The U.S. Securities and Exchange Commission (SEC) recently adopted final amendments to certain rules and forms under the Investment Company Act of 1940 (1940 Act) and the Securities Act of 1933 (1933 Act) to implement a provision of the Dodd-Frank Act1 — to eliminate credit ratings of “nationally recognized statistical rating organizations” (NRSROs) from SEC rules.2 To help carry out that Dodd-Frank Act mandate, on December 27, 2013, the SEC adopted amendments to Rule 5b-3 under the 1940 Act (Rule) and Forms N-1A, N-2 and N-3.3 The amendments are effective 30 days after publication in the Federal Register and the compliance date is 180 days after such publication.
The amendments remove a reference to required NRSRO credit ratings in Rule 5b-3 for certain securities held by funds as collateral for repurchase agreements, and replace that requirement with an alternative standard that the Adopting Release indicates is designed to “retain a similar degree of credit quality.” The amended Rule imposes a two-pronged test, discussed below, to measure the credit quality of certain collateral under repurchase agreements acquired by investment companies.
Forms N-1A, N-2 and N-3 (Forms), which are used to register the shares of mutual funds, closed-end funds and certain insurance company separate accounts that offer variable annuities, require shareholder reports to include a table, chart or graph depicting portfolio holdings by a reasonably identifiable category, such as type of securities, industry sector or credit quality. Funds that elect to use credit quality as the category are currently required to depict credit quality using the ratings assigned by a single NRSRO.4 The amendments to the Forms eliminate the required use of NRSRO credit ratings by funds that choose to use credit quality categorizations in the required table, chart or graph of portfolio holdings. Under the amendments, funds that choose to use credit quality to depict portfolio holdings must include a description of how the credit quality of the holding was determined. If a fund chooses to use credit ratings issued by a credit rating agency to depict the credit quality of portfolio holdings, the fund must include a description of how the credit ratings were identified and selected.
Amendment to Rule 5b-3
Rule 5b-3 allows funds that invest in repurchase agreements to “look through” to the securities collateralizing the agreement for purposes of satisfying certain diversification requirements5 and broker-dealer counterparty limits under the 1940 Act if the repurchase agreement is “collateralized fully.”6 Under current Rule 5b-3, a repurchase agreement is “collateralized fully” if, among other things, the collateral consists only of (i) cash items, (ii) U.S. government securities, (iii) securities that at the time the repurchase agreement is entered into are rated in the highest ratings category by the “requisite NRSROs,” or (iv) unrated securities that are of comparable quality to securities rated in the highest rating categories by the requisite NRSROs (as determined by the fund’s board or its delegate, such as the fund’s investment adviser). These requirements are intended to ensure the safety of the collateral and the fund’s ability to liquidate it quickly in the event of the counterparty’s default.
The amendment to Rule 5b-3 eliminates the requirement that collateral other than cash or government securities be rated in the highest category by the requisite NRSROs or be of comparable quality. In place of that requirement, the amended Rule requires that collateral other than cash or government securities consist of securities that the fund's board of directors (or its delegate) determines at the time the repurchase agreement is entered into (i) are issued by an issuer that has an “exceptionally strong capacity” to meet its financial obligations on the collateral, and (ii) are sufficiently liquid that they can be sold by the fund at approximately their carrying value in the ordinary course of business within seven calendar days.7 Thus, under the amended Rule, the fund’s board (or its delegate) will be required to make credit quality determinations for all collateral securities that are not cash items or government securities, rather than just for unrated securities. In response to comments by the Investment Company Institute and others, the SEC revised the credit quality determination standard from the version it originally drafted in 2011 when it proposed the amendment to Rule 5b-3.8 Under that proposed standard, issuers other than the U.S. government would have been required to have the “highest capacity” to meet financial obligations on collateral securities. The SEC replaced the proposed standard it with the “exceptionally strong capacity” standard, as noted above.
The amended Rule does not set forth specific factors or tests that the fund’s board (or its delegate) must apply in performing the required credit analysis. The Adopting Release states that in the context of the amended Rule, the new credit quality standards “provide sufficiently clear criteria under which a fund board or its delegate can make [such] determinations . . .” The SEC notes that under the amended Rule, the credit analysis may incorporate ratings, reports, opinions and other assessments issued by third parties, including NRSROs, and that boards could adopt standards that are more stringent than those required in the amended Rule.
Other aspects of the final amendments are similar to those in the proposed Rule. For example, the final Rule adopts a liquidity standard similar to the standard used in Rule 2a-7 governing money market funds. The final Rule, as proposed, defines an “issuer” to include an issuer of an unconditional guarantee of a security.9
As part of its continuing emphasis on Rule 38a-1 compliance procedures, the SEC included in the final Rule the requirement that a fund that enters into repurchase agreements and relies on Rule 5b-3 must maintain written policies and procedures that are reasonably designed to comply with the conditions of Rule 5b-3, including the credit quality and liquidity requirements. The SEC notes that funds may therefore need to amend their existing policies and procedures to meet these requirements.
Amendments to the Registration Forms
The amendments to Forms N-1A, N-2 and N-3 affect the requirement in those Forms that fund shareholder reports must include a table, chart or graph depicting portfolio holdings by reasonably identifiable categories, which can include credit quality. If credit quality is used to present portfolio holdings, the forms currently require that credit quality be depicted using the credit ratings assigned by a single NRSRO. As amended, Forms N-1A, N-2 and N-3 will no longer require the use of NRSRO credit ratings by funds that choose to use credit quality categorizations in the required table, chart or graph of portfolio holdings. Accordingly, funds that choose to show credit quality categorizations in the required table, chart or graph may use alternative categorizations that are not based on NRSRO credit ratings. However, funds may choose to continue to use NRSRO credit ratings.
Funds that choose to continue to use credit ratings will no longer be restricted to using the credit ratings assigned by a single NRSRO. For example, for split-rated securities, a fund may choose which NRSRO’s ratings to use (for example, the highest rating where there are multiple ratings by NRSROs), as long as the fund does so pursuant to a disclosed policy. The Adopting Release states that such policy disclosure helps mitigate the risk from “cherry-picking” the best ratings.
Funds that choose to depict portfolio holdings according to credit quality must include a description of how the credit quality is determined, and must include a discussion of the credit quality evaluation process, the rationale for its selection, and an overview of the factors considered, such as the terms of the security (e.g., interest rate and time to maturity), the obligor’s capacity to repay the debt, and the quality of any collateral. If a credit rating agency’s ratings are used, the disclosure must explain how the process of selection was carried out, including, among other things, how the ratings criteria were selected, what “due diligence” was performed, and how the fund reports unrated securities. Whether or not credit ratings are used, the description of how the quality of the fund’s holdings was determined must be placed near or as part of the graphic representation in the report.
Finally, the Adopting Release “notes” that if a fund does not use credit ratings, but instead uses internally-assigned ratings, it might be misleading for the fund to describe its portfolio holdings’ quality using descriptions similar to the ratings nomenclature used by rating agencies (e.g., AAA or Aa) or to characterize the securities as “rated.”10 The Adopting Release also states that if a fund were to use median ratings from among a number of credit rating agencies, the use of the term “average credit quality” for split-rated securities may be misleading. However, the Release does not address whether, under the SEC’s fund advertising rules, a fund may use its internally-assigned ratings in advertisements, and, if so, the types of disclosures that might be necessary.
The amended Rule will require additional procedures to be adopted by funds that enter into repurchase agreements in reliance on the Rule and will require additional board oversight of the process used. While the SEC was required to undertake this action by the Dodd-Frank mandate, the Commission was sensitive to the issue of increasing the workload of fund boards and investment advisers. The SEC states in the Adopting Release that additional burdens on fund boards should not be undue, because boards already oversee the determination of creditworthiness of issuers of unrated collateral securities for repurchase agreements. However, without a doubt, the new requirements will impose additional oversight responsibilities on fund boards. Also, there will need to be more complex reviews undertaken by the board or its delegate (i.e., the investment adviser) to evaluate the credit risk of collateral for such repurchase agreements.
Additionally, the amended Rule will require funds to update their procedures under Rule 38a-1 to cover this process. Funds that use credit quality (whether by reference to NRSRO ratings or by internally-generated evaluations of collateral issuer creditworthiness) to describe categories of securities in the portfolio holdings listings in fund shareholder reports will require additional procedures and disclosures to explain how credit quality was determined.