In response to a provision in the Dodd-Frank Act removing an investment grade credit rating requirement in Section 6(a)(5) of the Investment Company Act of 1940 (the “Investment Company Act”), which provides a registration exemption for business and industrial development companies (“BIDCOs”), the SEC adopted new Rule 6a-5 under the Investment Company Act. (BIDCOs are companies that operate under state statutes designed to promote direct investment and loan financing, as well as managerial assistance, to state and local enterprises.) The new rule establishes the credit quality standard that certain debt securities must meet in order to be eligible investments for an entity relying on the BIDCO exemption.
The Dodd-Frank Act contains a number of provisions designed to eliminate reliance on credit ratings in federal financial regulatory oversight. The most sweeping of these is the broad mandate requiring each federal agency to conduct a review of the use of credit ratings in its rules and, based on that review, remove any reference to or requirement of reliance on credit ratings in its rules and substitute another standard of creditworthiness that it deems appropriate. The Dodd‑Frank Act also directly amended a number of statutory provisions, such as Section 6(a)(5), to replace an existing credit rating requirement with a requirement to meet a standard of credit-worthiness to be established by the specified federal agency. (Section 6(a)(5) formerly required the debt securities in question to be rated investment grade by at least one nationally recognized statistical rating organization (“NRSRO”) in order to be eligible BIDCO investments.)
The BIDCO Exemption. Among the conditions in Section 6(a)(5) for the BIDCO exemption, Section 6(a)(5)(iv) prohibits a BIDCO from purchasing any security issued by an investment company or any company exempt from the definition of investment company under Section 3(c)(1) or 3(c)(7) of the Investment Company Act (a “private fund”) unless the security is (a) a debt security that meets the standard of credit-worthiness specified by the SEC (the “Credit-Worthiness Standard”); or (b) a security issued by a registered open-end fund that is required by its investment policies to invest not less than 65% of its total assets in debt securities that meet the Credit-Worthiness Standard or are determined by the fund to be of comparable quality.
Credit-Worthiness Standard. Under Rule 6a-5, a BIDCO meets the Credit-Worthiness Standard if the BIDCO’s board of directors or members (or its or their delegate) determines, at the time of purchase, that the debt security is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time. The SEC release adopting Rule 6a-5 notes that this standard is similar to the standard in Rule 10f-3 under the Investment Company Act for eligible municipal securities. The release states that the standard of credit-worthiness in Rule 6a-5 “is designed to achieve the same degree of risk limitation as the credit rating it replaces.” (Note that because Rule 6a-5 defines the Credit-Worthiness Standard, it also applies to the second category of eligible investments under Section 6(a)(5)(iv) as described above.)
Considerations. The SEC expressly chose not to specify particular factors or tests that are required for a determination under Rule 6a-5. The adopting release notes that “number and scope of factors that may be appropriate to making a credit quality determination with respect to a security may vary significantly depending on the particular security.” The release goes on to provide that:
The standard we are adopting is designed to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities. Debt securities (or their issuers) subject to a moderate level of credit risk would demonstrate at least average credit-worthiness relative to other similar debt issues (or issuers of similar debt). Moderate credit risk would denote current low expectations of default risk associated with the security, with an adequate capacity for payment by the issuer of principal and interest. In making their credit quality determinations, a BIDCO’s board of directors or members (or its or their delegate) can also consider credit quality reports prepared by outside sources, including NRSRO ratings, that the BIDCO board or members conclude are credible and reliable for this purpose. [footnotes omitted]
Effectiveness. Rule 6a-5 becomes effective December 24, 2012.