• SEC Moves Forward with Credit Rating Agency Reforms
  • October 28, 2009
  • Law Firm: Ropes & Gray LLP - Office
  • The SEC, continuing its efforts to tighten the regulation of rating agencies, has issued four releases addressing a number of the SEC rules that deal with security credit ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs). One of the releases, issued October 5, 2009, amended Rules 5b-3 and 10f-3 under the Investment Company Act. Rule 5b-3 permits an investment company to look through refunded securities to the underlying government securities held in escrow for purposes of determining diversification so long as certain conditions are met.

    One condition is that an independent certified public accountant must certify to the escrow agent that the escrowed securities will satisfy all scheduled principal, interest and premium payments on the refunded securities. Previously, Rule 5b-3 waived the certification requirement for refunded securities rated in the highest category by an NRSRO. The amendment to Rule 5b-3 eliminates this waiver. Effective November 12, 2009, all refunded securities will require an accountant’s certification regardless of credit rating, or investment companies will not be permitted to look through to the underlying escrowed securities.

    Rule 10f-3 under the Investment Company Act provides an exemption, subject to certain conditions, to the general prohibition in Section 10(f) of the Investment Company Act on an investment company acquiring securities for which an affiliate of the investment company is acting as a principal underwriter. Certain municipal securities with an NRSRO investment grade rating were previously included in the exemption. The SEC has amended the rule to replace the NRSRO rating requirement with certain credit and liquidity risk assessments as determined by the investment company’s board of directors.

    In another release issued the same day, the SEC deferred consideration of action and solicited additional comments on several rule changes it has been considering, including proposed amendments to Rules 2a-7 and 3a-7 under the Investment Company Act, additional amendments to Rule 5b-3 under the Investment Company Act, and proposed amendments to Rule 206(3)-3T under the Investment Advisers Act.

    The proposed amendments to Rule 2a-7 would remove references to NRSRO ratings in determining which valuation and pricing methods a money market fund is permitted to use. Rule 3a-7, which excludes a structured finance vehicle from the definition of investment company if, among other conditions, it receives a certain rating from an NRSRO, may be amended to eliminate references to NRSRO ratings in connection with another proposal regarding the offer and sale of asset-backed securities. In addition to the amendment to Rule 5b-3 noted above, the SEC is considering further amendments to eliminate the role of NRSRO credit ratings from the determination of whether a repurchase agreement is fully collateralized for purposes of treating the repurchase agreement as an investment in the underlying collateral.

    Finally, the SEC sought additional comments on a proposal to amend Advisers Act Rule 206(3)-3T. Section 206(3) of the Advisers Act generally prohibits an investment adviser from entering into a securities transaction as a principal with a client unless the investment adviser first discloses to the client in writing the capacity in which it is acting and obtains the client’s consent. Rule 206(3)-3T provides certain steps that an adviser can take to satisfy the requirements of Section 206(3), but it excludes transactions in securities that are issued or underwritten by the investment adviser or any “control persons” of the investment adviser. The rule provides an exception to this general exclusion for non-convertible debt securities underwritten by the investment adviser or a “control person” if such securities are investment grade, meaning that they are rated in one of the four highest rating categories by at least two NRSROs.

    The SEC proposed last year to amend Rule 206(3)-3T to require an investment adviser to make an individualized assessment of whether a security is investment grade for purposes of the rule, rather than permitting the investment adviser to rely exclusively on NRSRO ratings. In the latest release, the SEC stated that it is considering broader action than was originally proposed with respect to Rule 206(3)-3T, but it provided no details on the expected future proposal. Comments on the proposals above are due December 8, 2009.

    In a separate but related release, the SEC proposed amendments to certain rules to require disclosure regarding the use of credit ratings in connection with the offering of securities by issuers, including closed-end funds. Under current rules, an issuer is not required to disclose in its prospectus credit ratings that may be used in the marketing of the securities. The SEC proposes to amend Form N-2 (and Regulation S-K and other registration statement forms, but not Form N-1A) to require an issuer to disclose in its registration statement any credit ratings used by the registrant, the underwriter, or certain other parties in connection with marketing the issuer’s securities in a registered offering. This proposal would not require such disclosure if no credit ratings are used in marketing the offering.

    If the disclosure requirement is triggered, then the following information must be disclosed with regard to the credit rating, to inform investors so that they can understand the scope or meaning of ratings being used to market securities, to identify potential conflicts of interest faced by credit rating agencies, and to indicate situations in which an issuer may have engaged in “ratings shopping:”

    • Key elements of the credit rating, including the scope of the rating and any limitations;
    • Certain relationships between the agency providing the credit rating and the registrant or its affiliates; and
    • Any preliminary credit ratings obtained from agencies other than the rating agency that provided the final rating.

    The SEC is also proposing to require current disclosure of changes in credit ratings that were previously disclosed in a prospectus. Amendments to Rules 13a-11 and 15d-11 would require closed-end funds to report on Form 8-K certain changes in credit ratings previously disclosed on Form N-2.

    The SEC also issued a concept release requesting comment on whether to rescind Securities Act Rule 436(g), which operates to exempt certain credit ratings provided by NRSROs (but not credit ratings provided by other credit rating agencies) from Sections 7 and 11 of the Securities Act. Under Rule 436(g), credit ratings assigned by an NRSRO to a class of debt securities, a class of convertible debt securities, or a class of preferred stock are not considered a part of a registration statement prepared or certified by a person (an expert) for purposes of Section 7, and the NRSRO is not subject to liability under Section 11 even if the rating is disclosed in a registration statement. The SEC noted the disparate treatment afforded ratings agencies designated as NRSROs and those not so designated. Among other things, the release states that investors rely on credit rating agencies as experts and that, for this and other reasons, it may now be appropriate to hold NRSROs and other credit rating agencies to the same standard of liability as other experts under Section 11. Comments on this proposal are due December 14, 2009.