As noted in the July 1 Alert, the SEC recently voted to propose amendments to five rules under the Investment Company Act of 1940, as amended (the “1940 Act”), and the Investment Advisers Act of 1940, as amended (the “Advisers Act”) that, if adopted, would eliminate specific credit rating standards currently referenced in those rules. The affected rules would be: Rule 2a-7 (money market funds), Rule 3a-7 (investment company definition exception for certain structured finance vehicles), Rule 5b-3 (repurchase agreements look-through for the diversification test) and Rule 10f-3 (purchase in an underwritten offering in which an affiliate is a syndicate member) under the 1940 Act, and Rule 206(3)-3T (alternative notice and consent conditions for certain principal transactions) under the Advisers Act. The SEC has published a formal release describing the proposed amendments (the “Proposing Release”). This article examines the material changes contemplated by those proposed amendments and the Proposing Release. (The proposed amendments were included in one of three releases published by the SEC that relate to credit ratings. The other two releases propose additional requirements governing nationally recognized statistical rating organizations (“NRSROs”), including disclosure of certain conflicts of interest, and changes to certain rule and form requirements under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934, each as amended, that apply to structured finance products.)
The most significant changes in the Proposing Release affect money market funds, that is, funds governed by Rule 2a-7 under the 1940 Act. In general, Rule 2a-7 exempts a money market fund from the 1940 Act’s requirement to calculate its net asset value per share (NAV) using the market value of portfolio instruments, or in the absence of market quotations, a fair market value as determined in good faith by the fund’s board of directors. Instead, the rule permits a money market fund to maintain a stable share price by using the amortized cost method of valuation or the penny rounding method, subject to a number of conditions that are intended to minimize the difference between the money market fund’s stabilized share price and the market value of its portfolio. Currently, the principal conditions imposed by Rule 2a-7 relate to the quality of portfolio securities, the remaining maturity of portfolio securities and the diversification of issuers and guarantors within a money market fund portfolio. The proposed amendments make four important changes to Rule 2a-7, and especially to the condition relating to the quality of portfolio securities.
Minimal Credit Risk Determination: Redefining “Eligible Security” and “First Tier Security”. Currently under Rule 2a-7, a money market fund only may invest in a security that the fund’s board or, if the board has delegated that duty, the fund’s investment manager, determines presents minimal credit risks, and that at the time of the acquisition of the security, is an “Eligible Security.” In determining whether a security presents minimal credit risks, the fund’s board or investment manager currently is required to base its decision on factors pertaining to credit quality as well as the security’s assigned ratings. An Eligible Security currently is defined as a security that generally has received ratings from the “Requisite NRSROs” in one of the two highest ratings categories, or is a comparable unrated security. Rule 2a-7 also requires that immediately after a money market fund acquires a “Second Tier Security,” generally no more than 5 percent of the money market fund’s total assets may be Second Tier Securities. A “First Tier Security” generally is any “Rated Security” that has received a short-term rating from the Requisite NRSROs in the highest short-term rating category for debt obligations (or is a comparable unrated security), the security of another money market fund, or a “Government Security.” A Second Tier Security is any Eligible Security that is not a First Tier Security.
The proposed amendments would revise the definition of Eligible Security so that an Eligible Security would be any security that the fund board or investment manager determines presents minimal credit risks. Moreover, the proposed amendments would require the determination of whether a security presents minimal credit risks to be based on factors pertaining to credit quality and “the issuer’s ability to meet its short-term financial obligations,” rather than the previous standard which relied on credit quality and the security’s assigned ratings. In addition, the proposed amendments would define a First Tier Security as a security, the issuer of which the fund’s board or investment manager has determined has the “highest capacity to meet its short-term financial obligations.” The proposed amendments would not change the definition of a Second Tier Security, that is, a Second Tier Security would continue to be defined as an Eligible Security other than a First Tier Security. The proposed amendments also would not change the current requirement that generally, no more than 5 percent of a money market fund’s total assets may be Second Tier Securities. The proposed amendments would, however, eliminate the definitions in Rule 2a-7 for Rated Security, Unrated Security, and Requisite NRSROs.
Importantly, the Proposing Release provides no guidance on (1) what the SEC means by the phrase “highest capacity” when referring to an issuer’s ability to meet its short-term financial obligations, or (2) how fund boards and investment managers would determine if the issuer of a security meets that standard. The SEC, however, has invited comments on these proposed changes, and it is likely that the SEC will address that standard in a subsequent release if the SEC adopts the amendments, as proposed.
Portfolio Liquidity. In addition to the current principal conditions relating to portfolio quality, maturity, and diversification, the proposed amendments would add a fourth condition: portfolio liquidity. Previous SEC guidance had advised money market funds that they had a duty to meet certain liquidity requirements. This new condition would formalize some of that guidance. Under the proposed amendments, a money market fund would be required to hold securities that are sufficiently liquid “to meet reasonably foreseeable redemptions in light of the fund’s obligations under section 22(e) of [the 1940 Act] and any commitments the fund has made to its shareholders.” (Section 22(e) generally prohibits a registered investment company from suspending shareholders’ rights to redemption or postponing for more than 7 days the date of payment upon redemption of a redeemable security.) The new condition also would limit a money market fund’s investments in securities that are not “Liquid Securities” to not more than 10 percent of the fund’s total assets. A Liquid Security is defined in the proposed amendments as any security that can be sold or disposed of by the fund in the ordinary course within 7 business days at approximately the value ascribed to it by the fund. According to the Proposing Release, if changes in a money market fund’s portfolio or external events caused the fund’s illiquid securities to represent more than 10 percent of its total assets, the fund would be required to take steps to bring the aggregate amount of illiquid securities back within the proposed limits as soon as reasonably practical, but the fund would not be required to liquidate a portfolio security where it would suffer a loss on the sale of that security.
Monitoring Minimal Credit Risks: Ratings Downgrades and Defaults. Currently under Rule 2a-7, a fund board or the investment manager generally must reassess promptly whether a security continues to present minimal credit risks, and take such action as it determines to be in the best interests of the fund and its shareholders, if (A) the security ceases to be a First Tier Security (or if unrated, of comparable quality) or (B) the security was an unrated security or a Second Tier Security when acquired by the fund and has subsequently been assigned a rating by an NRSRO below the NRSRO’s second highest short-term rating category. Under the proposed amendments, the references to rating downgrades would be eliminated. In their place, the proposed amendments generally would require the fund board or the investment manager to reassess promptly whether a security continues to present minimal credit risks if the investment adviser or another board delegate becomes aware of any information about a portfolio security or an issuer of a portfolio security “that may suggest” that the security may not present minimal credit risks. Moreover, the proposed amendments generally would require the board or the investment manager to take such actions as it determines are in the best interest of the fund and its shareholders. The Proposing Release states that the fund’s investment manager is expected to exercise reasonable diligence in keeping abreast of new public information about a portfolio security, but would not be expected to subscribe to every rating service publication. The Proposing Release does not explain what the SEC intends by the phrase “information … that may suggest” that a security may not present minimal credit risks.
Rule 2a-7 currently requires a fund to dispose of a security as soon as reasonably consistent with achieving an orderly disposition of the security (a) in the event of a default with respect to that security (other than an immaterial default), (b) if the security ceases to be an Eligible Security, (c) if the security has been determined no longer to present minimal credit risks, or (d) if there has been an event of insolvency with respect to the security’s issuer or guarantor or the issuer of demand feature. The proposed amendments would retain those requirements, except that they would eliminate the requirement that a fund dispose of a security in the event the security has been determined to no longer present minimal credit risks. The current rule and the proposed amendments would permit a fund to retain the security, notwithstanding the requirement to dispose of it, if the fund’s board determined that disposing of it would not be in the best interests of the fund.
Notice to the SEC of a Rule 17a-9 Transaction. Rule 2a-7 currently requires a money market fund to notify the SEC only in the event of a default of one or more portfolio securities or an event of insolvency with respect to the issuer of a security or any demand feature or guarantee to which the security is subject if immediately before the default, the securities represented ½ of 1% or more of the fund’s total assets. The proposed amendments would retain that requirement but would add to it the requirement that a fund also must notify the SEC at any time an affiliated person or promoter of or underwriter to the fund purchases a security that no longer is an Eligible Security from the fund in reliance on Rule 17a-9 under the 1940 Act.
Rule 3a-7 under the 1940 Act excludes structured finance vehicles, or asset-backed securities, from the definition of “investment company” in Section 3(a) of the 1940 Act, subject to certain conditions. Among those conditions currently is the condition that the structured finance vehicle may not sell its fixed income securities to the public unless, at the time of the initial sale, the securities are rated by at least one NRSRO in one of the four highest categories assigned to long-term debt or the equivalent short-term rating category. The current rule also provides that a structured finance vehicle may issue lower rated or unrated fixed income securities, provided that (i) they are sold only to “accredited investors” or “qualified institutional buyers,” as defined in Regulation D and Rule 144A, respectively, under the Securities Act, or certain persons involved in the organization and operation of the issuer or an affiliate, and (ii) the issuer and any underwriter take reasonable care to ensure that the securities are sold and resold only to persons who meet those qualifications. The proposed amendments would no longer allow structured finance vehicles offered to the public to rely on the Rule.
The proposed amendments would also eliminate the condition in Rule 3a-7 that an issuer may acquire and dispose of assets provided that the acquisition or disposition does not result in a ratings downgrade of its fixed income securities. In its place, the proposed amendments would require an issuer to have procedures to ensure that the acquisition and disposition of securities does not adversely affect the full and timely payment of the outstanding fixed income securities. Finally, the proposed amendments would replace the current requirement that cash flows from the asset pool periodically be deposited in a segregated account, consistent with the fixed income securities rating, with a new requirement that the issuer periodically must deposit cash flows in a segregated account consistent with the full and timely payment of the outstanding fixed income securities.
Rule 5b-3 under the 1940 Act generally permits a registered investment company, subject to certain conditions, to treat a repurchase agreement as the acquisition of the underlying securities collateralizing the repurchase agreement, rather than the repurchase agreement itself, for purposes of Sections 5(b)(1) and 12(d)(3) of the 1940 Act, if the obligation of the seller to repurchase the securities from the fund is “collateralized fully.” (Section 5(b)(1) limits the amount that a registered investment company may invest in the securities of any one issuer if the fund holds itself out as “diversified.” Section 12(d)(3) prohibits a registered investment company from acquiring an interest in a broker, dealer, underwriter or investment adviser.) Under Rule 5b-3 currently, a repurchase agreement is “collateralized fully” if the collateral for the repurchase agreement generally consists entirely of cash, government securities, securities rated in the highest rating category of the “Requisite NRSROs,” or unrated securities of comparable quality. The proposed amendments would eliminate the requirement that collateral other than cash or government securities be rated by an NRSRO or be of comparable quality, and would replace it with a requirement that the fund’s board or its delegate must determine at the time the repurchase agreement is entered into that the securities to be held as collateral, other than cash or government securities, are (a) sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time, (b) subject to no greater than minimal credit risks, and (c) issued by a person “that has the highest capacity to meet its financial obligations.” As previously noted, the Proposing Release does not explain what the SEC means by the phrase “highest capacity” when referring to an issuer’s ability to meet its financial obligations. The Proposing Release does state, however, that the SEC expects that funds would continue to incorporate ratings in their evaluations of credit risk.
Rule 5b-3 also permits a registered investment company to deem the acquisition of a “refunded security” as the acquisition of the escrowed government securities for purposes of Section 5(b)(1) of the 1940 Act. A refunded security is a debt security, the principal and interest of which are paid by government securities that are held in escrow. Under Rule 5b-3, an independent public accountant must certify at the time securities are deposited or substituted with the escrow agent that the deposited securities will satisfy all scheduled payments of principal, interest and applicable premiums on the refunded securities. Currently, Rule 5b-3 waives the independent public accountant certification requirement if the refunded security has received a rating from a NRSRO in the highest category for debt ratings. The proposed amendments would eliminate that waiver.
Rule 10f-3 under the 1940 Act permits a registered investment company to acquire certain types of securities and securities in certain types of offerings, notwithstanding the prohibition in Section 10(f) of the 1940 Act against purchases by a registered investment company of a security for which an affiliated underwriter is acting as a principal underwriter during the existence of an underwriting or selling syndicate for that security. Among the securities that Rule 10f-3 permits a fund to purchase are “Eligible Municipal Securities.” Rule 10f-3 currently defines Eligible Municipal Securities to be municipal securities that have received an investment grade rating from at least one NRSRO or, if the issuer of the securities, or the entity supplying the revenues or other payments from which the issue is to be paid, has been in continuous operation for less than three years, in any of the three highest ratings from an NRSRO. Under the proposed amendments, Eligible Municipal Securities generally would mean securities that are sufficiently liquid that they can be sold at or near their carrying value within a short period of time and either (a) the securities are subject to no greater than moderate credit risk or (b) if the issuer of the securities or the entity supplying revenues or other payments from which the issue is to be paid has been in continuous operation for less than three years, the securities are subject to a minimal or low amount of credit risk. The Proposing Release does not provide any guidance on what is meant by the phrases “moderate credit risk” or “a minimal or low amount of credit risk.”
Section 206(3) of the Advisers Act prohibits an investment adviser, acting as principal for its own account, knowingly from selling any security to, or purchasing a security from, a client without first disclosing to the client in writing the capacity in which the investment adviser is acting and then receiving the client’s consent to the transaction. Rule 206(3)-3T under the Advisers Act creates a temporary exception to Section 206(3) for investment advisers that also are registered broker-dealers acting in a principal capacity with respect to certain investment advisory clients. Among the transactions permitted by Rule 206(3)-3T are when the investment adviser, or a person controlling, controlled by or under common control with the investment adviser is an underwriter of an investment grade debt security. The rule currently defines an investment grade debt security as a non-convertible debt security that, at the time of sale, is rated in one of the four highest rating categories of at least two NRSROs. Under the proposed amendments, an investment adviser would not be able to rely exclusively on the ratings provided by NRSROs, but will have to make its own assessment at the time of sale that a security is subject to no greater than moderate credit risk and sufficiently liquid that it can be sold at or near the carrying value within a reasonably short period of time. Moreover, as noted in the Proposing Release, an investment adviser intending to rely on amended Rule 206(3)-3T also would have to adopt and implement policies and procedures that cover the investment adviser’s methodology for determining if a security is an investment grade debt security for purposes of the rule.
Public CommentThe SEC has requested comment on numerous aspects of the proposed amendments. Comments must be received by September 5, 2008.