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Legal Update

US Securities and Exchange Commission Proposes to Remove References to Credit Ratings from Certain Investment Company Act Rules and Forms

8 March 2011
Mayer Brown Legal Update

On March 3, 2011, the US Securities and Exchange Commission (SEC), in Release No. 33-9193; IC-29592 (the Release), proposed removing references to credit ratings from nationally recognized statistical rating agencies (NRSROs) in certain of its rules and forms under the Investment Company Act of 1940, as amended (the Investment Company Act). The SEC proposed the revisions pursuant to Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The proposed rule is one of several that the SEC will be considering that relate to the use of credit rating in its rules and forms.1

In the Release, the SEC is proposing for public comment, amendments to rules 2a-7 [17 CFR 270.2a-7] and 5b-3 [17 CFR 270.5b-3] and new rule 6a-5 [17 CFR 270.6a-5] under the Investment Company Act. The SEC is also proposing for comment, amendments to Forms N-1A [17 CFR 239.15A and 17 CFR 274.11A], N-2 [17 CFR 239.14 and 17 CFR 274.11a-1] and N-3 [17 CFR 239.17a and 17 CFR 274.11b] under the Investment Company Act and the Securities Act of 1933 and Form N-MFP [17 CFR 274.201] under the Investment Company Act.

The proposed amendments to rule 2a-7 are probably the most significant. The SEC proposes to remove the requirements in the current rule for specified credit ratings and notes that this would affect five elements of the rule:

  • Determination of whether a security is an eligible security;
  • Determination of whether a security is a “first tier” security;
  • Credit quality standards for securities with a conditional demand feature;
  • Requirements for monitoring securities for rating downgrades and other credit events; and
  • Stress testing.

The SEC proposes that rule 2a-7 retain the current two-part requirement that the board of directors (BoD) of each money market fund (or its delegate) determine (i) that the security presents minimal credit risks (to be determined based on credit quality factors and the related issuer’s ability to meet its short-term financial obligations) and (ii) whether the security is either a first tier or second tier security. The SEC notes that the BoD (or delegate) will still be able to consider third-party quality determinations, including NRSRO ratings, if the BoD determines these to be credible and reliable (and suggests that the BoD or delegate undertake periodic reviews of the record of such third-party sources), but must make an independent judgment of credit risks.

As proposed, a security would only be a first tier security if the BoD (or delegate) determines that the related issuer has the “highest capacity to meet its short-term obligations.”2 An eligible security that is not a first tier security is a second tier security; the SEC states that the related credit risk should only differ to a small degree, and if the BoD (or delegate) determines that the related issuer has a “very strong” ability to meet its short-term debt obligations, and a “very low” vulnerability to default, the proposed standard would be met.

For securities with a conditional demand feature, the rule would require the fund’s BoD (or delegate) to determine that the underlying security, or any guarantee, be “high quality” and subject to “very low credit risk.” The Release states that a related issuer that is determined to have a “very strong” capacity to meet its financial commitments and a “very low” risk of default would meet this requirement.

The Release proposes that, rather than triggering a fund’s reassessment of a portfolio security based on a downgrade of the security by an NRSRO, a fund will need to reassess a security “promptly” to determine that the security still presents minimal credit risks if the fund’s adviser (or any person to whom the fund has delegated portfolio management responsibilities) becomes aware of credible information suggesting that the security is no longer first or second tier. The Release also states that the fund’s adviser is required to exercise reasonable diligence in keeping abreast of new information that the adviser believes to be credible regarding portfolio securities.

Similarly, for the purpose of required stress tests, the SEC proposes a hypothetical event that tests how an adverse change in the ability of the issuer of a security to meet its short-term financial obligations would affect the fund’s ability to maintain a stable value net asset per share. Under the proposed rule, funds could continue to test their portfolios by treating a credit rating downgrade as a credit event that might adversely affect the value or liquidity of the portfolio security.

For repurchase agreements to be considered “collateralized fully,” thus falling under rule 5b-3 and allowing the fund to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of complying with Sections 5(b)(1) and 12(d)(3) of the Investment Company Act, the collateral must meet certain requirements. The SEC proposes to replace the requirement that qualifying collateral (other than cash or government securities) be rated in the highest rating category by the requisite NRSROs (that the BoD or its delegate had determined to be appropriate) with a requirement that the collateral be determined by the BoD (or delegate) to be issued by an issuer that has the “highest capacity” to meet its financial obligations and is sufficiently liquid that it can be sold at approximately the fund’s carrying value in the ordinary course of business within seven days.

The Release suggests that a fund may rely on its existing policies and procedures as long as they are not inconsistent with the proposed amendments, but that a fund may chose to amend their policies and procedures to conform with the proposed amendments.

Comments on the proposal are due on or before April 25, 2011.

If you have any questions regarding this Legal Update, please contact at +1 312 701 7366, at +1 202 263 3379 or at +1 202 263 3336.

Learn more about Mayer Brown’s Private Investment Fund and Structured Finance practices.

  1. For more information on the first of these proposals, see our Legal Update, “US Securities and Exchange Commission Proposes to Remove References to Credit Ratings from Certain Securities Act and Exchange Act Rules and Forms.”
  2. In footnote 29 of the Release, the SEC notes that this standard is similar to that articulated by the NRSROs for their highest rating categories.


  • J. Paul Forrester
    T +1 312 701 7366
  • Stephanie M. Monaco
    T +1 202 263 3379
  • Amy Ward Pershkow
    T +1 202 263 3336

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