On December 27, 2013, the SEC adopted final amendments (“Final Amendments”) to remove certain references to ratings by nationally recognized statistical rating organizations (“NRSROs”) (e.g., Standard & Poor’s, Moody’s Investor Services or Fitch Ratings) in (1) Rule 5b-3 under the Investment Company Act of 1940 and (2) the requirements for portfolio holdings tables in registered fund shareholder reports as set forth in certain forms under the Investment Company Act of 1940 (SEC Release No. IC‑30847) (the “Release”). The Final Amendments respond to Section 939A of the Dodd-Frank Act, which requires that each Federal agency, including the SEC, remove from its regulations “any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.” (The SEC also issued a companion release adopting amendments that remove credit rating references in certain rules under the Securities Exchange Act of 1934, as discussed elsewhere in this edition of the Financial Services Alert.)
Amendments to Rule 5b-3
The Final Amendments substitute an alternative standard designed to reflect a similar degree of credit quality for the NRSRO credit rating standards currently used, in part, to determine whether a repurchase agreement is “collateralized fully” for purposes of Rule 5b‑3 under the Investment Company Act. Under the relevant part of Rule 5b-3, a registered fund that meets specified conditions is allowed to treat a repurchase agreement as the acquisition of the securities collateralizing the repurchase agreement for purposes of meeting certain diversification and broker-dealer counterparty requirements under the Investment Company Act. Under the current requirements, a repurchase agreement is collateralized fully if, among other things, the collateral for the repurchase agreement consists entirely of (i) cash items, (ii) government securities, (iii) securities that at the time the repurchase agreement is entered into are rated in the highest rating category by the “requisite NRSROs” or (iv) unrated securities that are of comparable quality to the securities that are rated in the highest rating category by the requisite NRSROs, as determined by the fund’s board of directors or its delegate. The Final Amendments replace categories (iii) and (iv) with a new category: securities that the fund’s board of directors or its delegate determines at the time the repurchase agreement is entered into are: (a) issued by an issuer that has an exceptionally strong capacity to meet its financial obligations on the securities collateralizing the repurchase agreement; and (b) sufficiently liquid such that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days.
Under the Final Amendments, a fund board or its delegate is required to make credit quality determinations for all collateral securities that are not cash items or government securities, not just for unrated securities. The Final Amendments do not include specific factors or tests that the board or its delegate must apply in performing its credit analysis. Rather, the Release discusses factors that a board may consider, including reports, opinions and other assessments issued by third parties, including NRSROs. The Release states that a board should evaluate the basis for using any third-party assessment, including an NRSRO rating, in determining whether collateral meets the new standard. The Release makes clear that fund boards cannot rely solely on the credit ratings of an NRSRO without performing additional due diligence. Fund boards are permitted to establish their own additional criteria for what the fund may accept as collateral for repurchase agreements under the Final Amendments, and, as currently allowed, may delegate the credit quality and liquidity determinations that the board believes are within the delegate’s expertise if the board retains sufficient oversight.
The Release observes that funds may need to amend their written policies and procedures and the provisions addressing collateral credit quality in their repurchase agreement arrangements with counterparties to ensure that they are reasonably designed to comply with the new standards of the Final Amendments (e.g., by changing or eliminating the consideration of specific credit ratings or incorporating other third-party evaluations of credit quality). The Release also notes that the Final Amendments “[do] not prohibit fund boards (or their delegates) from considering the credit quality standards in current repurchase agreements and policies and procedures adopted to comply with the current rule as part of their analysis, provided that fund boards (or their delegates) determine that the ratings specified in the repurchase agreements and policies and procedures meet the standards we are adopting today, and that the agencies providing the ratings used in the policies and procedures are credible and reliable for that use.”
The Final Amendments also adopt, as proposed, an amendment to Rule 5b-3 to define the issuer of a collateral security to include the issuer of an unconditional guarantee of that collateral security, such that a collateral security with an unconditional guarantee whose issuer meets the new credit quality test will satisfy that element of the standard. The Final Amendments do not affect money market funds that seek special treatment of their repurchase agreement holdings under the diversification provisions of Rule 2a-7 under the Investment Company Act.
Shareholder Report Requirements
The Final Amendments revise the shareholder report requirements in Forms N-1A, N-2 and N-3 under which a mutual fund, closed-end fund or insurance company separate account that offers variable annuities (each, a “Fund”), respectively, must present its portfolio holdings in a table, chart or graph organized by reasonably identifiable categories, such as type of security, industry sector, geographic region, credit quality, or maturity, in a manner reasonably designed to depict clearly the types of investments made by the Fund, given its investment objectives. The Final Amendments remove the current requirement under which a Fund that organizes the required table of portfolio holdings based on credit quality categorizations must use NRSRO credit ratings for that purpose. Accordingly, under the Final Amendments, a Fund that uses credit quality categorizations may do so based on credit ratings assigned by NRSROs, credit ratings assigned by credit rating agencies that are not NRSROs, or alternative categorizations that are not based on ratings provided by credit rating agencies, such as internal credit assessments.
A Fund must provide near, or as part of, the table that presents portfolio holdings based on credit quality, a description of how the credit quality of the holdings was determined, and if credit ratings assigned by a credit rating agency are used, an explanation of how they were identified and selected. According to the Release, the description should include the credit quality evaluation process, the rationale for its selection, and an overview of the factors considered, such as the terms of the security (e.g., interest rate, and time to maturity), the obligor’s capacity to repay the debt, and the quality of any collateral. In addition, “[t]his description should include, if applicable, a discussion of: (i) the criteria considered or process used in selecting the credit ratings (e.g., the fund might use the median credit rating from among three rating agencies); (ii) how the fund evaluated those criteria (i.e., the due diligence performed); (iii) how the fund reports credit ratings for any security that is not rated by the credit rating agency selected if the fund has a policy of using the ratings of a single rating agency (e.g., has the fund selected a designated alternate rating agency); (iv) how the fund reports credit ratings for any security that is not rated by any credit rating agency (i.e., the process for self-rating); or (v) other fund policies on selecting credit ratings for purposes of disclosure.”
The Release cautions that “[i]f a Fund does not use credit ratings, we note that it might be misleading for a fund to describe its portfolio holdings quality with similar descriptions as the ratings nomenclature used by rating agencies (e.g., AAA, Aa), or to characterize the securities as ‘rated.’ If a fund chooses to depict its portfolio using credit ratings issued by a credit rating agency, a fund could choose to use the median credit rating from among multiple credit rating agencies (discarding the highest and lowest ratings) when a security is split-rated. We note, however, that it might be misleading for a fund to disclose an average credit quality rating that is based on ratings from multiple credit rating agencies because credit rating agencies may use different criteria to evaluate the credit quality of an issuer. A fund might also choose other methods for evaluating credit quality of portfolio securities, such as a policy of selecting the highest or lowest credit rating for split-rated securities among the ratings issued by certain specified rating agencies.”
Effective Dates and Compliance
The Final Amendments take effect 30 days after their forthcoming publication in the Federal Register. Compliance is not required until 180 days after publication.