Alert May 03, 2011

SEC Proposes Removal of References to Credit Ratings in Rules and Forms under the 1934 Act

The SEC issued Release No. 34-64352, proposing amendments to rules and forms under the Securities Exchange Act of 1934 (the “1934 Act”) that would remove references to credit ratings by rating agencies (including nationally recognized statistical rating agencies or NRSROs).  This rulemaking is mandated by Section 939A of the Dodd-Frank Act, which requires the SEC to “remove any reference to or requirement of reliance on credit ratings, and to substitute in such regulations such standard of credit-worthiness” as the SEC determines to be appropriate.  The SEC is also seeking comment, in advance of proposed rulemaking, with respect to the appropriate tests to be used in the definitions of “mortgage‑related security” (Section 3(a)(41) of the 1934 Act) and “small business related security” (Section 3(a)(53) of the 1934 Act) in lieu of credit ratings by an NRSRO.

Internal Credit and Liquidity Risk Assessment

In several of the proposed rule changes where references to NRSRO ratings would be deleted as a measure of creditworthiness, broker-dealers would be permitted to use internally generated credit and liquidity risk assessments, provided that they establish, maintain and enforce written policies and procedures designed to assess such risks.  Among the factors the broker-dealer could consider in making risk assessments would be credit spreads, securities-related research, internal or external credit risk assessments (including those of credit rating agencies, whether or not they are NRSROs), default statistics and inclusion on a recognized index of instruments that are subject to a minimal amount of credit risk.  The rules and forms under the 1934 Act that fall in this category are:

  • Rule 15c3-1, the Net Capital Rule, which specifies percentage discounts (or “haircuts”) in the market value of securities.  Where lower haircut percentages are currently applied to securities rated investment grade, under the new standard they would be applied to securities determined by the broker-dealer, using its internal credit risk assessment procedures, to have a “minimal amount of credit risk.”
  • Appendix E to Rule 15c3-1.  Broker-dealers using alternative net capital (“ANC”) computations under Appendix E are required to deduct, from net capital, credit risk charges that take counterparty risk into consideration.  Currently, this can be based either on NRSRO credit ratings or the broker-dealer’s internal counterparty credit rating.  The proposal would delete the NRSRO alternative, requiring broker-dealers to use internal credit ratings, the methodology of which must be approved by the SEC.
  • Appendix F to Rule 15c3-1.  OTC derivatives dealers with strong internal risk management practices are allowed to utilize the mathematical modeling methods they use in their own business in order to compute deductions from net capital for market and credit risks from OTC derivatives transactions.  There are two elements to that computation:  counterparty risk and the concentration charge (where net replacement value in the account of any one counterparty exceeds 25% of the OTC derivatives dealer’s tentative net capital).  The provisions of Appendix F currently permit the dealer to use either NRSRO credit ratings or internal credit ratings to calculate both elements.  The proposed rule would delete the NRSRO alternative, requiring dealers to use internal credit ratings, the methodology of which must be approved by the SEC.

The SEC has also requested comment on whether internal credit ratings should be used, in rulemaking to supplement the definitions of “mortgage related securities” and “small business related securities” in Sections 3(a)(41) and 3(a)(53) of the 1934 Act, to replace the NRSRO credit rating standard deleted by the Dodd-Frank Act.

Major Market Foreign Currency

Appendix A to Rule 15c3-1 provides favorable treatment, for purposes of the Net Capital Rule, to currency options involving “major market foreign currency,” which is currently defined with reference to NRSRO credit ratings.  The proposed amendment would change the definition to refer to foreign currencies for which there is a substantial inter-bank forward currency market.

Customer Protection Rule

Rule 15c3-3, Note G, permits a broker-dealer to include required customer margin for transactions in securities products as a debit in the reserve formula computation if that margin is required and on deposit at a clearing agency or derivatives clearing organization that meets any one of four criteria, including maintaining the highest investment-grade rating from an NRSRO.  That criterion would be deleted, leaving the remaining three, which do not reference NRSRO ratings.

Regulation M

Rules 101 and 102 of Regulation M currently except transactions in “investment grade nonconvertible and asset-backed securities” from their prohibitions.  That standard would be replaced with an exception for non-convertible debt securities, non-convertible preferred securities and asset-backed securities if they:

  • are liquid relative to the market for that asset class;
  • trade in relation to general market interest rates and yield spreads; and
  • are relatively fungible with securities of similar characteristics and interest rate yield spreads.

A person seeking to rely on this exception would be required to obtain third party verification of its determination.  The SEC seeks comment on whether it should impose qualification standards on persons providing third party verification, what those qualification standards should be, and whether there should be limitations on how often a particular third party verifier can be used by a person seeking to use the exception.

Rule 10b-10 Confirmations

Rule 10b-10(a)(8) currently requires a broker-dealer to inform the customer in the confirmation if a debt security, other than a government security, is unrated by an NRSRO.  Although the SEC believes that deletion of this requirement is not technically required by Section 939A of the Dodd-Frank Act, because the reference is not designed to establish a standard of creditworthiness, the SEC proposes to delete the requirement as a change consistent with the intent of the Dodd-Frank Act.

The SEC also proposes non-substantive conforming changes to other rules and forms.  Comments on the proposal are due 60 days after its publication in the Federal Register.