- SEC Removes Rating Agency References in Several Rules, Signals Comprehensive Changes to ABS Regulation
- October 23, 2009 | Author: Charles A. Sweet
- Law Firm: Bingham McCutchen LLP - Washington Office
Continuing its piecemeal approach to reform of the credit rating process, the U.S. Securities and Exchange Commission has adopted final rules that remove references to credit ratings in several rules and forms under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Company Act of 1940 (the “Investment Company Act”), effective November 12, 2009.
Credit rating agencies that are registered with the SEC as “nationally recognized statistical rating organizations” (“NRSROs”) are subject to SEC oversight. The rule changes published and re-proposed this week will amend and add to the NRSRO regulations adopted by the SEC in 20071 and 2008.2
The SEC had originally proposed amending a much wider variety of rules under the Exchange Act, the Securities Act of 1933 (the “Securities Act”), the Investment Company Act and the Investment Advisers Act of 1940 (the “Investment Advisers Act”), to remove references to credit ratings. The SEC deferred action on many of the proposals not yet adopted, and reopened the comment period on those proposals.
Among the rules that may still be under consideration are many that would have a significant impact on the capital markets. These include rules that, as originally proposed, would require that initial investors in any shelf offering of asset-backed securities (“ABS”) be “qualified institutional buyers” as defined in Rule 144A (“QIBs”), and that would effectively ban public offerings of ABS that rely on Rule 3a-7 for an exemption from the registration requirements of the Investment Company Act by requiring all investors in such transactions to be either QIBs or “accredited investors” as defined in Rule 501(a) under the Securities Act. The SEC also noted that its staff is engaged in a comprehensive review of the regulatory scheme applicable to the ABS markets.
This memorandum summarizes significant aspects of both the adopted new rules, as set forth (together with commentary) in an adopting release (the “Adopting Release”),3 and those on which the comment period was reopened, as summarized in a new proposing release (the “Proposing Release”).4
Changes to Exchange Act Rules and Forms
The SEC has amended Rule 3a1-1, Regulation ATS, and Forms ATS-R and PILOT under the Exchange Act. In the Adopting Release, the SEC notes that many of the proposals on which negative comments were received would delete references to NRSRO credit ratings that serve as an indicator of the credit risk or liquidity of a particular security. However, as Rule 3a1-1, Regulation ATS, and Forms ATS-R and PILOT merely use NRSRO ratings to categorize trading activity into market segments, they do not pose the same concerns raised by the comments.
Rule 3a1-1, Regulation ATS (specifically, Rules 300, 301(b)(5) and 301(b)(6)), Form ATS-R, and Form PILOT all refer to and sometimes require reporting related to investment grade corporate debt securities and non-investment grade corporate debt securities in the context of alternative trading systems. Under each of these rules and forms, certain requirements are triggered if an alternative trading system handles more than a specified percentage of certain securities.
Currently, these rules and forms differentiate between “investment grade” and “non-investment grade” corporate debt securities. The term “investment grade corporate debt securities” is defined as corporate debt securities rated in one of the four highest categories by at least one NRSRO, and "non-investment grade corporate debt securities" are any corporate debt securities not receiving such a rating.
As revised, these rules and forms combine investment grade corporate debt securities and non-investment grade corporate debt securities into one category of security: “corporate debt securities.” A corporate debt security is defined as any security that evidences a liability of the issuer of such security, has a fixed maturity date that is at least one year following the date of issuance, and is not an exempted security (as defined in Section 3(a)(12) of the Exchange Act).
For Rule 3a1-1, the associated 5% and 40% volume thresholds remain unchanged, with the separate categories of investment grade and non-investment grade corporate debt being replaced by a single category of corporate debt defined under Rule 300. The Adopting Release notes that, because the categories have been combined, while the percentage thresholds remain unchanged, the dollar volume needed to reach these thresholds has increased.
For Regulation ATS, the 5% volume thresholds under Rule 301(b)(5) remain unchanged, and the 20% volume thresholds under Rule 301(b)(6) remain unchanged, in each case with the separate categories of investment grade and non-investment grade corporate debt being replaced by a single category of corporate debt security defined under Rule 300.
For Forms ATS-R and PILOT, reporting that currently is required with respect to separate categories of investment grade and non-investment grade corporate debt is being replaced by reporting with respect to a single category of corporate debt security.
Changes to Investment Company Act Rules and Forms
The SEC has amended Rules 5b-3 and 10f-3 under the Investment Company Act.
Among other things, Rule 5b-3 under the Investment Company Act defines a “refunded security” as a debt security whose principal and interest payments are to be paid by U.S. government securities that have been escrowed and pledged to payment of the debt security. Section 5(b)(1) of the Investment Company Act limits the amount of securities of any one issuer that a “diversified” fund may hold, but holdings of U.S. government securities may be unlimited. Under Rule 5b-3, ownership of a refunded security may be treated as ownership of the escrowed government security for purposes of these diversification requirements, under certain conditions. Among other things, an independent certified public accountant must have certified to the escrow agent that the escrowed securities will satisfy all scheduled payments of principal, interest and premiums on the refunded securities, unless the refunded security has a debt rating in the highest rating category from an NRSRO.
As adopted, the amendment eliminates this exception for highly rated debt securities. In the Adopting Release, the SEC notes its belief that bond indentures or resolutions authorizing refunded bonds typically require a similar certification anyway, as do NRSROs that evaluate refunded securities, so it should not be difficult or expensive for fund managers to confirm that the required certification has been provided.
Rule 10f-3 under the Investment Company Act permits a registered investment company that is affiliated with members of an underwriting syndicate to purchase securities in the underwriting if certain conditions are met. With respect to an underwriting of municipal securities, these conditions include, among others, that the securities meet the ratings standards set forth in the rule. The rule has been amended by redefining “eligible municipal securities” to delete the references to ratings, but include municipal securities that are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time, and also present no greater than moderate credit risks (or, if the security is less seasoned, minimal or low credit risks). In the Adopting Release, the SEC noted its belief that these standards are sufficiently clear to permit a fund board or investment adviser to understand the acceptable risks without a significant increase in time and cost of board oversight.
Reopening Comment Period on Other Proposed Changes
In 2008, the SEC had originally proposed amending a much wider variety of rules and forms under the Exchange Act, the Securities Act, the Investment Company Act and the Investment Advisers Act to remove references to the use of NRSRO credit ratings.5 In the Proposing Release, the SEC defers action and solicits additional comments on certain of those proposals, reopening the comment period until 60 days after publication of the Proposing Release in the Federal Register.
Proposed Amendments to Rules 101 and 102 of Regulation M Under Exchange Act
Rules 101 and 102 of Regulation M currently except from the requirements of Regulation M investment grade nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated by at least one NRSRO in one of its generic rating categories that signifies investment grade. The SEC proposed to remove from Rules 101 and 102 all references to NRSRO ratings and substitute new exceptions for nonconvertible debt securities and nonconvertible preferred securities based on the “well-known seasoned issuer” definition included in Rule 405 under the Securities Act. The SEC also proposed to except asset-backed securities if those securities are registered on Form S-3.
In the Proposing Release, the SEC notes that comments received were uniformly opposed to these proposals. Among other things, commenters believed that they would not further the SEC’s goal of reducing undue reliance on NRSRO ratings, and at the same time would both burden issuers and underwriters by imposing unwarranted restrictions on currently exempted securities, and exempt certain high-yield securities that are arguably more vulnerable to manipulation. Therefore, the SEC has deferred consideration of action on these proposals and requested additional comment, including inviting alternative proposals to achieve the SEC’s stated goals of reducing investors’ undue reliance on NRSRO ratings.
Proposed Amendments to Exchange Act Rule 10b-10
Rule 10b-10 currently requires broker-dealers to inform customers in transaction confirmations for debt securities, other than government securities, if the debt security is unrated by an NRSRO. The SEC proposed to delete this requirement. The Proposing Release notes that comments received on this proposal were few and mixed, and that the SEC is continuing to consider the relative benefits of retaining this information against the benefits of removing it. The SEC has deferred consideration of action on this proposal and requested additional comment, including inviting alternative proposals to achieve the SEC’s stated goals of reducing investors’ undue reliance on NRSRO ratings.
Proposed Amendments to Exchange Act Rule 15c3-1 (the “Net Capital Rule”)
Rule 15c3-1, the “net capital rule,” currently uses NRSRO ratings to determine haircuts for certain securities held by broker-dealers in their proprietary accounts. For commercial paper, the current rule requires credit ratings in one of the three highest rating categories by at least two NRSROs. The SEC proposed replacing this requirement with a new standard requiring that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For nonconvertible debt securities and preferred stock, the current rule requires credit ratings in one of the four highest rating categories by at least two NRSROs. The SEC proposed changing this requirement to a new standard requiring that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.
The concept behind these proposals was that broker-dealers should have their own credit evaluation processes rather than simply relying on ratings issued by NRSROs, though the Proposing Release notes that it would be appropriate, as one means of making the required determinations on credit risk and liquidity, for broker-dealers to continue to rely on credit ratings of NRSROs.
In the Proposing Release, the SEC notes that the majority of the comments received were opposed to these proposals for a variety of reasons. Among other things, commenters asserted that introducing subjectivity on the part of the interested decision-maker could incentivize broker-dealers to overestimate the creditworthiness of their securities, would require highly sophisticated analytical skills not possessed by all broker-dealers, and would require intensive oversight by the SEC. Therefore, the SEC has deferred consideration of action on these proposals and requested additional comment.
Proposed Amendments to Securities Act Rules
Under the instructions to Form S-3, ABS currently are eligible to be registered on Form S-3 and offered from time to time in takedowns from a shelf registration statement if (among other things) the securities are rated “investment grade” by at least one NRSRO. This generally means that the securities are assigned a rating in one of the four highest generic rating categories, without regard to plus or minus qualifiers or other gradations. The SEC proposed changes in the criteria for S-3 eligibility of ABS that would permit even unrated ABS to be offered via shelf registration statements, thereby eliminating the need in many offerings for concurrent private placements of securities that are not investment grade rated. On the other hand, the proposed rules would require that initial investors in any shelf offering of ABS be QIBs. Resales of ABS initially sold to QIBs could be made to any investor. In order to limit sales to relatively sophisticated investors the proposed rules would impose a requirement that the ABS be issued and transferable in minimum denominations of $250,000.6 Delinquent assets could not constitute 20% or more of the dollar value of the pool, and for leases other than motor vehicle leases, the residual value could not constitute 20% or more of the dollar value of the pool.
Under Rule 415, mortgage related securities currently are shelf-eligible whether or not eligible for registration on Form S-3. Section 3(a)(41) of the Exchange Act defines “mortgage related securities” as, among other things, securities that are rated in one of the two highest rating categories by at least one NRSRO. The SEC proposed to amend Rule 415 to delete the rating component for purposes of determining shelf eligibility and instead permit mortgage related securities to be eligible for shelf registration if initial sales and resales are made in minimum denominations of $250,000 and initial sales are made only to QIBs.
For transactions other than ABS, Forms S-3 and F-3 generally require that an issuer meet the form’s eligibility requirements, and that the transaction meet at least one of the form’s transaction requirements. One of the transaction requirements currently permits primary offerings of non-convertible securities if they are rated investment grade by at least one NRSRO. The SEC proposed to delete the rating reference and instead permit issuers to register primary offerings on non-convertible securities if the issuer has issued for cash more than $1 billion in non-convertible securities (other than common equity) through registered primary offerings over the prior three years, a test in line with the “well known seasoned issuer” definition in Rule 405.
The SEC also proposed a variety of changes in other Securities Act rules that refer to the shelf eligibility requirements.
According to the Proposing Release, most commenters opposed the proposed amendments to the shelf eligibility requirements. The SEC therefore deferred action on all of these proposals and requested additional comments.
Of particular importance for the ABS markets, the Proposing Release notes that the SEC staff is engaged in a broad review of its regulation of the ABS markets, including disclosure, the offering process and ongoing reporting, and is considering alternatives to the investment grade requirements for shelf eligibility other than the type of purchaser or denomination of the security. The SEC believes that any alternative to the investment grade rating requirements is better considered together with other changes to the ABS regulatory regime.
Proposed Amendments to Other Investment Company Act and Investment Advisers Act Rules
As noted in the Proposing Release, in June 2007 the SEC released a comprehensive set of proposals to reform Rule 2a-7 under the Investment Company Act, which governs the operation of money market funds, and related rules. That proposal, which among other things follows up on the SEC’s original proposals regarding the use of NRSRO credit ratings in Rule 2a-7 and asks for additional comment on that topic, is discussed more fully in our client alert dated July 6, 2009.7
Rule 3a-7 under the Investment Company Act excludes ABS issuers from the Investment Company Act’s definition of “investment company,” subject to certain conditions. Under the current rule, the securities, if offered to the general public, must be rated by at least one NRSRO in one of its four highest rating categories. The SEC proposed to remove this provision in its entirety, leaving only provisions that allow ABS relying on this rule to be sold (in both initial sales and resales) to certain types of accredited investors or to QIBs. If adopted as originally proposed, these changes would effectively ban public offerings of ABS that rely on Rule 3a-7 for an exemption from the registration requirements of the Investment Company Act. The SEC stated that it believes that most ABS issuers do not rely on this provision of Rule 3a-7 but rely instead on the exception from the Investment Company Act for companies whose securities are owned only by qualified purchasers. However, there are many types of public ABS transactions that do routinely rely on this provision of Rule 3a-7.8
Two other provisions of Rule 3a-7 were proposed to be revised. The rule permits the issuer to acquire additional eligible assets or dispose of assets only if, among other conditions, the acquisition or disposition does not result in a downgrading in the rating of the issuer’s securities. The SEC proposes instead that the issuer have procedures to ensure that the acquisition or disposition does not adversely affect full and timely payment of the issuer’s outstanding securities. Second, the rule requires that cash flows from the asset pool be deposited in a segregated account, “consistent with the rating” of the issuer’s outstanding securities, to minimize risk of loss of cash flows pending payment to securities holders. This provision would be amended to require that cash flows be deposited consistent with full and timely payment of the outstanding securities.
Among other things, Rule 5b-3 under the Investment Company Act permits a mutual fund to treat a repurchase agreement that is “fully collateralized” as an acquisition of the securities collateralizing the agreement for purposes of determining whether the fund is a diversified fund and whether the fund is in compliance with the prohibition under Section 12(d)(3) of the Investment Company Act against acquiring an interest in a broker, dealer or underwriter (where such an entity is the counterparty under the repurchase agreement). Rule 5b-3 is proposed to be amended by revising the categories of collateral used to determine whether the repurchase agreement is “fully collateralized.” Currently, qualifying securities are those with the highest rating by a requisite number of NRSROs. This provision would be revised to define qualifying securities as those determined by the fund’s board to present minimal credit risks and to be highly liquid.
Finally, Rule 206(3)-3T under the Investment Advisers Act permits an adviser who is a broker-dealer to act in a principal capacity with clients, but only in certain circumstances. An adviser may engage in principal transactions under the rule if the adviser or a control person of the adviser is the underwriter of the security only if the security is a non-convertible investment-grade debt security. The SEC proposed to eliminate the adviser’s ability to rely exclusively on an NRSRO rating to determine if the security is investment grade. Instead, the adviser would have to make its own assessment of the credit risks presented.
The Proposing Release notes that most of the comments received opposed these proposals, based on a variety of concerns, including that the subjectivity of the new standards would be difficult to apply and that it was premature to consider these changes while the SEC’s initiatives to improve NRSRO ratings accuracy and eliminate conflicts of interest are ongoing. Therefore, the SEC deferred action on these proposals and requested further comment, including inviting alternative proposals.
In the Proposing Release, the SEC refers to two additional related releases that have now been published. The first is a concept release soliciting comment on possible rescission of Rule 436(g) under the Securities Act, which currently provides that an NRSRO’s credit rating of debt or convertible debt securities or preferred stock in a registration statement is not considered to be part of the registration statement or certified by the NRSRO within the meaning of the Securities Act.9 The second is a set of amendments to require disclosure of information regarding credit ratings used in connection with registered offerings, “so that investors will better understand the credit rating and its limitations.”10 These releases will be the subject of a future client alert.
The adopted rule changes under the Exchange Act and Investment Company Act only eliminate references to NRSRO credit ratings in a small number of rules in which they appear. The fact that action on all of the other proposals was deferred and the comment period reopened, but with no new substantive proposals, would appear to signal the SEC’s continuing dissatisfaction with the rating agencies and the ratings process, but also significant frustration in its inability to generate workable alternative approaches to referencing credit ratings in the majority of rules in which they are used. We urge clients and other interested parties to review the proposals discussed above carefully and to consider submitting comments to the SEC. Comments on these proposals are due within 60 days of the date of the publication of the Proposing Release in the Federal Register.
The Proposing Release also confirms the SEC staff’s prior indications that participants in the ABS markets can expect a comprehensive set of proposed new changes to the overall ABS regulatory regime, in addition to changes in those rules specifically referenced in the Proposing Release.
1 Those rules generally identify conflicts of interest that an NRSRO must avoid or may disclose and manage; prohibit certain unfair, coercive or abusive practices; and impose reporting and recordkeeping requirements, among other things.
2 Those rules generally prohibit NRSRO recommendations on structure of a rated structured finance product; require records of the rationale for any material difference between a rating implied by any quantitative model that is a substantial component of the rating process and the issued rating; prohibit analysts from involvement in fee negotiations; prohibit the receipt of gifts by rating agency analysts; and require posting of a random sample of issuer-paid credit ratings and histories of ratings actions for certain classes of ratings, among other things.
3 References to Ratings of Nationally Recognized Statistical Ratings Organizations, Release Nos. 34-60789 and IC-28939, available at http://sec.gov/rules/final/2009/34-60789.pdf.
4 References to Ratings of Nationally Recognized Statistical Ratings Organizations, Release Nos. 33-9069, IA-2932 and IC-28940, available at http://sec.gov/rules/proposed/2009/33-9069.pdf.
5 References to Ratings of Nationally Recognized Statistical Rating Organizations, Release No. 34–58070, 73 Fed. Reg. 40088 (July 11, 2008); Security Ratings, Release Nos. 33–8940 and 34–5807, 73 Fed. Reg. 40106 (July 11, 2008); References to Ratings of Nationally Recognized Statistical Rating Organizations, Release Nos. IC–28327 and IA–2751, 73 Fed. Reg. 40124 (July 11, 2008).
6 It is unclear how interest-only securities would be treated for this purpose.
7 Available at http://www.bingham.com/Media.aspx?MediaID=8851.
8 This proposed change would not affect most offerings of mortgage-backed securities, in which the issuer commonly relies on Section 3(c)(5) of the Investment Company Act for exemption from registration. ABS backed by certain types of non-mortgage assets, such as student loans, may also be issued in reliance on Section 3(c)(5).
9 Concept Release on Possible Rescission of Rule 436(g) Under the Securities Act of 1933, Release Nos. 33-9071, 34-60798 and IC-28943, available at http://sec.gov/rules/concept/2009/33-9071.pdf.
10 Credit Ratings Disclosure, Release Nos. 33-9070, 34-60797 and IC-28942, available at http://sec.gov/rules/proposed/2009/33-9070.pdf.