe registered or made pursuant to another exemption.Regulation D does not exempt the issuer from any other

applicable US federal or state laws relating to the offer andsale of securities. Regardless of whether an issuer relies onSection 4(a)(2) or Regulation D, an issuer must be able todocument its compliance with the relevant exemption inthe following ways: through record keeping with respect toinvestors; by controlling the distribution of the offeringmemoranda; and by receiving and retaining appropriatesubscription documents evidencing the nature andqualification of investors. Regulation D is comprised ofeight rules—Rules 501 through 508:• Rule 501 sets forth definitions for terms used

throughout Regulation D.• Rule 502 sets forth the general conditions relating to

integration of offerings, information requirements,limitations on manner of offering, and limitations onresale.

• Rule 503 requires notices for sales.• Rule 504 provides an exemption pursuant to Section

3(b) of the Securities Act for offerings up to $1 million.• Rule 505 provides an exemption pursuant to Section

3(b) of the Securities Act for offerings up to $5 million.• Rule 506, which is the rule most often relied on for

Regulation D private placements, provides anexemption for limited offerings and sales without regardto dollar amount, and with or without generalsolicitation.3 Although the number of purchasers underRule 506 is limited to 35, issuers may sell securitiesunder Rule 506 to an unlimited number of “accreditedinvestors” (AIs) which are typically institutionalinvestors or high net-worth individuals.4 Rule 506(d)prohibits the use of the exemption by certain bad actorsand felons.

• Rule 507 states that no exemption under Rules 504,505 or 506 will be available for an issuer if such issueror any of its predecessors or affiliates has been subject toany order, judgment or decree of any court ofcompetent jurisdiction temporarily, preliminarily orpermanently enjoining such entity for failure to complywith Rule 503.

• Rule 508 states that a failure to comply with a term,condition or requirement of Rules 504, 505 or 506 willnot result in the loss of the exemption from registrationif the person relying on the exemption shows that: (1)the failure to comply did not pertain to a term,condition or requirement directly intended to protectthat particular individual or entity; (2) the failure tocomply was insignificant with respect to the offering asa whole; and (3) a good faith and reasonable attemptwas made to comply with all the applicable terms,conditions and requirements of Rules 504, 505 or 506.A failure by an issuer to perform a factual inquiry andprovide any disclosure regarding “bad actor” eventsrequired by Rule 506 would not be considered an“insignificant” deviation, and relief would not beavailable under Rule 508 if this disclosure is requiredand not adequately provided.5The SEC used authority granted by Section 3(b) of the

Securities Act to establish Rules 504 and 505 of RegulationD. Under Section 3(b), transactions can be exempted fromregistration based on the limited size or limited characterof the offering. Therefore, Rules 504 and 505 exemptcertain offerings with a total size of up to $5 million. Theseexemptions were created to help small businesses raisecapital. In contrast, the SEC established Rule 506 as anon-exclusive safe harbour under Section 4(a)(2). Rule506 provides the clearest guidance on the availability ofSection 4(a)(2). Typically, issuers try to follow Rule 506closely to conduct Section 4(a)(2) private placements. Likesecurities sold under Section 4(a)(2), securities sold under


Regulation D (except for certain securities sold under Rule504 of Regulation D) are considered restricted securitiesfor purposes of Rule 144 and cannot be freely resold to thepublic without registration or exemption from registration.

QuestionnairesThe issuer typically uses investor questionnaires to helpcollect and verify information about potential investors’suitability to participate in the offering. A potentialinvestor can qualify to participate in the offering if it is asufficiently sophisticated investor or by using a purchaserrepresentative. In such cases, a questionnaire is also sent tothe purchaser representative to verify that it is qualified toparticipate.The issuer has the burden of determining the status of

potential investors. If the issuer sells unregistered securitiesto an unqualified investor, the issuer cannot rely on theprivate placement exemption. Selling without aregistration statement or valid registration exemption giveseach purchaser (not just the unqualified purchaser) theright to rescind or cancel its purchase and recover thepurchase price (plus interest) from the issuer for one yearafter the sale. Under Section 12(a)(1) of the Securities Act,a purchaser no longer holding the securities can recoverdamages from the issuer regardless of whether or not itslosses arise from the issuer’s failure to register thosesecurities. To avoid this strict liability, issuers rely oninvestor questionnaires to protect the availability of theirregistration exemptions. Together, the purchaserrepresentative questionnaire and the investor questionnairehelp the issuer establish the status of its investor base andavoid strict liability under Section 12(a)(1) of theSecurities Act.

Information requirements for non-accreditedinvestorsTo use Rule 505 or 506, the issuer must provide each non-accredited investor with certain information. Rule502(b)(2) of Regulation D requires disclosure similar tothe type provided in a Securities Act registration statement.For example, depending on the size of the offering, issuersshould provide non-accredited investor with the mostrecent balance sheet, income statements, statements ofstockholders’ equity and similar audited financialstatements for the preceding two years, as well as adescription of the issuer’s business and the securities in theoffering. The issuer must also provide non-accreditedinvestors with a brief written description of any materialinformation about the offering that is given to accreditedinvestors. While disclosure requirements are not applicableto offerings made to accredited investors, it is best practiceto provide the same information to both accredited andnon-accredited investors in light of the antifraudprovisions of the federal securities laws. More often thannot, issuers will limit their offerings to accredited investorsonly and may not produce a disclosure document in

connection with the financing.Issuers must give all investors the opportunity to ask

questions about the terms and conditions of the offeringand to verify the accuracy of the disclosed writteninformation. This due diligence is often done in atelephone conference call with members of the issuer’smanagement team and counsel. For Regulation Dofferings involving a business combination or exchangeoffer, the issuer must also provide written informationabout any terms or arrangements in the proposedtransaction that are materially different from those for allother security holders.

Restriction on general solicitation and advertisingRule 502(c) of Regulation D prohibits any generalsolicitation or advertising of the unregistered offering by theissuer or any person acting on its behalf. General solicitationis also prohibited in a Section 4(a)(2) offering. Thisprohibition extends to advertisements, articles, notices orother publication in any US newspaper, magazine or similarmedia (including the internet), broadcasts over US televisionor radio (including the internet) and any seminar or meetingin the US whose attendees have been invited by any generalsolicitation or advertisement.6 The SEC Staff has providedguidance regarding the types of communications that wouldbe viewed as constituting a “general solicitation.” EffectiveSeptember 2013, Rule 502(c) was amended to allow general

solicitation under Rule 506(c) if all purchasers are accreditedinvestors, or the issuer reasonably believes that they are,immediately prior to the sale, and certain other requirementsare met. An issuer may still choose to conduct a Rule 506(b)offering without using general solicitation, in which case itmay offer and sell securities to non-accredited and accreditedinvestors.For reporting companies offering securities to non-

accredited investors, the prohibition on general solicitation isweighed against the issuer’s obligation to inform its investorsof material events, such as new securities offerings and theuse of proceeds from such offerings. Rule 135c of theSecurities Act addresses this tension by providing a safeharbour from the prohibition for certain publicannouncements of unregistered offerings. To use Rule 135c,


The three Regulation D exemptions have the following limitations:

Rule 504 Rule 505

Maximum size ofoffering

Issuers permitted to relyon this exemption

Types of investorsthat can buy thesecurities

Issuer to furnish certaininformation?Prohibition on gen-eral solicitation oradvertisement?Limitations onresale of securities?Subject to integration?Form D filing?

$1 million per year.

Non-reporting companies(including foreign privateissuers that provide infor-mation under Rule 12g3-2(b) of the Exchange Act),companies that are notinvestment companies (asdefined in the InvestmentCompany Act of 1940, asamended) and blank checkcompanies.Any investor. No limitationon the number of investorsor requirement of sophistication.

No.

Yes, subject to the twoexceptions provided byRule 504(b)(1).

Yes, subject to the twoexceptions provided byRule 504(b)(1).Yes.

Yes.

$5 million per year.

Companies that are notinvestment companies, sub-ject to the following excep-tion:Bad actor disqualification forcompanies where any officers,directors, general partners,10% owners or underwritershave been convicted or sub-ject to an SEC order withinthe past five to 10 years.An unlimited number ofaccredited investors and upto 35 non-accreditedinvestors.

Yes, to non-accreditedinvestors.

Yes.

Yes.

Yes.

Yes.

Rule 506(b)No limit on size ofoffering.

Any issuer. It is usedby both reporting companies and nonreportingcompanies. Rule506(d) prohibits theuse of the exemptionby certain bad actorsand felons.

An unlimited number ofaccredited investorsand up to 35 non-accredited investors(who alone or togetherwith their purchaserrepresentatives mustbe sophisticatedinvestors).Yes, to non-accreditedinvestors.

Yes.

Yes.

Yes.

Yes.

Rule 506(c)No limit on size ofoffering.

Any issuer. It is usedby both reporting companies and nonreportingcompanies. Rule506(d) prohibits theuse of the exemptionby certain bad actorsand felons.

Purchasers must beaccredited investors.Issuer must take reasonable steps toverify accreditedinvestor status.

N/A

No.

Yes.

Yes.

Yes.


the following conditions must be met:• The issuer must be a reporting company under the

Exchange Act or claim the Rule 12g3-2(b) exemptionfrom registration under the Exchange Act.

• The press release cannot be made to condition or primethe US market for the offered securities. Given thiscondition, most issuers are advised to publish the noticeonly after completing the solicitation phase of the offeringor excluding potential investors who start communicatingwith the offering participants after publication of thenotice.

• The type of information disclosed must be of the samegeneral type allowed in press releases for registeredofferings, such as name of the issuer, title and amount ofthe offering, the interest rate and maturity date of thesecurities, closing date of the offering, the purpose of theoffering without naming the initial purchasers or partiesacting as underwriters for the unregistered offering andany statements or legends required by US state or non-USlaw. The type of information disclosed also depends onthe offering type.

• The press release must contain a restricted legend stating:“The securities have not been registered under theSecurities Act and cannot be sold in the US withoutregistration or an applicable registration exemption.”

• The issuer must file a copy of the press release with theSEC on Form 6-K if it is a reporting issuer, or mustpublish it electronically in accordance with Rule 12g3-2(b).

Six-month integration safe harbourFor a valid Regulation D offering, all sales that are part of thesame Regulation D offering must satisfy all of the terms andconditions of Regulation D. To determine which sales forma part of the same Regulation D offering, Rule 502(a) ofRegulation D provides a six-month integration safe harbour.It provides that offers and sales made more than six monthsbefore the start, and more than six months after thecompletion, of a Regulation D offering are not typicallyintegrated with each other. This six-month rule is alsorelevant to the Section 4(a)(2) integration analysis. Offersand sales made under employee benefit plans are allowedduring this six-month period and are not integrated with theRegulation D offerings. There also are a number of otherspecific integration safe harbours.For offers and sales made during the six-month period,

securities counsel can help determine if different offeringsshould be integrated. The integration analysis becomesimportant in certain situations, including:• Where an issuer sells to non-accredited investors in a

continuous offering, or in a series of private placements,the issuer must determine if it sold to more than 35 non-accredited investors. When computing the number ofbuyers under Rule 501(h), any Regulation D offeringsmade simultaneously, or within six months of offeringsmade outside of the US in compliance with Regulation S,

are not integrated. In this case, non-US investors are notrelevant to the 35 non-accredited investors limit.

• Where there may have been a violation of the prohibitionagainst general solicitation or advertising. In this situation,the issuer must determine the scope of the offering withwhich the questionable communication is linked.

• Where the issuer conducts concurrent private and publicofferings. Under certain circumstances, there can be aprivate offering under Rule 506 of Regulation D orSection 4(a)(2) and a registered public offering that arenot integrated.7 For example, the private and publicofferings would not be integrated if the investors in theprivate offering were not solicited through the registrationstatement, but rather through a substantive, pre-existingrelationship with the issuer.8

Form D filingRegulation D requires an issuer (whether or not it is areporting company) to file with the SEC a notice on Form Dno later than 15 days after the first sale of securities madeunder Regulation D. Typically, issuers often comply withRegulation D in all other respects, other than this filingrequirement. However, there can be instances when issuersprefer to make a Form D filing to give the SEC notice oftheir unregistered offerings and ensure their privateplacements fall within the black letter of Regulation D.In connection with the amendments to Rule 506 effective

September 2013, Form D was amended to add a check boxto Item 6 for specifying the use of Rule 506(c) (offerings toaccredited investors using general solicitation). The signaturebox was also amended to add a certification that the issuer isnot disqualified from relying on Rule 506 due to thedisqualification provisions of Rule 506(d).The Form D filing is no longer a condition to the

availability of Regulation D for a particular offering.However, under Rule 507, the SEC can prohibit an issuerwho was previously subject to an injunction for failing to fileForm D, from future reliance on Regulation D (unless theSEC determines, on a showing of good cause, that theexemption should not be denied).

Private placement documentationSecurities acquired pursuant to a Section 4(a)(2) offeringmay be immediately resold under Rule 144A. The intent toresell under Rule 144A is not inconsistent with Section4(a)(2) and does not affect the availability of the issuer’sexemption. In a Rule 144A transaction, an investment bank,acting as the initial purchaser, will agree to purchase on a firmcommitment basis in a Section 4(a)(2) private placementunregistered securities from an issuer and the investmentbank then immediately resells these securities only to QIBs(or to other purchasers that the investment bank and anypersons acting on its behalf reasonably believe to be QIBs).As a result, Rule 144A transactions are structured as principaltransactions. In a Section 4(a)(2) transaction, an investmentbank will agree to place the unregistered securities, on a best


efforts basis, with investors who may choose to hold thesecurities for the long-term or resell the securities to apurchaser pursuant to another exemption from registration(usually, a Rule 144A resale to a QIB). Some 4(a)(2) transactions may be structured so that the

initial purchasers are all QIBs; in these “144A qualifying”transactions, the investment bank will act on an agency basisto arrange the sale of the securities directly by the issuer to theQIB investors. Each QIB investor, in its securities purchaseagreement, will make the usual representations made by apurchaser in a Section 4(a)(2) offering – including that itunderstands that the securities are restricted securities andcannot be freely resold, that it can fend for itself in thetransaction and that it has such knowledge and experience inbusiness matters so as to be capable of evaluating the meritsand risks of the prospective investment and that it has theability to bear the economic risks of the investment,including the complete loss thereof. When all of the investorsin a 144A qualifying Section 4(a)(2) private placement areQIBs, the securities will be eligible for settlement and transferthrough The Depository Trust Company.The following is a description of Section 4(a)(2) private

placement documentation. For a discussion ofdocumentation for a Rule 144A offering, please refer toChapter 5 (Mechanics of a Rule 144A/Regulation Soffering).The documentation typically used in Section 4(a)(2)

private placements includes a private placementmemorandum, a securities purchase agreement and aplacement agency agreement, along with legal opinions,comfort letters, and other ancillary documentation.

Private placement memorandumSection 4(a)(2) does not require specific disclosure for anoffering document. The information that is included in aprivate placement memorandum (PPM) will vary greatlydepending on the type of offering. For example, an offeringmemorandum used for a Rule 144A offering will be verydifferent from a PPM used for a Section 4(a)(2) offering to asmall number of investors.9 By and large PPMs or offeringcirculars used in a Rule 144A offering will be detailed andmay be similar to the type of the disclosure contained in aprospectus. However, a PPM for a 4(a)(2) offering maycontain an abbreviated business description, risk factors,some financial information and possibly incorporate otherpublicly available information about the issuer.

Securities purchase agreementThe form, organisation, and content of a securities purchaseagreement for a Section 4(a)(2) private placement will differdepending on the type of offering. Many foreign issuers offerdebt securities in cross-border debt private placements. Thebuyers in these offerings usually are institutional investors,often including insurance companies and pension funds.These cross-border private placements are often referred to as

“insurance private placements”. The documentation for thesecross-border private placements has become quitestandardised over the years.The securities purchase agreements in these transactions

are typically based on approved forms that contain standardrepresentations and warranties related to the issuer, thesecurities offered, the business and other representationsdesigned to supplement the due diligence investigation of theplacement agent (if applicable) and the purchasers. Inaddition, the agreement will contain representations,warranties and covenants specific to the Section 4(a)(2)offering, including, the issuer has not engaged in generalsolicitation or general advertising, the issuer has not engagedin other offerings that may be “integrated” with the Section4(a)(2) offering and the offered securities qualify for theSection 4(a)(2) exemption. Unlike an underwritingagreement for a public offering, the purchasers in a Section4(a)(2) private placement will also make limitedrepresentations to, and warranties and covenants with, theissuer, including that the purchasers are accredited investorsand the purchasers understand the risks of an investment inthe securities.

Placement agency agreementA placement agency agreement may be used in the context ofcertain private placements, although it is not common to usea placement agency agreement in the context of cross borderdebt private placements. More often than not, the issuer willenter into an engagement letter with the placement agent,which will address the fees and expenses to be paid by theissuer in connection with the transaction, as well as the termof the engagement. The engagement letter may containcertain basic representations and warranties from the issuer tothe placement agent. The engagement letter generally alsowill provide that the placement agent will receive the benefitof and be entitled to rely on the representations andwarranties of the issuer and of the investor made in thesecurities purchase agreement as well as on any legal opiniondelivered by the issuer’s counsel to the investors.

Comfort letters and legal opinionsWhile a comfort letter (a letter from the issuer’s independentcertified accountants that the financial statements includedin an offering document meet specified applicable standards)will almost invariably be delivered in connection with a Rule144A offering, it is usually not requested in a 4(a)(2) offeringto institutional investors.In a Section 4(a)(2) private placement, counsel to the

issuer and, to a more limited extent, counsel to the placementagent (if applicable) or the purchasers, are required to providestandard corporate and transaction opinions. In addition, tothe extent that a PPM was prepared and used in connectionwith the offering, financial intermediaries may require thatissuer’s counsel deliver negative assurance letters (also referredto as 10b-5 letters).

1. See SEC Release No. 33-3825; SEC Release No. 33-4552; and SEC Release No. 33-5121.

2. General solicitation is permitted in Rule 506offerings, but not in 4(a)(2) offerings.

3. Rule 506 of Regulation D is based on Section 4(a)(2),while Rules 504 and 505 were promulgated underSection 3(b) of the Securities Act.

4. Rule 501 promulgated under Regulation D sets forththe definition of an “accredited investor.” In order foran individual to qualify as an accredited investor, he orshe must : (1) earn an individual income of more than$200,000 per year, or a joint income of $300,000, ineach of the last two years and expect to reasonablymaintain the same level of income; (2) have a networth exceeding $1 million, either individually orjointly with his or her spouse; or (3) be a generalpartner, executive officer, director or a relatedcombination thereof for the issuer of a security beingoffered. Accredited investors are not counted as“purchasers” for purposes of counting purchasersunder Regulation D.

5. See SEC Release No. 33-9414; File No. S7-21-11(September 23 2013).

6. We discuss the SEC Staff ’s guidance regarding thetypes of communications that constitute a generalsolicitation in “Practice Pointers on Navigating theSecurities Act’s Prohibition on General Solicitationand General Advertising,” available at

7. See SEC Release No. 33-8828 and the Black BoxIncorporated (June 26 1990) and Squadron, Ellenoff,Pleasant & Lehrer (February 28 1992) SEC no-actionletters.

8. Id.

9. We discuss offering circulars in the context of a Rule144A offering in Chapter 5 (Mechanics of a Rule144A/Regulation S offering).


ENDNOTES

Structuring a Rule 144A offeringOfferings structured in reliance on Rule 144A include:• Offerings of debt or preferred securities, either of which

may be convertible into common stock, by publicreporting companies, structured either as standaloneRule 144A offerings, or with subsequent A/B exchangeoffers or resale registration rights;

• Offerings by foreign issuers of depositary receipts ordebt securities in order to access the US capital marketswithout becoming subject to US reportingrequirements;

• Offerings of common stock by private, non-reportingissuers (that is, equity Rule 144A offerings);

• Offerings of high yield debt securities by privatecompanies, structured either as standalone Rule 144Aofferings or with subsequent A/B exchange offers orresale registration rights; and

• Rule 144A continuous offering programmes for debt orstructured securities.Securities acquired pursuant to a Section 4(a)(2) offering

or a Regulation D offering may be immediately resoldunder Rule 144A. The intent to resell under Rule 144A isnot inconsistent with Section 4(a)(2) or Regulation D. Aninvestment bank, acting as the initial purchaser, will agreeto purchase on a firm commitment basis in a privateplacement an entire issue of unregistered securities from aforeign issuer. The investment bank will then immediatelyresell these securities to QIBs (or to purchasers that it andany persons acting on its behalf reasonably believe to beQIBs). This is possible because purchasing from an issuerwith a view to reselling under Rule 144A will not affect theavailability to the issuer of the Section 4(a)(2) orRegulation D exemption.

We discuss some of these transactions in more detailbelow, focusing on the offering process anddocumentation, disclosure issues and liability concernsrelevant for foreign issuers.

Standalone Rule 144A offeringA Rule 144A offering for an issuer that is not a USreporting issuer will often take the form of a standaloneoffering. A standalone Rule 144A transaction may bestructured as a “Rule 144A-only” (or “Rule 144A for life”)offering or as a “Rule 144A-eligible” offering. Both beginas private placements by an issuer to a broker-dealer that isacting as initial purchaser. However, the two offeringsdiffer with respect to permitted resales. In a Rule 144A-

only offering, until the securities become freely tradableunder Rule 144 or as a registered under the Securities Act,any resale may be made pursuant only to Rule 144A.Generally, in a Rule 144A- only offering, the initialoffering is made to QIBs (or to other purchasers that theinitial purchasers and any persons acting on their behalfreasonably believe to be QIBs), although some Rule 144A-only offerings permit institutional accredited investors thatare not QIBs to participate. In a Rule 144A-eligibleoffering, resales are permitted to be made pursuant to Rule144A as well as other available exemptions, including thehybrid Section 4(a)(1½) exemption, Rule 144 or in asecondary private placement.

Debt offeringsAlthough both equity and debt can be issued under Rule144A, the exclusion of fungible securities from Rule 144Ahas the practical effect of making Rule 144A offeringsmore common for debt or other securities, includingpreferred stock, that have been structured to avoidfungibility. Whether through a Rule 144A standaloneoffering, or a continuous offering programme as discussedbelow, foreign banks may consider using Rule 144A toissue different types of debt securities, including withoutlimitation:• Senior unsecured debt;• Senior secured debt (including covered bonds);• Subordinated debt;• Structured debt (for example, commodity-linked

notes);• Hybrid debt;• Contingent capital (CoCo) debt; and• Deposit liabilities.

A foreign bank may issue debt securities through its“home office” entity, its US branch entities, or otheraffiliated entities, such as financing SPVs. A foreign issuermust always consult its US tax counsel to discuss any USfederal income tax issues in structuring offerings of debtsecurities. The benefits of a Rule 144A offering comparedto a registered offering include:• More flexible disclosure requirements;• No liability for a registration statement under Section 5

of the Securities Act (although the anti-fraud provisionsare still applicable);

• Lower costs;• Limited ongoing reporting obligations; and• None of the corporate governance provisions of the US


CHAPTER 5

Mechanics of a Rule 144A/Regulation Soffering

federal securities laws and the US securities exchangesand related liabilities, particularly those of the Sarbanes-Oxley Act. The process of conducting a Rule 144A debt offering,

whether high yield, investment grade or convertible debt,closely follows that for a registered offering as discussedbelow.

Rule 144A continuous offering programmes fordebt or structured securitiesAn issuer that intends to engage in multiple offerings mayhave a “Rule 144A programme” or a combined “Rule144A/Regulation S programme.” These programmes areattractive to foreign banks, and are in fact often used byfinancial institution and insurance company issuers tooffer securities through one or more broker-dealers toinstitutional investors in continuous offerings. Rule 144Aprogrammes are established to offer securities (usually inthe form of MTN programmes) on an ongoing orcontinuous basis to QIBs, or non-US persons, in the caseof a Regulation S tranche. These continuous debtprogrammes mirror similar publicly registered offeringsand have the following benefits:• No public disclosure of innovative structures or

sensitive information;• Limited (or no) Finra filing requirements; and• Reduced potential for liability under the Securities Act.

A non-registered MTN programme may rely on eitherRegulation D (if the securities are sold directly toinvestors) or Rule 144A (with or without a RegulationS tranche) for the takedowns.

Combined Rule 144A and Regulation S offeringsThe addition of a Regulation S tranche to a Rule 144Aoffering can significantly expand the potential investorpool to include non-QIBs outside the United States. Thestructure of a combined Rule 144A and Regulation Soffering by a US or foreign issuer depends on, amongother factors:• Whether the Rule 144A domestic or the Regulation S

foreign tranche of the offering predominates and theissuer is a reporting issuer in the United States (USdomiciled or foreign); and

• To a lesser extent, whether the financial intermediary isUS or non-US based.Predominately, Rule 144A combined offerings are

focused on the US market. In such case, the combinedoffering will often be structured to resemble a US publicoffering in many respects, but with necessarymodifications based on applicable offshore jurisdictionlaws and customary practices. Accordingly, Rule 144Acombined offerings by a foreign issuer may includeappropriate modifications, for example to the offeringmemorandum, as we describe below. If an issuer isprimarily conducting a Regulation S offering targeting a

non-US market, the issuer will instead follow the localapproach in its Regulation S capital raising activities andinclude the necessary safeguards to comply with bothRegulation S and Rule 144A.

The offering process for a Rule 144A or combined Rule 144A/Regulation S offeringThe Rule 144A offering process, with or without aRegulation S tranche, is often similar to the public offeringprocess, particularly a firm commitment underwriting,without SEC filings or review. A fully marketed Rule 144Atransaction typically includes:• Preparation of the preliminary offering memorandum

and performance of necessary due diligence by theinitial purchasers;1

• Solicitation of orders using a “red herring” orpreliminary offering memorandum;

• Preparation of: (1) a purchase agreement between theissuer and the initial purchasers; (2) an indenture, ifdebt securities are being offered (see the section below,“—Debt instrument documents”) or a certificate ofdesignations or other instrument if preferred equity isbeing offered; (3) a registration rights agreement, if thesecurities will be registered with the SEC after the initialsettlement; and (4) other required deal and closingdocuments;

• Preparation and delivery of a final term sheet toinvestors indicating the final pricing terms;

• Execution of a purchase agreement between the issuerand the initial purchasers at pricing;

• Delivery of a comfort letter from the issuer’s auditors atpricing;

• Preparation and delivery of a final offeringmemorandum and confirmation of orders frominvestors;

• Closing within three to five business days after pricing;and

• At closing, execution, delivery and filing, as applicable,of any indenture, certificate of designations, or otherinstrument, and registration rights agreement; anddelivery of legal opinions and other closing documents,including a bring-down comfort letter.The process will also reflect the legal and customary

requirements of the foreign jurisdictions in which theRegulation S tranche, if any, will occur.

In terms of settlement and clearance, the purchaseagreement between the issuer and the initial purchasersshould specify whether the securities will be issued inbook-entry or certificated form. In most Rule 144Aofferings, the securities are represented by a “global”security deposited with DTC and registered in the name ofDTC’s nominee, Cede & Co., except for securities issuedto non-QIBs in certificated form or to others who arepermitted to request securities in such form. Use of globalsecurities held by depositaries such as DTC, Euroclear, andClearstream usually results in clearance procedures and


timing that, from the investors’ viewpoint, are identical tothose used for publicly offered securities.

The documentation for a Rule 144A or combined Rule 144A/Regulation S offeringThe documentation typically used in both debt and equityRule 144A transactions, with or without a Regulation Stranche, is similar to that used in registered offerings,including:• An offering memorandum, similar to a prospectus;• A purchase agreement between the issuer and the initial

purchasers, similar to an underwriting agreement;• An agreement among underwriters or syndication

agreement;• In some cases, a registration rights agreement between

the issuer and the initial purchasers;• In a debt offering, an indenture (or fiscal and paying

agency agreement);• Comfort letters from the issuer’s auditors; and• Closing documentation including “bring-down”

comfort letters, legal opinions, a 10b-5 letter from legalcounsel and closing certificates.The issuer will work with its counsel, investment bank,

investment bank’s counsel and independent accountants toprepare the necessary documents.

Documentation issuesWhile both debt and equity Rule 144A offerings andcombined Rule 144A/Regulation S offerings usedocumentation that resemble that used in registered publicofferings, many factors affect the documents and theirpreparation. These factors include the nature of the issuer(US or foreign, reporting or non-reporting, ratings and thelike), the nature of the initial purchasers (US or Europeanor other foreign-based institutions) and the intendedmarket for the offering. Combined Rule 144A/RegulationS offerings by non-US issuers or led by non-US financialintermediaries may use documents based on the country-specific practices of the relevant non-US jurisdiction orjurisdictions, particularly if the Rule 144A tranche is small.However, the disclosure documents in such a case generallywill contain the same substantive information so thatinvestors have the same “disclosure package.”

In a Rule 144A programme or Rule 144A/Regulation Sprogramme, similar to a registered MTN programme, anissuer uses a master set of disclosure documents,agreements with dealers and fiscal and paying agencyagreements to minimise the new documentation needed atthe time of each takedown.

Offering memorandumRule 144A does not mandate specific disclosure for anoffering document.2 In practice, most Rule 144A offeringmemoranda resemble in content and style a prospectus fora registered public offering under the Securities Act. Thisapproach can bolster the defense against potential

liabilities of the issuer and the initial purchasers forviolations of the antifraud provisions of the US securitieslaws and assist in the marketing of the securities.3

As with preparing a prospectus for a public offering, thetwo primary reference points in preparing a Rule 144Aoffering memorandum are the specific requirements ofRegulation S-K under the Securities Act and thefundamental concept of materiality. Regulation S-K andForm S-1 or S-3 set forth the specific matters that the SECrequires in a registered offering by domestic issuers, andForm F-1 or F-3 and Form 20-F set forth similar, but notwholly identical, information that the SEC requires in aregistered offering by foreign issuers. The mattersaddressed in both Regulation S-K and Form 20-F include,among others, the issuer’s business, properties, risks,financial condition and results of operations, together withmanagement’s discussion and analysis of such financialcondition and results of operations, management,executive compensation, and corporate governance. Inaddition, Regulation S-X, which governs the financialstatements included in a registered offering of US andforeign issuers, is also a useful guide. The financialstatements included in a Rule 144A/Regulation S offeringmemorandum might not necessarily comply with all therequirements of Regulation S-X, particularly with respectto the number of years to be included in the “selectedfinancial data” disclosure. For purposes of compliance withRegulation S, the offering memorandum for a combinedRule 144A/Regulation S offering contains extensivedisclosure regarding resale limitations and transferrestrictions, and, if the securities will be held in book-entryformat (as is customary), the book-entry process.

Purchase agreementThe form, organisation and content of a purchaseagreement for a Rule 144A offering usually resembles afirm commitment underwriting agreement for a publicoffering, modified to reflect the private offeringmethodology. In a combined Rule 144A/Regulation Stransaction, a purchase agreement will contain standardrepresentations and warranties related to the issuer and itsbusiness and the securities offered, as well as otherrepresentations designed to supplement the due diligenceinvestigation of the initial purchasers. In addition, thepurchase agreement will contain representations,warranties and covenants specific to the Rule144A/Regulation S offering, including:• The issuer has not engaged in general solicitation or

general advertising (unless the issuer chooses to usegeneral solicitation or general advertising, which arenow permitted for Rule 144A offerings so long as thesecurities are sold to a QIB or to a purchaser that theseller and any person acting on the seller’s behalfreasonably believes is a QIB);

• The offered securities meet the eligibility requirementsunder Rule 144A;


• The issuer is not an open-end investment company,unit investment trust or face-amount certificatecompany;

• The issuer will not use “directed selling efforts” asdefined under Regulation S, and if the securities offeredare Category 2 or 3 securities, it has implemented thenecessary Regulation S offering restrictions; and

• If the securities are debt securities or ADRs, the issuerwill not resell any securities in which it or any of itsaffiliates has acquired a beneficial ownership interest. Unlike an underwriting agreement for a public offering,

the initial purchasers in a combined Rule 144A/RegulationS transaction will also make limited representations,warranties and covenants, typically as to the relevantsecurities law requirements.

Debt instrument documentsIn addition to the documents necessary for any Rule 144Aoffering, a debt offering requires an instrument to governthe terms of the debt. It is standard to use an indenture,although if the debt securities will not be registeredsubsequently with the SEC, particularly if the offering is astandalone Regulation S offering, a fiscal and payingagency agreement may be used to cover substantially thesame matters. The parties to the indenture (or otheragreement) are the issuer, any guarantors of the debtsecurities and the trustee. A foreign bank that engages in acontinuous Rule 144A programme (with or without aRegulation S component) or MTN programme, or expectsto offer additional debt securities, may also use a“universal” indenture, similar to that used in registeredshelf offerings, which permits the issuance of differenttranches or classes of debt securities.

It is standard to have registration rights for the commonstock that is issuable upon conversion of a convertiblesecurity or exercise of a warrant, particularly if the issueralready is a reporting company. Registration rights are alsocommon for Rule 144A offerings of high yield debt. FewRule 144A/Regulation S offerings by foreign issuers thatare non-reporting companies are done with registrationrights because many foreign issuers find ongoing reportingobligations and compliance with US federal securities lawstoo burdensome.

Comfort letters and legal opinionsA comfort letter is a letter from the issuer’s independentcertified accountants that the financial statementsincluded in a particular document used in an offering meetspecified applicable standards. It may also include theaccountants’ conclusions regarding its comparison ofspecified financial information in the offering documentto the information contained in the issuer’s financialstatements or accounting records. In certain combinedofferings for foreign issuers (and in Regulation S offerings),including those with separate syndicates for the Rule 144Aand Regulation S tranches, foreign accountants expect to

enter into an engagement letter with the investment banksacting as agents or initial purchasers before they provide acomfort letter. The comfort letter will also not follow thestandard disclosure US issuers and financial intermediariesexpect because of the different regulatory schemeapplicable to the foreign issuer.

In a Rule 144A/Regulation S offering, counsel to theissuer and, to a more limited extent, counsel to the initialpurchasers, are required to provide standard corporate andtransaction opinions. In addition, financial intermediarieswill require, under most circumstances, that both issuer’sand initial purchasers’ counsel provide 10b-5 lettersconsistent with standard US public market underwritingpractice. In a Regulation S transaction, the delivery ornon-delivery of a 10b-5 letter by a US law firm can be akey factor in determining the jurisdictions into which asecurities offering will be targeted. US broker-dealers willnot participate in a Rule 144A offering without a 10b-5letter from a US law firm that is based upon a duediligence investigation customary in the US market. Withforeign issuers, access, cost and timing issues may arise inRule 144A/Regulation S offerings because of theextensiveness of the due diligence investigation required byUS counsel to give this opinion. Accordingly, this factormust be considered early on in the process.

Disclosure issuesOffering memorandumBecause the antifraud provisions of the US securities lawsapply to Rule 144A offerings,4 most Rule 144A offeringmemoranda are similar in content and style to a prospectusfor a registered offering under the Securities Act. Thebenefits of this more inclusive offering document are thatit may be used by the initial purchasers as a marketingdocument for the ultimate investors and serve as a defenceagainst potential liabilities of the issuer and the initialpurchasers for violations of the antifraud provisions of theUS securities laws.5 For an issuer that is not public in anyjurisdiction, drafting a Rule 144A offering memorandumcan be a difficult, expensive and time-consuming process.The fact that the offering memorandum is not subject toSEC review does afford the parties more flexibility. Theissuer, its counsel and the initial purchasers mightdetermine to include more abbreviated disclosure in a Rule144A offering memorandum.

The main benefit for a reporting company (US orforeign) conducting a Rule 144A offering is that thedisclosure for the offering memorandum can be preparedmore quickly. A US reporting company can incorporate byreference into the offering memorandum its Exchange Actfilings. A foreign issuer that is a reporting company mayneed to furnish information about the offering to the SECunder Form 6-K to the extent that such information isrequired to be: (1) made public under the laws of its homejurisdiction; (2) filed with a securities exchange whichmakes the information public; or (3) distributed to its


security holders (as is typically the case with an offeringmemorandum).

Regulation FD?For Regulation FD purposes, a reporting company mustbe careful not to disclose material information in anoffering memorandum that is not otherwise publiclydisclosed. Foreign issuers, unlike their US counterparts,are not subject to Regulation FD.6 While this is anapparent advantage for them, they must still be mindful ofthe antifraud provisions of the US securities laws. Inaddition, recipients of any material, non-publicinformation disclosed in the offering memorandum oroffering process may want the foreign issuer to disclose theinformation publicly in order to allow them to sell thesecurities being offered or any other securities that therecipients may own that would be affected by suchmaterial non-public information. Accordingly, whileRegulation FD does not apply to non-US reportingcompanies, many consider it good practice to complywith, or take actions guided by, its requirements.

Other communication issuesPress releasesIssuers may use a Rule 135c-compliant press release toannounce a Regulation S offering. Under Rule 135c of theSecurities Act, an announcement that an issuer proposes tomake, is making or has made an unregistered offering willnot be deemed to be an offer of securities, for purposes ofSection 5 of the Securities Act, if, among other things, theannouncement contains certain limited informationregarding the offering (e.g., the name of the issuer, thebasic terms and size of the offering, the timing of theoffering, a brief statement of the manner and purpose ofthe offering and statements that the securities have notbeen registered) and is not used for the purpose ofconditioning the market in the United States for theoffered securities. A Rule 135c-compliant press release isnot a “directed selling effort” and therefore will not affectthe availability of the Regulation S safe harbor.

In addition, for Regulation S offerings with a Rule 144Atranche, the SEC has clarified that general solicitation andgeneral advertising in connection with a Rule 144Aoffering will not be viewed as “directed selling efforts” inconnection with a concurrent Regulation S offering. Thisis particularly relevant because general solicitation andgeneral advertising are now permitted for Rule 144Aofferings (so long as the securities are sold to a QIB or to apurchaser that the seller and any person acting on theseller’s behalf reasonably believes is a QIB). As a result,issuers are now permitted to broadly disseminate a pressrelease regarding a proposed or completed Rule 144Aoffering free of the prior restrictions on the types ofpermitted information under Rule 135c.

Offering participants should keep in mind that Rule135c is a non-exclusive safe harbour, and offering-related

press releases may be able to satisfy a different safe harbour,such as Rule 135e under the Securities Act in respect ofany offshore activities for any Regulation S tranche. Rule135e provides that, subject to certain conditions, foreignissuers and their representatives will not be deemed to offerany security for sale by virtue of providing any journalistwith access to press conferences conducted outside theUnited States, conducting meetings with issuer or sellingsecurity holder representatives outside the United States,or providing written press-related materials released (andreceived by the recipient) outside the United States.Foreign issuers should consult their counsel in advance ofmaking any communications, whether in or outside theUnited States, to carefully examine the applicability ofthese safe harbours.

Due diligenceGeneralRule 144A and Regulation S offerings do not subject theissuer and the initial purchasers to liability under Section11 of the Securities Act, thereby limiting the potentialneed to establish a formal due diligence defence.Nonetheless, a thorough due diligence investigation bylawyers, accountants, the issuer and the initial purchasersgenerally will result in better disclosure and a lower risk ofliability or potential liability for material misstatements oromissions.7

The due diligence processThe due diligence process in Rule 144A and combinedRule 144A/Regulation S offerings is similar to the processfollowed in connection with registered public offerings.Generally, the process is divided into two parts: (a)business and management due diligence, and (b)documentary, or legal, due diligence. The actual extent ofdiligence required may vary based on:• The nature of the issuer, including whether the issuer is

a newer entity, a well-established company (whetherpublic or not) or a US reporting company;

• The business of the issuer and its current risk profile;and

• The securities to be offered, whether investment gradeor high yield debt securities (and the ratings, if any, ofsimilar securities of the issuer) or preferred or commonequity.Foreign issuers contemplating an offering to US

institutional investors are expected to comply with, andfacilitate, the due diligence process, including making itssenior management team available for discussions andopening its books and records to the initial purchasers. Inorder to help establish a due diligence defence, marketpractice generally requires the initial purchasers in Rule144A and Regulation S offerings to condition the closingof the offerings upon receipt of documents similar to thoseused in an underwritten offering, including a comfortletter, legal opinions (including 10b-5 letters) and officer


certificates. As with either a registered offering or a Rule144A offering, due diligence will also be affected by theinitial purchasers’ knowledge about, and any ongoingrelationships with, the issuer.

Liability concernsGeneralThe Rule 144A safe harbour and Regulation S areexemptions from the registration and prospectus deliveryrequirements of the Securities Act. However, the antifraudprovisions of the securities laws still apply to thesetransactions. Thus, while it is generally believed that Rule144A and Regulation S offerings are not subject to theliability provisions of Section 11 or Section 12(a)(2) of theSecurities Act, the issuer and the initial purchasers could,under some circumstances, be subject to liability forrescission damages under Section 12(a)(1) of the SecuritiesAct for the sale of an unregistered security, as well asprivate rights of action under Section 10(b) of theExchange Act and Rule 10b-5 under the Exchange Act formaterial misstatements or omissions.

The antifraud provisions of the Securities ActIn general, purchasers of an issuer’s securities in a registeredoffering have private rights of action against variousparticipants in the offering for materially deficientdisclosure in registration statements under Section 11 ofthe Securities Act and in prospectuses and oralcommunications under Section 12(a)(2) of the SecuritiesAct. Under Section 11, liability exists for untruestatements of material facts or omissions of material factsrequired to be included in a registration statement ornecessary to make the statements in the registrationstatement not misleading at the time the registrationstatement became effective. Under Section 12(a)(2), sellershave liability to purchasers for offers or sales by means of aprospectus or oral communication that includes an untruestatement of material fact or omits to state a material factthat makes the statements made, based on thecircumstances under which they were made, notmisleading. In addition, Section 17(a) of the Securities Actis a general antifraud provision that provides, among otherthings, that it is unlawful for any person in the offer andsale of securities to obtain money or property by means ofany untrue statement of a material fact or any omission tostate a material fact necessary in order to make thestatements made, in light of the circumstances underwhich they were made, not misleading.

Purchasers also may have private rights of action underSection 10(b) of the Exchange Act and Rule 10b-5 underthe Exchange Act. Claims brought under Section 10(b)and Rule 10b-5 are implied causes of action covering alltransactions in securities, including private placements,and all persons who use any manipulative or deceptivedevices in connection with the purchase or sale of anysecurities. Courts have held that claims brought under

Section 10(b) and Rule 10b-5 require proof that thedefendant acted with scienter (meaning intent orknowledge of the violation), which is not a requirement foractions brought under Sections 11 or 12 of the SecuritiesAct.

Each of these statutes and rules has many decades ofjudicial interpretations explicating their elements anddefences. While the antifraud protections often frightenforeign issuers from accessing the US capital markets andlitigation can always be brought, experienced counsel canbe very helpful in guiding issuers and investment banksthrough the process in order to minimise the possibility ofsuch litigation.



1. The offering participants should also determinewhether any state’s blue sky laws will apply to theproposed offering. For information regarding blue skylaws, see Chapter 11 (Blue sky laws).

2. Rule 144A(d)(4) is interpreted to identify theminimum information required to be made availablein connection with an initial offering or resales of Rule144A securities. For more information, see“Information requirements for non-reporting issuers”in Chapter 2 (Overview of financing through exemptofferings).

3. For more information, see “Liability concerns” below.

4. Rule 144A is an exemption from registration underSection 5 of the Securities Act. As stated inPreliminary Note 1 to Rule 144A, it does not relate tothe antifraud or other provisions of the US federalsecurities laws.


6. The definition of “issuer” for purposes of RegulationFD in Rule 101(b) excludes foreign governments andFPIs, each as defined in Rule 405 under the SecuritiesAct.


ENDNOTES


Section 3(a)(2) exempts any security issued orguaranteed by a bank from registration under theSecurities Act. This exemption is based on theprinciple that, whether chartered under state or

federal law, banks are highly and relatively uniformlyregulated, and as a result will provide adequate disclosureto investors about their business and operations in theabsence of federal securities registration requirements.Banks are also subject to various capital requirements thatmay help increase the likelihood that holders of their debtsecurities will receive timely principal and interestpayments.

What is a bank?Section 3(a)(2) broadly defines a “bank” to mean anynational bank, or any banking institution organised underthe law of any State, territory, or the District of Columbia,the business of which is substantially confined to bankingand is supervised by the State or territorial bankingcommission or similar official. To qualify as a bank underSection 3(a)(2), the institution must meet tworequirements: (i) it must be a national bank or anyinstitution supervised by a state banking commission orsimilar authority; and (ii) its business must be substantiallyconfined to banking. Therefore, securities issued by bankholding companies, finance companies, investment banksand loan companies are not exempt from registrationunder Section 3(a)(2). Even though many investors maythink of them as banks, their businesses are notsubstantially confined to banking. Securities offered by anyof these institutions must be registered under the SecuritiesAct unless the offering falls under another exemption fromregistration.

Foreign banks and Section 3(a)(2)Branches and agencies of foreign banks are operationalarms of foreign banks conducting business in the UnitedStates under licences granted either by the Office of theComptroller of the Currency (OCC) or a state authority.However, an agency or branch is not a separate legal entityfrom the foreign bank itself. As a result, a foreign bank maynot be a national bank or may not be organised under thelaws of any state. Therefore, a foreign bank must focus onthe SEC’s definition of a “bank” under Section 3(a)(2).

In 1964, the SEC reviewed the availability of the Section

3(a)(2) exemption for US branches of foreign banks,particularly with respect to their day-to-day bankingoperations. After review of the issues involved, particularlythe comparability of regulation of these branches, the SECwas satisfied that the foreign bank branches in questionwere subject to the type and extent of supervisioncontemplated by Section 3(a)(2) for domestic banks, andauthorised the Division of Corporation Finance to issueno-action letters with respect to the sale withoutregistration of various instruments. The Division thengranted the first no-action letter with respect to certificatesof deposit and pass book accounts issued by a New Yorkstate branch of a foreign bank. Other letters followed.

In 1974, this no-action policy was re-examined. TheSEC reaffirmed its prior position, in part as a policydecision intended to further the “principle of nationaltreatment,” that foreign and domestic banks should beafforded the same privileges and be subject to the samerules applicable to US banks. In addition, the SECdetermined that the branches and agencies in questionappeared to be subject to regulatory schemes that werevirtually indistinguishable from those to which theirdomestic counterparts were subject.

In 1978, Congress passed the International Banking Act(IBA). Prior to the IBA, the only branches and agencies offoreign banks in the United States were those licensed bystates. Under the IBA, a foreign bank can establish a“federal” branch or agency licensed and supervised by theOCC. Congress enacted the IBA to establish “the principleof parity of treatment between foreign and domestic banksin like circumstances” (the principle of nationaltreatment). The SEC continued to issue many no-actionletters to foreign branches, permitting reliance on theSection 3(a)(2) exemption for their securities.

In 1986, the SEC recognised that the passage of the IBArepresented a Congressional public policy of “nationaltreatment,” and sought to formalise its positions in aninterpretive release.1 For purposes of the exemption fromregistration provided by Section 3(a)(2), the SEC deems abranch or agency of a foreign bank located in the UnitedStates to be a “national bank,” or a “banking institutionorganised under the laws of any State, Territory, or theDistrict of Columbia,” provided that the nature and extentof federal and/or state regulation and supervision of theparticular branch or agency is substantially equivalent to

CHAPTER 6

Section 3(a)(2) and considerations forforeign banks financing in the UnitedStates


that applicable to federal or state chartered domestic banksdoing business in the same jurisdiction. The determinationwith respect to the requirement of “substantially equivalentregulation,” as well as the determination as to whether thebusiness of the branch or agency in question “issubstantially confined to banking and is supervised by theState or territorial banking commission or similar official”is the responsibility of issuers and their counsel. Thesedeterminations are made with regard to the bankingregulations in effect at the time the securities are issued orguaranteed.

In light of the issuance of this interpretive release, theSEC no longer grants no-action letters regarding securitiesissued or guaranteed by foreign bank branches andagencies. However, the approximately 100 no-actionletters granted under Section 3(a)(2) prior to the 1986interpretative release are instructive as to the considerationgiven by the staff of the SEC to the strength of theapplicable regulatory regime, the type of instrument, themanner of offering and the denominations of the securitiesto be offered.

Generally, these no-action letters permitted US branchesand agencies of foreign banks to issue debt securitieswithout registration. Over time, the SEC developed apolicy of conditioning its decision on the receipt of anopinion of counsel that the nature and extent of federaland state regulation and supervision of the branch oragency in question were substantially equivalent to thatapplicable to federal or state chartered domestic banksdoing business in the same jurisdiction.

Securities guaranteed by a bankThe Section 3(a)(2) exemption is also available forsecurities “guaranteed” by a bank. Whether securities areguaranteed by a bank is interpreted broadly by the SEC.The staff of the SEC has taken the position in no-actionletters that the term “guarantee” is not limited to aguaranty in a legal sense, but also includes arrangements inwhich the bank agrees to ensure the payment of a security.As a result, many US branches of foreign banks have alsoissued letters of credit in connection with the obligationsof US commercial borrowers. Because a letter of credit isconsidered to be a guarantee for the purposes of Section3(a)(2), the letter (and the obligations of the underlyingcommercial borrower) are exempt from registration. Theguarantee must be full and unconditional. Guarantees by aforeign bank (other than those by an eligible US branch oragency) would not qualify for the Section 3(a)(2)exemption.

Types of securitiesThe exemption under Section 3(a)(2) applies not only tosecurities issued or guaranteed by a bank but also tocertificates of deposit issued or guaranteed by a bank (tothe extent considered securities instead of bank deposits).Structured notes linked to the performance of an index or

another underlying asset are also commonly issued bybanks in reliance on the Section 3(a)(2) exemption.2 Inthese instances, even though the return of the note islinked to an underlying asset, the investor is buying debtof the issuer and must rely on the credit of the issuer forrepayment of the note, no matter how the underlying assetperforms. This strengthens the argument that thestructured instrument is covered under the Section 3(a)(2)exemption.

Because bank notes are not subject to the SEC’sregistration requirements, structured bank notessometimes are linked to different types of assets thanregistered structured notes, particularly when the investoris sophisticated and understands the relevant risks. Forexample, because bank notes are not subject to the “strictliability” provisions of Sections 11 and 12(a)(2) of theSecurities Act, an issuer may be more comfortable linkingthe bank note to a complex underlying asset or investmentstrategy, which may be difficult to describe in a registrationstatement. In addition, registered offerings of equity-linked structured notes are typically linked only tolarge-cap US stocks due to the Morgan Stanley no-actionletter3 requirements. However, some bank notes may belinked to debt securities (credit-linked notes), small-capstocks or securities traded only on non-US exchanges.

Section 3(a)(2) bank notes can be senior orsubordinated, fixed or floating rate, zero-coupon, non-USdollar denominated, amortising, multi-currency orindexed (structured) securities. Common reference ratesfor floating rate bank notes include Libor (LondonInterbank Offered Rate), Euribor (Euro Interbank OfferedRate), the prime rate, the Treasury rate, the federal fundsrate and the CMS (Constant Maturity Swap) rate.

Section 3(a)(2) bank notes are not considered “restrictedsecurities,” as would debt securities issued by a bank or itsUS branch under Rule 144A under the Securities Act.Accordingly, Section 3(a)(2) bank notes are typicallyeligible for inclusion in indices that measure theperformance of investment grade debt securities.

OCC registrationThe OCC regulates disclosure in connection with offersand sales of securities by national banks and federallylicensed US branches and agencies of foreign banks (butnot state banks). 12 C.F.R. Part 16, the OCC’s SecuritiesOffering Disclosure Rules (OCC Regulations), providesthat these banks may not offer and sell their securities untila registration statement has been filed and declaredeffective with the OCC, unless an exemption applies.Issuers are required to follow the form requirements of theform that they would use to register securities under theSecurities Act if they were not exempt from suchregistration.

The OCC Regulations provide an exemption from theregistration requirements if the securities would be exemptfrom registration under the Securities Act other than by


reason of Sections 3(a)(2) or 3(a)(11), or the securities areoffered in transactions that satisfy one of the followingexemptions under the Securities Act:• Regulation D offerings;• Rule 144A offerings to QIBs; and• Regulation S offerings effected outside of the United

States.Amendments to Rule 144A and Rule 506 of Regulation

D allow general solicitation or general advertising of offers,provided that the securities are sold only to accreditedinvestors (in the case of Rule 506 offerings) or QIBs (in thecase of Rule 144A offerings). In a Rule 506 offering, theissuer must take reasonable steps to verify that thepurchasers are accredited investors.

Rule 506 now includes disqualification provisions,which prohibit the use of the exemption by certain badactors and felons. These disqualification events apply tothe issuer, persons related to the issuer and anyone whowill be paid (directly or indirectly) remuneration inconnection with the offering (placement agents andothers).

The OCC Regulations also contain an exemption foroffers and sales of nonconvertible debt securities if anumber of conditions are met under Part 16.6, including:• The issuer or its parent bank holding company has a

class of securities registered under Section 15(d) of theExchange Act, or, in the case of issuances by a federalbranch or agency of a foreign bank, such federal branchor agency provides the OCC the information specifiedin Rule 12g3-2(b) under the Exchange Act and providesinvestors with the information specified in Rule144A(d)(4)(i) under the Securities Act;

• All offers and sales are to “accredited investors”, asdefined in Rule 501 under the Securities Act;

• The securities are “investment grade”, as discussedbelow;

• The securities are sold in a minimum denomination of$250,000 and are legended to provide that they cannotbe exchanged for securities in smaller denominations;

• Prior to or simultaneously with the sale of the securities,the purchaser receives an offering document thatcontains a description of the terms of the securities, theuse of proceeds and the method of distribution, andincorporates certain financial reports or reports filedunder the Exchange Act; and

• The offering document and any amendments are filedwith the OCC no later than the fifth business day afterthey are first used.The definition of “investment grade” under Part 16.6

does not require a specific rating for the relevantnonconvertible debt securities. Rather, the condition willbe satisfied if the issuer of a security has “adequate capacityto meet financial commitments under the security for theprojected life of the asset or exposure. An issuer has anadequate capacity to meet financial commitments if therisk of default by the obligor is low and the full and timely

repayment of principal and interest is expected.” Anexisting investment grade rating could be one factor thatoffering participants may take into consideration indetermining whether an issue of debt securities is“investment grade” for purposes of the OCC Regulations.

FDIC guidanceFor state banks and state-licensed branches of foreignbanks with insured deposits, the Federal Deposit InsuranceCorporation (FDIC) adopted a Statement of PolicyRegarding the Use of Offering Circulars in Connectionwith Public Distribution of Bank Securities for state non-member banks (FDIC Policy).4 The FDIC Policy requiresthat an offering circular include prominent statements thatthe securities are not deposits, are not insured by the FDICor any other agency, and are subject to investment risk.The FDIC Policy states that the offering circular shouldinclude detailed prospectus-like disclosure, similar to thetype contemplated by Regulation A under the SecuritiesAct or the offering circular requirements of the Office ofthe Thrift Supervision (OTS).5 While the Dodd-Frankfinancial regulatory reform bill mandated that thesupervisory functions of the OTS be shifted to the OCCand also eliminated the OTS, the FDIC Policy predatesthe Dodd-Frank changes and therefore continues to referto the OTS’s requirements.

The FDIC Policy further states that the goals of thePolicy will be met if the securities are offered and sold in atransaction that, among other options: (i) satisfied therequirements of Regulation D of the Securities Act relatingto private offers and/or sales to accredited investors; or (ii)the information and disclosure requirements of theregulations of the OTS regarding securities offerings,which require that debt securities be issued indenominations of $100,000 or more. To the extent anoffering meets these requirements, it will be deemed tosatisfy the FDIC Policy requirements. Nonetheless, anissuer may still want to include more detailed disclosure, asthe FDIC Policy emphasises the applicability of the anti-fraud provisions of the Securities Act and Exchange Act toofferings by banks.

Securities liabilitySecurities offered or guaranteed by a bank under Section3(a)(2) are not subject to the civil liability provisions underSection 11 and Section 12(a)(2) of the Securities Act.However, offerings under Section 3(a)(2) are subject toSection 10(b) of the Exchange Act and the anti-fraudprovisions of Rule 10b-5 under the Exchange Act.Moreover, investors may have a fraud-based cause of actionunder state common or statutory law. Therefore, whenconsidering an offering under Section 3(a)(2), a bank (andits underwriters) must take into consideration whatdisclosure is necessary to avoid liability under the anti-fraud provisions, even if the document does not need tocomply with the specific form requirements of the SEC or


another regulator. As a result, the form and content ofbank note offering documents issued under Section 3(a)(2)are similar in many respects to that used for a registeredoffering. Also, broker-dealers must carefully assess thesuitability of the relevant investors, particularly in the caseof offerings of structured products.

Blue sky lawsSecurities issued under Section 3(a)(2) are considered“covered securities” under Section 18 of the Securities Act.As a result, a state may not require registration orqualification of Section 3(a)(2) bank notes or comment onthe related offering document. However, states mayrequire certain notice filings and charge filing fees inconnection with an offering. Most states do not requireregistration for bank notes offered by a foreign bankthrough its US branch or agency under the principles ofcomity, on the theory that the domestic branch or agencyis subject to oversight and regulation by US bankingauthorities. However, it is understood that there are a fewstates, including Texas, that do not extend the exemptionto US branches or agencies of foreign banks.

Minimum denominationsThe Securities Act contains no requirements regardingminimum denominations for securities issued pursuant toSection 3(a)(2). A review of several no-action letters revealsthat the SEC has not directly conditioned the granting ofany no-action letter on a bank security being issued in adenomination of $100,000 or greater. While issuers haveidentified large denominations in no-action letter requestsas an argument in their favour, the SEC has not issued anystatement indicating that issuances under Section 3(a)(2)are or should be conditioned on compliance with anyminimum denomination requirements, or particular salesrestrictions.

As referred to above, Part 16.6 of the OCC Regulationsprovide an exemption for offerings of “non-convertibledebt” to accredited investors in denominations of$250,000 or more. Under Part 16.6, each note ordebenture must show on its face that it cannot beexchanged for notes or debentures in smallerdenominations and permits sales only to accreditedinvestors. The OCC has commented that theserequirements “serve as important investor/consumerprotection tools and foster safe and sound banking rules.”6

Some third party commentary also advocates the issuanceof subordinated debt of banks only in largedenominations.7 The reasoning behind this position is thatsecurities issued in increments in excess of $100,000 (theinsurance limit for deposits) will clearly indicate toinvestors that the debt is uninsured and is specificallysubordinated to the bank’s other debts. Notably, securitiesissued in large increments are generally issued toinstitutional investors who presumably understand thatthe securities are uninsured. Issuances of banks’ securities

in smaller denominations marketed to less sophisticatedretail investors lack a large face value that will put suchinvestors on notice that the securities are not insured.

An agency of a foreign bank subject to New Yorkbanking regulations would have to notify theSuperintendent of the New York Department of FinancialServices of any upcoming transaction. Absent objectionfrom the Superintendent within 30 days of such notice,the agency would be able to sell securities, and only tocertain authorised institutional purchasers in minimumdenominations of $100,000.8

Offering documentsAs a result of the applicable liability provisions describedabove, the offering documentation for bank notes issomewhat similar to that of a registered offering. The formof these documents is not subject to the relevant SEC formrules, and may vary somewhat from those used in aregistered offering. However, the content (as well as thetypes of documents incorporated by reference) tends to besomewhat similar.

The principal document used to describe the securitiesand the issuer is an offering memorandum, which may becalled an offering circular. In addition to a detaileddescription of the securities section, an offeringmemorandum will either include a description of theissuer’s business and financial statements, or incorporatethem by reference from the issuer’s publicly availabledocuments in the United States or its home jurisdiction.

In addition, the issuer and the selling agents for theseofferings may use a variety of term sheets to offer thesesecurities.

A bank may choose to issue bank notes on a stand-alonebasis, or to establish a bank note programme if the bankanticipates substantial issuance volume. A bank noteprogramme will function much like other continuousoffering programmes, such as medium-term noteprogrammes. In addition to the disclosure documents, thefollowing documents are typically used to establish a banknote programme:• One or more paying agency agreements with a paying

agent;• A distribution agreement between the issuer and the

selling agents or dealers; and• An administrative procedures memorandum, which

describes the exchange of information, settlementprocedures, and responsibility for preparing documentsamong the issuer, the selling agents, the paying agent,their respective counsels, and the applicable clearingsystem in order to offer, issue and close each series ofsecurities under the programme.Additional agreements for a bank note programme may

include a calculation agency agreement or a currencyexchange rate agency agreement. Under a calculationagency agreement, the calculation agent, which often is thesame entity as the paying agent, agrees to calculate the rate


of interest due on floating rate notes. This type ofagreement also may be used in connection with structurednotes to calculate the returns payable on the note.

In the case of structured notes, a broker-dealer (usually,the arranger or one of its affiliates) is more likely to serveas calculation agent. Under a currency exchange rateagency agreement, an exchange rate agent (again, often thepaying agent) converts the payments made by the issuer onforeign currency-denominated notes into US dollars forthe benefit of US investors.

In addition, at the time a programme is established, theissuer generally is required to furnish a variety ofdocuments to the selling agents, as would be the case in atypical underwritten or syndicated offering:• Officer’s certificates as to the accuracy of the disclosure

documents;• Legal opinions as to the authorisation of the

programme, the absence of misstatements in theoffering documents, the applicability of the Section3(a)(2) exemption and similar matters; and

• A comfort letter (or agreed upon procedures letter)from the issuer’s independent auditors.Depending upon the arrangements between the issuer

and the selling agents, some or all of these documents willbe required to be delivered to the selling agents on aperiodic basis as part of the selling agents’ ongoing duediligence process. Some or all of these documents also maybe required in connection with certain takedowns, such aslarge syndicated offerings of bank notes.

Finra requirementsEven though securities offerings under Section 3(a)(2) areexempt from registration under the Securities Act, theoffering documents and distribution agreements for publicsecurities offerings conducted by banks must be filed withthe Financial Industry Regulatory Authority, Inc. (Finra)for review under Finra Rule 5110(b)(9), unless anexemption is available. For purposes of Finra Rule 5110,an offering of Section 3(a)(2) bank notes is a “publicoffering.” One exemption from filing under Finra Rule5110 is that the issuer has outstanding investment graderated unsecured non-convertible debt with a term of issueof at least four years, or that the issuance of non-convertible debt securities is so rated.

A slightly different exemption is applicable to anissuance of bank notes in which a broker-dealer affiliate ofthe issuer participates in the offering. That participationconstitutes a “conflict of interest” for purposes of FinraRule 5121, and occurs frequently when the issuer is part ofa large financial institution with an affiliated broker-dealerparticipating in the offering. If the offering documentshave the prominent conflicts of interest disclosure requiredby Finra Rule 5121 and the securities are either investmentgrade rated or in the same series that have equal rights andobligations as investment grade rated securities, then nofiling under Finra Rule 5110 would be required.

“Prominent disclosure” for purposes of Finra Rule 5121means that the offering document include disclosure onthe front page that a conflict of interest exists, with a cross-reference to the discussion within the offering document,and disclosure in any summary of the offering document.

If there are no outstanding securities of a national bank(including a branch or agency of a foreign bank regulatedby the OCC) in the same series that are rated investmentgrade and have equal rights and obligations as the banknotes to be issued, the proposed offering is to be issuedunder Part 16.6 of the OCC Regulations and there is a“conflict of interest” within the meaning of Finra Rule5121, then the issuer must obtain an investment graderating for the offered securities in order to avoid a filingunder Finra Rule 5110. This would be the case even if thenational bank has made the “investment grade”determination discussed above under “OCC Registration.”

There are other Finra requirements applicable toofferings of Section 3(a)(2) bank notes:• Suitability: Finra members selling Section 3(a)(2) bank

notes are subject to Finra Rule 2111, the suitability rule.Under Finra Rule 2111, a member firm or registeredrepresentative must perform a reasonable basis suitabilitydetermination before recommending a transaction orinvestment strategy involving a security. A reasonable basissuitability determination is necessary to ensure that atransaction or investment strategy is suitable for at leastsome investors. That determination will be morecomplicated with respect to structured bank notes, ascompared to fixed or floating rate bank notes.

• Communication rules: Under Finra Rule 2210,“Communications with the Public,” certain “retailcommunications” (as defined in the rule) published orused broadly by a new Finra member firm relating to anoffering of Section 3(a)(2) bank notes would have to befiled with Finra no later than 10 business days prior totheir first use.9 All retail communications are subject toapproval by a principal of the member firm prior to firstuse or filing with Finra. Institutional communicationsmust be subject to a member firm’s written proceduresdesigned to ensure that the communications complywith applicable Finra standards. All membercommunications, including those relating to an offeringof Section 3(a)(2) bank notes, must be based onprinciples of fair dealing and good faith, must be fairand balanced, and must provide a sound basis forevaluating the facts in regard to any particular banknote. The communications may not omit any materialfact or qualification if the omission, in light of thecontext of the material presented, would cause thecommunication to be misleading.

• Trace reporting: Transactions under Section 3(a)(2)must be reported through the Trade Reporting andCompliance Engine (Trace).10 All brokers and dealerswho are Finra members have an obligation to reportSection 3(a)(2) transactions to Trace.


ConclusionSection 3(a)(2) provides bank issuers, including branchesand agencies of foreign banks, with the ability to issuedifferent types of securities without registering the offeringwith the SEC. When relying on Section 3(a)(2), an issuermust carefully consider the disclosure included in itsoffering document, so as not to subject itself to liabilityunder the anti-fraud provisions of the securities laws andto comply with the regulations and other guidanceadopted by the various banking regulators. Banks seekingto employ industry best practices typically utilisedisclosure, and meet standards, similar to those used in thecontext of registered offerings.


1. See Securities Issued Or Guaranteed By United StatesBranches Or Agencies of Foreign Banks, SEC ReleaseNo. 33-6661 (September 23 1986).

2. In addition to structured bank notes, banks may issuestructured certificates of deposit.

3. See Morgan Stanley & Co. Incorporated, SEC No-action Letter (June 24 1996). Under the terms of theMorgan Stanley letter, an issuer of a debt security(ELN issuer) linked to an underlying common stockonly has to include summary information about theissuer of the common stock (the “linked stock issuer”),disclosure as to availability of information about thelinked stock issuer and information about theunderlying common stock (generally, the US nationalsecurities exchange on which the common stock islisted and the high and low quarterly sales prices forthe two previous full years), provided that the linkedstock issuer meets certain eligibility requirements.Those requirements are that (1) the linked stock issuerhas a class of equity securities registered under Section12 of the Exchange Act and (2) the linked stock issuer(i) is eligible to use Securities Act Form S-3 or F-3 or(ii) meets the listing criteria for issuers of the equitysecurities underlying equity-linked notes that are to belisted on a national securities exchange. If the linkedstock issuer does not meet the eligibility requirements,the ELN issuer would have to include detailedinformation about the linked stock issuer, potentiallyexposing the ELN issuer to liability for the linkedstock issuer’s misstatements or omissions.

4. See 61 Fed. Reg. 46808, September 5 1996. Thepolicy was most recently revised in September 1996,and may be found at http://www.fdic.gov/regulations/laws/rules/5000-500.html#fdic5000statementop.

5. These requirements can be found at 12 C.F.R. 563g.

6. Federal Register, Vol. 73, No. 80, April 24 2008, at22228.

7. See Statement of the Shadow Financial RegulatoryCommittee Meeting (Washington), March 2 2000.

8. N.Y. Banking Law § 202-a(1); N.Y. Comp. Codes R.& Regs. tit. 3, §§ 81.1-3.

9. This requirement applies to a Finra member firm forthe period of one year beginning on the date reflectedin the Central Registration Depository system as thedate that the firm’s Finra membership becameeffective. Finra recently proposed amendments toRule 2210(c)(1)(A) pursuant to which the pre-usefiling requirement would be changed to a requirementto file within 10 business days of first use and applyonly to new member firms’ websites and materialchanges to their websites.

10. Trace is the Finra -developed vehicle that facilitates themandatory reporting of over-the-counter secondarymarket transactions in eligible fixed income securities.

ENDNOTES


Foreign bank branches in the United States,federally or state-licensed, may exercise bankingpowers, such as accepting certain types of deposits.Before 1991, foreign bank branches could accept

both retail and wholesale deposits. However, althoughforeign bank branches may receive deposits of any sizefrom foreigners, the Federal Deposit InsuranceCorporation Improvement Act of 1991 prohibited thesebranches from accepting deposits of less than $250,000from US citizens and residents. A grandfathering provisionpermits insured federal branches in existence on the date ofAct’s enactment to continue accepting insured deposits ofless than $250,000.1Furthermore, as a result of the Foreign Bank Supervision

Enhancement Act of 1991, deposits in any foreign bankbranch established after December 19 1991, are notcovered by US deposit insurance. US subsidiaries offoreign banks, because they are chartered in the UnitedStates, may become members of the Federal Reserve andundertake any banking activities permitted for US-ownedbanks.

When is a certificate of deposit a security?A certificate of deposit (CD) is a special type of depositaccount with a bank that typically offers a higher rate ofinterest than a regular savings account. Section 2(a)(1) ofthe Securities Act includes “certificates of deposit” in thedefinition of the term “security.” However, under relevantfederal judicial and regulatory guidance, a CD insured bythe Federal Deposit Insurance Corporation (FDIC) isgenerally not considered a “security” under the federalsecurities laws and generally is not subject to theregistration requirements of federal securities laws.In furtherance of the concept of “national treatment,”

the SEC has determined for purposes of an exemptionfrom the registration requirements of the Securities Actthat US branches of a foreign bank appear to be “virtuallyindistinguishable” from their domestic counterparts andhave “substantially equivalent” US federal and stateregulation and supervision as comparably-licensed, state-chartered banks.2 However, there are limited circumstancesin which courts have characterised certain CDs assecurities.In Marine Bank v Weaver,3 the US Supreme Court set

forth the analytical framework for determining whether aCD would be considered a “security” for purposes of the

antifraud provisions of the Exchange Act. The Courtfocused on the difference between bank-issued CDs andother long-term debt obligations. According to the Court,FDIC-insured CDs are afforded protection by the reserve,reporting and inspection requirements of the FederalDeposit Insurance Act. Since holders of these deposits areguaranteed payment of principal by the US government,the Court opined that it was not necessary to provide theadded protections to CD holders that are afforded underthe antifraud provisions of the US federal securities laws.However, as a caveat, the Court added that all CDs are notautomatically outside of the definition of “security” underthe federal securities laws, and that “each transaction mustbe analyzed and evaluated on the basis of the content ofthe instrument in question, the purpose intended to beserved, and the factual setting as a whole.”4The Court’s holding in Marine Bank set forth a

relatively straightforward analytical framework with regardto CDs that was made less straightforward three years later,in Gary Plastics Packaging v Merrill Lynch, Pierce, Fenner, &Smith Inc.5 In that case, Merrill Lynch had marketed“bundled” insured certificates of deposit that it obtainedfrom various banks. Merrill Lynch purportedly promisedto maintain a secondary market to guarantee purchasersliquidity for their deposits, and represented to purchasersthat it had reviewed the financial soundness of the issuingbanks.The US Second Circuit Court of Appeals began its

analysis by analogising the CDs offered in Gary Plastics to“investment contracts.” An instrument is an “investmentcontract” if it evidences: (1) an investment; (2) in a commonenterprise; (3) with a reasonable expectation of profits; and(4) profit is to be derived from the entrepreneurial ormanagerial efforts of others. Due to the fact that the broker’screation and maintenance of a secondary market was acritical part of its marketing efforts, and permitted investorsto make a profit from these investments, the Court held thatthe CDs were securities for purposes of the antifraudprovisions of the Securities Act and the Exchange Act.Consequently, the additional protections of those antifraudprovisions were deemed appropriate.As one result of this case, while brokers who offer these

products indicate that they may make a secondary marketin them (and in fact many do), these issuances do notinvolve a commitment or an agreement on the part of anybroker to do so.

CHAPTER 7

Bank deposit products versus securities


Blue sky lawsCDs are usually not considered securities under the USfederal securities laws, as discussed above. However, thatview may not apply to an analysis under each US state’ssecurities, or blue sky, laws.If a particular CD were viewed as a security under the

Securities Act, that CD would be a bank security exemptfrom federal registration under Section 3(a)(2). Thesetypes of securities are considered “covered securities” underSection 18 of the Securities Act, with respect to which aUS state’s registration or qualification provisions arepreempted, and that US state may not require anyparticular disclosure in the offering document relating tothe security. However, because bank securities generally arenot listed on a national securities exchange, US states mayrequire a notice filing and a fee in connection with anoffering of bank securities. Blue sky laws should be examined to ensure that either

no notice filing or fee is required, or the US state’s existingexemption for securities issued by banks does not require afiling. A US state may not view an agency of a foreignbank, whose securities are eligible for the Section 3(a)(2)exemption, as within the US state’s exemption forsecurities issued by banks. Generally, blue sky filings arenot needed in any US state in which CDs or banksecurities are offered.

Structured CDsStructured CDs are investments representing a bankdeposit of a specified amount of money for a fixed periodof time, which have periodic interest payments and/or areturn at maturity that is linked to an underlying asset,such as an equity index, a foreign currency exchange rate,a commodity, or some combination of these. Liketraditional CDs, structured CDs entitle the holder to hisor her principal investment, plus one or more additionalpayments. However, unlike traditional CDs, which usuallypay interest periodically, structured CDs generally pay anadditional payment at maturity based on the underlyingasset. The most common form of structured CDs issued byUS-charted banks is insured by the FDIC, however banksmay offer structured CDs that are not so insured.What sets a structured CD apart from a traditional CD

is its customisable features, limited only to the issuingbank’s imagination (and applicable laws). This allowsinvestors access to a number of investment strategies, aswell as the opportunity to gain upside exposure to a varietyof market measures. While traditional CDs contemplate aspecific fixed or floating rate of income, the incomereceived from structured CDs is mainly derived from theperformance of the underlying reference asset. Here is abasic example of a structured CD:

Bank X issues a certificate of deposit with a two-year termand a minimum investment of $1,000. In lieu of a fixedinterest rate, Bank X has offered to pay an amount equalto the appreciation of the Dow Jones Industrial Average

Index (the DJIA) over that two-year term of the note. Ifthe DJIA increases by 20% in the two-year time period,Bank X will pay an additional $200 for each $1,000invested, or $1,200 in total. However, if the DJIAdeclines, Bank X will only pay out at maturity theprincipal amount invested.In addition, structured CDs may or may not be interest

bearing, and may offer a variety of payment calculations.For example, payments may be calculated using thepercentage increase of the underlying asset based on thestarting level (determined on the pricing date) and theending level (determined before the date of maturity), orpayments may be calculated using the average value of theunderlying asset on a series of observation datesthroughout the term of the structured CD. In addition,the payments may be subject to a cap, or ceiling,representing a maximum appreciation in the value of theunderlying asset. Depending on the terms, a particularseries of structured CDs may also have a participation rate,which represents the leverage or exposure of the structuredCDs to movements in the underlying asset.In short, structured CDs can be designed using many of

the same features as “structured notes,” with oneexception: at minimum, the holder of a structured CDusually receives an amount equal to the principal atmaturity. This feature arises largely from the fact that theFDIC takes the position that, in order to be insurable as a“deposit”, the holder of the instrument must be entitled toat least the return of the principal amount. As a result,regardless of how poorly the underlying asset performs, atmaturity, a holder will still receive the original investmentamount. However, this protection is only available if theinvestment is held to maturity.For deposit amounts of structured CDs that are FDIC-

insured, it is important to note that the FDIC insurance islimited to the principal invested and any guaranteedinterest rate, but not the “contingent” interest. Further,investors are still subject to the direct credit risk of theissuing bank for any dollar amount over the maximumapplicable deposit insurance coverage – for example, if theinvestor holds other deposits with the applicable bank thattogether exceed the applicable deposit insurance limit.Another notable aspect of many structured CDs is the

estate feature (otherwise commonly known as a ‘death put’or ‘survivor’s option’). To the extent provided in the termsof the particular structured CD, if at any time thedepositor of a structured CD passes away (or in some cases,becomes legally incapacitated), the holder’s estate or legalrepresentative has the right, but not the obligation, toredeem the structured CD for the full deposit amountbefore the maturity date, without being subject to anypenalty provisions. The estate or representative also maychoose not to exercise the estate feature and instead holdthe structured CD to maturity.An investment in structured CDs may give rise to a

number of potential risks that investors should be aware of


before making an investment. As mentioned above, theprincipal protection feature only applies if a structured CDis held to maturity. Accordingly, an investor must beprepared to commit his or her investment in a structuredCD for the full term of the structured CD. Depending on the terms of the structured CDs, there may

be no assurance of any return above the deposit amount. Inthe end, if the market measure performs unfavorably, eventhough the investor may receive a return of its principal, theinvestor will still experience an opportunity cost as comparedto investing in a traditional, interest-paying CD or anotherinvestment. Conversely, even if the market measure performsfavorably, depending on the terms of the structured CD, thereturn on the investment may be limited by a predeterminedreturn, a participation rate of less than 100%, or some otherterm specific to a particular structured CD. These types offeatures would cause the structured CD to perform less wellthan the relevant underlying asset. Further, for structuredCDs that are FDIC-insured, the premiums and assessmentspaid by the bank issuer to the FDIC are usually passed on tothe investor in the form of a lower participation rate or alower maximum payment, as compared to non-FDIC-insured CDs and investments. In other words, a differentinvestment, such as a non-insured structured CD or notewith comparable terms, may offer greater upside potential.Some structured CDs may also have a call feature. This

provision allows the issuing bank, at its option, to redeemthe structured CDs at a specified call price on one or morecall dates prior to maturity. By agreeing to a specified callprice, the investor effectively forgoes any possible returnsthat could be realised had the structured CD not beencalled, or had the structured CD been called on a laterdate. In addition, if a structured CD is called, the investormay not be able to reinvest the proceeds in a similarinstrument, since interest rates and the level of theunderlying asset may have changed since the structuredCD was initially purchased.Finally, structured CDs are not liquid investments.

Issuing banks rarely create a secondary market forstructured CDs, and even if a secondary market is created,the issuing banks are under no obligation to maintain it.As a result, if an investor decides to sell his or herstructured CD prior to maturity, the amount the investorreceives could potentially be lower than the initialprincipal amount. Although structured and other CDs may not be

considered securities for purposes of the registrationprovisions of the Securities Act, as discussed above under“When is a certificate of deposit a security?”, a court couldview a structured CD as subject to the anti-fraudprovisions of the Exchange Act. Consequently, issuers ofstructured CDs generally include in their offeringdocuments disclosure about the issuer and the productthat is substantially similar to the disclosure in a registeredoffering of a similar structured security.


1. Section 335(a) of the Dodd-Frank Wall Street Reformand Consumer Protection Act amended Section11(a)(1)(E) of the Federal Deposit Insurance Act (12U.S.C. § 1821(a)(1)(E)) to increase the standardmaximum deposit insurance amount from $100,000to $250,000.

2. See SEC Release No. 33-6661 (September 23 1986).

3. 455 U.S. 551 (1982).

4. Id. at 560, n.11.

5. 756 F.2d 230 (2d Cir. 1985).

ENDNOTES

Foreign issuers may also access the US capitalmarkets by issuing commercial paper (CP). CP isshort-term, non-convertible debt typically issuedby US and non-US banks, financial companies

and other large, investment grade companies. CP issuerstypically establish CP programmes in order to allowfrequent, often daily, issuances on short notice. CPprogrammes are similar to MTN programmes, where themain programme documentation, due diligence anddeliverables are provided upon the CP programme’sestablishment. CP is not registered under the SecuritiesAct and may be issued pursuant to the exemption fromregistration under Section 3(a)(3) of the Securities Act.However, CP can also be issued without registration in aprivate placement pursuant to Section 4(a)(2) of theSecurities Act using the resale exemption provided underRule 144A of the Securities Act.

What is CP?CP is a promissory note with a maturity of nine months orless, although typically with a maturity of 30 days or less.CP is generally unsecured, issued in large denominations($100,000 or more) and sold in book-entry form at adiscount from face value. Although CP typically is issuedas a non-interest bearing security, it is sometimes offered ininterest bearing form. As a result of its unregistered nature,CP is mainly purchased by institutional investors,including money market funds, insurance companies andbanks. CP purchasers are almost always either QIBs orIAIs.

CP is an attractive funding instrument because itprovides short-term liquidity and can be rolled over atmaturity. CP issuers generally use the proceeds of CPissuances to fund short-term liquidity needs, as analternative to short-term borrowing under lines of creditfrom banks, including revolving credit facilities. Issuersusually roll over their CP, which means they repaymaturing CP with the proceeds of new issuances.

In order to meet their payment obligations in the eventof a disruption in the CP market, issuers maintainundrawn, revolving credit facilities or bank letters of creditin amounts equal to the maximum amounts of CP issuableunder their programmes. CP issuers will not borrow underthese credit facilities unless they are unable to repaymaturing CP with new issuances or other available cash.

In those instances where a CP issuer obtains a bank letter

of credit, the CP and the bank letter of credit will beexempt from registration under the exemption provided bySection 3(a)(2) for bank-issued securities.

Banks that enter the CP market often do so by creatinga subsidiary to act as issuer under a CP programme, inwhich case the parent bank provides back-stop financingor serves as guarantor.

Although the majority of CP is issued by operatingcompanies is unsecured, CP can also be asset-backedcommercial paper (ABCP), in which case a bankruptcy-remote special purpose vehicle (SPV) or conduit isestablished to act as the issuer. The SPV uses the proceedsof ABCP issuance primarily to purchase interests in varioustypes of financial assets. Repayment of the ABCP issued bythe conduit depends primarily on the cash collections itreceives from its underlying asset portfolio and its ability toissue new ABCP. Typically, a bank or other financialinstitution will provide liquidity support to bridge thesituation where maturing ABCP cannot be refinanced bythe issuance of new ABCP due to a market disruption.Some common assets financed with ABCP include tradereceivables, consumer debt receivables, and auto andequipment loans and leases. An ABCP conduit may alsouse the proceeds to invest in securities (including asset-and mortgage-backed securities, corporate andgovernment bonds, and CP issued by other entities), andto make unsecured corporate loans.

Exemptions from registration for CPBecause of its short-term nature and frequent issuance, itis not practical to register CP under the Securities Act.Consequently, CP is issued pursuant to the exemptionfrom registration under Section 3(a)(3) or in a privateplacement pursuant to Section 4(a)(2) using the resaleexemption provided under Rule 144A. Thus a CPprogramme is usually structured as a 3(a)(3) programme ora 144A programme. In addition, CP can also benefit fromthe exemption provided by Section 3(a)(2) of theSecurities Act for securities that are either issued orguaranteed by a bank or supported by a letter of creditfrom a bank.

Section 3(a)(3) exemption requirementsSection 3(a)(3) itself is brief and exempts from registration“any note, draft, bill of exchange or banker’s acceptancewhich arises out of a current transaction or the proceeds of


CHAPTER 8

Considerations related to commercial paper

which have been or are to be used for current transactions,and which has a maturity at the time of issuance notexceeding nine months, exclusive of days of grace, or anyrenewal thereof the maturity of which is likewise limited”.An SEC interpretive release and subsequent SEC no-action letters have established the following four criteriathat must be satisfied:

The CP should – • be prime quality and negotiable;• be a type not ordinarily purchased by the general

public;• be issued to facilitate current transactions; and• have a maturity not exceeding nine months.

The prime quality requirement has customarily beensatisfied on the basis of ratings of the CP by nationallyrecognised rating services (for example, at least A-2, P-2 orF2 from Standard & Poor’s, Moody’s and Fitch,respectively). Such ratings depend on the creditworthinessof the issuer (or the guarantor, if any). If the CP is unratedor less than investment grade, then the CP issuer couldobtain a committed back-up bank facility, although it isunclear whether the SEC would issue a no-action letterpermitting this arrangement. Alternatively, if the CP isunrated, the sponsoring dealer could provide a letter toissuer’s counsel stating that in such dealer’s view the CPwould, if rated, be given a prime rating and that issuer’scounsel may use such letter as the basis for opining that theCP is entitled to the Section 3(a)(3) exemption.

With respect to the requirement that the CP be of a“type not ordinarily purchased by the general public”, therelevant factors are denomination, type of purchaser andmanner of sale. The minimum denominations described inSEC no-action letters are typically $100,000, although inpractice CP is usually sold in much higher denominations.Purchasers of CP usually are required to be institutionalinvestors or sophisticated individuals who would qualify aspurchasers in a 4(a)(2) private placement and SEC no-action letters often refer to sales to “institutions orindividuals who normally purchase commercial paper”.The marketing of CP also should be clearly aimed at suchpurchasers and advertising in publications of generalcirculation should generally be avoided. However, the SEChas not objected to tombstone advertisements announcing3(a)(3) programme establishments or limitedadvertisements in publications of general circulation.

The requirement that the CP have a maturity notexceeding nine months can be satisfied by limiting thepermitted maturity to 270 days in the documentationestablishing the CP programme. Demand notes and noteswith automatic rollover, extension or renewal provisionsthat extend maturity past the 270-day mark would notmeet this requirement.

The current transactions requirement has been thesubject of the majority of the SEC no-action lettersregarding Section 3(a)(3). For corporate issuers, using CPto finance inventory or accounts receivable financing,

recurring or short-term operating expenses, such as thepayment of salaries, rent, taxes, dividends or generaladministrative expenses and the interim financing ofequipment or construction costs, pending permanentfinancing, for a period of not longer than one year willsatisfy the current transaction requirement.

In those cases where it is not possible to trace theapplication of proceeds to particular uses, the SEC hasaccepted the use of limits on the amount of CP to be issuedaccording to formulas based on various categories of currenttransactions. The more expansive of these formulas includelimiting the amount of CP outstanding at any one time tonot more than the aggregate amount utilised by the CP issuerfor specified current transactions, including in circumstanceswhere the proceeds are loaned or advanced to a guarantor orits subsidiaries. The SEC also has indicated that a CP issuershould use a balance sheet test for determining such CPcapacity whereby the CP issuer determines the capital it hascommitted to current assets and the expenses of operating itsbusiness over the preceding 12-month period. The principaluse of proceeds that clearly do not qualify for currenttransaction status include financing the purchase ofsecurities, whether in connection with a takeover, forinvestment purposes or as issuer repurchases, capitalexpenditures such as the purchase of land, machinery,equipment, plants or buildings, and the repayment of debtoriginally incurred for an unacceptable purpose.

The 3(a)(3) exemption is an exemption for the CP notesthemselves. Therefore, if the conditions are met, there is noneed for the issuer or secondary market resellers to ensurethat each sale or presale of CP notes qualified as a privateplacement in accordance with the Securities Act.Consequently, 3(a)(3) programmes are often preferred to4(a)(2) programmes. However, the primary reason issuers areunable to use the 3(a)(3) exemption is that they plan to usethe proceeds for purposes that do not clearly meet the currenttransactions requirement or the CP would have a maturitylonger than nine months. Some issuers maintainsimultaneous 3(a)(3) programmes and a 4(a)(2) programmesand issue CP under a 4(a)(2) programme when raisingmoney for the purchase of a fixed asset or for takeoverfinancing. In such cases, the SEC has issued no-action lettersto the effect that it will not apply the “integration doctrine”to the CP issuances so long as the purposes are distinct theproceeds of the two programmes are segregated.

Section 4(a)(2) exemption requirements4(a)(2) programmes are structured so that the sale of theCP notes by the issuer (either to the dealers as principal ordirectly to purchasers) is exempt under the safe harbourprovided by Rule 506 under Regulation D. Resales by thedealers to QIBs (or purchasers that the dealers and anypersons acting on the dealers’ behalf reasonably believe tobe QIBs) are exempt under the safe harbour of Rule 144A.Resales by the dealers to AIs are exempt under the so-called“Section 4(a)(1½)” exemption.


Information requirementsBecause resales by the dealers and secondary markettransfers rely on Rule 144A, a 4(a)(2) programme issuer(or a guarantor) of a 4(a)(2) programme, must complywith the information requirements of Rule 144A(d)(4).4(a)(2) programme issuers undertake to comply with theserequirements by including such information in the privateplacement memorandum (PPM) for the programme.However, public companies will automatically be incompliance if they continue to file reports under theSecurities Exchange Act of 1934, as amended. 4(a)(2)programme PPMs typically include language offeringpurchasers the opportunity to ask questions of, and receiveanswers from, the issuer/guarantor about the terms andconditions of the offering or generally about the companyand when sales are made to AIs under Regulation D suchan offer is required in accordance with Rule 502(b)(2)(v)under Regulation D.

Why would an issuer choose a 4(a)(2) programme?An issuer may decide to structure its CP programme as a4(a)(2) programme in order to avoid the currenttransactions test and the 270-day limitation on maturityunder Section 3(a)(3). An issuer of CP under a 4(a)(2)programme can use the proceeds for any purpose,including to finance capital expenditures or acquisitions orto refinance existing debt originally incurred for thesepurposes (subject to Regulation T restrictions, which wediscuss below). CP notes issued under a 4(a)(2)programme also are not subject to the 270-day maturitylimitation, although their maturity will still be limited bymarketability and by concerns under the InvestmentCompany Act. Although a 4(a)(2) programme would notbe subject to the 270-day maturity limitation of Section3(a)(3), the maturity of CP rarely exceeds 397 days. CPwith a longer maturity is generally not marketed, in partbecause money market funds (which are major purchasersof CP) are restricted under Rule 2a-7 under theInvestment Company Act from purchasing notes withmaturities exceeding 397 days. Limiting the CP’s maturityto 270 days, however, can provide the issuer with anexemption from registration under the InvestmentCompany Act.

Disadvantages of a 4(a)(2) programmeThe drawbacks to a 4(a)(2) programme mostly are due tothe fact that the CP notes, unlike 3(a)(3) CP or 3(a)(2) CP,are restricted securities. As a result, each resale must beexempt from registration because CP notes sold in a4(a)(2) programme are privately placed. Each resale of theCP, including each resale by a purchaser in the secondarymarket, must be made in a transaction exempt from theregistration requirement. However, the practical impact ofthis is somewhat lessened due to the fact that investorsoften hold CP until maturity and the Rule 144A marketprovides significant liquidity. As a result, in 4(a)(2)

programmes, the PPM will specify that purchasers canresell their CP only to QIBs under Rule 144A or to theissuer or a programme dealer. The issuer or dealers canresell CP they reacquire using the same exemption used inthe original sale, if desired. In addition, 4(a)(2) CP isgenerally sold in larger minimum denominations than3(a)(3) CP ($250,000 rather than $100,000) inrecognition of the heightened need to limit the types ofacceptable purchasers.

The documentation for a 4(a)(2) programme alsorequires additional language regarding the 4(a)(2)exemption. For example, the PPM, dealer agreement andmaster note all include selling restrictions and restrictivelegends. The PPM and master note also include deemedrepresentations of the purchasers of the CP, while thedealer agreement contains customary representations andcovenants typically found in Regulation D and Rule 144Aofferings.

Finally, Regulation T of the Federal Reserve Boardrestricts broker-dealers from extending unsecured credit ifthe proceeds are used to buy, carry or trade in securities. Abroker-dealer’s purchase of restricted securities as principal,which can occur under a 4(a)(2) programme, is subject toRegulation T, which imposes limitations on the use ofproceeds. The form dealer agreement of the SecuritiesIndustry and Financial Markets Association (Sifma) for4(a)(2) programmes contains procedures for addressingthis issue, mainly by requiring the CP issuer to notify thedealers if it will or may use the proceeds to purchase orcarry securities.

Rule 144A exemption requirementsOften issuers have not relied on Rule 144A in order thatprivately placed CP could be sold to purchasers who arenot QIBs. Instead, Regulation D was used to permit salesto AIs. However, if the CP will be sold to QIBs, then CPissuers may structure their programmes so that dealers mayuse Rule 144A for sales of CP so long as the otherrequirements of Rule 144A are met, which include thefollowing:• The reseller (or any person acting on its behalf ) taking

reasonable steps to ensure that the buyer is aware thatthe reseller may rely on Rule 144A in connection withthe resale.

• The CP resold :(a) when issued was not of the sameclass as securities listed on US national securitiesexchange or quoted on a US automated inter-dealerquotation system; and (b) are not securities of an open-end investment company, unit investment trust, orface-amount certificate company that is, or is requiredto be, registered under the Investment Company Act.

• In the case of a CP issuer that is neither an ExchangeAct reporting company, nor a foreign issuer exemptfrom reporting pursuant to Rule 12g3-2(b) of theExchange Act, nor a foreign government, the holderand a prospective buyer designated by the holder must


have the right to obtain from the CP issuer and mustreceive, upon request, certain reasonably currentinformation regarding the CP issuer.The documentation for a Rule 144A programme also

will be very similar to a 3(a)(3) programme (for example,offering memorandum, dealer agreement, issuing andpayment agent agreement, master note and the like). Thismeans that a 3(a)(3) programme could be converted overto a Rule 144A programme with relative ease.1

Establishing a CP programmeIn order for CP to qualify for the exemption under Section3(a)(3), and generally to be marketable, it must be highlyrated, and therefore only investment grade issuers issue3(a)(3) CP. This explains why 3(a)(3) CP is typically issuedby US and non-US financial companies, banks and bankholding companies and other large blue chip companies,or subsidiaries of these companies. Non-US investmentgrade issuers who want to issue US CP often form a UScorporate subsidiary to act as the issuer under a CPprogramme. For the subsidiary’s CP to benefit from theparent’s credit ratings, the parent guarantees the CP, whichmeans that that the parent is party to all the mainprogramme documents.

CP issuers can market directly to investors, but mostchoose to use the services of dealers. CP programmes, likeMTN programmes, may include more than one dealer. Ina CP programme with more than one dealer, one dealermay take the lead in negotiating documents and advisingthe issuer, but that dealer will generally not take on aformal title (such as arranger). In 4(a)(2) programmes,dealers are sometimes referred to as placement agents.

In order to establish a CP programme, the issuer willneed an issuing and paying agent (IPA), which is a third-party trust company or bank that serves a functionsomewhat like a trustee under an indenture. The IPA playsvarious roles under a CP programme, includingcoordinating settlement of CP notes with The DepositoryTrust Company (DTC), processing payments under CPnotes, assigning CUSIP numbers to each issuance of CPand acting as custodian of the master note representing theCP issued under the programme.

CP issuers (and guarantors) are expected to deliver legalopinion letters to the dealers when a CP programme isestablished. Typically outside New York counsel deliversmany of the required opinion paragraphs, while in-houseand/or local counsel qualified in the issuer’s or guarantor’sjurisdiction deliver others. Dealers and IPAs typically donot hire their own counsel for CP programmes. CP dealersinstead rely on the opinion delivered to them by issuer’scounsel, in contrast to other types of offerings (forexample, term securities under Rule 144A/Regulation Sofferings, 4(a)(2) private placements and 3(a)(2)offerings). To the extent an IPA’s internal policy requires alegal opinion on certain points, issuer’s counsel usuallyallows the IPA to rely on issuer’s counsel’s opinion to the

dealers. However, for a CP programme with uniquefeatures or where the standard form documents areexpected to be negotiated for other reasons, the dealers andthe IPA may hire separate outside counsel.

Documentation for a CP programmeThe documents used in a CP programme are fairlystandardised. They are generally not heavily negotiatedcompared to the documents for other kinds of capitalmarkets transactions. The key documents for a CPprogramme are the PPM, the dealer agreement, the issuingand paying agent agreement, the master note, the guaranty,if any, and the legal opinions.

Private Placement Memorandum (PPM)The PPM is the main offering document for a CPprogramme. CP PPMs are much shorter than theprospectuses used in registered offerings and the offeringmemoranda used in other unregistered offerings. CPPPMs are much shorter because, due to the short-termnature of CP, investors rely mainly on the credit ratings ofthe CP issuer or guarantor, rather than disclosure, whendeciding whether to purchase. This is due to the short-term nature of CP and to the fact that CP must be highlyrated to be marketable. Money market funds, which aremajor purchasers, are subject to restrictions under Rule 2a-7 of the Investment Company Act that limit their abilityto invest in securities that are not in the two highest ratingscategories. Nevertheless, CP PPMs incorporate byreference or include the publicly available or fileddisclosure of the issuer and/or guarantor for the benefit ofinvestors. In addition, CP PPMs typically includelanguage stating that purchasers will have the opportunityto ask questions of, and receive answers from, the issuer.

A typical CP PPM includes a very short description ofthe CP issuer and/or guarantor. The rest of the PPMdescribes the CP notes themselves, including the ratings,denominations, as well as the relevant exemption fromregistration and the use of proceeds. A brief sectiondescribing the tax treatment of payments under the CPmay be included, particularly if the CP issuer or guarantoris a non-US entity. In a 4(a)(2) programme, the PPM alsowill include the deemed representation of the purchasersthat they are AIs and the limitations on transfer of thenotes. Similarly, in a Rule 144A programme, the offeringmemorandum also will include the deemed representationof the purchasers that they are QIBs. The actual terms of aCP note are disclosed in a confirmation of purchase.

CP programmes may have one or more dealers. If thereis more than one dealer, the CP issuer is generally expectedto provide each dealer with a customised version of thePPM with only that dealer’s name on the cover. This is incontrast to other types of securities offerings, where thenames of all the dealers or investment banks appeartogether on the cover of the offering document.


Dealer agreementThe dealer agreement (also sometimes called theplacement agreement in a 4(a)(2) or 144A programme)governs the relationship between the CP issuer and thedealers for the duration of the CP programme and sets themanner of sale of CP to or through the dealers. Thedealers’ role is to locate investors and to advise the CPissuer regarding potential investors and offeringprocedures. The dealers also coordinate with the ratingsagencies as most CP is rated by rating agencies.

Sifma publishes model dealer agreements for 3(a)(3)programmes and 4(a)(2) programmes. These modelagreements include forms of legal opinion letters andinclude explanatory notes. Each dealer though usually hasits own standard form of dealer agreement in the same waythat each underwriter has a standard form of underwritingagreement. A typical dealer agreement provides for thepurchase of CP as principal or as agent, includes CP issuerrepresentations, warranties and covenants, requires certaindeliverables to be provided at signing, includesundertakings by the CP issuer to inform the dealers ofmaterial developments and provides for the CP issuer’sindemnification of the dealers for certain losses related tothe PPM. If a CP programme has more than one dealer,the CP issuer typically enters into a separate dealeragreement with each dealer.

The dealer agreement typically allows the parties toagree, on an issuance-by-issuance basis, either for thedealers to purchase CP notes from the issuer as principal(which is similar to a firm commitment underwriting) orfor the dealers to simply arrange for sales from the issuer topurchasers. However, most dealers act as principal inpurchasing CP from the issuer and reselling the CP toinvestors. Investors usually hold CP to maturity, butdealers may provide liquidity to their clients byrepurchasing the CP prior to maturity. The issuercompensates the dealers for acting as principal or agent bypaying them a fee based on the amount of CP purchasedby the dealers. Alternatively, dealers may be compensatedthrough a reselling commission.

The dealer agreement also contains representations,warranties and covenants by the CP issuer that are deemedto be made on the date the CP programme commencesand again each time CP is issued or the PPM is amended.The representations, warranties and covenants, amongother things, establish the factual basis for the relevantregistration exemption, confirm the accuracy of the PPMand confirm the due corporate existence of the CP issuer(and guarantor) and the due authorisation, execution andenforceability of the CP programme documents.

Upon signing, the dealer agreement also requires the CPissuer to deliver certificates and legal opinion letters, aswell as executed versions of the other CP programmedocuments. The CP issuer also agrees to indemnify thedealers for losses arising from material misstatements oromissions in the PPM (which may include the CP issuer’s

public filings and other public information included orincorporated by reference in the PPM) and from theissuer’s breach of a representation, warranty or covenant inthe dealer agreement, including any CP issuer action thatmay invalidate the relevant registration exemption.

Issuing and paying agent agreement (IPAA)The IPAA governs the relationship between the CP issuerand the IPA. For instance, the IPAA specifies how the CPissuer and the IPA will communicate about CP issuancesand the timing of those communications, specifies theamount of the IPA’s fees and contains representations andwarranties and indemnification provisions designed toprotect the IPA from liability to the CP purchasers. EachIPA has a preferred form of IPAA which contains standardterms that are usually market standard and non-controversial.

Master noteThe CP issued under a CP programme is typicallyrepresented by a single master note, registered in the nameof Cede & Co., as nominee for DTC, and held by the IPAas custodian for DTC. DTC makes available a standardform of master note for corporate CP. Most CPtransactions are settled by book-entry through DTC’sMoney Market Instrument (MMI) programme and mostCP is identified by a CUSIP number. DTC provides thedealers with a record of the transactions and the dealersprovide investors with trade confirmations. Secondarymarket trades also are recorded with computer entries.

Unlike a global note, which represents just one issue ofsecurities (or a portion of one issuance that exceeds $500million), a master note can represent all issuances under aCP programme. The terms of each CP issuance arerecorded in the IPA’s book-entry system. Those records arecontinuously updated by the IPA as CP matures and newCP is issued. DTC’s master note form allows theattachment of riders, and typical riders include legendsrequired for the relevant registration exemptions (in thecase of a 4(a)(2) programme or a Rule 144A programme)and, where a programme contemplates interest bearing CPnotes, details regarding interest calculations andprocedures for interest payments.

GuarantyWhen an investment grade issuer establishes a CPprogramme through a subsidiary (as is often the case forforeign issuers wishing to access the US market), the CPissued by the subsidiary is guaranteed by the parent. Theparent executes a stand-alone guaranty. The Sifma formdealer agreements for guaranteed CP include guarantyforms, which dealers are typically reluctant to negotiate.

Legal opinionsPursuant to the dealer agreement, before CP can be issued,counsel to the issuer and, if applicable, the guarantor must


deliver legal opinions to the dealers. The Sifma dealeragreement forms include forms of these opinions. Theopinion paragraphs are often given by some combinationof New York outside counsel, in-house counsel and outsidecounsel qualified in the jurisdiction of the CP issuerand/or guarantor. The opinions typically include opinionparagraphs on: (1) the corporate existence of the CP issuerand/or the guarantor; (2) the due authorisation, executionand enforceability of the CP programme documents; (3)the exemption from registration of the CP notes under theSecurities Act; (4) the CP issuer not being an investmentcompany under the Investment Company Act; (5) theabsence of foreign withholding tax; and (6) the pari passuranking of the CP.

Other considerationsExemptions under the Investment Company ActWhen foreign issuers enter the US CP market, they oftendo so by forming a US corporate subsidiary to act as theCP issuer under the CP programme. In such cases, it islikely that the CP issuer will fall within the definition of“investment company” under the Investment CompanyAct. Therefore, the CP issuer will need to avail itself of anapplicable exemption from registration under theInvestment Company Act. Some common exemptionsused for CP issuance include Rule 3a-5 (an exemption forcertain finance subsidiaries), Rule 3a-6 and Section 3(c)(1)(available only if the CP issuer has solely short-term CP, inother words, CP notes with maturities of 270 days or less,outstanding). However, in order to establish theseexemptions, both the subsidiary and the foreign parentmust meet certain requirements. In order to deliver anopinion on investment company status, counsel for the CPissuer often must analyse the parent’s unconsolidatedfinancial statements and obtain back-up certificatesconfirming certain facts. Because these considerations canrequire structural changes to the CP programme andinvolve significant administrative efforts for the CP issuer,they should be discussed as early as possible in the processfor establishing the CP programme.

Foreign withholding taxDepending on the home jurisdiction of the CP issuerand/or guarantor, foreign withholding tax requirementsmay apply to CP payments. Foreign and US tax counselshould be involved in the planning stages of the CPprogramme establishment when a foreign issuer orguarantor is involved. This is particularly true whendealing with jurisdictions where at-source withholding taxrelief is available only through investor certifications.

Amendment to Rule 2a-7On September 16 2015, the SEC adopted a revision toRule 2a-7 that removed references to credit ratings. Theamendment implements Section 939A of the Dodd-FrankWall Street Reform and Consumer Protection Act. Section

939A requires federal agencies to review how existingregulations rely on credit ratings and remove thosereferences when appropriate. Under the revised rule, asecurity having a rating in one of the two highest ratingscategories would no longer be a required element indetermining whether a security is a permitted investmentfor a money market fund. This requirement has beenreplaced by a new requirement that the money marketfund’s board or its delegate determine that the securitypresents minimal credit risks to the fund.


1. For more information regarding Rule 144A, seeChapter 5 (Mechanics of a Rule 144A/Regulation Soffering). A conversion of a 3(a)(3) programme mustbe handled with care to avoid an integration problem.


ENDNOTE


Foreign companies realise a number of benefits bybeing a public company in the United States. Thesebenefits include increased visibility and prestige,ready access to the US capital markets, which are

still the largest and most liquid in the world, and anenhanced ability to attract and retain key employees byoffering them a share in the company’s growth and successthrough equity based compensation structures. Foreignprivate issuers contemplating accessing the US markets mustdetermine whether they are willing to subject themselves tothe ongoing securities reporting and disclosure requirements,as well as the corporate governance requirements, which arepart and parcel of registering securities publicly in the UnitedStates. Becoming and remaining a US public company is anexpensive, time-consuming project that may force foreigncompanies to reorganise their operations and corporategovernance in ways that such companies would notnecessarily choose absent US requirements.

What is a FPI?The US federal securities laws define a “foreign issuer” as anyissuer that is a foreign government, a foreign national of anyforeign country, or a corporation or other organisationincorporated or organised under the laws of any foreigncountry.1 A FPI is any issuer (other than a foreigngovernment) incorporated or organised under the laws of ajurisdiction outside of the United States, unless more than50% of the issuer’s outstanding voting securities are helddirectly or indirectly by residents of the United States, and anyof the following applies: (1) the majority of the issuer’sexecutive offices or directors are US citizens or residents; (2)the majority of the issuer’s assets are located in the UnitedStates; or (3) the issuer’s business is principally administered inthe United States.2 A foreign company that obtains FPI statuscan avail itself of the benefits of FPI status immediately.A FPI is only required to determine its status on the last

business day of the most recently completed second fiscalquarter. A FPI that obtains its issuer status is notimmediately obligated to comply with US reportingobligations. Reporting obligations begin the first day ofthe FPI’s next fiscal year, when it is required to file anannual report on Form 20-F for the fiscal year its issuerstatus was determined (within four months of the end ofthat fiscal year). However, a foreign company that obtainsFPI status following an annual qualification test can availitself of the benefits of FPI status immediately.

How does a FPI become subject to US report-ing requirements?The term public company is most frequently used to referto a company that has completed an initial public offering(IPO) of its equity securities in the United States andregistered those securities with the SEC under theSecurities Act and the Exchange Act. However, a FPI maybecome subject to the periodic reporting requirement ofthe Exchange Act in three ways:• A FPI may voluntarily choose to list a class of equity or

debt securities on a US national securities exchange (forexample, NYSE, Nasdaq and the like), either inconjunction with a securities offering, or without acapital raise. In order to list a class of securities on a USnational securities exchange, the FPI must register thatclass of securities under Section 12(b) of the ExchangeAct. The FPI also must meet the specified quantitativeand qualitative standards of the relevant US nationalsecurities exchange. Each US national securitiesexchange establishes minimum quantitativerequirements regarding the number of stockholders(not solely record holders), number of shares held bynon-insiders (the public float), aggregate market valueof the company’s public float, minimum stock price andcertain financial standards. The FPI also must satisfycertain corporate governance requirements.

• A FPI also may become subject to SEC reportingrequirements within 120 days after the last day of itsfirst fiscal year ended on which it has: (1) total assetsgreater than $10 million; (2) 2,000 or more holders ofits equity securities worldwide or 500 holders of itsequity securities worldwide who are not accreditedinvestors; and (3) 300 or more holders of its equitysecurities resident in the United States. If the FPI issubject to SEC reporting requirements, it must registerthose securities with the SEC under Section 12(g) of theExchange Act, unless it qualifies for the exemption fromregistration available under Exchange Act Rule 12g3-2(b).

• A FPI also may choose to register an offering of itssecurities under the Securities Act in order to execute apublic offering of its securities. Immediately uponconsummation of the public offering, the FPI becomessubject to periodic and current reporting requirementsunder Section 15(d) of the Exchange Act for at least thefiscal year in which the Securities Act registration

CHAPTER 9

Exchange Act registration


became effective, whether or not the FPIcontemporaneously lists a class of securities on anexchange.By registering securities under Section 12(b) or Section

12(g) of the Exchange Act, a FPI becomes subject to thereporting requirements of Section 13(a) of the ExchangeAct. In addition, FPIs subject to Section 15(d) of theExchange Act must file periodic reports and otherinformation required by Section 13 of the Exchange Act asif they had registered securities under Section 12.

Reporting obligations of a FPI once it becomespublicOnce a FPI becomes a public company, it must complywith the reporting and disclosure requirements under theSEC’s rules and regulations, including an ongoingrequirement to file periodic reports with the SEC. In somecases these rules and regulations include specialaccommodations designed to encourage foreign companiesto enter the US capital markets by reducing the reportingburdens on FPIs that become public companies. FPIs areobligated to file the following Exchange Act reports withthe SEC:

1. Annual Report on Form 20-F.Form 20-F is unique to a FPI and can be used for anAnnual Report similar to a Form 10-K, filed by USdomestic issuers. The information required to be disclosedin a Form 20-F includes, but is not limited to, thefollowing:• Operating results;• Liquidity and capital resources;• Trend information;• Off-balance sheet arrangements;• Consolidated statements and other financial

information;• Significant business changes;• Selected financial data;• Risk factors;• History and development of the registrant;• Business overview; and• Organisational structure.Form 20-F also requires a description of the FPI’s

corporate governance and a statement regarding thosecorporate governance practices that conform to its home-country requirements and not those of the US nationalsecurities exchanges on which its securities are listed. Arecent addition to the required disclosure is informationrelating to changes in, and disagreements with, the FPI’scertifying accountant, including a letter, which must befiled as an exhibit, from the former accountant statingwhether it agrees with the statements furnished by the FPIand, if not, stating the respects in which it does not agree.A FPI may also be required to disclose specialisedinformation. For example, a FPI must provide specifiedinformation if it, or any of its subsidiaries, are engaged in

oil and gas operations that are material to its businessoperations or financial position.A FPI has four months after the end of its fiscal year to

file an Annual Report on Form 20-F. However, if the Form20-F is incorporated by reference to a FPI’s Securities Actregistration statement, the Form 20-F should be filed nolater than three months after the end of the FPI’s fiscalyear.3 Form 20-F may also be used for registrationstatements (similar to Form 10 for US domestic issuers)when a FPI is not engaged in a public offering of itssecurities, but is still required to be registered under theExchange Act (for example, when it has equity securitiesheld by 2,000 or more holders of its equity securitiesworldwide or 500 holders of its equity securitiesworldwide who are not accredited investors, and there isno other exemption available).

2. Reports on Form 6-K.In addition to an Annual Report on Form 20-F, a FPI mustfurnish Reports on Form 6-K to the SEC from time totime. Generally, Reports on Form 6-K containinformation that is material to an investment decision inthe securities of a FPI, and may include press releases,security holder reports and other materials that a FPIpublishes in its home country in accordance with home-country law or custom, as well as any other informationthat the FPI may want to make publicly available.Reports on Form 6-K generally take the place of

Quarterly Reports on Form 10-Q (which include financialreports) and Current Reports on Form 8-K (which includedisclosure on material events) that US domestic issuers arerequired to file. Unlike Form 10-Q or Form 8-K, there areno specific disclosures required by Form 6-K. Instead, aFPI must furnish under cover of Form 6-K informationthat it:• Makes or is required to make public pursuant to the

laws of the jurisdiction of its domicile or the laws in thejurisdiction in which it is incorporated or organised;

• Files or is required to file with a stock exchange onwhich its securities are traded and which was madepublic by that exchange; or

• Distributes or is required to distribute to its securityholders.Reports on Form 6-K must be furnished to the SEC

promptly after the information is made public by a FPI, asrequired by the country of its domicile or under the lawsof which it was incorporated or organised, or by a foreignsecurities exchange with which the FPI has filed theinformation. For many of the larger FPIs, the Form 6-Ksthat are filed with the SEC generally include similar typesof information and are filed with the same frequency as theForm 10-Qs and 8-Ks that are filed by US domesticissuers.


FPI accommodations under US securities lawsA FPI receives certain regulatory concessions compared tothose received by US domestic issuers, including:• Annual report filings: Currently, a FPI must file an

Annual Report on Form 20 F within four months afterthe fiscal year covered by the report. By contrast, adomestic issuer must file an Annual Report on Form10-K between 60 and 90 days following the end of itsfiscal year, depending on its capitalisation and otherfactors.

• Quarterly financial reports: A FPI is not required underUS federal securities laws or the rules of the US nationalsecurities exchanges to file or make publicly availablequarterly financial information, subject to certainexceptions. By contrast, US domestic issuers arerequired to file unaudited financial information onQuarterly Reports on Form 10-Q.

• Proxy solicitations: A FPI is not required under USfederal securities laws or the rules of the US nationalsecurities exchanges to file proxy solicitation materialson Schedule 14A or 14C in connection with annual orspecial meetings of its security holders.

• Audit committee: There are numerous accommodationswith respect to the nature and composition of a FPI’saudit committee or permitted alternative.

• Internal control reporting: Both a FPI and a US domesticissuer must annually assess their internal control overfinancial reporting and in most instances provide anindependent auditor’s audit of such internal control.US domestic issuers are also obligated on a quarterlybasis to, among other matters, assess changes in theirinternal control over financial reporting. However, if aFPI qualifies as an EGC (as defined below) and elects tobe treated as such, it would be exempt from therequirement to obtain an attestation report on internalcontrol over financial reporting from its registeredpublic accounting firm.

• Executive compensation: A FPI is exempt from thedetailed disclosure requirements regarding individualexecutive compensation and compensation plananalysis now required by the SEC. A FPI is required tomake certain disclosures regarding executivecompensation on an individual basis unless it is notrequired to do so under home-country laws and theinformation is not otherwise publicly disclosed by theFPI. In addition, a FPI must file as exhibits to its publicfilings individual management contracts andcompensatory plans if required by its home-countryregulations or if it previously disclosed such documents.

• Directors/officers equity holdings: Directors and officersof a FPI do not have to report their equity holdings andtransactions under Section 16 of the Exchange Act,subject to certain exceptions. However, shareholders,including directors and officers, may have filingobligations under Section 13(d) of the Exchange Act.

• IFRS-No US Gaap reconciliation: A FPI may prepare its

financial statements in accordance with IFRS as issuedby the International Accounting Standards Board (Iasb)without reconciliation to US Gaap.

• Confidential submissions: A FPI that is registering for thefirst time with the SEC may submit its registrationstatement on a confidential basis to the SEC staff (if theFPI is listed or is concurrently listing its securities on anon-US exchange, is being privatised by a foreigngovernment, can demonstrate that the public filing ofan initial registration statement would conflict with itshome-country law or is a foreign governmentregistering debt securities), until the FPI begins tomarket the offering using the prospectus in theregistration statement. US domestic issuers must file allregistration statements publicly on the Electronic DataGathering and Retrieval system, or Edgar. If a FPIcannot submit its registration statement confidentially,it may still qualify as an “emerging growth company”(EGC) under Title I of the JOBS Act, in which case itcould still submit registration statements confidentially,provided that the FPI elects to be treated as an EGCand the initial confidential submissions and allamendments are filed with the SEC no later than 21days prior to the FPI’s commencement of the roadshow.4

• Exemption from Exchange Act reporting: A FPI may beautomatically exempt from Exchange Act reportingobligations if the FPI satisfies certain conditions.

• Easy termination of registration/de-registration: A FPI,regardless of the number of its US security holders, mayterminate its registration of equity securities under theExchange Act and cease filing reports with the SEC,subject to certain conditions. This rule allows a USlisted FPI to exit the US capital markets with relativeease and terminate its reporting duties under Section15(d) of the Exchange Act.

Financial disclosureA FPI is required to make significant disclosures regardingits financial condition under Items 8 and 18 of its AnnualReports on Form 20-F. Item 8 of Form 20-F sets forth thefinancial information that must be included, as well as theperiods covered (generally, three years of audited financialstatements) and the age of the financial statements.5 Inaddition, Item 8 obligates a FPI to disclose any legal orarbitration proceedings involving a third party that mayhave, or have recently had, a significant impact on theFPI’s financial position or profitability, as well as anysignificant changes since the date of the annual financialstatements (or since the date of the most recent interimfinancial statements).Item 18 of Form 20-F addresses the requirements for a

FPI’s financial statements and accountants’ certificates thatmust be furnished with the Form 20-F. FPIs are notrequired to prepare their financial statements inaccordance with US Gaap. A FPI may prepare its financial


statements in accordance with the English languageversion of IFRS as issued by Iasb in their filings with theSEC. However, in those instances where the financialstatements are prepared using a basis of accounting otherthan IFRS as issued by the Iasb, the FPI must provide allother information required by US Gaap and Regulation S-X, unless such requirements specifically do not apply tothe registrant as a FPI.6Item 18(b) of Form 20-F grants a limited exemption to

the above mentioned requirement for: (1) any period inwhich net income has not been presented on a basis asreconciled to US Gaap; (2) the financial statementsprovided pursuant to Rule 3-05 of Regulation S-X inconnection with a business acquired or to be acquired; or(3) the financial statements of a less-than-majority ownedinvestee.US Gaap reconciliations may not be necessary where the

financial statement information is for either a business aFPI has acquired or plans to acquire, a less-than-majority-owned investee, or a joint venture. If the target’s orless-than-majority-owned investee’s financial informationis not prepared in accordance with US Gaap, then suchtarget or investee must account for less than 30% of a FPI’sassets or income in order to avoid US Gaap reconciliation.If, however, the target’s or less-than-majority-ownedinvestee’s financial information is prepared in accordancewith IFRS as issued by Iasb (even if the FPI’s financialstatements are not prepared in accordance with US Gaapor IFRS as issued by Iasb), the FPI is not obligated toreconcile such financial statements with US Gaap,regardless of the significance of the entity to the FPI’soperations.In the case of a joint venture, if a FPI prepares financial

statements on a basis of accounting, other than US Gaap,that allows proportionate consolidation for investments injoint ventures that would be accounted for under theequity method pursuant to US Gaap, it may omitdifferences in classification or display that result fromusing proportionate consolidation in the reconciliation toUS Gaap. In order to avail itself of such omissions, thejoint venture must be an operating entity, the significantfinancial operating policies of which are, by contractualarrangement, jointly controlled by all parties having anequity interest in the entity. Financial statements that arepresented using proportionate consolidation must providesummarised balance sheet and income statementinformation and summarised cash flow informationresulting from operating, financing and investing activitiesrelating to its pro rata interest in the joint venture.Notwithstanding the above, compliance with Item 17 of

Form 20-F is permitted for non-issuer financial statementssuch as those pursuant to Rules 3-05, 3-09, 3-10(i) and 3-14 of Regulation S-X, as well as non-issuer target companyfinancial statements included in Forms F-4 and proxystatements. Item 17 compliance also is permitted for proforma information pursuant to Article 11 of Regulation S-

X. This is significant because Item 17 requires a FPI tofurnish the financial statements and accountant’scertificates that are customarily furnished by US domesticissuers and requires more onerous US Gaap reconciliation.

Rule 12g3-2(b) exemptionRule 12g3-2(b) under the Exchange Act exempts certainFPIs that have sold securities in the United States from thereporting obligations of the Exchange Act even if the FPI’sequity securities are traded on a limited basis in the over-the-counter market in the United States. A FPI can claiman exemption under Rule 12g3-2(b) if:• it is not required to file or furnish reports under Section

13(a) or Section 15(d) of the Exchange Act, whichmeans that the FPI has neither registered securitiesunder Section 12(b) (for exchange-listed securities) orSection 12(g) (for other trading systems) of theExchange Act or completed a registered public offeringin the United States in the prior 12 months;

• it currently maintains a listing of the relevant securitieson at least one non-US securities exchange that, on itsown or combined with the trading of the samesecurities in another foreign jurisdiction, constitutes theprimary trading market for those securities, as definedin the rule; and

• it has published specified non-US disclosure documentsin English on its website or through an electronicinformation delivery system generally available to thepublic in its primary trading market, since the first dayof its most recently completed fiscal year.A FPI that satisfies the Rule 12g3-2(b) exemption will

also be permitted to have established an unlisted,sponsored, or unsponsored depositary facility for itsAmerican Depositary Receipts (which we discuss in greaterdetail below).

Officer certificationThe principal executive officer(s) and the principalfinancial officer(s) (or persons performing similarfunctions) of a FPI are obligated to make certaincertifications in a company’s periodic reports. Thesecertifications must be included in a FPI’s Form 20- F.Other reports filed or furnished by a FPI, such as Reportson Form 6-K, are not subject to the certificationrequirements because they are not considered periodic(unlike, for example a Form 10-Q), and not made inconnection with any securities offerings. Form 20-Frequires the following certifications (although certain ofthe certifications with respect to internal control overfinancial reporting are not made until the FPI has been areporting company for at least a year):• The signing officer has reviewed the report of the FPI;• Based on the officer’s knowledge, the report does not

contain any untrue statement of a material fact or omitto state a material fact necessary to make the statementsmade, in light of the circumstances under which such


statements were made, not misleading with respect tothe period covered by the report;

• Based on the officer’s knowledge, the financial statements,and other financial information included in the report,fairly present in all material respects the financialcondition, results of operations and cash flows of the FPIas of, and for, the periods presented in the report;

• The FPI’s other certifying officer(s) and the signingofficer are responsible for establishing and maintainingdisclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) andinternal control over financial reporting (as defined inExchange Act Rules 13a-15(f ) and 15d-15(f )) for theFPI and have:

• Designed such disclosure controls and procedures, orcaused such disclosure controls and procedures to bedesigned under their supervision, to ensure thatmaterial information relating to the FPI, including itsconsolidated subsidiaries, is made known to suchofficers by others within those entities, particularlyduring the period in which the report is being prepared;

• Designed such internal control over financial reporting,or caused such internal control over financial reportingto be designed under their supervision, to providereasonable assurance regarding the reliability offinancial reporting and the preparation of financialstatements for external purposes in accordance withgenerally accepted accounting principles;

• Evaluated the effectiveness of the FPI’s disclosurecontrols and procedures and presented in the reporttheir conclusions about the effectiveness of thedisclosure controls and procedures, as of the end of theperiod covered by the report based on such evaluation;and

• Disclosed in the report any change in the FPI’s internalcontrol over financial reporting that occurred duringthe FPI’s most recent fiscal quarter (the FPI’s fourthfiscal quarter in the case of an annual report) that hasmaterially affected, or is reasonably likely to materiallyaffect, the FPI’s internal control over financialreporting; and

• The FPI’s certifying officer(s) and the signing officerhave disclosed, based on their most recent evaluation ofinternal control over financial reporting, to the FPI’sauditors and the audit committee of the FPI’s board ofdirectors (or persons performing the equivalentfunctions):

• All significant deficiencies and material weaknesses inthe design or operation of internal control over financialreporting that are reasonably likely to adversely affectthe FPI’s ability to record, process, summarise andreport financial information; and

• Any fraud, whether or not material, that involvesmanagement or other employees who have a significantrole in the FPI’s internal control over financialreporting.

Internal control certificationA FPI’s obligation to comply with the internal controlcertification requirements does not begin until it is eitherrequired to file an annual report pursuant to Section 13(a)or 15(d) of the Exchange Act for the prior fiscal year or hadfiled an annual report with the SEC for the prior fiscalyear. A FPI that is not required to comply with Items 15(b)and (c) of Form 20-F must include a statement in the firstannual report that it files in substantially the followingform:

“This annual report does not include a report ofmanagement’s assessment regarding internal controlover financial reporting or an attestation report of thecompany’s registered public accounting firm due to atransition period established by rules of the Securitiesand Exchange Commission for newly publiccompanies.”The Exchange Act requires that each periodic report

filed under the Exchange Act, including Form 20-F, mustinclude the internal control certifications and must besigned by the registrant’s chief executive officer and chieffinancial officer. Item 15 of Form 20-F contains theinternal control certification requirements applicable to aFPI. Under Item 15(b), a FPI must disclose:• A statement of management’s responsibility for

establishing and maintaining adequate internal controlover financial reporting for the FPI;

• A statement identifying the framework used bymanagement to evaluate the effectiveness of the FPI’sinternal control over financial reporting;

• Management’s assessment of the effectiveness of theFPI’s internal control over financial reporting as of theend of its most recent fiscal year, including a statementas to whether or not internal control over financialreporting is effective; and

• A statement that the registered public accounting firmthat audited the financial statements included in theannual report has issued an attestation report onmanagement’s assessment of the FPI’s internal controlover financial reporting.Further, under Item 15(c), every registered public

accounting firm that prepares or issues an audit report ona FPI’s annual financial statements must attest to, andreport on, the assessment made by management. Suchattestation must be made in accordance with standards forattestation engagements issued or adopted by the PublicCompany Accounting Oversight Board, and cannot be thesubject of a separate engagement of the registered publicaccounting firm. However, the universal practice is for theauditors to audit management’s internal controls overfinancial reporting, and not actually attest tomanagement’s assessment. Furthermore, if a FPI qualifiesas an EGC and elects to be treated as such, it would beexempt from the requirement to obtain an attestationreport on internal control over financial reporting from itsregistered public accounting firm.


Corporate governance practicesThe SEC and the United States national securitiesexchanges, separately, through statutes, rules andregulations, govern corporate governance practices in theUnited States. However, a FPI registered in the UnitedStates may continue to follow certain corporategovernance practices in accordance with its home-countryrules and regulations. The SEC and the US nationalsecurities exchanges acknowledge the disparities betweendomestic and foreign governance practices and thepotential cost of conforming to US standards. Accordingly,a FPI is granted exemptions from certain corporategovernance requirements in the event that it chooses tofollow its home-country corporate governance practices(particularly with regard to audit committee andcompensation committee requirements).

Audit committees.The SEC provides exemptions to its independencerequirement for audit committee members in order toaccommodate the following global practices:• Employee representation: If a non-management employee

is elected or named to the board of directors or auditcommittee of a FPI pursuant to the FPI’s governing lawor documents, an employee collective bargaining orsimilar agreement, or other home-country legal orlisting requirement, he or she may serve as a committeemember.

• Two-tiered board systems: A two-tiered system consists ofa management board and a supervisory/non-management board. The SEC treats thesupervisory/non-management board as a “board ofdirectors” for purposes of Rule 10A-3(b)(1) of theExchange Act. As a result, a FPI’s supervisory/non-management board can either form a separate auditcommittee or, if the supervisory/non-managementboard is independent, the entire supervisory/non-management board can be designated as the auditcommittee.

• Controlling security holder representation: The SECpermits one member of a FPI’s audit committee to be ashareholder, or representative of a shareholder orshareholder group owning more than 50% of the FPI’svoting securities, subject to certain conditions.

• Foreign government representation: In some instances, aforeign government may be a significant security holderor own special shares that entitle the government toexercise certain rights related to a FPI. The SEC permitsa representative of a foreign government or foreigngovernmental entity to be an audit committee member,subject to certain conditions.

• Listed issuers that are foreign governments: The SECgrants an exemption to the audit committeeindependence requirements to listed issuers that areforeign governments.

• Board of auditors: The SEC permits auditor oversight

through a board of auditors, subject to certainconditions.The US national securities exchanges, including the

NYSE and Nasdaq, also impose rules and regulationsgoverning audit committee composition and disclosuresfor companies that list on their exchanges. Like the SEC,each US national securities exchange provides exemptionsfor a FPI that prefers following its home-country practicesin lieu of the exchange’s rules. For example, under Nasdaqrules, a FPI opting to follow its home-country auditcommittee practices is required to submit a letter fromhome-country counsel certifying its practice is notprohibited by home-country law. A FPI is required tosubmit such a letter only once, either at the time of initiallisting or prior to the time the FPI initiates a non-conforming audit committee practice. Similarly, under theNYSE Listed Companies Manual, a FPI may follow itshome-country audit committee practice, provided it:• Discloses how its corporate governance practices differ

from those of domestically listed companies;• Satisfies the independence requirements imposed by

Section 10A-3 of the Exchange Act;• Certifies to the NYSE that the FPI is not aware of any

violation of the NYSE corporate governance listingstandards; and

• Submits an executed written affirmation annually or aninterim written affirmation each time a change occursto the FPI’s board or any of the committees of theboard, and includes information, if applicable,indicating that a previously independent auditcommittee member is no longer independent, that amember has been added to the audit committee, or theFPI is no longer eligible to rely on, or has chosen not tocontinue to rely on, a previously applicable exemptionto the audit committee independence rules.The SEC, the NYSE and Nasdaq each require that a FPI

disclose in its Annual Report on Form 20-F each USnational securities exchange requirement that it does notfollow and describe its alternative home-country practice.

Compensation committees.Form 20-F requires a FPI to disclose informationregarding its compensation committee, including thenames of the committee members and a summary of theterms under which the committee operates. Similar to theaudit committee requirements, both the NYSE andNasdaq permit a FPI to follow home-country practiceswith regard to its compensation committee.

Beneficial ownership reporting obligationsOnce a company becomes a public company underSection 12 of the Exchange Act, its shareholders becomesubject to the reporting obligations under Section 13(d)and 13(g) of the Exchange Act, relating to their ownershipof the company’s shares. These requirements apply toshareholders of all public companies with securities

registered under Section 12, including US and non-USshareholders of FPIs. The underlying premise of thereporting requirements is to give other shareholders andthe securities markets notice of significant acquisitions orpotential changes in control of public companies.Section 13(d) and Section 13(g) of the Exchange Act

require the reporting of beneficial ownership of a publiccompany’s equity securities by any shareholder (or groupof shareholders acting together) owning more than 5% ofthe FPI’s equity securities (whether held directly orindirectly). Each 5% or more shareholder (or group) mustreport its ownership, and any changes in its ownership, ofthe FPI’s equity securities. This information is reported oneither Schedule 13D or Schedule 13G, as applicable.These filings are the responsibility of each shareholder andare generally prepared and filed by the shareholder’scounsel (or with FPI’s counsel’s assistance). These reportsmust be filed with the SEC through Edgar.

Initial reporting on Schedule 13G by exempt share-holders.Each shareholder (including any director or officer) thatbeneficially owned 5% or more of a public FPI’s equitysecurities before such securities were registered under theExchange Act must file a Schedule 13G after the end of thecalendar year in which the equity securities were firstregistered. These shareholders are called exemptshareholders because they were 5% shareholders before theequity securities were registered.

Reporting on Schedule 13D.Once a FPI becomes public in the United States, anyperson that acquires 5% or more of its equity securities orany exempt shareholder that acquires more than 2% of itsequity securities within a 12-month period is required tofile a Schedule 13D if he or she is not a “passive investor.”Schedule 13Ds are filed by those investors whose purposeis not passive, but rather are interested in influencing, oreven changing, how the FPI is run. Directors and officerswho are 5% shareholders cannot be considered passiveinvestors because of their influence over the FPI, so theymust file a Schedule 13D.Schedule 13D is a longer, more extensive form than

Schedule 13G. It requires the shareholder to discloseinformation including:• The identity of the shareholder.• How many shares of the company the shareholder owns

and how the shares are owned.• The source of the funds used to buy the shares.• The shareholder’s purpose for owning the shares.A shareholder must amend its Schedule 13D promptly

to report any material change to the information in theschedule and any increase or decrease of 1% or more in itsbeneficial ownership of the FPI’s shares.

Reporting on Schedule 13G.A Schedule 13G must be filed by a passive investor thatowns less than 20% of the equity securities of a FPI (butmore than 5%) and who did not acquire its shares for thepurpose, or with the effect, of changing or influencingcontrol of the FPI. Schedule 13G requires less disclosureabout the shareholder than Schedule 13D. The primaryinformation disclosed in a Schedule 13G consists of:• The identity of the shareholder.• How many shares of the FPI the shareholder owns and

how the shares are owned.• A certification that the shareholder is a passive investor.Generally a shareholder must amend its Schedule 13G

annually, after the end of each calendar year, to report anychanges in its beneficial ownership of the FPI’s equitysecurities. However, if a shareholder’s ownership exceeds10%, it must amend its Schedule 13G promptly after thedate it exceeds 10% ownership. After exceeding 10%ownership, a shareholder must also promptly amend itsSchedule 13G to report any increase or decrease of morethan 5% in its beneficial ownership of the FPI’s equitysecurities.

American Depositary ReceiptsAn American Depositary Receipt (ADR) is a negotiableinstrument issued by a US depository bank that representsan ownership interest in a specified number of securitiesthat have been deposited with a custodian, typically in theFPI’s country of origin. ADRs can represent one or moreshares, or a fraction of a share, of a FPI, and are offered aseither unsponsored or sponsored programmes.Unsponsored ADR programmes are issued by a depositorybank without a formal agreement with the FPI whoseshares underlie the ADR. Consequently, an unsponsoredADR programme affords the FPI little to no control overthe marketing or other terms of the offering. UnsponsoredADRs are only permitted to trade in over-the-countermarkets.In contrast, sponsored ADRs are depositary receipts that

are issued pursuant to a formal agreement, known as adepository agreement, between the depository bank and aFPI. The depository agreement between the FPI and thedepository bank will, among other matters, cover fees(including fees paid by investors), communications withinvestors and monitoring theThe level of US trading activity will determine whether

US registration will be required. There are three levels ofsponsored ADR programmes:• Level I ADRs: A sponsored Level I ADR programme is

the simplest method for FPIs to access the US capitalmarkets, and is similar to an unsponsored ADRprogramme. Unlike the other two levels of ADRs, LevelI ADRs are traded in the US over-the-counter marketwith prices published in the OTC Pink (formerly thePink Sheets).7 In order to establish a Level I ADR, a FPImust: (1) qualify for an exemption under Rule 12g3-


2(b) of the Exchange Act; (2) execute a depositagreement with the depository bank and the ADRholders, which details the rights and responsibilities ofeach party; and (3) furnish a Form F-6 with the SEC toregister the ADRs under the Securities Act. Note thatfinancial statements and a description of the FPI’sbusiness are not required to be included in a Form F-6registration statement.

• Level II ADRs: Level II ADR programmes enable a FPIto list its depositary receipts on a US national securitiesexchange, such as the NYSE or Nasdaq, but do notinvolve raising new capital. The requirements of a LevelII ADR programme are significantly more burdensomethan a Level I ADR. Under a Level II ADR, a FPI isobligated to file a registration statement on Form 20-Fand comply with ongoing SEC reporting requirements,including filing Annual Reports on Form 20-F andReports on Form 6-K, as needed. In addition, a FPImust also satisfy any listing requirements of the relevantUS national securities exchange.

• Level III ADRs: A Level III ADR programme is used forcapital raising by a FPI. Under a Level III ADRprogramme, the depository bank and the FPI mustmeet all of the Level II ADR programme requirements.In addition, the FPI must file a registration statementon Form F-1 under the Securities Act in order toregister the securities underlying the ADRs. After theoffering, the FPI will be subject to disclosureobligations under Section 15(d) of the Exchange Actand may have additional disclosure obligations underSection 13(a) of the Exchange Act if the ADRs are listedon a US national securities exchange.For each of the three types of sponsored ADR

programmes, the instructions on Form F-6 require that thedepository bank, the FPI, its principal executive officer,financial officer, controller or principal accounting officer,at least a majority of the board of directors or personsperforming similar functions and its authorisedrepresentative in the United States sign the registrationstatement on Form F-6.



1. See Rule 405 under the Securities Act and Rule 3b-4(b) under the Exchange Act.

2. See Rule 405 under the Securities Act and Rule 3b-4(c) under the Exchange Act.

3. Item 8.A.4 of Form 20-F.

4. An EGC is defined as an issuer with total grossrevenues of under $1 billion (subject to inflationaryadjustment by the SEC every five years) during itsmost recently completed fiscal year. A companyremains an EGC until the earlier of five years or: • The last day of the fiscal year during which the

issuer has total annual gross revenues in excess of$1 billion (subject to inflationary indexing);

• The last day of the issuer’s fiscal year following thefifth anniversary of the date of the first sale ofcommon equity securities of the issuer pursuant toan effective registration statement under theSecurities Act;

• The date on which such issuer has, during the priorthree-year period, issued more than $1 billion innonconvertible debt; or

• The date on which the issuer is deemed a “largeaccelerated filer.”

An issuer will not be able to qualify as an EGC if itfirst sold its common stock in an IPO prior toDecember 8 2011.

On July 10 2013, pursuant to Section 201(a) of theJOBS Act, the SEC issued final rules relaxing theprohibition on general solicitation and generaladvertising for certain private placements underRule 506 under Regulation D and Rule 144Aofferings. For more information, see Chapter 4(Mechanics of a Section 4(a)(2) offering) andChapter 5 (Mechanics of a Rule 144A/RegulationS offering).

5. However, a FPI that qualifies as an EGC may complywith the scaled-down disclosure requirements forEGCs, which include (1) two, rather than three, yearsof audited financial statements for initial registrationstatements, (2) for subsequent registration statements(or periodic reports), financial information within theselected financial data or MD&A disclosure for onlythose periods subsequent to those presented in theinitial registration statements, and (3) the executivecompensation disclosures for “smaller reporting

companies” which are less detailed than for other typesof issuers. A “smaller reporting company” is generallydefined for the purposes of initial testing as an issuerthat has a public float of less than $75 million or, inthe case of an issuer that has no public float (eg, anIPO registrant), has annual revenues of less than $50million.

6. Regulation S-X sets forth the form, content of andrequirements for financial statements required to befiled as part of: (a) registration statements under theSecurities Act; (b) registration statements underSection 12 of the Exchange Act, annual or otherreports under Sections 13 and 15(d) of the ExchangeAct and proxy and information statements underSection 14 of the Exchange Act; and (c) registrationstatements and shareholder reports filed under theInvestment Company Act, except as otherwisespecifically provided in the forms.

7. OTC Pink is an electronic quotation system run byOTC Markets Group with bid and ask prices of over-the-counter stocks, including the market makers whotrade them.

ENDNOTES

The Investment Company Act governs theregistration and regulation of investmentcompanies, which may be better known toforeign issuers as collective investment vehicles.

Under the US regulatory scheme, every investmentcompany is subject to registration and regulation pursuantto the Investment Company Act, unless it is exempt.Section 7(d) of the Investment Company Act generallyprohibits any foreign entity that meets the definition of“investment company,” including a foreign bank, frommaking a public offering of its securities in the UnitedStates in the absence of complying with the Act.An investment company is defined broadly as an entity

that holds itself out as being engaged primarily in“investing, reinvesting or trading in securities” and alsoincludes entities engaged in the business of investing,reinvesting, owning, holding or trading in securities ifsecurities represent 40% or more of the value of its assets.”As a result, foreign issuers that are banks, insurancecompanies or specialised finance companies may find thatthey inadvertently fall within the definition of an“investment company.” Similarly, certain operatingcompanies that devote themselves principally to researchand development activities and retain offering proceeds incash, cash equivalents or securities also should take care toavoid being classified as “investment companies” withinthe meaning of the Investment Company Act.Foreign banks may be exempt from the Investment

Company Act. The most commonly used exemptions are:Rule 3a-6 for foreign banks; Rule 3a-5 for financesubsidiaries of foreign banks; and Rule 3a-1 for foreign bankholding companies. Each rule is discussed below. However,in certain cases, foreign banks may potentially qualify forother Investment Company Act exemptions. Non-bankaffiliates of banks also could be “investment companies.” Aforeign bank also may choose to limit its offering of securitiessolely to investors that are “qualified purchasers” and rely onthe exemption provided by Section 3(c)(7) of the InvestmentCompany Act. Finally, even if an issuer does not qualify foran Investment Company Act exemption, it may neverthelessseek an exemption from the SEC under Section 6(c) of theInvestment Company Act.

Rule 3a-6 exemptionRule 3a-6 provides that “a foreign bank … shall not beconsidered an investment company for purposes of the

Investment Company Act.” Thus, the exception is broaderthan merely exempting foreign banks from the registrationrequirements of the Investment Company Act.Rule 3a-6(b)(1)(i) defines a “foreign bank” as a banking

institution incorporated or organised under the laws of acountry other than the United States, or a politicalsubdivision of a country other than the United States, thatis: (a) regulated as such by that country’s or subdivision’sgovernment or any agency thereof; (b) engagedsubstantially in commercial banking activity; and (c) notoperated for the purpose of evading the provisions of theInvestment Company Act.Rule 3a-6(b)(1)(ii) includes other entities within the

definition of “foreign bank.” Under Rule 3a-6(b)(1)(ii)(A),a “foreign bank” also includes a trust company or loancompany that is: (1) organised or incorporated under thelaws of Canada or a political subdivision thereof; (2)regulated as a trust company or a loan company by thatcountry’s or subdivision’s government or any agencythereof; and (3) not operated for the purpose of evadingthe provisions of the Investment Company Act. UnderRule 3a-6(b)(1)(ii)(B), a “foreign bank” includes abuilding society that is: (1) organised under the laws of theUnited Kingdom or a political subdivision thereof; (2)regulated as a building society by the country’s orsubdivision’s government or any agency thereof; and (3)not operated for the purpose of evading the provisions ofthe Investment Company Act. Finally, Rule 3a-6(b)(1)(iii)states that “[n]othing in this section shall be construed toinclude within the definition of foreign bank a common orcollective trust or other separate pool of assets organised inthe form of a trust or otherwise in which interests areseparately offered.” A special purpose vehicle (even ifsponsored by a foreign bank) would have to find anotherexemption from the application of the InvestmentCompany Act.The term “engaged substantially in commercial banking

activity,” used in the foreign bank definition discussedabove, means “engaged regularly in, and deriving asubstantial portion of its business from, extendingcommercial and other types of credit, and acceptingdemand and other types of deposits, that are customary forcommercial banks in the country in which the head officeof the banking institution is located.” Greater certaintyregarding the meaning of the term was provided by a no-action letter, in which the SEC Staff explained:


CHAPTER 10

Foreign banks and the InvestmentCompany Act

“[T]he banking activities in which a foreign bankengages clearly must be more than nominal to satisfythe “substantial” standard in the rule. In addition, inorder to meet this standard, [we] generally wouldexpect a foreign bank: (1) to be authorised to acceptdemand and other types of deposits and to extendcommercial and other types of credit; (2) to hold itselfout as engaging in, and to engage in, each of thoseactivities on a continuous basis, including activelysoliciting depositors and borrowers; (3) to engage inboth deposit taking and credit extension at a levelsufficient to require separate identification of each inpublicly disseminated reports and regulatory filingsdescribing the bank’s activities; and (4) to engage ineither deposit taking or credit extension as one of thebank’s principal activities.”1One commentator notes that Rule 3a-6 has four

principal effects, which are as follows:“First, it enables foreign banks … to sell their

securities in the United States without falling underthe definition of an investment company, regardless ofwhether those securities are debt securities, preferredstock, common stock, or any other types of securities.Second, it allows finance subsidiaries of foreign banks… to rely upon Rule 3a-5 under the 1940 Act whenissuing debt securities or nonvoting preferred stock inthe United States. Third, it allows holding companiesof foreign banks … to rely upon Rule 3a-1 under the1940 Act. Fourth, it enables investment companies toacquire the securities of foreign banks … withoutregard to the limitations imposed by Section 12(d)(1)of the 1940 Act upon an investment company’sacquisition of securities of another investmentcompany.”2

US branches and agencies of foreign banks Neither the exemption for banks in Section 3(c)(3) of theInvestment Company Act nor the exemption for foreignbanks in Rule 3a-6 expressly applies to US agencies orbranches of foreign banks. Nonetheless, the SEC hasissued an interpretive release in which it stated that solely:“[F]or purposes of determining whether the issuance of

securities by a United Stated branch or agency of a foreignbank would require the foreign bank or agency to registerunder the [1940] Act, the Commission will deem such abranch or agency to be a “bank” within the meaning ofSection 2(a)(5)(C) of the [1940] Act, provided that thenature and extent of Federal and/or State regulation andsupervision of the particular branch or agency aresubstantially equivalent to those applicable to bankschartered under Federal or State law in the samejurisdiction.”3This interpretative position was adopted for the limited

purpose of US branches and agencies of foreign banksissuing securities in the United States, and is not intendedto address the status of US branches and agencies of

foreign banks under the Investment Company Act for anyother purposes, for example, as eligible custodians ortrustees under the Investment Company Act. Inpromulgating the interpretive release, the SEC Staff didnot state whether a US agency or branch of a foreign bankfalling within the interpretive position would additionallyhave to satisfy the criteria of Section 3(c)(3).

Rule 3a-5 exemptionRule 3a-5(a) provides that a “finance subsidiary will not beconsidered an investment company under Section 3(a) ofthe Investment Company Act and securities of a financesubsidiary held by the parent company or a companycontrolled by the parent company will not be considered“investment securities” under Section 3(a)(1)(C) of theInvestment Company Act” if certain conditions are met.

The definition of finance subsidiaries. A “financesubsidiary” is “any corporation: (i) all of whose securitiesother than debt securities or non-voting preferred stockmeeting the applicable requirements of paragraphs (a)(1)through (a)(3) or directors’ qualifying shares are owned byits parent company or a company controlled by its parentcompany; and (ii) the primary purpose of which is tofinance the business operations of its parent company orcompanies controlled by its parent company.” Generally,for purposes of Rule 3a-5, a finance subsidiary’s primarypurpose of financing the business operations of its parentcompany will be evidenced if the finance subsidiarydevotes at least 55% of its assets to such financing activitiesand derives at least 55% of its income from thoseactivities.”

The definition of a parent company. Rule 3a-5(b)(2)defines a “parent company” as “any corporation,partnership or joint venture: (i) that is not considered aninvestment company under Section 3(a) [of theInvestment Company Act] or that is excepted or exemptedby order from the definition of investment company bySection 3(b) [of the Investment Company Act] or by therules or regulations under Section 3(a) [of the InvestmentCompany Act]; (ii) that is organised or formed under thelaws of the United States or of a state or that is a [FPI], orthat is a foreign bank or foreign insurance company asthose terms are used in rule 3a-6; and (iii) in the case of apartnership or joint venture, each partner or participant inthe joint venture meets the requirements of paragraphs(b)(2)(i) and (ii).”

The definition of a company controlled by the parentcompany. Rule 3a-5(b)(3) defines a “company controlledby the parent company” as “any corporation, partnershipor joint venture: (i) that is not considered an investmentcompany under Section 3(a) or that is excepted orexempted by order from the definition of investmentcompany by Section 3(b) or by the rules or regulationsunder Section 3(a) [of the Investment Company Act]; (ii)that is either organised or formed under the laws of theUnited States or of a state or that is a [FPI], or that is a


foreign bank or foreign insurance company as those termsare used in Rule 3a-6; and (iii) in the case of a corporation,more than 25% of whose outstanding voting securities arebeneficially owned directly or indirectly by the parentcompany; or (iv) in the case of a partnership or jointventure, each partner or participant in the joint venturemeets the requirements of paragraphs (b)(3)(i) and (ii),and the parent company has the power to exercise acontrolled influence over the management or policies ofthe partnership or joint venture.”

The conditions for finance subsidiaries. In order to qualifyunder Rule 3a-5, finance subsidiaries must meet certainconditions, which are as follows:(1) Any debt securities of the finance subsidiary issued to

or held by the public are unconditionally guaranteed bythe parent company as to the payment of principal,interest and premium, if any (except that the guaranteemay be subordinated in right of payment to other debt ofthe parent company);(2) Any non-voting preferred stock of the finance

subsidiary issued to or held by the public isunconditionally guaranteed by the parent company as topayment of dividends, payment of the liquidationpreference in the event of liquidation, and payments to bemade under a sinking fund, if a sinking fund is to beprovided (except that the guarantee may be subordinatedin right of payment to other debt of the parent company);(3) The parent company’s guarantee provides that in the

event of a default in payment of principal, interest,premium, dividends, liquidation preference or paymentsmade under a sinking fund on any debt securities or non-voting preferred stock issued by the finance subsidiary, theholders of those securities may institute legal proceedingsdirectly against the parent company (or, in the case of apartnership or joint venture, against the partners orparticipants in the joint venture) to enforce the guaranteewithout first proceeding against the finance subsidiary;(4) Any securities issued by the finance subsidiary which

are convertible or exchangeable are convertible orexchangeable only for securities issued by the parentcompany (and, in the case of a partnership or jointventure, for securities issued by the parent company orparticipants in the joint venture) or for debt securities ornon-voting preferred stock issued by the finance subsidiarymeeting the applicable requirements of paragraphs (1)through (3) above;(5) The finance subsidiary invests in or loans to its

parent company or a company controlled by its parentcompany at least 85% of any cash or cash equivalentsraised by the finance subsidiary through an offering of itsdebt securities or non-voting preferred stock or throughother borrowings as soon as practicable, but in no eventlater than six months after the finance subsidiary’s receiptof such cash or cash equivalents;(6) The finance subsidiary does not invest in, reinvest in,

own, hold or trade in securities other than government

securities, securities of its parent company or a companycontrolled by its parent company (or, in the case of apartnership or joint venture, the securities of the partnersor participants in the joint venture) or debt securities(including repurchase agreements) which are exemptedfrom the provisions of the Securities Act by Section 3(a)(3)of the Investment Company Act; and(7) Where the parent company is a foreign bank as the

term is used in Rule 3a-6, the parent company may, in lieuof the guaranty required by paragraphs (1) or (2) above,issue, in favour of the holders of the finance subsidiary’sdebt securities or non-voting preferred stock, as the casemay be, an irrevocable letter of credit in an amountsufficient to fund all of the amounts required to beguaranteed by paragraphs (1) and (2) above; provided, that:(i) payment on such letter of credit shall be conditionalonly upon the presentation of customary documentation;and (ii) the beneficiary of such letter of credit is notrequired by either the letter of credit or applicable law toinstitute proceedings against the finance subsidiary beforeenforcing its remedies under the letter of credit.Notwithstanding Rules 3a-5(a)(1) and (2), the SEC

Staff has taken the view that a finance subsidiary may issuedebt securities and non-voting preferred stock that are notguaranteed by its parent company in a private placementin the United States under Section 4(a)(2) or under Rule506 under Regulation D or in a public offering outside theUnited States in reliance upon Regulation S. The SECStaff also has taken the position that securities issued by afinance subsidiary in a private placement, which are notguaranteed by the parent company, may be resold toqualified institutional buyers pursuant to Rule 144A andto institutional accredited investors. Furthermore, underappropriate circumstances, the SEC has granted exemptiveorders when a finance subsidiary’s securities were notunconditionally guaranteed by the parent company.4

Rule 3a-1 exemptionForeign bank holding companies may qualify for anexception under Rule 3a-1. Rule 3a-1 provides thatnotwithstanding Section 3(a)(1)(C) of the InvestmentCompany Act, an issuer will be deemed not be aninvestment company under the Investment Company Actif:(a) No more than 45% of the value (as defined in

Section 2(a)(41) of the Investment Company Act) of suchissuer’s total assets (exclusive of government securities andcash items) consists of, and no more than 45% of suchissuer’s net income after taxes (for the last four fiscalquarters combined) is derived from, securities other than:(1) government securities; (2) securities issued byemployees’ securities companies; (3) securities issued bythe majority-owned subsidiaries of the issuer (other thansubsidiaries relying on the exclusion from the definition ofinvestment company in Sections 3(b)(3) or (c)(1) of theInvestment Company Act) which are not investment


companies; and (4) securities issued by companies: (i)which are controlled primarily by such issuer; (ii) throughwhich such issuer engages in a business other than that ofinvesting, reinvesting, owning, holding or trading insecurities; and (iii) which are not investment companies;(b) The issuer is not an investment company as defined

in Sections 3(a)(1)(A) or (B) of the Investment CompanyAct and is not a special situation investment company; and(c) The percentages described in paragraph (a) are

determined on an unconsolidated basis, except that theissuer shall consolidate its financial statements with thefinancial statements of any wholly-owned subsidiaries.As discussed above, foreign banks qualifying for an

exemption under Rule 3a-6 would not be considered“investment companies,” and, as a result, their holdingcompanies could potentially rely upon Rule 3a-1. TheSEC has stated: “With the adoption of Rule 3a-6, foreignbanks … are no longer regarded as “investmentcompanies” under the [Investment Company] Act.Therefore, foreign bank … holding companies qualify forthe exception from the definition of investment companyin Section [3(a)(1)(C) under the Investment CompanyAct] or Rule 3a-1 on the same basis as United Statesbanks… .”5

Section 3(c)(7)A foreign bank, a finance subsidiary, or a special purposetrust or issuance vehicle sponsored by a foreign bank orfinance subsidiary also may qualify for an exemption underSection 3(c)(7) of the Investment Company Act. Section3(c)(7) provides an exemption to “[a]ny issuer, theoutstanding securities of which are owned exclusively bypurchasers who, at the time of acquisition of suchsecurities, are qualified purchasers, and which is notmaking and does not at that time propose to make a publicoffering of such securities.” Note that these types ofentities need to rely on Section 4(a)(2) and Rule 506promulgated thereunder for a Securities Act exemption,since Section 3(c)(7) requires an actual private placement.The definition of ”qualified purchaser” is set forth inSection 2(a)(51)(A) of the Securities Act, and generallyincludes a natural person (including any person who holdsa joint, community property, or other similar sharedownership interest in an issuer that is excepted underSection 3(c)(7) with that person’s qualified purchaserspouse) who owns not less than $5 million in investments,and an entity acting for its own account or the account ofother qualified purchasers, who in the aggregate owns andinvests on a discretionary basis, not less than $25 millionin investments. Generally, special purpose issuance vehicleswill rely on this Section 3(c)(7) exemption and structuretheir offerings as private placements of Rule 144A eligiblesecurities with the transfer restrictions expressly limitingtransfers or resales to QIBs that are also qualifiedpurchasers.



1. Seward & Kissel, SEC No-Action Letter, 2005 SECNo-Act. LEXIS 751 (October 12 2005).

2. Robert H. Rosenblum, Investment CompanyDetermination under the 1940 Act: Exemptions andExceptions (2003), §29.1.

3. Status under the Investment Company Act of UnitedStates Branches or Agencies of Foreign Banks IssuingSecurities, 1940 Act Release No. 17681 (August 171990).

4. See Robert H. Rosenblum, Investment CompanyDetermination under the 1940 Act: Exemptions andExceptions (2003), §28.5.

5. Rule 3a-6 Adopting Release, 1940 Act Rel. No. 18381(October 29 1991).

ENDNOTES


Every US state has its own blue sky or securities lawthat is designed to protect investors againstfraudulent sales practices and activities,independent of the US federal securities laws. Blue

sky laws may require registration of, or at least notice filingswith respect to, securities exempt from registration under USfederal securities laws. While these laws vary from state tostate, most state laws require issuers to register their offeringsbefore the issuers can sell their securities to residents of theparticular state, unless the securities offerings are exemptfrom registration. These laws also address the licensing ofbrokerage firms, and their brokers and certain investmentadvisers and their representatives.

Covered securitiesIn October 1996, Congress enacted the National SecuritiesMarkets Improvement Act (NSMIA), which pre-emptedthe application of blue sky laws regarding a substantialnumber of securities offerings and/or transactions, andwhich substantially changed the scope of blue skyregulation. NSMIA amended Section 18 of the SecuritiesAct to exempt “covered securities” from the registrationrequirements of the blue sky laws. Any offering documentwith respect to a covered security is similarly exempt fromstate regulation if the document is prepared by or on behalfof the issuer.Covered securities include the following:

• Securities listed or authorised for listing on the NYSE orNasdaq, and securities of the same issuer that are equal orsenior in rank to such listed securities (collectively, “listedcovered securities”);

• Securities registered under the Investment Company Act;• Securities offered under to Rule 506 under Regulation D;

and• Securities exempt under Section 3(a) of the Securities Act

(with certain exceptions).No state filings or fees may be required in offerings of

covered securities, but states still may require certain noticefilings to be made and may charge filing fees for offerings ofother covered securities.1 NSMIA also permits states tocontinue to enforce their own antifraud laws.2

Bank notesAs we have discussed, Section 3(a)(2) of the Securities Actexempts from registration under the Securities Act anysecurity issued or guaranteed by a bank. This exemption is

premised on the notion that, whether state or federal, banksare highly and relatively uniformly regulated, and as a resultwill provide adequate disclosure to investors about theirfinances in the absence of federal securities registrationrequirements. In addition, banks are also subject to variouscapital requirements that may increase the likelihood thatholders of their debt securities will receive timely payments ofprincipal and interest. Bank notes qualify as coveredsecurities because they are exempt from registration underthe Securities Act under to Section 3(a)(2). However, banknotes typically are not listed or authorised for listing on theNYSE or Nasdaq, which means that states may still requirecertain notice filings and charge filing fees for bank noteofferings.Most states provide exemptions from registration for bank

notes. For example, the State of Texas provides an exemptionfrom registration for securities issued by domestic banks andcertain thrifts:

“The sale by the issuer itself, or by a registered dealer,of any security issued or guaranteed by any bankorganised and subject to regulation under the laws of theUnited States or under the laws of any State or territoryof the United States, or any insular possession thereof, orby any savings and loan association organised andsubject to regulation under the laws of this State, or thesale by the issuer itself of any security issued by anyfederal savings and loan association.”3In addition, most states do not require registration for

bank notes offered by a foreign bank through its US branchor agency under the principles of comity, on the theory thatthe domestic branch or agency is subject to oversight andregulation by US banking authorities. However, it isunderstood that there are a few states, including Texas, thatdo not extend the exemption to US branches or agencies.Nevertheless, in 1998 the Texas State Securities Board (the

Board) issued no-action letter relief and did not requireregistration for bonds issued by the State of Bank of India inminimum denominations of $1,000 and marketed to USresidents of Indian origin (NRIs) through US branches.4 TheBoard emphasised that the bonds would be treated as bankdeposits subject to the banking regulations administered bythe Reserve Bank of India and the Indian Government, thatreserve requirements had been extended to NRI deposits,and that the bonds were subject to the same reserverequirements applicable to similar deposits.The Board also pointed out that the bonds would be

CHAPTER 11

Blue sky laws


marketed in the United States through the issuer’s NewYork and Chicago branches, which were regulated by NewYork and Illinois, respectively, and by the Federal DepositInsurance Corporation, and that the issuer representedthat the nature and extent of state and federal regulation ofthe branches was substantially equivalent to that applicableto Texas state-chartered banks. This would suggest thatbank notes offered by US branches or agencies of foreignbanks should also be accorded similar relief in Texas, assuch branches or agencies would be subject to the sameregulation and oversight as US banks.5As a reminder, where certain covered securities,

including bank notes, are offered, a state may still reservethe right to require a notice filing and the payment of afiling fee if the security is not otherwise exempt fromregistration under that state’s laws.6 In addition, somestates may require filing fees for each series of bank notesoffered (rather than a single one-time fee) and may notplace a cap on aggregate fees paid.

Section 3(a)(3) securitiesShort-term securities issued pursuant to Section 3(a)(3) ofthe Securities Act (such as commercial paper) are coveredsecurities under NSMIA, and therefore exempt fromregistration under state blue sky laws.

Rule 144A securitiesRule 144A is a safe harbour exemption from theregistration requirements of the Securities Act for certainresales of qualifying securities by certain persons other thanthe issuer of the securities. The exemption applies to resalesof securities to QIBs (or purchasers that the sellers and anypersons acting on the sellers’ behalf reasonably believe tobe QIBs). The securities eligible for resale under Rule144A are securities of US and foreign issuers that are notlisted on a US securities exchange or quoted on a USautomated inter-dealer quotation system.The securities laws of each state provide for an

exemption from state securities registration for both salesand resales of securities to specified types of institutionalinvestors. The institutional investor exemption in moststates is self-executing, which means that no compliancemeasures, such as filings or fee payments, are needed toqualify for the exemption. Thus, if the investor to whichthe foreign issuer is making an offer or sale qualifies as an“institutional investor”, as defined in that state’s blue skystatute, the foreign issuer is not required to pay any fees to,nor make filings with, the state securities regulators exceptfor (where required) the filing of a Form U-2 (the UniformConsent to Service of Process designating a state’s Secretaryof State or securities commissioner as the issuer’s agent forservice of process in that state).The breadth of the institutional investor exemption,

however, varies from state to state. Most states haveadopted provisions similar to those in the UniformSecurities Act, which exempts offers and sales to specified

types of institutional investors, such as banks, savingsinstitutions, trust companies, insurance companies,registered investment companies or to a broker-dealer,whether the purchaser is acting for itself or in somefiduciary capacity. Despite certain similarities betweenthese institutions and “accredited investors” as defined inRegulation D, it should be noted that individuals,regardless of financial sophistication or assets held, are notcovered by the exemption.

Regulation DRegulation D provides a limited safe harbour fromregistration for offers and sales by issuers. The safe harbourcan be utilised under the provisions of Rules 504, 505 or506 under Regulation D. The first, Rule 504, provides anexemption pursuant to Section 3(b) of the Securities Actfor offerings of up to $1 million. The second, Rule 505,provides an exemption pursuant to Section 3(b) forofferings of up to $5 million. The third, Rule 506, whichis the most popular, provides an exemption pursuant toSection 4(a)(2) of the Securities Act for limited offeringsand sales without regard to dollar amount, but only to 35purchasers and an unlimited number of “accreditedinvestors”, who are typically institutional investors or highnet-worth individuals. Under Rule 506, “non-accreditedinvestors” must also have sufficient knowledge andexperience in financial and business matters to be capableof evaluating the merits and risks of the proposedinvestment; and this ‘sophistication requirement’ is thedistinguishing feature of Rule 506. In order to avail itselfof any of the safe harbours, the issuer must also takereasonable care to ensure that the purchasers of thesecurities are not “underwriters” and must file a Form D,including a sales report, with the SEC no later than 15days after the first sale of securities under the offering.Until September 2013, general solicitation was not

permitted in private placements in accordance with Rule506. However, in July 2013, pursuant to Section 201 ofthe JOBS Act, the SEC revised Rule 506 to permit generalsolicitation if: the issuer takes “reasonable steps to verify”that purchasers are accredited investors, all purchasers areaccredited investors, or the issuer reasonably believes thatthey are, immediately prior to the sale, and certain otherrequirements are met.Securities offered pursuant to the Rule 506 safe harbour

fall under NSMIA’s definition of “covered securities”, andare therefore exempt from blue sky filings as describedabove; however, securities issued in reliance on Rules 504or 505 are not “covered securities.”


1. Sections 18(c)(2)(A) and (B) of the Securities Act.

2. Section 18(c)(1) of the Securities Act.

3. Tex. Rev. Civ. Stat. Ann. art. 581-5, § L.

4. See 3A Blue Sky L. Rep. (CCH) ¶ 55,828O.

5. Another helpful fact would be a minimumdenomination significantly higher than $1,000 pernote, in order to help insure that the offering is moreof an institutional offering than a retail offering.

6. See, e.g., 7 Tex. Admin. Code §§ 114.1-.4, 3A BlueSky L. Rep. (CCH) ¶¶ 55,590P – 55,590S.

ENDNOTES


The SEC has delegated part of the responsibilityfor enforcing securities laws to various self-regulatory organisations (SROs), as definedunder the Exchange Act, including the various

stock exchanges and Finra. Finra is the largest non-governmental regulator for all securities firms doingbusiness in the United States. It was created in July 2007through the consolidation of the National Association ofSecurities Dealers (NASD) and the member regulation,enforcement and arbitration functions of the NYSE. TheFinra rulebook consists of, among other things, thefollowing:• A set of Finra rules, including some based on the rules

of the NASD (NASD Rules) and rules incorporated forthe NYSE (the Incorporated NYSE Rules) but that mayno longer be identical to the predecessor rules;

• NASD Rules that have not yet been converted intoFinra rules; and

• Incorporated NYSE Rules that have not yet beenconverted into Finra rules.

While the NASD Rules generally apply to all Finramembers (these are broker-dealers), the IncorporatedNYSE Rules apply only to Finra members that are alsomembers of the NYSE (again, broker-dealers).

Foreign bank issuers will be required to consider Finrarules in various contexts. First, almost any financingundertaken by a foreign bank issuer will entail theassistance of a financial intermediary. The financialintermediary will be a registered broker-dealer that is aFinra member.

Finra membersForeign bank issuers should understand that the broker-dealer will be subject to supervision by Finra and requiredto comply with Finra rules. Finra rules impose a numberof requirements on Finra members. For example, broker-dealers are subject to standards of conduct, including aduty of fair dealing, which includes a suitability obligation,and a duty of best execution. Broker-dealers owe variousduties to their customers, such as the duty to recommendsuitable investments, obtain best execution when effectingtrades and charge fair commissions or mark-ups.

Also a general matter, NASD Rules and Finra rulesrequire that firms ensure their communications with thepublic are based on principles of fair dealing and goodfaith, are fair and balanced and provide a sound basis for

evaluating the facts about any particular security, industryor service. Risk disclosures in offering documents (aprospectus or an offering circular or private placementmemorandum) do not cure deficient disclosure in salesmaterials. Finra Rule 2090, the know-your-customer rule,requires that firms “use reasonable diligence, in regard tothe opening of every account, to know (and retain) theessential facts concerning every customer…” Finra Rule2111 requires that firms have a reasonable basis fordetermining that a product is suitable for investors ingeneral and that it is suitable for each specific customerprior to recommending the purchase or sale of a security.

Changes to the suitability rule also identify aquantitative suitability assessment that requires a broker-dealer to assess whether a transaction or series oftransactions (if viewed together) are suitable for the client.The rule requires firms to make reasonable efforts toobtain information concerning: the customer’s financialstatus, tax status, investment objectives, time horizon,liquidity needs, risk tolerance and any other informationconsidered reasonable by the member or registeredrepresentative in making recommendations to thecustomer. A firm’s registered representatives mustfamiliarise themselves “with each customer’s financialsituation, trading experience, and ability to meet the risksinvolved with such products.”1

Apart from these Finra rules that impose certain dutieson Finra members and prescribe compliance with certainrequirements in connection with broker-dealer activity, theFinra rules also address the conduct of certain offerings ofsecurities, whether public offerings or private placements.

Finra compensation reviewFinra determines whether the terms of the “underwritingcompensation” and arrangements relating to “publicofferings” are “unfair and unreasonable.” The Finra rulesaddress each of those concepts, particularly Finra Rule5110. Finra Rule 5110 addresses commercial fairness inunderwriting and other arrangements for the distributionof securities and provides for review by Finra ofunderwriting or other arrangements in connection withmost public offerings in order to enable Finra to assess thefairness and reasonableness of proposed underwritingcompensation. The rule is intended to prohibit thepayment of underwriting compensation that is consideredunfair or unreasonable. A determination regarding the

CHAPTER 12

Regulation by the Financial IndustryRegulatory Authority


fairness or reasonableness of compensation will be highlyfact specific and will depend on the type of offering. Anoffering that is required to be filed with Finra may notproceed until Finra has delivered a no-objection opinionrelating to the underwriting compensation.

The Finra rules generally apply only to public offerings.A public offering includes any registered or non-registeredprimary or secondary distribution, and excludes anyprivate placement made pursuant to certain provisions andrules of the Securities Act and any exempted securitypursuant to the definition in the Exchange Act.

Finra Rule 5110(b)(1) states that “[n]o member orperson associated with a member shall participate in anymanner in any public offering of securities subject to thisRule, [Finra] Rule 2310 or [Finra] Rule 5121 unlessdocuments and information as specified herein relating tothe offering have been filed with and reviewed by Finra.”Unless specifically exempt, as discussed below, Finrarequires that certain documents and agreements be filed,including:• The registration statement, offering circular or offering

memorandum;• Any proposed underwriting agreement, agreement

among underwriters, agency agreement or similaragreement or any other document that describes theunderwriting or other arrangements in connection withthe distribution;

• Each pre- and post-effective amendment to theregistration statement or other offering document;

• The final registration statement as declared effective bythe SEC, or the equivalent final offering document, anda list of all members of the underwriting syndicate, ifnot indicated; and

• The executed form of the final underwriting documents In addition, the Finra filing must include the following

information:• An estimate of the maximum public offering price;• An estimate of the maximum underwriting discount or

commission;• An estimate of the maximum reimbursement for

underwriter’s expenses and underwriter’s counsel’s fees;and

• A statement of the association or affiliation with anyFinra member of any officer or director of the issuer,any beneficial owner of 5% or more of any class of theissuer’s securities, and of any beneficial owner of theissuer’s unregistered equity securities that were acquiredduring the 180-day period immediately preceding therequired filing date of the public offering.

All documents and information are filed with Finrathrough its electronic filing system, Public OfferingSystem. Documents or information filed with Finra, unlessalready publicly available, will be treated as confidential.Finra uses these documents to determine compliance withapplicable Finra rules and for other regulatory purposes itdeems appropriate.

In June 2014, Finra amended Finra Rule 5110 toinclude, among other things, the following changes:• The definition of “participation or participating in a

public offering” now excludes the activities of any Finramember that acts exclusively as an “independentfinancial adviser;”

• Disclosure of affiliations of officers, directors andbeneficial owners of 5% of the issuer’s securities withFinra members that are not “participating” in the publicoffering is no longer required;

• Engagement letters in connection with the publicoffering can now provide for participating Finramembers to receive termination fees or “rights of firstrefusal” (RoFRs) if the Finra member is terminatedbefore the public offering is completed, as long as thosetermination fees or RoFRs are subject to certainconditions, including the right of the issuer toterminate the Finra member for cause, ending the Finramember’s right to termination fees; and

• Shares that a Finra member or its affiliate acquires fromacquisitions and conversions to prevent dilution, whichwere already excluded from underwriter compensation,are now also exempt from the rule’s lock-up restrictions.

ExemptionsThere are several types of offerings that are exempt fromthe Finra filing requirements. These include:• Securities offered by an issuer that has unsecured

nonconvertible debt with a term of at least four years,or unsecured non-convertible preferred securities, ratedby a nationally recognised statistical rating organisation(NSRO) in one of its four highest generic ratingcategories, except that an initial public offering of theequity of an issuer is always required to be filed;

• Non-convertible debt securities and non-convertiblepreferred securities rated by an NSRO in one of its fourhighest generic rating categories;

• Offerings of securities pursuant to a shelf registrationstatement of an issuer that: (i) has been a reportingcompany for at least three years; and (ii) has anaggregate market value of the voting stock held by non-affiliates of at least $150 million (or $100 millionaggregate market value and an annual trading volume ofthree million shares);

• Securities exempt from SEC registration pursuant toprovisions of Sections 4(a)(1), 4(a)(2) or 4(a)(6) of theSecurities Act, or pursuant to Rule 504 under theSecurities Act, if the securities are “restricted securities”under Securities Act Rules 144(a)(3), 505 or 506. Thismeans that private placements conducted in reliance onthe exemption from registration provided by Section4(a)(2) and/or Regulation D are exempt from the Finracompensation review.2

The offering documents and distribution agreements forpublic securities offerings conducted by banks underSection 3(a)(2) of the Securities Act must be filed with


Finra for review under Finra Rule 5110(b)(9), unless oneof the exemptions above is available. For example, a foreignbank issuer that offers its securities pursuant to Section3(a)(2) may nonetheless limit the public nature of theoffering and conduct the offering in compliance withRegulation D. Such an offering would be exempt from theFinra compensation review.

Conflicts of interestFinra Rule 5121 is intended to protect investors in thesecurities by providing for, under specified conditions, oneor more of the following: (1) disclosure in the offeringdocument of the nature of the conflict, includingparticipation of the member in the offering; (2) disclosureof the participation of a “qualified independentunderwriter” (QIU) in the offering; and (3) escrow of theproceeds of the offering. Finra Rule 5121 has particularimportance when a broker-dealer seeks to sell securities ofan affiliate. Finra Rule 5121 applies only to “publicofferings” (as defined in the rule).

Finra Rule 5121 provides that a conflict of interest existsif, at the time of a member’s participation, any of thefollowing four conditions applies:• The securities are to be issued by the member;• The issuer controls, is controlled by, or is under

common control with the member or the member’sassociated persons;

• At least 5% of the net offering proceeds, net ofunderwriting compensation, is intended to be usedeither to reduce or retire the balance of a loan or creditfacility extended by the member, its affiliates, and itsassociated persons (in the aggregate) or otherwise bedirected to the member, its affiliates, and associatedpersons (in the aggregate); or

• As a result of the public offering and any transactionscontemplated at the time of the public offering, themember will be an affiliate of the issuer, the memberwill become publicly owned, or the issuer will become amember or form a broker-dealer subsidiary.

If a conflict of interest exists, then the member mustcomply with the conditions of Finra Rule 5121, whichrequire “prominent disclosure” in specified locations in theoffering document of the nature of the conflict of interest(even if the lead underwriter does not have a conflict ofinterest) and under specified circumstances, could involvethe services of a “qualified independent underwriter” (asdefined in Finra Rule 5121). The QIU must satisfy certainrequirements, must participate in the preparation of theregistration statement and the offering document, andmust exercise the usual standards of due diligence inrespect of the offering. There must also be prominentdisclosure of the name of the member acting as QIU anda brief general statement regarding the role andresponsibilities of a QIU. A QIU is not required undercertain limited circumstances. For example, a QIU is notrequired if the securities offered are investment grade rated

or are securities in the same series that have equal rightsand obligations as investment grade rated securities andother conditions are satisfied.

In June 2014, Finra amended the definition of “control”under Finra Rule 5121 to no longer include beneficialownership of 10% or more of the outstandingsubordinated debt of an entity.

Finra’s communications rulesIn June 2012, Finra approved new rules, included underFinra Rules 2210 and 2212 through 2216, relating tobroker-dealers’ communications with the public andimpacting a wide variety of securities offerings. In May2015, Finra proposed amendments to Finra Rule 2210, aswell as Finra Rules 2214 (Requirements for the Use ofInvestment Analysis Tools) and Finra Rule 2213(Requirements for the Use of Bond Mutual Fund VolatilityRatings).3 We discuss below some of the most significantrules that are currently applicable.

Filing requirements. Finra Rule 2210(c)(3)(E) requiresbroker-dealers to file with Finra “retail communications4

concerning any security that is registered under theSecurities Act and that is derived from or based on a singlesecurity, a basket of securities, an index, a commodity, adebt issuance or a foreign currency”. In addition, FinraRule 2210(a)(4) provides that Finra members may nottreat communications as institutional communications ifthey have “reason to believe” that the communication (orany excerpt) will be forwarded to any retail investors.5

Exemption from filing for certain materials. Finra Rule2210(c)(7)(E) exempts from the filing requirement anyprospectuses, preliminary prospectuses, offering circularsand similar documents that have been filed with the SEC.This exemption would remove a wide variety ofprospectuses and free-writing prospectuses from the filingrequirements, since so many of them are in fact filed withthe SEC under Securities Act Rules 424(b) or 433.However, this provision would not exempt from filing aninvestment company prospectus published pursuant toSecurities Act Rule 482 and free writing prospectuses thathave been filed with the SEC under Securities Act Rule433(d)(1)(ii). Securities Act Rule 433(d)(1)(ii) is theprovision that requires underwriters to file those freewriting prospectuses that they distribute “in a mannerreasonably designed to lead to its broad unrestricteddissemination.”

Adequacy of communications. Old Finra Rule 2210(d)(1)had required a Finra member’s communications to be fair,balanced and accurate and to provide a sound basis forevaluating the facts in regard to any particular security orservice. Old Finra Rule 2210(d)(1) also prohibited a Finramember from omitting any material fact or qualificationfrom a communication if the omission, in light of thecontext of the material presented, would cause thecommunication to be misleading, making any false,exaggerated, unwarranted, promissory or misleading


statement or claim in any communication, and frompublishing, circulating or distributing any communicationthat the Finra member knows or has reason to knowcontains any untrue statement of a material fact or isotherwise false or misleading.

New Finra Rule 2210(d)(1) specifies that Finramembers, in addition to the above, must:• Ensure that statements are clear and not misleading

within the context in which they are made, and thatthey provide balanced treatment of risks and potentialbenefits (communications must be consistent with therisks of fluctuating prices and the uncertainty ofdividends, rates of return and yield inherent toinvestments);

• Consider the nature of the audience to which thecommunication will be directed, and must providedetails and explanations appropriate to the audience;and

• Ensure that communications do not predict or projectperformance, imply that past performance will recur ormake any exaggerated or unwarranted claim, opinion orforecast, except in certain limited circumstances.

Broadly disseminated underwriter FWPs are subject tothe content standards of new Finra Rule 2210(d). Incontrast, documents such as prospectuses and preliminaryprospectuses are “issuer documents” that are exempt fromthese content standards. However, most broker-dealerscurrently prepare these documents in an effort to complywith both SEC rules and guidance (and potential liabilityfor misstatements under the securities laws) and Finra’srules and guidance.

Principal approval requirements. Finra Rule2210(b)(1)(A) requires an appropriately qualifiedregistered principal of a Finra member to approve eachretail communication before the earlier of its first use orfiling with Finra.

Research reportsIn November 2014, Finra proposed to adopt NASD Rule2711 as new Finra Rule 2241, with several modificationsin February 2015, to address conflicts of interest relating toequity research analysts and research reports. At the sametime, Finra proposed to adopt new Finra Rule 2242, asamended in February 2015, which is designed to addressconflicts of interest relating to the publication anddistribution of debt research reports. Old NASD Rule2711 was designed to address conflicts of interest inconnection with the preparation of analyst research reportsand public appearances related to equity securities, andhelp increase analyst independence. Finalised versions ofFinra Rules 2241 and 2242 were approved by the SEC inJuly 2015, and Finra Rule 2241 became effective onDecember 24 2015 and Finra Rule 2242 became effectiveon July 16 2016. We briefly discuss below therequirements of Finra Rules 2241 and 2242.6

The changes provided in Finra Rule 2241 reflect a more

flexible principles-based approach and incorporate manyof the Finra interpretations that have developed over thelast decade. Finra Rule 2241 also seeks to establish a levelplaying field between investment banks subject to theGlobal Research Analyst Settlement and those that are not,as well as for issuers that are EGCs.7

The main part of Finra Rule 2241 is section (b),“Identifying and Managing Conflicts of Interest.” Thesection fundamentally reorganises Old NASD Rule 2711and sets forth the principles underlying the new rule. FinraRule 2241(b)(1) requires firms to establish, maintain andenforce written policies and procedures reasonablydesigned to identify and effectively manage conflicts ofinterest related to (a) the preparation, content anddistribution of research reports, (b) public appearances byresearch analysts, and (c) the interaction between researchanalysts and persons outside of the research department,including investment banking and sales and tradingpersonnel, the subject companies and customers. FinraRule 2241(c) sets forth the general principle that a firmshould adopt written policies and procedures relating tothe content of, location of disclosures within, andprocedures for research reports. There are a few changesfrom existing requirements although some are recast aspolicies and procedures rather than requirements.

Like Finra Rule 2241, Finra Rule 2242 differs from OldNASD Rule 2711 in three key respects: • it delineates the prohibited and permissible

communications between debt research analysts andprincipal trading and sales and trading personnel;

• it exempts debt research provided solely to institutionalinvestors from many of the structural protections andprescriptive disclosure requirements that apply toresearch reports distributed to retail investors (a “retailinvestor” means any person other than an institutionalinvestor); and

• in addition to the exemption for limited investmentbanking activity found in the prior equity research rules(as well as Finra Rule 2241), Finra Rule 2242 adds anexemption for members that engage in limitedinvestment banking activity or those with limitedprincipal trading activity and revenues generated fromdebt trading.

Maintaining separation between investmentbanking and research departmentsFinra Rules 2241 and 2242 each require that a firm’spolicies and procedures establish information barriers orother institutional safeguards that ensure that the researchdepartment is insulated from the review, pressure oroversight by persons engaged in investment bankingservices, sales and trading (or, in the case of debt research,principal trading or sales and trading activities) and otherpersons who may be biased in their judgment orsupervision.

To that effect, firms must establish, maintain and


enforce written policies and procedures that are reasonablydesigned to identify and effectively manage any conflicts ofinterest related to research reports. Specifically, a firm’spolicies must address the preparation, content anddistribution of research reports, public appearances byresearch personnel and the interaction between researchpersonnel and those outside of the firm’s researchdepartment.

Written policies must also be reasonably designed to: • promote objective and reliable research that provides

only the truly held opinions of research personnel; • affirmatively seek to diminish the manipulation of

research personnel (or their research reports) in anattempt to favour the interests of the firm or a currentor prospective customer or class of customers;

• provide for separate reporting lines for both researchand investment banking personnel;

• provide for a dedicated legal and compliance staff forthe research department;

• prohibit investment banking personnel fromthreatening to retaliate against research personnel for anunfavorable report;8

• prohibit investment banking personnel, and other firmemployees engaged in investment banking servicesactivities, from directing research personnel to engagein sales or marketing efforts related to any investmentbanking transactions;

• prohibit three-way meetings with research personnel,investors and investment banking personnel (with theexception of certain meetings with EGCs); and

• ensure the independent review of the researchdepartment.

The head of the research department may report to orthrough a person or persons to whom the head ofinvestment banking also reports, provided that suchperson(s) have no direct responsibility for investmentbanking activities or decisions.

CompensationIn accordance with Finra Rules 2241 and 2242, firms mustimplement written policies and procedures that at aminimum prohibit investment banking personnel (or, inthe case of debt research, personnel engaged in investmentbanking services transactions, principal trading activitiesor sales and trading), from supervising or controllingresearch analysts, including exerting any influence orcontrol over research analyst compensation anddeterminations.

Quiet periodsSection 105 of the JOBS Act permits a broker-dealer topublish or distribute a research report about an EGC thatproposes to register an offering of common stock underthe Securities Act or has a registration statement pending,and the research report will not be deemed an “offer”under Section 2(a)(3) of the Securities Act, even if the

broker-dealer will participate or is participating in theoffering.9 However, Finra Rule 2241 has further shortenedthe various quiet periods surrounding equity offerings.Specifically, a firm must implement policies andprocedures that stipulate the following quiet periods: (i) aminimum of ten days in the case of an IPO; and (ii) aminimum of three days in the case of a secondary offering.Finra interprets the date of the offering to be the later ofthe effective date of the registration statement or the firstdate on which the securities were bona fide offered to thepublic.10

Regulation D offeringsIn April 2010, Finra issued Regulatory Notice 10-22reminding broker-dealers of their obligation, enforceableunder US federal securities laws and Finra Rule 2310, toconduct a reasonable investigation of the issuer and thesecurities they recommend in offerings made pursuant toRegulation D. The notice also reinforces the obligations ofbroker-dealers that recommend securities offered underRegulation D to comply with the suitability requirements,the advertising and supervisory rules of Finra and SECrules and regulations.

The notice details a broker-dealer’s duty, whenrecommending a security, under case law and SECinterpretations, to conduct a reasonable investigation ofboth the securities offered and the issuer’s representationsabout those securities. Broker-dealers acting as placementagents in connection with a private offering made inreliance on Regulation D will conduct a reasonableinvestigation concerning the issuer, its management, itsbusiness prospects, and the intended use of proceeds of theoffering. The level of diligence undertaken by theplacement agent will vary depending upon thesophistication of the issuer, the broker-dealer’s familiaritywith the issuer and its business, and the nature of theprospective offerees (whether investors are sophisticatedinstitutions or individual investors). The notice remindsbroker-dealers that if they are involved in the preparationof the offering materials, they will have heightened duediligence obligations.11

Finra Rule 5123Finra Rule 5123 was adopted in response to concerns withprivate placements. Under Finra Rule 5123, a Finramember participating in a non-public offering mustsubmit to Finra, or have submitted on its behalf by adesignated member, a copy of any private placementmemorandum, term sheet or other offering document,including any materially amended versions of thosedocuments, used in connection with the offering within15 calendar days of the date of first sale, or indicate toFinra that no such documents were used. Finra Rule 5123applies to a “private placement” which refers to a non-public offering of securities conducted in reliance on anavailable exemption from registration under the Securities

Act. The definition does not apply to securities offeredpursuant to: Sections 4(a)(1), 4(a)(3) and 4(a)(4) of theSecurities Act (which generally exempt secondarytransactions); Sections 3(a)(2) (offerings by banks), 3(a)(9)(exchange transactions), 3(a)(10) (securities subject to afairness hearing) or 3(a)(12) (securities issued by a bank orbank holding company pursuant to reorganization orsimilar transactions) of the Securities Act; and Section1145 of the US Bankruptcy Code (securities issued in acourt- approved reorganisation plan that are not otherwiseentitled to the exemption from registration afforded bySection 3(a)(10) of the Securities Act).12

To facilitate submission of the required information,Finra developed the Private Placement Form for theprocessing of specified private placement filings throughFinra’s Firm Gateway. Finra members must complete andsubmit the Private Placement Form electronically throughFinra’s Firm Gateway. The Private Placement Formrequests the following information:• Identifying and contact information for the Finra

member and the issuer;• Disclosure of any affiliate relationship between the

Finra member and the issuer or sponsor; and• Basic information about the nature of the offering (eg

type of security, offering size, offering period,underwriting discounts/commission, etc).

In addition, Finra Rule 6750 and Finra’s Trace (TradeReporting and Compliance Engine) disseminationprotocols require the dissemination of transactions inTrace-eligible securities that are effected pursuant to Rule144A. Finra Rule 7730 also requires real-time and historicdata sets for Rule 144A transactions.

Certificates of depositAs we discuss in Chapter 7, CDs generally are consideredbank deposits, and not securities. Traditional CDs bear afixed interest rate over a fixed period and benefit fromFDIC insurance up to the insurance limit. However, theremay be non-traditional CD products, such as certainbrokered CDs or market-linked CDs that may be moreakin to securities than traditional bank deposits. Also,there may be bundled CDs with other features that againresemble securities rather than traditional bank deposits.Traditional CDs generally fall outside of Finra supervision.CDs that may be considered securities may be subject toFinra rules. As a result, it will be important to understandwhether a CD is a bank deposit or a security.


1. For more information regarding Finra guidanceregarding suitability with respect to structuredproducts, see “Finra developments relating to the salesand marketing of structured products” in Chapter 13(Special considerations related to structuredproducts).

2. Finra has not amended Rule 5110 to include theexemption from registration under Section 4(a)(7) ofthe Securities Act. Section 4(a)(7) became effectiveimmediately after the Fixing America’s SurfaceTransportation Act was signed into law on December4 2015. Section 4(a)(7) provides a resale exemptionfor certain transactions involving unregistered resalesand partially resembles the Section 4(a)(1½)exemption for private resales of restricted securities,although it is more limited in scope. The Section4(a)(7) resale exemption requires, among other things,that (1) each purchaser is an accredited investor, (2)neither the seller nor any person acting on the seller’sbehalf engages in any form of general solicitation and(3) in the case of an issuer that is not a reportingcompany, exempt from the reporting requirementspursuant to Rule 12g3-2(b) under the Exchange Act,or a foreign government eligible to register securitieson Schedule B, at the request of the seller, the sellerand a prospective purchaser obtain from the issuerreasonably current information regarding the issuer.

3. The proposed amendments would revise the filingrequirements under Finra Rules 2210 and 2214 and thecontent and disclosure requirements under Finra Rule2213. The proposed changes to Finra Rule 2210 includethe following: (1) amending Finra Rule 2210(c)(1)(A)to require new Finra members to file with Finra broadlydisseminated retail communications, such as generallyaccessible websites, print media communications, andtelevision and radio commercials, at least 10 businessdays prior to use; and (2) amending Finra Rule2210(c)(7)(F), which currently provides a filingexclusion for “prospectuses, preliminary prospectuses,fund profiles, offering circulars and similar documentsthat have been filed with the SEC or any state, or that isexempt from such registration” to also exclude “similaroffering documents concerning securities offerings thatare exempt from SEC or state registrationrequirements.” At this time, the proposed amendmentshave not been finalised. See Finra Regulatory Notice 15-16 (May 2015), available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory_Notice_15-16.pdf.

4. The term “retail communication” includes any written(including electronic) communication that isdistributed or made available to more than 25 retailinvestors within any 30 calendar-day period. See FinraRule 2210(a)(5). The term “retail investor” includesany person other than an institutional investor,regardless of whether the person has an account withthe member. See Finra Rule 2210(a)(6). The term“institutional investor” includes registered investmentcompanies, insurance companies, banks, registeredbroker-dealers, registered investment advisers, certainretirement plans, governmental entities, andindividual investors and other entities with at least$50 million in assets. See Finra Rule 2210(a)(4).

5. The term “institutional communication” includes anywritten (including electronic) communication that isdistributed or made available only to institutionalinvestors, but does not include a Finra member’sinternal communications. See Finra Rule 2210(a)(3).

6. For more information regarding Finra Rules 2241 and2242, see our Client Alert, “Finra’s Final EquityResearch Rules Go Effective; Final Debt ResearchRules’ Effective Date Quickly Approaching” (January25 2016), available at: http://www.mofo.com/~/media/Files/ClientAlert/2016/01/160125FINRAFinalEquityDebtResearchRules.pdf.

7. The Global Research Analyst Settlement (the GlobalSettlement) is an enforcement agreement firstannounced in December 2002 and approved by theUnited States District Court for the Southern Districtof New York on October 31 2003, among the SEC,the NASD, the NYSE, the New York State AttorneyGeneral and ten of the then-largest investmentbanking firms in the United States. The GlobalSettlement addressed issues related to conflicts ofinterest between the research and investment bankingdepartments of these firms that became apparentduring the “dot com” boom and then bust of the late1990s and early 2000s.

8. While Finra Rule 2242 maintains an analogous anti-retaliation provision, it creates a broader prohibitionby applying it to any employee of the firm and not justthose engaged specifically in investment bankingservices activities.


ENDNOTES

9. The JOBS Act prohibits a national securitiesassociation or the SEC from maintaining rulesrestricting research analysts from participating inmeetings with investment banking personnel and anEGC in connection with an EGC’s IPO. Prior to theenactment of the JOBS Act, research personnel wereprohibited from attending meetings with an issuer’smanagement that were also attended by investmentbanking personnel in connection with an IPO,including pitch meetings. Section 105(b) of the JOBSAct permits research personnel to participate in anycommunication with the management of an EGCconcerning an IPO that is also attended by any otherassociated person of a broker, dealer, or member of anational securities association whose functional role isother than as an analyst, including investmentbanking personnel. For more information regardingEGCs, see “FPI accommodations under US securitieslaws” in Chapter 9 (Exchange Act registration).

10. Finra Rule 2241 also expressly excludes from the quietperiod: (i) the publication or distribution of a researchreport or public appearance following an IPO orsecondary offering by an EGC, as defined underSection 3(a)(80) of the Securities Act; (ii) thepublication or distribution of a research report, ormaking of a public appearance, concerning the effectsof a significant news or event on an issuer providedthat the firm’s legal or compliance personnel providedprior authorisation before such publication wasdistributed or public appearance made; and (iii) thedistribution of research reports or making of a publicappearance pursuant to Rule 139 under the SecuritiesAct. Finra Rule 2241 also eliminates the quiet periodsof 15 days before and after the expiration, waiver ortermination of a lock-up agreement that hadpreviously applied.

11. The policing of private placements, includingofferings made pursuant to Regulation D and subjectto Finra Rule 5123, have been a regulatory priority forFinra since 2013. Finra enforcement actions relatingto private placements also have been dramaticallyincreasing since 2010. In January 2016, Finraannounced that its focus on private placements in2016 will address concerns with respect to suitability,disclosure and due diligence. According to Finra, theseconcerns are relevant regardless of the underlyingindustry of the issuer or the type of investment (eg,notes offerings, pre-initial public offering investmentfunds, real estate programs, EB-5 investment funds orstart-up companies). Finra indicated that its focus onprivate placements will reflect recent regulatorydevelopments, including the ability to conductgeneral solicitations under Rule 506(c) of RegulationD and new Regulation Crowdfunding, which became

effective in May 2016. Finra also noted that somecommunications used by firms concerning privateplacements have not reflected the significant risks ofloss of principal and lack of liquidity associated withthese investments. Finra indicated that where acommunication addresses a specific investmentbenefit associated with a private placement offering, afirm must ensure that the key risks associated withsuch benefit are disclosed. Finra also noted that it willcontinue to evaluate firms’ compliance with respect totheir communications, including general solicitationadvertisements and materials posted on the Internet.See Finra’s 2016 Regulatory and ExaminationsPriorities Letter (January 15 2016), available at:http://www.finra.org/sites/default/files/2016-regulatory-and-examination-priorities-letter.pdf

12. Finra Rule 5123 also exempts other types of privateplacements from the notice filing requirement,including: (1) offerings sold by a Finra member solelyto (a) institutional accounts, as defined in Finra Rule4512(c), (b) qualified purchasers, as defined inSection 2(a)(51)(A) of the Investment Company Act,(c) QIBs, as defined in Rule 144A, or (d) accreditedinvestors as defined in Rules 501(a)(1), (2), (3) or (7)under the Securities Act; (2) offerings of exemptedsecurities, as defined in Section 3(a)(12) of theExchange Act; (3) offerings made pursuant to Rule144A or Regulation S; and (4) offerings of exemptsecurities with short-term maturities under Section3(a)(3) of the Securities Act and debt securities sold bymembers pursuant to Section 4(a)(2) of the SecuritiesAct so long as the maturity does not exceed 397 daysand the securities are issued in minimumdenominations of $150,000 (or the equivalent thereofin another currency).



In the aftermath of the financial crisis of 2008,financial engineering engendered suspicion, andfinancial products perceived to be complex haveattracted regulatory attention. Structured products

are among the financial products that have been underincreasing regulatory scrutiny. Some of this attention maybe unwarranted and may be the result of a case of mistakenidentity. That is, financial products bearing very differentcharacteristics are often grouped together and referred to as“structured products” if the products entail anystructuring. For example, news articles may discussstructured finance products, or structured credit products,such as collateralized debt obligations (CDOs) orcollateralized loan obligations (CLOs), in the same breathas market-linked debt securities. This undifferentiatedapproach has led to a fair bit of confusion. Structuredproducts, or market-linked investments, are debt securitieswith cash flow characteristics that depend on theperformance of one or more reference assets. Theprototypical structured product may be a senior note witha return based on a popular equity index, such as the S&P500 Index or the Dow Jones Industrial Average (DJIA).

The market for these products has proven resilient andhas grown in recent years, with reported US sales reaching$44.1 billion in 2015. These products are designed to meetthe risk/reward needs of investors and offer distinctbenefits that cannot typically be obtained from other typesof investments. However, the US regulatory frameworkapplicable to these products is difficult to navigate, and thepurpose of this chapter is to discuss recent regulatory andenforcement developments and highlight disclosure andcompliance concerns for market participants, as a widevariety of non-US banks, particularly European andCanadian banks, are frequent issuers of structuredproducts in the United States.

Types of structured productsStructured products include equity-linked, index-linked,interest rate-linked, commodity-linked and currency-linked instruments. From a cash flow perspective, astructured product may look like a combination of atraditional debt security and a derivatives contract;however, structured products are not derivatives contracts.Structured products may simply involve, for example,trading away a portion of the full potential upsideassociated with a direct investment in the reference asset

(such as an investment in the S&P 500 Index or the DJIA)in exchange for a return of principal at maturity (subject tothe issuer’s credit risk), or in exchange for assuming somelesser risk to the reference asset. Structured products maybe structured as senior debt securities offered by an issuer(often a financial institution that is a “well-knownseasoned issuer”) under a shelf registration statement (ifthe securities are registered) or a program offering circularor offering memorandum (if the securities areunregistered), or they may be structured as market-linkedCDs offered by a bank.

Regulatory framework applicable to structuredproductsAs a result of the various forms that structured productsmay take, there is no single regulation or body ofregulation applicable to the issuance, sale and marketing ofstructured products. First, the applicable regulatoryscheme may turn on whether the structured product is asecurity (and whether it is a registered security or anunregistered security offered in a private placement or as abank note) or a bank product. Second, the nature of thereference asset may raise particular considerations, as wediscuss below in the context of commodity-linkedproducts. Third, many structured products have distincttax benefits, so tax considerations often are central to thestructuring process. Fourth, questions may ariseconcerning the Employee Retirement Income Security Actof 1974 (Erisa), the Investment Company Act and theInvestment Advisers Act of 1940, which need to be vettedcarefully. Fifth, the nature of the investor base may raiseparticular concerns. For example, structured products thatare sold to retail investors are typically subject to higherscrutiny and more stringent regulatory requirements thanproducts sold to institutional investors. Sixth, the broker-dealers that market structured products are subject toregulation by SROs, including national securitiesexchanges (e.g., the NYSE and Nasdaq) and Finra.1

For issuers of structured products, there are still otherconsiderations that arise that are not unique to structuredproducts offerings, but rather arise in connection withsecurities offerings generally. These considerations includeissuer blackout periods, corporate authorisation of theissuance and sale of the securities and the availability of aneffective registration statement or an up-to-date offeringcircular or offering memorandum. Similarly, there are

CHAPTER 13

Special considerations related to structured products


Finra regulations applicable to all securities offerings, suchas those relating to communications and underwritingcompensation, which also must be considered in thecontext of a structured products offering.

Securities liability at the time of saleMost causes of action relating to structured products thatare securities would be brought by investors alleginginsufficient or inaccurate disclosure. In December 2005,the SEC, as part of its securities offering reform (SecuritiesOffering Reform), in new Rule 159 under the SecuritiesAct, codified its interpretation regarding the time at whichliability is measured under Section 12(a)(2) of theSecurities Act. The information upon which liability isbased for insufficient or inadequate disclosure isestablished at the time of sale, or the moment the investorbecomes contractually obligated to purchase a security.Time of sale liability also has been applied by marketparticipants to unregistered offerings, due to the concernthat a court or securities regulator could apply theprinciples underlying Rule 159 under the Securities Act tothe context of unregistered offerings.

As a result, a seller must convey information to aninvestor before an investment decision is made, and maynot correct material misstatements or omissions in theinformation conveyed to an investor after the investmentdecision is made at the time of sale. Thus, an issuer maynot avoid liability for a material misstatement or omissionin a preliminary prospectus or supplement by simplycorrecting the text of the final prospectus or supplement.Previously, a final prospectus or supplement may havebeen used to correct or supplement information that hadbeen provided to investors, but information conveyed afterthe time of sale now may no longer be considered inassessing liability. As a result of the increasing complexityof many structured products subsequent to SecuritiesOffering Reform, many issuers and underwriters havegiven additional thought to the disclosure documents forstructured products and have implemented revised policiesand procedures relating to the sales and marketing ofstructured products.

Securities Offering Reform also introduced the conceptof a free writing prospectus, which is any writtencommunication used during the offering process otherthan the SEC-filed statutory prospectus. Free writingprospectuses are generally not subject to any contentrequirements or restrictions, but are subject to liabilityunder Section 12(a)(2) of the Securities Act (although notSection 11 of the Securities Act), as well as the antifraudprovisions of the US securities laws. Finra’s disclosure rulesalso regulate the content of free writing prospectuses. As aresult, distribution agreements between issuers andunderwriters of structured products, and selling groupagreements between lead underwriters and selling groupmembers, often contain detailed provisions as to the use,preparation and required approvals of offering documents

and other marketing materials.An issuer is responsible for any free writing prospectus

that is prepared by or on behalf of, or used or referred toby, the issuer. Free writing prospectuses that includemarketing information about particular types of structuredproducts or a specific structured product and hypotheticalexamples or plain English discussions of product features,are frequently being used in conjunction with theprospectus or prospectus supplement for registeredstructured products. Free writing prospectuses are alsofrequently used in lieu of a full preliminary statutoryprospectus because, in principle, the base offeringdocuments that relate to all of the issuer’s securities neednot be attached to the free writing prospectus. In addition,since there may be many variables that are determined onthe pricing or trade date for structured products, whichmay impact potential returns to an investor (e.g., trigger orbarrier prices, index levels or return caps), free writingprospectuses may be used (usually in the form of final termsheets) to convey this information at the time of sale priorto confirmation of sales. Market participants inunregistered offerings similarly use marketing materialsand final term sheets that are analogous to free writingprospectuses to provide additional information regardingproducts and product features and to convey pricinginformation.

Disclosure issuesDistributors of structured products generally will rely ondisclosures provided by the issuer and the underwriter ofthe products. However, it is important that the disclosurespresent a fair and balanced picture of the risks and benefitsof the structured product. The SEC’s prospectus disclosurerules, particularly those of Item 202 of Regulation S-K(description of securities) and Item 503 (risk factors)contain very little specific guidance that is useful in thecontext of structured products. However, a generalconsensus among market participants does exist as to theprincipal disclosures that should be made (althoughpractices and text differ among issuers). In addition, Finraand the SEC have in the past few years have providedhelpful guidance on disclosures related to structuredproducts.

In April 2012, the SEC’s Division of Corporate Financeannounced that it had sent a letter to certain financialinstitutions relating to their structured note offerings. TheSEC letter consisted of fourteen comments, and restatedcertain of the SEC Staff ’s views with respect to structuredproducts. For example, the SEC letter requested thatissuers evaluate the names or titles of their structuredproducts (such as the use of “principal protected notes”) toensure that these names are not confusing or misleading toinvestors. The SEC Staff requested that issuers ensure thatprospectuses include prominent disclosures alertinginvestors that they are exposed to issuer credit risk if theypurchase structured notes. The SEC letter reminded


issuers that disclaimers of responsibility for informationregarding an underlying reference asset is inconsistent withthe issuer’s obligations under the US securities laws, andthat some disclaimers of this kind may need to be revised.The SEC letter also sought additional information fromissuers of structured products. For example, the SEC letterrequested information as to the circumstances underwhich an issuer or its broker-dealer affiliate repurchasesnotes from investors prior to maturity, suggesting thatissuers provide more information about this in theiroffering documents. As discussed above, informationabout registered structured products is conveyed through alayered disclosure approach, which includes term sheets,prospectus supplements and product supplements. Thepotential complexity of this format is an issue that hasarisen in a number of different contexts, including inconnection with the securities litigation relating toLehman Brothers’ principal-protected structured notesand the SEC’s releases relating to asset-backed securities. Inaddition, different underwriters make different uses ofshort-form, free writing prospectuses and statutoryprospectuses.

The SEC letter also requested additional disclosure as tothe estimated value of structured notes on the pricing date.In February 2013, the SEC Staff provided additionalguidance regarding the type of disclosure regarding pricingthat would be required. The SEC Staff noted that issuersmust disclose the “issuer’s valuation” on the cover page ofthe offering document, and share this information withinvestors prior to the time of sale. This estimated valueshould be based on the value of the “bond” componentand the “derivative” component of the offered structurednote. Disclosure documents should include a descriptionof the estimated value, and any models used to calculatethis amount, such as the issuer’s internal funding rate orsecondary market spreads. In discussing the value of thederivative component that is factored into the estimatedvalue, the issuer also should discuss any valuation modelsor assumptions, particularly if the issuer has used inputsother than mid-market prices. The value of the derivativecomponent generally should exclude the issuer’s hedgingcosts. The offering document also should include narrativedisclosure explaining the fees, costs and other amountsthat may be added to the issuer’s valuation to calculate theoriginal issue price of the structured notes and whetherthose amounts received from investors are used or retainedby the issuer or an affiliate. Risk factor disclosure shouldalert potential investors that the estimated value will belower than the issue price of the notes. The disclosures alsoshould address any risks inherent in the valuation orpricing of the bond or derivative components, includingthe use of any assumptions or internal models. The riskfactors also should alert investors that there will not be aliquid secondary market for the securities, and thatsecondary market prices may be lower than the issue price.The SEC’s guidance regarding pricing disclosure has

resulted in significant changes to the disclosures used bymarket participants in connection with structured productofferings.

Type of structured productThe disclosures regarding the type of structured productand its structure must be written clearly so that the averageinvestor is able to understand how the structured productworks. The type of structured product will also determinethe type of disclosure and amount of information thatneeds to be disclosed. More complex structured products,such as highly leveraged exchange traded notes (ETNs)with frequent rebalancing and long/short strategies,structured products linked to hypothetical bond/yieldcurves and commodity-linked structured products withreference assets consisting of hypothetical baskets offutures contracts, may require a significant amount ofdisclosure to explain how the reference assets or baskets areconstructed or composed and returns are calculated.Depending on the structured product, there also may berestrictions related to the potential investors. Certainstructured products may only be offered to accreditedinvestors or only to options-eligible accounts,, or may besubject to minimum denomination requirements, andcertain structured products may not be appropriate forErisa accounts.

Structured product namesDistributors should ensure that structured product namesare not confusing or misleading to investors. For example,both Finra and the SEC have expressed concerns regardingthe use of the term “principal protection” withoutproviding accompanying prominent disclosure concerningissuer credit risk. The concern stems from the fact that anunsecured obligation to make principal payments does notdispense with the risk that if the issuer goes intobankruptcy, it may not have sufficient funds to make suchprincipal payments to investors.

Credit riskAll disclosure and marketing documents should emphasisethat structured products are subject to issuer credit risk. Inlight of the current challenges facing financial institutions,market participants should monitor changes in the issuer’screditworthiness, reflected in the issuer’s credit ratings.Distributors must have procedures in place for notifyingpotential investors of changes in issuer credit ratings, or ofany emerging risks affecting an issuer.

Risk disclosuresSpecial attention should be paid to highlighting clearly therisks associated with the structured product, including thelack of a liquid secondary market, the special tax featuresof the structured product, actual or potential conflicts ofinterest, and risks specific to particular payout structures.Again, the more complex the structured product, the


greater the level of risk disclosure that should be includedin the relevant offering document. And needless to say, thelength of the risk factor section will not help ensure againstUS securities liability if the content of the risk factors doesnot adequately explain the specific risks inherent in thestructured product.

FeesInvestors should understand the fees and commissionsassociated with the structured product. As a result, issuersand distributors should aim to provide transparency withrespect to the disclosure on fees and commissions. Theexistence of embedded fees and costs will add to theperception that the structured product is complex and thusimpact Finra suitability requirements (which we discussbelow).

Broker-dealer standard of careThe distributors of structured products are predominantlybroker-dealers who owe various duties to their customers,which include the duty to recommend so-called suitableinvestments, the duty to obtain best execution wheneffecting trades and the duty to charge fair commissions ormark-ups. Finra rules further require that member firmsensure that their communications with customers and thepublic are based on principles of fair dealing and goodfaith, are fair and balanced and provide a sound basis forevaluating any particular security, industry or service. Riskdisclosures in a prospectus or supplement do not curedeficient disclosure in sales or marketing materials. FinraRule 2090, commonly referred to as the know-your-customer rule, requires that member firms performreasonable diligence, with respect to the opening of everyaccount, and to know (and retain) the essential factsconcerning every customer.

Finra Rule 2111 requires that Finra members have areasonable basis for determining that a structured productmay be suitable for investors in general (commonlyreferred to as reasonable-basis suitability) and that it issuitable for each specific customer (commonly referred toas customer-specific suitability), prior to recommendingthe purchase or sale of a security. Customer-specificsuitability is the more quantitative suitability assessment ofthe two types of suitability. Finra Rule 2111 furtherrequires member firms to make reasonable efforts to obtaininformation concerning:• The customer’s financial status;• The customer’s tax status;• The customer’s investment objectives;• The customer’s time horizon;• The customer’s liquidity needs;• The customer’s risk tolerance; and• Any other information considered reasonable by the

Finra member or registered representative in makingrecommendations to the customer.Registered representatives of the broker-dealer also must

familiarise themselves with each customer’s financialsituation, trading experience and ability to incur the risksinvolved with the relevant security.

Finra developments relating to the sales andmarketing of structured productsNotice to Members 3-71, 5-26 and 5-59Finra (and its predecessor, the NASD, referred to hereinthroughout as Finra) have issued various Notices toMembers and alerts that relate directly to the sales andmarketing of structured products. In November 2003,Finra issued Notice to Members 3-71 regarding non-conventional investments, which was followed in April2005 by Notice to Members 5-26 regarding new productsand in September 2005 by Notice to Members 5-59regarding structured products.

The three notices raise similar issues. Finra notes thatFinra members must develop and implement writtenprocedures to identify and consider new products, as wellas post-approval follow-up and review procedures. Finrareminds its members that, in order to discharge theirsuitability obligation in connection with marketing andselling new products or structured products, Finramembers should conduct adequate diligence. Finramembers should conduct the diligence necessary to permitthem to understand product features. The nature of thediligence will vary by product, but should take intoaccount distinct product features and should include anunderstanding of the liquidity of the product, thecreditworthiness of the issuer, the principal, return and/orinterest rate and the tax consequences.

In Notice to Members 5-59, Finra notes that Finramembers should consider whether an investment meetsthe reasonable-basis suitability standard if it is priced suchthat the potential yield is not an appropriate rate of returnin relation to the volatility of the reference asset based oncomparable or similar investments. Given that structuredproducts are varied, comparing the yield/volatility profileof similar investments may pose challenges. Finra membersalso must perform a customer-specific suitability analysisto ensure that an investment in the product is suitable ona customer-by-customer basis. This requires taking intoaccount the customer’s financial and tax status, investmentobjectives and other similar information, without placingundue reliance on net worth alone. Notice to Members 5-59 also suggests that Finra members consider whether aninvestor meets the suitability requirements for optionstrading.

Any offering or sales material should provide balanceddisclosure of the risk and rewards associated with theparticular product, especially when selling to retailinvestors. In particular, the notices emphasise that manyunique features associated with structured products maynot be readily understood by retail investors. Finramembers should avoid potentially misleadingcharacterisations of structured products in offering or sales


materials (for example, referring to the products as“income-producing”, “conservative” or “yield-enhancing”). Notice to Members 5-59 also notes thatoffering materials that omit a description of the derivativecomponent of the product and instead present suchproducts as ordinary debt securities would violate FinraRule 2210.

Offering documents also should highlight and explainthe risks associated with structured products, whichgenerally include market risk, interest rate risk, a risk ofembedded leverage, the risk of reduced liquidity, issuercredit risk, uncertain tax treatment or adverse taxconsequences and the possibility that there may not be anycurrent income for the holder. Risks specific to eachproduct or structure also should be explained.

Regulatory Notices 09-73, 10-09 and 10-51Following the failure of Lehman Brothers in September2008, holders of Lehman Brothers structured products,including principal-protected products, faced losses. Inlegal or regulatory actions, holders of Lehman Brothersprincipal-protected notes alleged that they believed thatthe term “principal-protected” meant repayment ofprincipal was guaranteed, and did not understand that thenotes were senior unsecured debt obligations of the issuer,subject to issuer credit risk. Regulators took note andissued new guidance. In December 2009, Finra releasedRegulatory Notice 09-73 regarding principal protectednotes, which reminds Finra members thatcommunications must be fair and balanced and provideappropriate disclosures, including disclosures regardingissuer credit risk. Finra cautions that Finra membersshould conduct reasonable suitability assessments prior torecommending principal-protected notes. Finally, Finraemphasises that Finra members must train their registeredrepresentatives regarding the terms, conditions, risks andrewards of these products.

In 2010, Finra issued Regulatory Notice 10-09regarding reverse convertible securities, which had becomequite popular. The notice focuses on sales and marketingcommunications relating to reverse convertibles andrecommended that Finra members ensure investorsunderstand that reverse convertibles do not provide forprincipal protection; as a result, investors may experiencelosses on their investments.

As commodity-linked products became increasinglypopular, Finra issued Regulatory Notice 10-51 regardingcommodity futures-linked securities, reminding firms oftheir sales practice obligations for such products. Thenotice highlights certain of the risks that may result fromthe methodologies used in connection with commodityfutures-linked securities, including possible deviationbetween the performance of the commodity futures-linkedsecurity and the performance of the referencedcommodity.

Regulatory Notice 12-03In January 2012, Finra issued Regulatory Notice 12-03regarding complex products. The notice identifies the typesof products that may be considered “complex” and providesguidance to Finra members regarding supervisory concernsassociated with sales of complex products. The notice makesclear that in Finra’s view, member firms have heightenedobligations in respect of the sale of complex products. Thenotice also highlights additional steps to be taken inconnection with new product review, training, suitabilityassessments and post-sale review for complex products.

Enforcement actionsIn addition to providing regulatory guidance, Finra alsohas pursued enforcement actions against member firmsinvolved in structured product sales. Generally, theseenforcement actions have involved the misselling ofstructured products, a lack of appropriate training andinsufficient supervisory procedures.

Useful remindersIssuers of structured products and the broker-dealers thatdistribute structured products should anticipate thatregulators will remain focused on this area. Consistentwith their objective of protecting investors, regulators willseek to reduce complexity for retail investors and seekgreater transparency and clarity in structured productdisclosures. Moreover, given economic uncertainty and thelosses borne by investors in complex structured creditproducts, concerns are likely to continue to be raised as towhether market-linked products are too complex for retailinvestors. Many of these discussions are likely to gloss overthe distinctions between complexity and riskiness and mayfail to distinguish among different types of retail investorswith differing levels of sophistication.

In light of the regulatory environment, broker-dealersshould take care to:• Review their new product approval process;• Adopt detailed policies and procedures that address the

distinct issues posed by structured products;• Address know-your-customer and suitability

obligations, recognizing that special procedures will berequired in respect of structured products;

• Implement approaches to monitor concentration ofstructured products, single issuer exposures and tradesprior to maturity in client accounts;

• Document a process or policies and proceduresregarding the pricing of structured products andsecondary market activities;

• Design comprehensive mandatory training andeducation specific to structured products;

• Focus on disclosures in offering documents and othermarketing materials; and

• Document arrangements with distributors of structuredproducts and vet distributors carefully based on know-your-distributor procedures.


Special attention should also be paid to product names,descriptions of pay-out structures and product features,and clear discussions of the product’s risks, including thelack of a secondary market, the special tax features, thebuy-and-hold nature of the product, the fees and expensesassociated with the product and the potential conflicts ofinterest presented by the investment.

As with offerings involving other types of products,broker-dealers should consider carefully their existingpolicies and procedures related to information walls inorder to, among other things, help ensure that from acompliance perspective product marketers are walled offfrom research analysts. In addition, broker-dealers should“window-clean” in order to make sure that they have apolicies and procedures for:• Vetting underlying stocks that may be reference assets

or constituents of a narrow-based index that is areference index;

• Licensing indices for use in structured products;• Generating accurate and descriptive account statements

that properly describe the products that customers havepurchased;

• Vetting any marketing materials with Finra and filingany such materials with Finra; and

• Complying with trade reporting rules.There also are a number of changes on the horizon,

including those that may arise as a result of ongoingrulemaking in connection with the Dodd-Frank Act. Forexample, the possible imposition of a fiduciary duty onbroker-dealers is likely to affect the structured productsmarket. Similarly, the Department of Labor’s rules relatingto retirement accounts, adopted in 2016, will affect sales ofstructured products to these types of investors.

Bank regulatory issues arising from hedgingBanks or their branches should consider closely theregulatory issues that may arise in connection with theissuance of structured products. To the extent that aforeign bank or branch seeks to issue structured productsfrom the bank in reliance on the Section 3(a)(2) exception,the foreign bank or branch should consult with counselconcerning the types of products it intends to issue. Inaddition, the foreign bank should consult with itsprincipal regulator. The Department New York ofFinancial Services has published several rulings regardinglinked securities, although these, by and large, addressnotes linked to broad-based indices. A foreign bank alsoshould consider the FDIC’s guidance in respect ofdomestic retail deposits. An uninsured foreign bankbranch will want to make certain that any structured notesare considered “securities” and not deposit products.Finally, a foreign bank will want to consider carefully howthe exposures arising in respect of structured products itissues are hedged. Depending on the structure of theforeign bank, hedging the associated exposures may raiseregulatory concerns.


1. For more information regarding Finra, see Chapter 12(Regulation by the Financial Industry RegulatoryAuthority).

ENDNOTE


What are covered bonds?Covered bonds are debt obligations that provide fullrecourse to the issuing bank, to an affiliated group towhich the issuing entity belongs or both. Upon an issuerdefault, investors also have recourse to designated collateralknown as a cover pool, which is separate and distinct fromthe issuer’s other assets. If the issuer defaults, cash from thecover pool continues to pay the covered bonds onscheduled payment dates and at maturity; the bonds arenot accelerated. The cover pool usually consists of high-quality assets, including residential mortgages, public debtor ship loans.Used since the 18th century in Europe, covered bonds

are relatively new to the United States. Most Europeancountries have a statutory framework for the issuance ofcovered bonds. In the United States, a statutory frameworkto foster the issuance of covered bonds has yet to emerge,while investor appetite for foreign-bank covered bonds isgaining strength.

How are covered bonds structured?The structure of a covered bond issuance generally fallswithin one of two broad categories, determined by thejurisdiction of the covered bond issuer. As noted above,most European jurisdictions have adopted legislationproviding statutory priority for coveredbond holders over the cover pool upon theoccurrence of an event of default. As aresult, most European banks issue coveredbonds directly, without the use of a special-purpose entity. This direct issuancestructure generally is referred to as alegislative covered bond. As illustrated tothe right, the institution originating themortgage loans (or other cover pool assets)is usually the same entity that issues thecovered bonds. In jurisdictions wherecovered bond legislation has not yet beenenacted (for example, the United States orthe United Kingdom or Canada prior toenactment of legislation) or wherejurisdiction-specific practice dictates,issuers rely on contractual arrangements toring-fence the cover pool from unsecuredcreditor claims. These covered bonds areoften referred to as structured coveredbonds.

Regardless of legislative or structured issuance, there arefive general principles underlying all covered bonds. First,the maturity date of covered bonds may not be acceleratedfor insolvency of the issuer, ensuring the covered bondinvestor’s desired maturity profile. Second, the cover poolmust be separate or otherwise segregated from the otherassets of the issuer, affording the covered bond holders firstpriority to the assets in the cover pool upon an insolvencyof the issuer. Third, the covered bonds must be secured byhigh-quality assets, usually determined by eligibilitycriteria in the related covered bond legislation. Fourth, the

CHAPTER 14

Covered bond basics

Covered bond proceeds Covered bonds

Covered bond investor

Covered bond issuer Issuer

Cover pool Asset monitor

Asset monitor reviews cover pool

Direct issuance structure

Repayment of inter-company loan

Inter-companyloan

Assets & relatedsecurity

Consideration

Covered bond

Coveredbonds

Financial institution

Seller

Financial institution

Issuer

Coveredbondholders

Interest rate swap provider

Covered bond

Cover pool

Bond trustee

Covered bond swap provider

Covered bond guarantee

Two-tier structure


issuer must be a regulated financial institution, ensuring ahigh level of transparency through disclosure, as well ascomprehensive regulatory supervision. Finally, the coverpool must be dynamic, requiring the issuer to substituteeligible performing assets for assets that have becomedefective or delinquent or otherwise unsuitable forinclusion in the cover pool.

Legislative covered bondsAs discussed above, covered bonds may be issued directlyby institutions in countries with covered bond legislation.Above is a diagram of the direct issuance structure. Thecover pool is held by the issuer, but segregated andprotected by the legislation.

Structured covered bondsCovered bonds issued in jurisdictions with no legislativeframework, or which continue to use the previouslyadopted structure after enactment of legislation (forexample, the United Kingdom and Canada), rely on a two-tiered issuance structure. The two-tier structure attemptsto replicate the benefits conferred by legislation.

United Kingdom and CanadaIn the United Kingdom and in Canada, for example, thedepository institution establishes a special purpose vehicleto act as the guarantor of the covered bonds. The special

purpose guarantor purchases from the depositaryinstitution the assets constituting the cover pool using theproceeds of a loan from the depository institution to thespecial purpose guarantor. The depository institutionissues the covered bonds which are guaranteed by thespecial purpose guarantor. The two-tier structure illustratesthis approach.

The United StatesIn the United States, the depository institution establishesa special purpose vehicle to act as issuer of the coveredbonds. The special purpose vehicle issuer sells coveredbonds to investors and uses the proceeds to purchasemortgage bonds from the bank (originator/aggregator),which acts as the mortgage bond issuer. The bank-issuedmortgage bonds, which are direct and unconditionalobligations of the bank, serve as collateral for the coveredbonds. The cover pool, a specific, pledged pool ofmortgage loans on the bank’s balance sheet, secures themortgage bonds, which back the covered bonds. Thebelow diagram illustrates this approach.

The cover poolThe cover pool generally consists of high-quality assets,including residential mortgage loans, commercialmortgage loans, public debt or ship loans. The assets aresubject to eligibility criteria. These criteria are specified

(solely upon acceleration of the

Mortgage Bonds)

Covered Bond Proceeds

Covered bonds

Covered bond investor

Covered bond issuer Issuer

Covered bond indenture trustee

Pledge of floating rate mortgage bonds

Mortgage bond indenture trustee

Pledge of cover pool

Mortgage bond proceeds

Floating rate mortgage bonds

Covered bond swap provider(s)

Specified instrument provider(s)

Bank Mortgage bond issuer

Mortgage bond proceeds

Income and principal from specified instruments Specified currency covered bond rate

US$ floating

Cover pool

United States structure


either by legislation or by contract. Cover pool assets mustbe replaced if they fail to meet the specified eligibilitycriteria.The issuer also must ensure that the cover pool meets

certain asset-coverage requirements, which will require theissuer to add assets to the cover pool to replace amortized,matured or defaulted assets. If loans in the cover poolprepay, the loans must be replenished. The bank isrequired to conduct a periodic asset-coverage test to ensurethat the ratio of cover pool assets to the covered bondsoutstanding exceeds the asset coverage requirement.Further, covered bonds are issued on a bullet-repaymentbasis so that investors are not exposed to prepayment risk. Covered bonds are overcollateralised (that is, the

collateral constituting the cover pool has a principalamount in excess of the face amount of the covered bondsoutstanding). This helps to preserve the value of theinvestors’ claims upon the occurrence of an insolvency ofan issuer and to obtain the desired ratings for the coveredbonds from rating agencies. In European jurisdictions withlegislation, the statute may specify a minimumovercollateralisation level.

Covered bonds issued by foreign issuers intothe United StatesDespite the lack of issuance of covered bonds by US banks,approximately $30 billion of covered bonds were issuedinto the United States by foreign banks in 2010, $40billion in 2011, and $44 billion in 2012. Issuance into theUnited States in 2013 slowed to about $25 billion due toCanadian and European developments, and slowed furtherin 2014 to about $9 billion. 2015 saw issuance recover toabout $22 billion and at mid-2016 issuance stands at$12.5 billion. Negative interest rates in Europe areinfluencing decisions to issue in US dollars. United Statesinvestors have a healthy and growing appetite for coveredbonds. Foreign banks have met investor demand by issuingcovered bonds into the United States relying on theirdomestic covered bond frameworks. The cover poolssupporting these foreign-issued covered bonds have beencomprised exclusively of assets located outside the UnitedStates.

Compliance with US securities lawsWhen issuing covered bonds into the United States,foreign issuers must comply with US securities laws,including the Securities Act of 1933. The Securities Actrequires that all securities issued and sold in the UnitedStates be either registered or exempt from registration.Until 2012, offerings of covered bonds by foreign bankshad been structured as exempt offerings. However, in amajor development, Royal Bank of Canada (RBC)registered the first-ever offering of covered bonds with theSEC in 2012 and other Canadian banks have followedsuit.

Rule 144A and Regulation SAs discussed in Chapter 5 (Mechanics of a Rule144A/Regulation S offering), one approach for offeringdebt securities to US persons without pursuing a registeredpublic offering is to rely on the exemption fromregistration provided by Rule 144A. The covered bonds offoreign issuers are first offered in a private placement to theinitial purchasers (the dealers that will distribute thesecurities) in reliance on Section 4(a)(2) of the SecuritiesAct. The initial purchasers will immediately re-sell thecovered bonds to QIBs in reliance on the Rule 144A safeharbor. Contemporaneously, the covered bonds also maybe offered outside of the United States to non-US personsin reliance on Regulation S under the Securities Act.

Section 3(a)(2)If a foreign bank has a branch or agency in the UnitedStates, it may be able to rely on Section 3(a)(2). To qualifyfor a Section 3(a)(2) offering, the covered bonds must beeither issued or guaranteed by the US branch or agency ofa foreign bank. The SEC treats the US branch or agency ofa foreign bank as a bank for purposes of Section 3(a)(2) ifthe nature and extent of regulation and supervision of suchbranch or agency is “substantially equivalent to that ofapplicable federal or state chartered domestic banks doingbusiness in the same jurisdiction”. If the covered bonds areguaranteed by such a branch or agency, the guaranty orassurance must cover the entire obligation. The guaranteeor assurance cannot be for a partial repayment of thecovered bonds.Relying on the Section 3(a)(2) exemption has certain

advantages. First, securities sold in reliance on Section3(a)(2) are not restricted securities, while securities sold ina private placement and resold in reliance on the Rule144A safe harbor are “restricted securities”. Manyinstitutional investors are subject to limitations on theamount of restricted securities that they may purchase.Second, resales of Rule 144A securities may only be madeto QIBs, whereas, 3(a)(2) securities generally may be soldto a broader universe of investors as discussed in Chapter6 (Section 3(a)(2) and considerations for foreign banksfinancing in the United States). Finally, restricted securitiesare not eligible to be included in bond indices and aretherefore viewed as less liquid.

SEC registrationIn order to register its covered bonds, RBC obtained a noaction letter from the SEC in May 2012 that set forthprospectus disclosure requirements for the bonds. The noaction letter also requires monthly and annual filings withthe SEC on the cover pool that are similar to the filings foran asset-backed security offering under Regulation AB.RBC is already an SEC-filer in connection with its seniordebt programme. SEC registration significantly expanded the investor base

in the United States for RBC’s offerings, the bonds are not


“restricted securities,” and the increased transparency andTRACE eligibility significantly improve the secondarymarket. For issuers that have senior debt programmesalready registered with the SEC, this was expected tobecome the favored avenue for issuance of covered bondsin the United States. Recent changes to Regulation ABmake this doubtful.

DocumentationProspectusMany European covered bonds are listed on securitiesexchanges. In connection with such listing, theprospectuses of such covered bonds are reviewed andcleared by entities including the UK Listing Authority(UKLA) and the Luxembourg Stock Exchange. TheUKLA and the Luxembourg Stock Exchange require thatthe prospectuses include disclosure about the issuer or theissuer group and about the programme, including financialinformation. Generally, issuers also are required by statuteto provide covered bond investors with periodic reports onthe cover pool, including, for residential mortgage loans,statistics on dwelling type, geographical location, loanamount, loan balance, remaining term, credit score,interest rate, occupancy, and loan-to-value ratio. Thesereports usually are not posted with the related listingauthority, but often are posted on the issuer’s website.There is a growing trend in both the US and Europeanmarkets for investors to receive more information andobtain more transparency with respect to the cover pool.A European covered bond issuer with a current

prospectus (prepared in accordance with UKLA orLuxembourg Stock Exchange standards) can access the USRule 144A market relatively easily. The prospectus can besupplemented with a few additional sections for the USmarket. The additional sections that would need to beadded generally will include: disclosure regarding US taximplications, Employee Retirement Income Security Act(ERISA) implications, settlement information forclearance of the covered bonds through DTC, the identityof the US paying agent, information regarding any sellingrestrictions and transfer restrictions in the case of a Rule144A offering and information regarding the role, if any,of any US branch of a foreign bank in offerings andfinancial data regarding such branch in the case of aSection 3(a)(2) offering.

Existing programme agreementsGenerally, few changes are required for an existingEuropean covered bond programme to be amended inorder to accommodate an offering in the United States.There is no requirement that the programme agreementsbe governed by US law, so the existing agreements remainlargely unchanged. A few changes are necessary. First, a co-issuing agent must be appointed in the US under theexisting agency agreement (or other agreement providingfor the issuance of securities) to provide for issuance of,

and payment on, the bonds. This change is oftenaccomplished by notice, without the amendment of theagency agreement.Second, as required by DTC, the global bonds must be

issued in the name of DTC’s nominee, Cede & Co., andphysically held by the US issuing agent. This may requireamendment of the agency agreement. Finally, theprogramme agreement (or other agreement governing theoffering and distribution of the covered bonds) must beamended to include representations, warranties andcovenants typical for an offering to US investors, sellingrestrictions, US-style indemnification provisions for falseor misleading statements or omissions contained in theoffering document, typical market-out provisions, and arequirement that the issuer’s accountants deliver a comfortletter and perform certain agreed upon procedures.

Additional documents required for branch issuanceor guaranteeIn the case of an offering under Section 3(a)(2), steps mustbe taken to effect the issuance of the bonds through the USbranch or agency of a foreign bank or for such branch oragency to guarantee the obligations evidenced by thecovered bonds. In the case of an issuance of the coveredbonds by the US branch or agency of a non-US bank, thefinal terms and subscription agreement or otherdocuments to be executed for the issuance of a new seriesof bonds must be executed by the bank “acting through thebranch [agency]” and the global bonds issued to DTCshould show the bank “acting through the branch[agency]” as the obligor. In the case of a guarantee by the branch, the bank

“acting through the branch [agency]” would execute thefinal terms and the subscription agreement as guarantor.While it may initially appear strange that a branch office ofa non-US bank would guarantee the obligations of thenon-US bank, the structure is significant. The US branchor agency of a non-US bank is regulated by a US regulatorand such branch or agency must often maintain separatecapital in its local US jurisdiction. In the case of the branchor agency’s failure, the US banking regulator will marshalthe assets of the branch or agency in the jurisdiction andapply those assets to repayment of claims against thebranch or agency before releasing assets to the home officeof the branch or agency or to insolvency proceedings in thehome jurisdiction of the bank.

10b-5 negative assurance letters and due diligenceSeveral liability and diligence-related documents arecommonly delivered at closing in connection with theissuance of debt securities into US markets. Thesedocuments include: (1) an auditor comfort letter, (2) apool audit letter (agreed upon procedures letter) and (3) a10b-5 negative assurance letter.In an SEC-registered offering, a Rule 144A offering or

in a Section 3(a)(2) offering, an underwriter, initial


purchaser or dealer is subject to US securities law liabilityif there are material misstatements or omissions containedin disclosure documents in a securities offering.1 Generally,however, under applicable law, the underwriter, initialpurchaser or dealer may limit its liability if it can establishthat it did not know and, in the exercise of reasonable care,could not have known of such misstatement or omission.This is often referred to as the due diligence defence.The diligence process will entail discussions with the

issuer’s management, review of certain corporatedocuments, including the issuer’s board minutes andmaterial contracts and other similar agreements and areview of the issuer’s mortgage business policies andprocedures. Some non-US issuers may find this inquiryintrusive. However, the diligence process can be handledwith due consideration for the confidentiality of sensitiveinformation. Furthermore, the review relating to a debtoffering by a regulated financial institution with publiclyavailable financial data should not be a lengthy process.For a regulated financial institution, a great deal ofinformation about the institution is publicly available.Discussions with management should take hours, not daysand the review of agreements, board minutes and otherdocuments should be efficient.As part of the diligence process, there also will be various

business and regulatory diligence conference calls anddiscussions with the issuer’s accountants, counsel and otheradvisors. Naturally, conducting diligence for the very firstoffering will be more time-consuming than for subsequentofferings. Subsequent offerings require only a review ofnew agreements and new board minutes. It should also benoted that diligence conducted, for example, for a coveredbond programme can also serve as the basis for diligencefor other securities offerings by the same issuer, such asofferings pursuant to an MTN programme or a 3(a)(2)banknote programme. Accordingly, once initial diligence iscompleted, the issuer may achieve future efficiencies if theissuer and the dealers work with the same counsel on otherofferings.The underwriter/initial purchaser/dealer also will

request that the issuer’s counsel and its own counsel delivera Rule 10b-5 (negative assurance) letter at closing. In theletter, counsel will state that it is unaware of any untruestatement of material fact or omission to state a materialfact necessary in order to make the statements made in thedisclosure document and other related offering materials,in light of the circumstances under which they were made,not misleading.

ProcessThe process of preparing for and conducting a Rule 144Aor 3(a)(2) offering should generally be familiar to aEuropean issuer. After selecting the arranger/dealer for aUS offering, the offering process would typically involvethe following steps:• Reviewing the existing programme agreements;

• Amending programme agreements, as needed;• Drafting final terms and subscription agreement;• In the case of a 3(a)(2) offering, discussing the offering

with US banking regulators;• Due diligence review;• Obtaining a comfort letter; • Preparing roadshow materials;• Selecting the co-managers;• Bring-down diligence;• Launching the offering;• Pricing; and• Closing.For a 3(a)(2) offering, the US bank regulator for the

branch or agency should be consulted in advance. Coveredbonds may not be familiar instruments to many stateregulators and an effort should be made to explain to theregulator the role of the branch or agency and features of acovered bond. For an SEC-registered offering, there will be several

additional steps:• Obtaining a no action letter from the SEC, if necessary;• Filing an SEC registration statement, including a

compliant prospectus, for review by the SEC;• Amending the trust deed or issuing agency agreement

to comply with the Trust Indenture Act of 1939, asamended;

• Drafting an underwriting agreement for the offering; • Obtaining an SEC order of effectiveness for the

registration statement; and• Drafting a prospectus supplement for the specific bonds

to be offered.


1. Liability in a Rule 144A offering is different incertain respects from liability in a Section 3(a)(2)offering. For a discussion of liability in a Rule 144Aoffering, see “Due diligence” and “Liability concerns”in Chapter 5 (Mechanics of a Rule 144A/RegulationS offering). For a discussion of liability in a 3(a)(2)offering, see “Securities liability” in Chapter 6(Section 3(a)(2) and considerations for foreign banksfinancing in the United States).

ENDNOTE


Non-US sovereign governments and theirpolitical subdivisions frequently offer debtsecurities and guarantees of other debtsecurities in the United States by registering

and issuing the debt securities and guarantees underSchedule B of the Securities Act. Schedule B is a scheduleto the Securities Act that sets out the requirements to beincluded in the registration statements of sovereign foreigngovernments and their political subdivisions for guaranteesand offerings of debt securities. Schedule B also offers aseparate and generally more streamlined registrationprocess for sovereign issuers compared with the process fordomestic and foreign private issuers not entitled to useSchedule B.The justification for the more streamlined process is the

ability of sovereigns to satisfy interest and premiumpayments on debt securities by levying taxes. Sovereignissuers use Schedule B for issuing debt securities (sovereignissuers do not issue equity). References in this chapter to“sovereign issuer” include any foreign government,political subdivision, international organisation andinstrumentality that is permitted to file under Schedule B. There is no specific registration statement form for

Schedule B sovereign issuers as there is for both domesticand foreign private issuers for other types of offerings (forexample, Form S-1 and Form F-1). The registrationstatement for sovereign issuers must simply contain theinformation specified in Schedule B. Although therequirements for Schedule B registration statements are farshorter, the common practice is to disclose informationanalogous in scope to that required under Form S-1.Schedule B’s short length, which allows sovereign issuersfar more latitude in drafting and the relative lack ofstatutory guidance has resulted in Schedule B practiceevolving informally through SEC no-action letterguidance, the SEC review process itself and the self-policing mechanisms of sovereign issuers and underwritersand each of their counsel.

Who can use Schedule B?Section 7 of the Securities Act provides that Schedule Bapplies to securities issued by a “foreign government, orpolitical subdivision thereof.” Although this phrase is notspecifically defined in the Securities Act, its meaning andby extension the types of issuers that may use Schedule B,have evolved over time along with the rest of Schedule B

practice. Schedule B is clearly available to any non-USsovereign nation and political subdivisions of suchsovereign nation, which may include states, provinces,cities and municipalities. There are other classes of issuerswhere the application of Schedule B is unclear, especiallywith respect to nations where many corporations arepartially nationalised. In situations where Schedule Bapplicability is unclear, the issuer and its US counselshould arrange a pre-filing conference with the SEC staffto obtain clearance to use Schedule B.The SEC staff has permitted international organisations

with sovereign nations as members to use Schedule B.1Some recent examples of organisations using Schedule Binclude the Council of Europe Development Bank andCorporación Andina de Fomento, both multilateralfinancial institutions with European and South Americannations as their members, respectively. The internationalorganisations permitted to use Schedule B typically servegovernmental functions and have their financialobligations backed by the member nations in the eventthat the organisations cannot meet their obligations undertheir debt securities. Securities offerings of certaininternational organisations, including the AfricanDevelopment Bank, the Asian Development Bank, theEuropean Bank for Reconstruction and Development, theInter-American Development Bank and the InternationalBank for Reconstruction and Development, are governedby specific statutes and regulations that are even morefavorable that Schedule B.2The SEC staff also has permitted issuers that are part of,

or owned by, sovereign nations to use Schedule B becauseinvestments in such issuers are secure from default to thesame degree as sovereign credits.3 These decisions havetypically focused on the guarantee of the issuer’s securitiesby a sovereign, the issuer serving a governmental purposeand the existence of sovereign ownership or control of theissuer.

Guarantee of the issuer’s securities by a sovereign The most important factor for issuers that are part of, orowned by, sovereign nations is the existence of a sovereignguarantee or equivalent credit support of the issuer’ssecurities. The guarantee can be an express guarantee, astatutory guarantee or a legal requirement by operation oflaw requiring the sovereign to provide funding for theissuer to satisfy its obligations. A guarantee by a political

CHAPTER 15

Schedule B filers


subdivision of a sovereign nation also is acceptable,assuming the political subdivision can levy taxes. Commonexamples of the latter are Canadian power and utilitycompanies that regularly issue Schedule B securitiesguaranteed by the province they are located in. Where anexpress guarantee is provided, the guarantee is considereda separate security just as any other guarantee of a debtsecurity, which means it must also be registered underSchedule B with the underlying debt securities and usuallyunder the same registration statement. In such cases, boththe issuer and the guarantor need to sign the registrationstatement. In such cases, both the issuer and the guarantorneed to sign to registration statement. Even where anexpress guarantee is absent but the issuer is using ScheduleB because of some other type of credit support from asovereign, the SEC staff will typically require both theissuer and the sovereign to sign the registration statement. Whatever the exact form of the sovereign guarantee or

credit support, the SEC has generally taken the positionthat the sovereign guarantee or credit support must carrywith it the “full faith and credit” of the sovereign. The SECalso has viewed the legal opinion of local counsel asauthority for the sovereign’s guarantee or other necessarysupport. However, it seems unlikely that the SEC wouldgrant Schedule B status where the sovereign’s support tookthe form of a mere contractual keep-well arrangement thatfell short of a guarantee, even if the arrangement carriedthe full faith and credit of the sovereign. Nevertheless, anumber of central banks have been permitted to registerdebt securities under Schedule B even though suchobligations did not carry the full faith and credit of thesovereign or benefit from a formal sovereign guarantee orother keep-well arrangement.4

Issuer serves governmental purposeIssuers that are formed by foreign governments to performgovernmental functions are more likely to receivepermission to use Schedule B. Examples of such issuersinclude foreign national development banks and foreignmunicipal school districts. In addition, issuers engaged inactivities that bring them into excessive competition withprivate companies engaged in similar activities would notlikely be able to use Schedule B.

Sovereign ownership or control of the issuerIssuers that are owned or controlled by foreigngovernments also are more likely to receive permission touse Schedule B. The SEC staff typically looks for whole orsubstantially whole ownership of the issuer by thesovereign. With respect to control over the issuer, the SECstaff generally looks for governmental supervision,budgetary control and appointment of executives by thesovereign. In determining whether an issuer should betreated as part of a foreign government, the SEC hasapplied these criteria on the basis of al the relevant factsand circumstances.

Disclosure required under Schedule BSchedule B requires a short list of disclosures for ScheduleB registration statements compared with registrationstatements for other registered securities offerings.Schedule B specifically requires disclosure of the followingitems:• The net amount and proposed use of proceeds of the

offering;• The amount and principal terms of the sovereign

issuer’s “funded” (long-term) and “floating” (short-term) debt (both foreign and domestic);

• Any defaults by the sovereign issuer on externalsecurities during the preceding 20 years;

• The sovereign issuer’s revenues and expenditures(including deficits) during the three most recent fiscalyears;

• The name(s) of any authorised agent(s) in the UnitedStates;

• The name(s) of counsel will pass upon the legality ofthe securities being offered;

• The terms of the distribution, including theunderwriting arrangements, if any, and the names of theunderwriters;

• The price at which the securities are to be offered (orthe method by which the price is to be determined);

• The commissions or other compensation to be paid tothe underwriters; and

• Other expenses of the offering.In practice, however, underwriters and investors have

come to expect far more disclosure than what is specificallyrequired under Schedule B because of the general liabilityprovisions of US securities laws that require allinformation that would be considered important byinvestors in deciding whether to invest in the securitiesbeing offered or that is needed to ensure that the statementmade in the prospectus are not misleading.In addition, more robust disclosure often is necessary for

marketing purposes from the underwriters’ perspective.Over the years, the disclosure format for sovereign issuershas become highly standardised and includes informationregarding the home-country, its form of government andgeneral political situation, the principal features of itseconomy, its natural resources and population, its balanceof trade, its balance of payments, its aggregate externalindebtedness, other factors affecting the availability of thecurrency in which the proposed registered offering is to bemade, and the terms of the securities. In the case ofsecurities that are guaranteed by a sovereign, essentially thesame disclosure requirements apply to the sovereign.A typical Schedule B registration statement contains a

prospectus, certain undertakings (included in a Part II),the specific disclosures required by Items 3, 11 and 14 ofSchedule B and various exhibits, usually comprising theform of underwriting agreement, the form of fiscal andpaying agent agreement and the consents of governmentofficials, auditors and law firms named in the prospectus.


Although Schedule B does not require audited financialstatements, common practice is to include such financialstatements (in English translation). However, the financialstatements do not need to be presented in or reconciledwith US generally accepted accounting practices.Nevertheless, sovereigns typically include someexplanation of the financial statement presentation andmethods to help US investors understand the financialstatements.Schedule B registration statements must be filed with

the SEC and declared effective before an offering canproceed. Once Schedule B registration statements are filedthey appear on Edgar under the designation S-B with aSecurities Act file number just like any other Securities Actregistration statement. The SEC staff assigned to theOffice of International Corporate Finance, a subdivision ofthe Division of Corporation Finance, will review,comment on and ultimately declare the Schedule Bregistration statements effective.

Applicability of the Exchange Act and the TrustIndenture ActSovereign issuers are not required to file periodic reportsunder Sections 12(g) or 15(d) of the Exchange Act. Section12(g) applies to issuers of equity securities and foreigngovernments issue only debt securities and Section 15(d)expressly exempts foreign governments and their politicalsubdivisions. Only foreign governments and their politicalsubdivisions that voluntarily list their debt securities on aUS national securities exchange must file Exchange Actreports. Instead of filing the annual and periodic reportsthat are required of domestic and foreign private issuers,sovereign issuers first file a registration statement on Form18 that includes its US national securities exchange listingapplication. Sovereign issuers then must file annual reportson Form 18-K and may keep such reports current withamendments on Form 18-K/A throughout the year. Thedisclosures required under Form 18 and Form 18-Kthough are similar to the disclosures required underSchedule B.Section 304(a)(6) of the Trust Indenture Act, exempts

debt securities issued or guaranteed by a foreigngovernment or its subdivisions. As a result, Schedule Bissuers enter into a fiscal and paying agent agreement,rather than an indenture, to specify the mechanics ofissuing and paying principal and interest on the debtsecurities.

Shelf registrations under Schedule BRule 415 under the Securities Act, which permits delayedor continuous registered offerings (commonly referred toas shelf registrations), expressly prevents sovereign issuersfrom using shelf registrations. However, there is anuncodified but accepted practice allowing Schedule Bissuers to use a delayed or continuous offering or shelfprocedure similar to that under Rule 415 used by non-

sovereign issuers.5 Under this shelf procedure, a sovereignissuer can register an amount of debt securities itreasonably expects to offer over a two year period. ASchedule B shelf registration filing though is only availableto seasoned sovereign issuers that have registered securitiesor guarantees of securities on Schedule B within the pastfive years and have not had any material defaults on theirindebtedness for the past five years.6 Nevertheless, the SEChas permitted a non-seasoned sovereign issuer to file aSchedule B shelf registration statement, but in the limitedcase of the registration solely of its guarantees of registereddebt securities issued by banking institutions.7 In addition,the registration statement cannot be used for othersecurities and the sovereign must file a prospectussupplement each time its guarantees are issued.8Just as in a Rule 415 shelf registration statement, a base

prospectus is filed with the registration statement to beupdated by preliminary and final prospectus supplementsas needed. The SEC reviews the registration statementwith the base prospectus containing a full description ofthe issuer and its finances and must declare the registrationstatement effective before the offering can proceed.Prospectus supplements are then filed under Rule 424(b)under the Securities Act for each offering containing thematerial terms of the offered security and any materialrecent developments. Most exhibits to the registrationstatement can be filed before it is declared effective.Therefore, forms of documents that are not finalised, suchas the underwriting agreement and in some cases the fiscaland paying agent agreement, can be filed as forms beforeeffectiveness with the final versions filed as post-effectiveamendments to the registration statement. Similarly, aqualified legal opinion on the validity of the securities istypically filed before the registration statement is effectivewith a traditional validity opinion on the securities filed asan exhibit to a post-effective amendment.

Alternate shelf registration procedure on Form 18-K Seasoned sovereign issuers also may take advantage of analternative shelf registration procedure under Form 18-Kpermitted by a long line of SEC no-action letters.9Sovereign issuers hoping to take advantage of the Form 18-K shelf registration procedure for the first time shouldrequest no-action letter relief from the SEC staff beforeproceeding. The Form 18-K shelf registration procedurealso is available for political subdivisions andinstrumentalities of seasoned sovereign issuers.The seasoned sovereign issuer must first voluntarily file

Form 18 and Form 18-K, unless it is already doing sobecause it has listed debt securities in the United States.The Form 18-K must include all of the informationrequired by the form and by Schedule B, as well as anyadditional information that would be material to investorsjust as in any registered securities offering. Throughout theseasoned sovereign issuer’s fiscal year, the Form 18-K isupdated by filing amendments on Form 18-K/A, rather


than post-effective amendments to its Schedule Bregistration statement. Typical updates on Form 18-K/Ainclude the inclusion of interim financial statements,revised budget estimates and material recent developmentswhen considered necessary for disclosure purposes.When seasoned sovereign issuers file Schedule B

registration statements, they must incorporate by referencethe previously filed Form 18-K and all subsequentamendments. The Schedule B registration statementshould include the undertakings required by Item512(a)(1),(2) and (3) and Item 512(i)(2) of Regulation S-K normally applicable to Rule 415 offerings that, amongother things, include the obligation to include anyprospectus required by Section 10(a)(3) of the SecuritiesAct and reflect in the base prospectus any facts or eventsarising after the effective date of the registration statement(or the most recent post-effective amendment) that,individually or in the aggregate, represent a fundamentalchange in the information included in the registrationstatement. However, the seasoned sovereign issuer is notrequired to file a post-effective amendment otherwiserequired by the undertakings if the information requiredto be included in a post-effective amendment is containedin any report filed under the Exchange Act that isincorporated by reference in the registration statement.At the time of any shelf takedown, the seasoned

sovereign issuer must file a prospectus supplement underRule 424(b) of the Securities Act that includes a completedescription of the securities being offered and any materialrecent developments since the date of the base prospectusor the last Form 18-K that are not already filed on Form18-K/A. The prospectus supplement should state thatcopies of any documents incorporated by reference and allexhibits will be furnished promptly upon request and freeof charge. The information and documents required bySchedule B to be described or filed in or with theregistration statement that would typically be filed by post-effective amendment at the time of an offering (forexample, the underwriting amendment, the names andaddresses of the underwriters and an itemised list ofexpenses and legal opinions) are instead included in (or asexhibits to) the Form 18-K or Form 18-K/A andincorporated by reference into the registration statement.

Limitations on sovereign liabilityWhen issuing Schedule B debt securities, sovereign issuerstypically appoint an agent in the United States for serviceof process and submit to a particular US jurisdiction forany lawsuits or actions related to the securities (typicallyNew York state or federal courts). The consent to service ofprocess and the submission to jurisdiction thoughexpressly carve out actions arising out of or based on USfederal or state securities laws. Sovereign issuers alsotypically waive their sovereign immunity, although thewaiver does not apply to actions arising out of or based onUS federal or state securities laws. However, whether a

sovereign can assert sovereign immunity from US federalsecurities laws remains an unsettled question.The Foreign Sovereign Immunities Act of 1976 (FSIA)

grants sovereign immunity to sovereigns and their agenciesand instrumentalities subject to certain exceptions.10 Oneexception provides that sovereign immunity does not applyin actions based upon: (1) a “commercial activity” carriedon in, or having substantial contact with, the UnitedStates; (2) an act performed in the United States inconnection with a commercial activity of the sovereignelsewhere; or (3) an act outside the territory of the UnitedStates in connection with a commercial activity of thesovereign elsewhere that causes a direct effect in the UnitedStates.11 Although not directly applicable to sovereignimmunity under US federal securities laws actions, the USSupreme Court has held that a sovereign’s issuance of debtobligations was a commercial activity under the FSIA andaccordingly, the sovereign was not immune to a breach ofcontract claim.12

Acts of stateA claim of sovereign immunity can be further complicatedby the acts of state doctrine under which US courts deferto foreign courts and will not substitute their ownjudgments if an act by a sovereign issuer that injuressecurityholders is an act by that sovereign issuer within itsown territory. Examples of such actions include changes incurrency controls that result in restrictions on payments inforeign currencies, changes in economic policy and acts ofwar. This means that even if a US court were to ignore aclaim of sovereign immunity in a securities action againsta sovereign issuer, the sovereign issuer may still be able toavoid or limit liability if an act of state (as opposed to acommercial activity) caused the injury to securityholders.

Jurisdiction, immunity and enforcement disclosureSchedule B registration statements typically includedisclosure regarding the jurisdiction, immunity andenforcement issues discussed above. The disclosure usuallyis found in the prospectus towards the beginning, in therisk factors section or in the description of debt securitiessection. The disclosure needs to be tailored to the relevantjurisdiction and the particular laws governing the securitiesand the sovereign issuer. The most common points coveredin the disclosure include the following:• Because the issuer or guarantor is a foreign sovereign

government, it may be difficult to obtain or enforcejudgments against it in US courts or in the sovereign’scourts.

• The sovereign issuer has appointed its consulate in theUnited States or another agent for service of process.

• The sovereign issuer has submitted to the jurisdiction ofUS federal and state courts in New York and waivedimmunity from jurisdiction and any objection that itmay have to the venue of such courts.

• The sovereign issuer reserves the right to plead


sovereign immunity under the FSIA in actions broughtagainst it under US federal securities laws or any statesecurities laws, and its submission to jurisdiction,appointment of the agent for service of process andwaiver of immunity do not include such actions.

• In the absence of the sovereign issuer’s waiver ofimmunity with respect to such actions, it would beimpossible to obtain a US judgment in an actionbrought against the sovereign issuer under US federal orstate securities laws unless a US court were to determinethat the sovereign issuer is not entitled under the FSIAto sovereign immunity with respect to the action.

• Execution of a lien on the sovereign issuer’s property inthe United States to enforce a judgment in the UnitedStates may not be possible except under the limitedcircumstances specified in the FSIA, and even ifsecurityholders are able to obtain a judgment againstthe sovereign issuer in the United States or in thesovereign issuer’s courts, they might not be able toenforce it in the sovereign issuer’s home country.

Regulation MRegulation M governs the activities of underwriters,issuers, selling securityholders and other offeringparticipants in connection with securities offerings andwas adopted by the SEC to prevent manipulative conductby persons with an interest in the outcomes of securitiesofferings. Rules 101 and 102 of Regulation M prohibitissuers, selling securityholders, distribution participantsand any of their affiliated purchasers from directly orindirectly bidding for, purchasing, or attempting to induceanother person to bid for or purchase a “covered security”until a restricted period has ended. Covered securities, forthis purpose, mean the securities being distributed or anyreference security, into which a subject security may beconverted, exchanged or exercised, or under which theterms of the subject security may in whole or significantpart determine its price.Rules 101 and 102 apply to sovereign debt securities.

Sovereign issuers cannot satisfy the requirements of onepopular exemption from Regulation M for issuers whosecommon equity securities have a public float value of atleast $150 million because sovereign issuers do not issueequity securities. However, there is an exemption forsovereign debt securities that are rated investment grade,similar to domestic or foreign private non-convertibleinvestment grade debt.13In cases where the sovereign debt securities are not rated

investment grade, the SEC staff has granted non-actionletter relief from Rule 101 to permit the lead underwritersof sovereign issuances and their affiliates to conductmarket- making activities during the restricted periodimposed by Regulation M. In addition to being helpful formarket making in sovereign debt, the SEC no-action letterrelief also facilitates the reopening of previously issuedseries of sovereign debt securities, a fairly common method

of raising capital for sovereign issuers but one requiring anexemption from Regulation M because the distributedsecurities are identical to those already outstanding. Thisrelief has been granted in a line of SEC no-action lettersand is typically based on the following criteria, which arenot exhaustive and not all of which need be satisfied inevery situation:14• The issuer is a sovereign government whose financial

affairs are widely reported on.• The issuer’s public sector external debt is large in

principal amount, typically well over US$1 billion.• The market for the debt securities is expected to be

highly liquid and to have significant depth of trading.• The underwriters estimate that a significant number of

dealers (at least 10) are expected to regularly place bidsand offers for the debt securities, of which a number (atleast five) are expected to be continuous market makers.

• The underwriters estimate that daily purchases and salesof the debt securities by the underwriters and theiraffiliates will not account, on average, for more than apercentage of the average daily trading volume in thedebt securities (this number is typically not higher than20% to 25% but has been as high as 30% and 35%).

• The debt securities are expected to trade primarily onthe basis of a spread to the US Treasury security with acorresponding maturity, in a manner similar to tradingin investment grade debt securities.

• Bid and ask prices for the debt securities in the over-the-counter market is expected to be widely available.

• The debt securities are expected to be rated not farbelow investment grade (for example, BB by Standard& Poors and Ba2 by Moody’s).

• The debt securities are offered under the sovereign’sSchedule B registration statement.However, even if the SEC is satisfied that enough criteria

are satisfied, the relief will still be subject to twoconditions. First, the prospectus supplement for theoffering must disclose that the underwriters and certainaffiliates have been exempted from the provisions ofRegulation M. Such disclosure typically is included in theunderwriting section of the prospectus supplement.Second, the underwriters and their affiliates must providethe SEC’s Division of Trading and Markets, upon request,a daily time-sequenced schedule of all transactions in thedebt securities made during the period that begins fivebusiness days prior to the pricing of the offering and endswhen the distribution of the debt securities in the UnitedStates is completed or abandoned.

Requirements under FinraSchedule B offerings are subject to Finra’s corporatefinancing rule (Finra Rule 5110). Finra Rule 5110regulates, among other things, the pricing and conduct ofdue diligence for registered offerings in which a Finramember is a participant. Under Finra Rule 5110, no Finramember or any of its associated persons may participate in


any manner in any public offering of securities unlesscertain documents and information relating to the offeringhave been filed and reviewed by Finra, subject to certainexceptions. In addition, under Finra Rule 5121, no Finramember that has a conflict of interest may participate in aregistered offering unless the offering meets one of thespecified exemptions or a “qualified independentunderwriter” participates in the offering. Under Finra Rule5121, a conflict of interest exists if:• The securities are to be issued by the Finra member;• The issuer controls, is controlled by or is under

common control with the Finra member or themember’s associated persons;

• Where at least 5% of the net offering proceeds, notincluding underwriting compensation, are intended tobe either used to reduce or retire the balance of a loanor credit facility extended by the Finra member, itsaffiliates and its associated persons (in the aggregate) orotherwise directed to the Finra member, its affiliatesand associated persons (in the aggregate); or

• As a result of the registered offering and anytransactions contemplated at the time of the registeredoffering, the Finra member will be an affiliate of theissuer, the Finra member will become publicly owned orthe issuer will become a Finra member or form abroker-dealer subsidiary.However, sovereign debt with a maturity of at least four

years that is rated investment grade is exempt from thefiling requirements under Finra Rule 5110. If sovereigndebt does not qualify for this exemption, then theSchedule B registration statement must be filed with Finra,the sovereign issuer must pay a filing fee and certaindisclosures regarding the conflict of interest must beincluded in the prospectus for the offering. For moreinformation regarding Finra, see Chapter 12 (Regulationby the Financial Industry Regulatory Authority).

Documentation for a Schedule B offeringThe documentation for Schedule B offerings is similar tothe documentation for other registered securities offerings.However, the documentation needs to reflect thedifferences between each sovereign issuer and its structureand governing laws, and the underwriting agreement andthe legal opinions will materially differ from otherregistered offerings. There are no comfort letters issued inSchedule B offerings as Schedule B does not requireaudited financial statements to be included in theregistration statement. In addition, in place of boardresolutions, sovereign issuers must obtain governmentalapprovals for the Schedule B offering. The Schedule Bdocumentation typically includes the following:• The Schedule B registration statement and prospectus

(and for shelf issuers, prospectus supplements togetherwith Forms 18-K and 18-K/A);

• A free writing prospectus filed with the SEC disclosingthe material terms of the securities offered;

• A fiscal and paying agent agreement;• All certificates, authorisations and receipts required

under the fiscal and paying agent agreement, which aresimilar to those required by standard indentures andtypically executed by senior members of the sovereignissuer’s treasury department, finance ministry or similarfinancial subdivision;

• A DTC issuer blanket letter of representations;• Any listing applications and confirmations if the

securities are to be listed on a US national securitiesexchange.

• An underwriting agreement;• Any applicable home-country governmental approvals;

and• Legal opinions required under the underwriting

agreement.

Underwriting agreementA copy of the underwriting agreement must be filed as anexhibit to a Schedule B registration statement. In the caseof shelf registrations, a form of underwriting agreementtypically is filed with the registration statement, and afteran offering the sovereign issuer will update the form ofunderwriting agreement with the final underwritingagreement filed as an exhibit on Form 18-K/A. Theunderwriting agreement between the sovereign issuer andthe underwriters will be very similar to underwritingagreements used for other registered offerings. Thearrangements relating to service of process, jurisdictionand conditional waiver of sovereign immunity (asdiscussed above) will be set out in the underwritingagreement. Although certain of the representations andwarranties given by the sovereign issuer will mirror those ofnon-sovereign issuers, there are a number that are uniqueto sovereign issuers:• The obligations of the sovereign issuer under the debt

securities are supported by the home-country’s full faithand credit.

• No documents or instruments need to be registered,recorded or filed with any court or other authoritywithin the home-country (other than with respect totranslations) to ensure the legality, validity,enforceability, priority or admissibility in evidence onthe sovereign issuer of the underwriting agreement, thefiscal and paying agent agreement, the securities or anyother document or instrument related to the offer andsale of the securities.

• There is no tax, levy, deduction, charge or withholdingimposed by the sovereign issuer or any of its politicalsubdivisions on any transaction or document executioncontemplated in the underwriting agreement.

• The statements with respect to matters of the sovereignissuer’s governing law set forth in the prospectus arecorrect.

• The sovereign issuer has the power and authority toissue the securities.


• Any failure of the sovereign issuer to make the necessaryor appropriate provisions in its budget for the timelypayment of all amounts due under the securities willnot constitute a defense to enforcement of theobligations.

• All consents to service of process, submission tojurisdiction and waivers of immunity are binding on thesovereign issuer.

Governmental authorityInstead of board resolutions authorising the issuance ofsecurities and the performance of the obligations underthose securities, Schedule B issuances requiregovernmental approvals. The action required and themethod of documentation will vary with each sovereignissuer and will depend on how the home-country’sgovernment is structured. The authorisation can be assimple as an executive decree or may require multiplegovernmental bodies to issue letters, certificates andresolutions. For example, a home-country’s legislature,central bank, and treasury and finance ministry may allneed to authorise the securities and obligations. USsecurities counsel for the sovereign issuer and for theunderwriters must work closely with local counsel indetermining what is required under the home-country’slaws, and the process and documentation required willneed to be covered in the legal opinion to be provided bylocal counsel.

Legal opinionsSchedule B requires validity opinions to be filed as exhibitsto the registration statement, along with Englishtranslations, if needed. The validity opinions must cover allof the applicable laws or other home-country actsauthorising the securities. Sovereign issuers typicallyengage US counsel and sometimes local counsel (in thehome-country) to provide legal opinions, while theunderwriters engage both US counsel and local counsel (inthe home-country). US counsel and local counsel (as wellas in-house counsel for the sovereign issuer) provide legalopinions to the underwriters. In-house counsel for thesovereign issuer typically is a top-ranking attorney in thehome-country’s department of justice or finance.The matters covered in the opinions from US counsel

are similar to those covered in opinions for other registeredofferings, including the validity of the securities and theadequacy of the disclosure in the Schedule B registrationstatement and the prospectus (often referred to as the 10b-5 paragraph). Similarly, the opinions from local and in-

house counsel cover many of the same matters covered inlocal and in-house counsel opinions for other registeredofferings. However, there will be certain opinion pointsincluded in the opinions from local and in-house counselthat are unique to sovereign issuers and that mirror thesovereign issuer’s representations and warranties containedin the underwriting agreement, including the following:

• The sovereign issuer has full power and authority underits constitution or similar governing framework toperform its obligations under the debt securities, theunderwriting agreement and the fiscal and paying agentagreement, and all transactions contemplated by thoseagreements.

• There is no conflict with the general laws of the home-country and those laws specified in the opinion thatcover the authorisation of the sovereign issuer to incurdebt obligations.

• All necessary action, authorisations, approvals andconsents, which are itemised in the opinion, from allgovernmental authorities within the home-countryhave been taken and obtained and are in full force andeffect.

• The choice of law is valid and the sovereign issuer’sconsent to service of process, submission to USjurisdiction, waiver of objection to venue and waiver ofsovereign immunity are legal and binding under thehome-country’s laws.

• It is unnecessary to file or register any transactionagreement, document or other document with anycourt or other authority in the home-country, or to payany registration fee or stamp or similar tax to ensure thelegality, validity, enforceability or admissibility inevidence of such agreement or document.

• The transaction agreements are in proper legal formunder the laws of the home-country for enforcementagainst the sovereign issuer.


1. See SEC No-Action Letter, NordiskaInvesteringsbanken (December 30 1981).

2. See, e.g., General Rules and Regulations Pursuant to §9(A) of the European Bank for Reconstruction andDevelopment Act, 17 C.F.R. §§ 290.1 et seq.

3. Certain foreign banks that are eligible to use ScheduleB may also be able to take advantage of the exemptionfrom registration under Section 3(a)(2) under theSecurities Act if they issue securities through a USfederal or state branch. For more informationregarding Section 3(a)(2) offerings, see Chapter 6(Section 3(a)(2) and considerations for foreign banksfinancing in the United States).

4. See SEC No-Action Letter, Bank of Greece (June 21993).

5. See SEC Release No. 33-6240 (September 10 1980);SEC Release No. 33-6424 (September 2 1982).

6. See SEC No-Action Letter, Republic of Venezuela(November 24 1980).

7. See SEC No-Action Letter, Commonwealth ofAustralia (February 26 2009).

8. See id.

9. See, e.g., SEC No-Action Letter, Canada and itsCrown Corporations (April 16, 1991); SEC No-Action Letter, United Mexican States (February 25,1994); SEC No- Action Letter, Republic of Hungary(September 27 2007).

10. See 28 U.SC. §§ 1602–1611.

11. See 28 U.SC. § 1605(a)(2).

12. See Republic of Argentina v. Weltover, 504 US 607(1992).

13. See Rules 101(c)(2) and 102(d)(2) under RegulationM.

14. See, e.g., SEC No-Action Letter, Republic of Uruguay(June 24 2008); SEC No-Action Letter, Republic ofPanama (January 16 2004); SEC No-Action Letter,Republic of Colombia (December 2 2002); SEC No-Action Letter, Regulation M – Sovereign BondExemption (January 12 2000).

ENDNOTES

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