Frequently Asked Questions About Commercial Paper And .
FREQUENTLY ASKED QUESTIONS ABOUTCOMMERCIAL PAPER ANDCOMMERCIAL PAPER PROGRAMSUnderstanding Commercial PaperWhy is commercial paper attractive?CP is an attractive funding alternative for issuers forWhat is commercial paper?several reasons.Commercial paper (“CP”) is a term used to refer toCP proceeds to fund short‐term liquidity needs insteadshort‐term debt securities that are in the form of aof relying on short‐term borrowings under revolvingpromissory note and have maturities of nine months orcredit facilities and other lines of credit from banks.less (although typically 30 days or less). CP is usuallySecond, CP issuers can easily roll over CP, which meansunsecured, issued in large denominations of 100,000,that the proceeds from new issuances are used to pay 100,000, 100,000 or more and sold at a discount fromthe obligations resulting from maturing issuances. Asthe face value.CP is typically non‐interest bearing.such, CP issuers can often continue to utilize CPInstitutional money market investors, including moneyproceeds uninterrupted. Third, there are clearly definedmarket funds, insurance companies and banks, haveexemptions from registration under the Securities Act ofbeen the main purchasers of CP, and these purchasers1933, as amended (the “Securities Act”), for CP. Fourth,are almost always (1) in the United States, eitherCP programs are relatively straightforward to set upqualified institutional buyers (“QIBs”) or institutionaland do not require extensive disclosures.accredited investors (“IAIs”) and (2) in Europe,qualified investors.First, CP issuers frequently useCP has been attractive to institutional money marketinvestors mainly because the short‐term maturity of CPCP is issued to U.S. investors pursuant to U.S.enables such investors to satisfy certain liquidity andCP programs and to European investors pursuant toinvestment rating requirements under the InvestmentEuro CP programs. We discuss the differences betweenCompany Act of 1940, as amended (the “InvestmentU.S. CP programs and Euro CP programs below underCompany Act”).“Structure of U.S. Commercial Paper Programs” andcommercial paper rated? Is a back‐up bank facility required?”“Structure of Euro Commercial Paper Programs.”below.For more information, see “Is
Is commercial paper rated? Is a back‐up bank facility“prime” rating, a CP issuance under Section 3(a)(3) isrequired?not possible.CP is often rated, in the United States, by a nationallytraditionally been major purchasers of CP, hadrecognized statistical rating organization (“NRSRO”),previously been subject to restrictions under Rule 2a‐7and in Europe, by a credit rating agency, such asunder the Investment Company Act (“Rule 2a‐7”) thatStandard & Poor’s, Moody’s and Fitch.limited their ability to invest in securities that are not inThere is noexpress rule requiring that CP be rated, but existingMoney market funds, which havethe two highest rating categories.1guidance from the Securities and Exchange CommissionStandard & Poor’s, Moody’s and Fitch utilize three(the “SEC”) and practical considerations have created ageneric short‐term ratings, which apply to CP, in orderde facto rating requirement in the United States. As isof credit quality from high to low: tier‐1, tier‐2, anddiscussed below in “What U.S. offering exemptions aretier‐3. Standard & Poor’s and Fitch have also used aused for commercial paper?,” CP in the United States isplus ( ) with respect to their tier‐1 rating to denoteissued pursuant to the exemption from registrationoverwhelming safety. Since the analytical approach inunderActassigning a short‐term rating is virtually identical to the(“Section 3(a)(3)”) or in a private placement pursuant toone followed in assigning a term debt rating (i.e.,Section 4(a)(2) of the Securities Act (“Section 4(a)(2)”).medium‐term note and/or long‐term bond), a strongThe SEC, in an interpretive release and subsequent no‐link or “correlation” between an issuer’s short‐term andaction letters, has established various criteria that mustterm debt ratings has evolved for the rating agencies, asbe satisfied in order for an issuer to rely on ). Among these requirements is that CP must beof prime quality.This prime quality condition has customarily beensatisfied when CP is rated highly by an NRSRO. If CP isunrated or rated less than investment grade, then theCP issuer could obtain a back‐up bank facility, althoughit is unclear whether the SEC would issue a no‐actionletter permitting this arrangement. Alternatively, if CPis unrated, the sponsoring dealer could provide a letterto issuer’s counsel stating that in such dealer’s view theCP would, if rated, be given a prime rating and thatissuer’s counsel may use such letter as the basis foropining that the CP is entitled to the exemption underSection 3(a)(3).Without a rating provided by an NRSRO or somealternative arrangement that confers the comfort of aMorrison & Foerster LLPIn March 2011, the SEC proposed amendments to Rule 2a‐7 toremove references to credit ratings. The amendments wereintended to implement the provisions of the Dodd‐Frank WallStreet Reform and Consumer Protection Act of 2010 (the“Dodd‐Frank Act”), specifically section 939A, which isdesigned to reduce reliance on credit ratings in response to thefinancial crisis of 2008.The SEC re‐proposed theseamendments in July 2014 and adopted them inSeptember 2015. Under the amendments, money market fundboards (or their delegates) must determine that portfoliosecurities have “minimal credit risk” and apply a four‐prongedtest instead of relying in part on objective standards, such ascredit ratings. In addition, other money market reforms,including the requirement of a basis point floating net assetvalue (NAV) per share on institutional prime and tax‐exemptmoney market funds and the imposition of liquidity fees andredemption gates, which were adopted in July 2014, haveresulted in money market funds moving away from CP inorder to improve liquidity. Since the effectiveness of thesemoney market reforms in October 2016, approximately 1 trillion of funds have moved away from CP, which issignificant given that the size of the money market fundindustry is approximately 2.6 trillion. Source: BloombergMarkets.12
Term RatingCP RatingAAA to AATier‐1 AA‐ to ATier‐1A‐ to BBBTier‐2BBB‐ and lowerTier‐3 and lowerWhat U.S. offering exemptions are used for commercialpaper?CP is not registered under the Securities Act and isissued pursuant to the exemption from registrationunder Section 3(a)(3) or in a private placement pursuantto Section 4(a)(2). In addition, CP can also benefit fromCan a guaranty be used instead of a back‐up bankthe general exemption under Section 3(a)(2) of theSecurities Act (“Section 3(a)(2)”) for securities that arefacility?either issued or guaranteed by certain banks orYes, commercial paper can be guaranteed by ansupported by a letter of credit from a bank.organization with excellent credit, such as a bank.2 Insuch cases, a letter of credit is typically used for thisWould any filing or action be required under the Officepurpose (such CP is referred to as “letter of credit CP”).of the Comptroller of the Currency’s Securities OfferingThe letter of credit is an unconditional obligation of theDisclosure Rules (12 C.F.R. Part 16) if the issuer of theissuing bank to pay out of its own funds maturing CP,letter of credit is a national bank?in exchange for a fee which is a certain percentage of theamount of CP issued. Most letters of credit are “direct‐pay” (i.e., the letter of credit bank pays the CP holdersand the issuer or the issuer’s parent reimburses theletter of credit bank pursuant to a reimbursementagreement).The other type of letter of credit is a“stand‐by” letter of credit. Under a stand‐by letter ofcredit, the letter of credit bank must pay only in theevent that the issuer does not. Due to certain negativecase law, the short‐term nature of CP and theNo. The Office of the Comptroller of the Currency (the“OCC”) does not view a letter of credit as security, butas a loan.Therefore, it is not necessary to find ure Rules for the letter of credit. However, theSEC would view a letter of credit issued by a bank as aguarantee, which would be an exempt security underSection 3(a)(2) and would also cause the CP itself to bean exempt security under Section 3(a)(2), as the CPwould be a security guaranteed by a bank.expectation of CP investors to quickly receive interest, ifapplicable, and principal payments, a stand‐by letter ofcredit is not as popular with CP investors as a direct‐Structure of U.S. Commercial Paper Programspay letter of credit.Are there different types of U.S. commercial paperprograms?The amendments to Rule 2a‐7 also included the removal fromthe rule’s issuer diversification requirement the exclusion forsecurities that are guaranteed by a non‐controlled person.Accordingly, a money market fund is required to limit itsinvestments in securities of a non‐governmental issuer to nomore than 5% of the money market fund’s total assets,regardless of whether or not the security is guaranteed by anon‐controlled person.2Morrison & Foerster LLPYes, a U.S. CP program can be structured for theissuanceofCPSection aintainaSection 3(a)(3) program and a Section 4(a)(2) programsimultaneously.For a helpful summary of the3
differences between Section 3(a)(3) programs andissuer’s counsel stating that in such dealer’s view the CPSection 4(a)(2) programs, see the “Comparison Table” atwould, if rated, be given a prime rating and that issuer’sthe end of these Frequently Asked Questions.counsel may use such letter as the basis for opining thatthe CP is entitled to the Section 3(a)(3) exemption.What are the requirements for issuing commercial paperpursuant to Section 3(a)(3)?How is the “type not ordinarily purchased by the generalpublic” requirement satisfied?Section 3(a)(3) itself is brief and exempts “any note,draft, bill of exchange or banker’s acceptance whicharises out of a current transaction or the proceeds ofwhich have been or are to be used for currenttransactions, and which has a maturity at the time ofissuance not exceeding nine months, exclusive of daysof grace, or any renewal thereof the maturity of which islikewise limited.” However, a long line of SEC releases,no‐action letters and other guidance have establishedthat CP must:With respect to the requirement that the CP be of a“type not ordinarily purchased by the general public,”the relevant factors are (1) denomination, (2) type ofpurchaser and (3) manner of sale.The minimumdenomination described in SEC no‐action letters istypically 100,000, although in practice CP usually issold in higher denominations. CP purchasers should iduals and SEC no‐action letters often refer to salesto “institutions or individuals who normally purchase be of prime quality and negotiable; be of a type not ordinarily purchased by thegeneral public; be of a type eligible for discounting by FederalReserve banks; have a maturity not exceeding nine months;and commercial paper.” The marketing of CP also shouldbe clearly aimed at appropriate purchasers andadvertising in publications of general circulation shouldgenerally be avoided.However, the SEC has notobjected to tombstone advertisements announcingSection 3(a)(3) program establishments or limitedadvertisements in publications of general circulation.be issued to facilitate current transactions.How is the “type eligible for discounting by Federal ReserveHow is the “prime quality and negotiable” requirementbanks” requirement satisfied?satisfied?RegulationThe prime quality requirement has customarily beensatisfied when CP is rated highly enough by an NRSRO.Such ratings depend on the creditworthiness of theAoftheFederalReserveBoard(“Regulation A”) sets forth the eligibility requirementsfor discounting, which is the method by which a non‐interest bearing note is valued prior to maturity.3issuer or the guarantor, if any. If the CP is unrated orrated less than investment grade, then the CP issuerOne of the functions of Federal Reserve banks is to extendtemporary credit to member banks of the Federal ReserveSystem, thereby assisting the member banks with absorbingsudden withdrawals of deposits or seasonal requirements thatcannot be replenished from the member banks’ own resources.A member bank may borrow from a Federal Reserve bank inone of two ways. It can rediscount short‐term commercial,industrial, agricultural or other business paper that it has3could obtain a 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 toMorrison & Foerster LLP4
Regulation A provides that a Federal Reserve bank mayprovisions that extend maturity past the 270‐day markdiscount for a member bank a negotiable note, draft, orwould not meet this requirement.bill of exchange bearing the endorsement of a memberHow is the “current transactions” requirement satisfied?bank that: (1) has a maturity not exceeding 90 days(except agricultural paper which may carry a maturityof up to nine months); (2) has been issued or drawn, orthe proceeds of which are to be used in producing,purchasing, carrying or marketing goods or in meetingcurrent operating expenses of a commercial, agriculturalor industrial business; and (3) is to be used neither forpermanent or fixed investment such as land, buildingsor machinery, nor for speculative transaction ortransactions in securities (except direct obligations ofthe U.S. government).However, even if CP fails tosatisfy the eligibility requirements under Regulation A,such CP may still qualify for the Section 3(a)(3)exemption if such CP is “of a type” so eligible fordiscounting.4 Notwithstanding the above, the SEC invarious no‐action letters has considered as satisfied therequirement that CP be of a “type eligible fordiscounting by Federal Reserve banks” if the primequality requirement also is satisfied for such CP.The current transactions requirement has been thesubject of the majority of the SEC no‐action lettersregarding Section 3(a)(3).For corporate issuers, it isoften clear enough that the proceeds of the CP will beused for current transactions, including financing ofinventory or accounts receivable (also referred to as“working capital”), recurring or short‐term operatingexpenses, such as the payment of salaries, rent, taxes,dividends or general administrative expenses and theinterim financing of equipment or construction costs,pending permanent financing, for a period of not longerthan one year. The proceeds of CP are often used to payoff maturing CP.In those cases where it is not possible to traceparticular proceeds to particular uses, the SEC hasaccepted the use of limitations on the amount of CPissued according to formulas based on variouscategories of current transactions. The more expansiveof these formulas include limiting the amount of CPHow is the “maturity not exceeding nine months”requirement satisfied?outstanding at any one time to not more than theaggregate amount utilized by the CP issuer for specifiedThe requirement that the CP have a maturity notcurrent transactions, including in circumstances whereexceeding nine months can be satisfied by limiting thethe proceeds are loaned or advanced to a guarantor orpermitted maturity to 270 days in the documentationits subsidiaries. The SEC also has indicated that a CPestablishing the CP program. Demand notes and notesissuer should use a balance sheet test for determiningwiththe relevant CP capacity, whereby the CP es the capital it has committed to current assetspreviously discounted for its customers (under this method,the borrowings are referred to as discounts). Alternatively, itcan issue its own promissory notes secured by paper eligiblefor discounting, government securities or other acceptablecollateral (borrowing of this type is referred to as “advances”).4 A Federal Reserve bank, if it chooses, may make advances onnotes regardless of whether such notes conform to theeligibility requirements set forth in the regulations regardingautomatic discountability of such notes.Morrison & Foerster LLPand the expenses of operating its business over thepreceding 12‐month period. Principal uses of proceedsthat clearly do not qualify for current transaction statusinclude financing the purchase of securities, whether inconnection with a takeover, for investment purposes or5
as issuer repurchases, capital expenditures such as the same as for Rule 505 of Regulation D.purchase of land, machinery, equipment, plants orbuildings, and the repayment of debt originallyincurred for an unacceptable purpose.the financial statement requirements are theResales of CP by dealers to QIBs (or to purchasers thatdealers and any persons acting on the dealers’ behalfWhat are the requirements for issuing commercial paperreasonably believe to be QIBs) are exempt under thesafe harbor of Rule 144A under the Securities Actpursuant to Section 4(a)(2)?(“Rule 144A”).Section 4(a)(2) programs are structured so that the saleof CP by the issuer (either to dealers acting as principalsor directly to purchasers) is exempt from registrationunder Section 4(a)(2) or the safe harbor provided byRule 506 of Regulation D under the Securities ActexemptResales of CP by dealers to IAIs )”In addition, resales of CP by dealers(including dealers no longer acting as underwriters withrespect to such CP) to IAIs are exempt under the dealerexemption under Section 4(a)(3) of the Securities Act.(“Regulation D”). Under Rule 506(b) of Regulation D,an issuer can be assured it is within the Section 4(a)(2)exemption by satisfying the following standards:Because resales by dealers and secondary markettransfers are made in reliance on Rule 144A, aSection 4(a)(2) program issuer (and guarantor, if any) the issuer cannot use general solicitation oradvertising to market the securities; the issuer may sell its securities to an unlimitednumber of accredited investors and up to35 otherpurchasers(allnon‐accreditedinvestors, either alone or with a purchaserrepresentative, must be sophisticated); the issuer must decide what information togive to accredited investors, so long as it doesnot violate the anti‐fraud prohibitions of thefederal securities laws (but the issuer must givemust comply with the information requirements ofRule 144A(d)(4). Public companies are automatically incompliance if they continue to file reports under theSecurities Exchange Act of 1934, as amended (the“Exchange Act”).Section 4(a)(2) program privateplacement memorandums (“PPMs”) include languageoffering purchasers the opportunity to ask questions of,and receive answers from, the issuer/guarantor aboutthe terms and conditions of the offering or generallyaboutthecompanyinaccordancewithRule 502(b)(2)(iv) of Regulation D.non‐accredited investors disclosure documents that are generally similar to, but briefer than,What are the advantages and disadvantages of usingthose used in registered offerings and if thethe Section 3(a)(3) exemption?issuer provides information to accreditedThe Section 3(a)(3) exemption is an exemption for theinvestors, it must make this informationCP itself. Therefore, if the conditions established by theavailable to non‐accredited investors as well);SEC are met, there is no need for the issuer or secondarythe issuer must be available to answermarket resellers to ensure that each sale of CP is aquestions by prospective purchasers; andprivate placement in accordance with the Securities Act.As a result, Section 3(a)(3) programs are often preferredMorrison & Foerster LLP6
to Section 4(a)(2) programs. However, issuers often are
FREQUENTLY ASKED QUESTIONS ABOUT COMMERCIAL PAPER AND COMMERCIAL PAPER PROGRAMS Understanding Commercial Paper What is commercial paper? Commercial paper (“CP”) is a term used to refer to short‐term debt securities that are in the form o
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