SEC Adopts Amendments Removing References to Credit Ratings from Exchange Act Rules Relating to Broker-Dealer Financial Responsibility and Confirmations of Transactions

by Goodwin

The SEC issued Release No. 34-71194 (the “Adopting Release”) adopting amendments under the Securities Exchange Act of 1934 (the “Exchange Act”) that remove references to credit ratings by ratings agencies (including nationally recognized statistical rating agencies or “NRSROs”) in certain rules and one form relating to broker-dealer financial responsibility and confirmations of securities transactions (the “Amendments”).  The Amendments are part of the SEC’s response to Section 939A of the Dodd-Frank Act, which requires that each Federal agency, including the SEC, remove from its regulations “any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.”  With certain modifications, the Amendments are generally consistent with corresponding proposals in Release No. 34-64352 (the “Proposing Release”), which was discussed in the May 3, 2011 Financial Services Alert.  The Adopting Release notes that the SEC is reviewing comments and considering alternatives related to proposed changes to Regulation M under the Exchange Act also included in the Proposing Release, which it intends to address separately.  At the same time as the Adopting Release, the SEC issued a companion release adopting amendments that remove certain NRSRO credit rating related requirements in Rule 5b-3 under the Investment Company Act and in the portfolio holdings tables requirements for registered fund shareholder reports, as summarized elsewhere in this edition of the Financial Services Alert.

This article provides a summary of the Amendments.

The Broker-Dealer Financial Responsibility Rules

Net Capital Rule

Rule 15c3-1 prescribes a net liquid assets test that is designed to require a broker-dealer to maintain sufficient liquid assets to meet all obligations to customers and counterparties and have adequate additional resources to wind down its business in an orderly manner without the need for a formal proceeding if the firm fails financially.  In regard to this test, and related computations, a broker-dealer must make certain calculations and adjustments, including prescribed percentage deductions (“haircuts”) from the mark-to-market value of specific proprietary positions (e.g., securities, money market instruments, and commodities) that, under the current version of Rule 15c3-1, vary based on corresponding credit ratings.  In the Proposing Release, the SEC proposed an alternative standard of creditworthiness as a condition for qualifying for lower haircuts, while retaining conditions permitting the application of lower haircuts to these classes of securities that are not based on credit ratings.  The SEC adopted the amendments described in the Proposing Release, with certain modifications.

Removal of References.  The Amendments replace references to NRSRO credit ratings in the provisions establishing lower haircuts for commercial paper, nonconvertible debt, and preferred stock (each, a “security”) with an alternative standard for establishing that the securities involve a minimal amount of credit risk.  Consistent with the Proposing Release, when a broker-dealer applies haircuts for a security that has a ready market for purposes of its net capital computation, it will have the option of: (1) using the firm’s own written policies and procedures to determine whether the security has only a minimal amount credit risk and, if so, applying the appropriate lower haircut if it meets the other conditions prescribed in Rule 15c3-1 or (2) applying the greater deduction applicable to the position, such as the 15% haircut under the catchall provision of Rule 15c3-1(c)(vi)(J).  Thus, the Amendments provide that a broker-dealer may apply the lower haircuts applicable to commercial paper (i.e., between 0% and 1/2 of 1%), nonconvertible debt (i.e., between 2% and 9%), and preferred stock (i.e., 10%) if the security has only a minimal amount of credit risk.  A security without a ready market, however, will continue to be subject to a 100% haircut.  In the Adopting Release, the SEC noted that it did not intend for the new standard to result in a more liberal requirement that broadens the scope of the rule by allowing more positions to qualify for the haircuts.

Factors to Assess Credit Risk.  When assessing whether a security or money market instrument has only a minimal amount of credit risk for purposes of Rule 15c3-1, a broker-dealer may consider, pursuant to the requisite policies and procedures and to the extent appropriate, the following factors: (i) credit spreads; (ii) securities-related research; (iii) internal or external credit risk assessments; (iv) default statistics; (v) inclusion in an index; (vi) enhancements and priorities; (vii) price, yield and/or volume; and (viii) asset class-specific factors.  The SEC made clear its intention that this list of factors not be considered exhaustive or mutually exclusive.

Higher Haircuts.  Under the Amendments, a broker-dealer must apply a higher haircut on a proprietary position in a security if the firm determines the security has more than a minimal amount of credit risk or the firm opts not to have the policies and procedures called for by Rule 15c3-1.  If the security held by the broker-dealer does not trade in a ready market, the broker- dealer must, as in the current rule, apply a 100% haircut irrespective of the firm’s credit risk determination.

Record Retention.  Under the Amendments, and consistent with the Proposing Release, a broker-dealer must preserve and maintain records related to Rule 15c3-1 in the manner required by Rule 17a-4(a)(13).  The Amendments do not require a broker-dealer to maintain a record of each of its credit risk determinations for purposes of Rule 15c3-1 but a broker-dealer would need to be able to support each of its credit risk determinations both for internal risk management purposes and in the context of an SEC or other regulatory examination, either with records of its credit risk determinations or access to records of inputs used at the time of the original determination from which it can replicate the outputs generated by  the model used by the broker-dealer in making the determination.

Policies and Procedures.  The SEC restructured the Amendments by adding a new paragraph to specify requirements applicable to the policies and procedures called for by Rule 15c3-1.  Consistent with the Proposing Release, the Amendments require that the security or money market instrument have only a minimal amount of credit risk in order for the lower haircut to be applied; however, the reference to policies and procedures in such security-specific paragraphs has been removed.  Instead, a new paragraph applicable to various types of securities and money market instruments generally requires that (a) broker-dealers assess the creditworthiness of the security or money market instrument pursuant to policies and procedures for assessing and monitoring creditworthiness that the broker or dealer establishes, documents, maintains, and enforces and (b) such policies and procedures must be reasonably designed for the purpose of determining whether a security or money market instrument has only a minimal amount of credit risk.  Securities or money market instruments assessed to have only a minimal amount of credit risk also must meet the other non-credit rating conditions prescribed in Rule 15c3-1 in order to apply the lower haircuts available under applicable paragraphs.  In the Adopting Release, the SEC noted that the word “monitoring” had been added to clarify that, after the initial determination by a broker-dealer, a position must continue to have only a minimal amount of credit risk in order to remain qualified for the lower haircut and that monitoring must be done in accordance with the firm’s policies and procedures. 

Updating Assessments.  In the Proposing Release, the SEC requested comment on how often a broker-dealer should be required to update its assessments.  In the Adopting Release, the SEC noted that it generally believes the frequency of review should depend on a variety factors but also noted that the requirement for a broker-dealer to maintain its required minimum amount of net capital is moment-to-moment.  Consequently, the SEC indicated that a broker-dealer’s policies and procedures intended to satisfy Rule 15c3-1 must include a process that is designed to ensure that its credit determinations are current, and address the frequency with which the broker-dealer reviews and reassesses its credit determinations.

Reasonably Designed.  The SEC also modified the Proposing Release by including a qualifier that the policies and procedures prescribed by the rule must be “reasonably designed” for the purpose of assessing creditworthiness.  The SEC noted in the Adopting Release that it generally believes the starting point for reviewing whether a firm is in compliance with the Amendments should be to evaluate the reasonableness of the firm’s policies and procedures in light of the firm’s circumstances (e.g., the size of the broker-dealer and the types and sizes of the positions typically held by the broker-dealer).  In this regard, the SEC indicated that the policies and procedures must specify with sufficient detail the steps the broker-dealer will take in performing a credit assessment so that SEC and SRO examiners can evaluate them.

The Adopting Release provides that policies and procedures that are reasonably designed “should result in assessments of creditworthiness that typically are consistent with market data.”  As noted in the Adopting Release, this standard for evaluating the reasonableness of a broker-dealer’s policies and procedures will require examiners to compare market data (e.g., external factors such as credit spreads or yields) with the broker-dealer’s determinations that a security has only a minimal amount of credit risk. Notwithstanding the reasonableness of a broker-dealer’s policies and procedures, examiners may still question a broker-dealer’s credit risk determination, and are particularly likely to question a determination related to large concentrated positions or that is not consistent with market data.

SEC Discussion of Costs of Credit Risk Determinations.  In the section of the Adopting Release discussing the costs and benefits of the rule amendments, the SEC noted that two commenters had provided comments on the cost of compliance with the Rule 15c3-1 amendments.  One noted that “the cost and complexity of developing a credit evaluation infrastructure covering many issuers and securities may be beyond the means of many broker-dealers” and the second stated the view that “the cost to comply may be prohibitively high for the smaller or middle-market broker-dealers.”  The SEC responded that it does not intend or expect broker-dealers to individually duplicate the function of credit rating agencies.  It further stated that it expected the costs of conforming to the amendments to Rule 15c3-1 to be minimal for large broker-dealers that already have a sophisticated internal credit review function but conceded that broker-dealers with less sophisticated internal procedures for analyzing credit risk would incur costs to establish and develop procedures to assess financial instruments for the purpose of determining whether the lower haircut may be applied.  Finally, the SEC noted that, because it had not specified a list of factors to be used to make the assessment, firms will be able to create policies and procedures using a small number of objective factors and external assessments.  The SEC did, however, provide a list of factors a broker-dealer could consider, to the extent appropriate, when assessing whether a security or money market instrument has only a minimal amount of credit risk for purposes of Rule 15c3-1, noting it did not intend the list to be exhaustive or mutually exclusive.

Appendices and Form Amendments

The SEC also adopted amendments, certain of which are non-substantive conforming edits, to Appendices A, E, F, and G to Rule 15c3-1, Form X-17A-5, Part IIB, and Appendix A to Rule 15c3-3 under the Exchange Act as proposed.

Transaction Confirmation Rule

Rule 10b-10

Rule 10b-10 under the Exchange Act, the SEC’s customer confirmation rule, generally requires broker-dealers effecting transactions for customers in securities, other than U.S. savings bonds or municipal securities, to provide those customers with a written notification, at or before completion of the securities transaction, disclosing certain information about the terms of the transaction.  Paragraph (a)(8) of Rule 10b-10 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.  The Amendments delete paragraph (a)(8) from Rule 10b-10.


The Amendments will become effective 180 days after their forthcoming publication in the Federal Register.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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