Introduction

In response to the subprime mortgage crisis and issues related to the quality of credit ratings utilized by money market funds to evaluate the quality of each instrument, the Securities and Exchange Commission (the "SEC") proposed amendments to its rules under the Investment Company Act of 1940 (the "Investment Company Act") and the Investment Advisers Act of 1940 (the "Advisers Act") to eliminate references to credit ratings of Nationally Recognized Statistical Rating Organizations, known as Rating Agencies, reducing undue reliance on credit ratings and improving the analysis that underlies investment decisions. This is one of three companion releases proposed to address issues related to Rating Agenices.

Portfolio Investments of Money Market Funds—Rule 2a-7

Rule 2a-7, promulgated under the Investment Company Act, governs the operation of money market funds and limits the portfolio investments of a money market fund to securities that have received one of the two highest short-term ratings. The SEC has proposed to eliminate all references to Rating Agencies in Rule 2a-7 and to amend the rule in four ways described below:

  • Under the proposed rule, the board of directors of money market funds, rather than credit ratings, would determine whether each portfolio instrument presents minimal credit risks. However, the board of directors could look to credit ratings to make a credit risk determination.
  • A money market fund would be required to hold securities that are sufficiently liquid to meet reasonably foreseeable redemptions in light of the fund's obligations under Section 22(e) of the Investment Company Act and any commitments the fund has made to its shareholders. In addition, the money market fund would not be allowed to invest more than 10% of its total assets in illiquid securities.1
  • If the money market fund's investment adviser becomes aware of any information suggesting that a security may not continue to present minimal credit risks, the money market fund's board of directors must promptly reassess whether the security in fact continues to present minimal credit risks. The SEC expects that an investment adviser will exercise reasonable diligence in keeping abreast of new information reported in the financial press.
  • A money market fund would be required to provide the SEC with prompt notice when an affiliate of the money market fund (or its promoter or principal underwriter) purchases a security that is no longer an eligible security.2

Structured Finance Vehicles

Rule 3a-7 of the Investment Company Act excludes structured finance vehicles from its definition of "investment company" as long as certain requirements are met. The SEC has proposed three changes to the requirements for a structured finance vehicle to be excluded from the definition of investment company.

First, the SEC has proposed to remove the current requirement that structured finance vehicles offered to the general public be rated by at least one Rating Agency in one of the four highest ratings categories. Since most structured finance vehicles do not rely on Rule 3a-7 for exclusion from the Investment Company Act, the SEC has proposed to eliminate the rule's exclusion for structured finance offerings to the general public.

Second, the SEC has proposed to remove the current requirement that an issuer acquire or dispose of assets only if, among other conditions, there is no resulting downgrade in credit rating. Instead, the SEC has proposed to require that an issuer follow procedures to ensure that the acquisition or disposition of assets does not adversely affect the full and timely payment of outstanding fixed income securities.

Finally, the SEC has proposed to amend the requirement that cash flows from the asset pool periodically be deposited in a segregated account whose maintenance is consistent with the ratings of the outstanding fixed income securities. The SEC has proposed to require that the cash flows be deposited in a segregated account consistent with the full and timely payment of the outstanding fixed income securities. The SEC believes that the proposed amendment will minimize the risk of lost cash flows pending payment to the fixed income securities holders.

Repurchase Agreements—Rule 5b-3

In determining whether a fund is able to invest in repurchase agreements, Rule 5b-3 of the Investment Company Act allows a fund to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement.3 However, the obligation of the seller to repurchase the securities from the fund must be collateralized fully.

Currently, a repurchase agreement is "collateralized fully" if, among other requirements, the collateral for the repurchase agreement consists entirely of: (i) cash items; (ii) government securities; (iii) securities that, at the time the repurchase agreement is entered into, are rated in the highest rating category by certain Rating Agencies; or (iv) unrated securities that are comparable to securities rated in the highest rating category, as determined by the fund's board of directors. The SEC has proposed to eliminate the requirement that collateral, other than cash or government securities, receive the highest credit rating. As an alternative, the SEC has proposed to require that collateral, other than cash or government securities, consists of securities that the fund's board of directors determines: (i) are sufficiently liquid to be sold at or near their carrying value within a reasonably short period of time; (ii) are subject to no greater than minimal credit risk; and (iii) are issued by a person that has the highest capacity to meet its financial obligations. Although the rule would no longer require that the collateral receive the highest credit rating, the SEC acknowledges that an evaluation of the collateral could draw upon the assessments that a Rating Agency has issued.

Also under Rule 5b-3, a fund may fulfill its diversification requirements by deeming the acquisition of a refunded security as the acquisition of an escrowed government security. A refunded security is a debt security that, among other things, has received certain certifications from an independent accountant. Currently, these certifications are not required if a Rating Agency has given the refunded security a debt rating in the highest rating category. The SEC has proposed to eliminate this exception to the certifications requirement.

Affiliation with Underwriting Syndicate—Rule 10f-3

Rule 10f-3 of the Investment Company Act permits a fund that is affiliated with members of an underwriting syndicate to purchase securities, including eligible municipal securities, from the syndicate if certain conditions are met. Currently, eligible municipal securities must have an investment grade rating from at least one Rating Agency or, if the issuer or entity supplying the payments from which the issue is to be paid has been in continuous operation for less than three years (i.e., a less seasoned security), one of the three highest ratings from a Rating Agency.

The SEC has proposed to amend the definition of "eligible municipal securities" to mean securities that are sufficiently liquid to be sold at or near their carrying value within a reasonably short period of time. In addition, the securities would have to be either: (i) subject to no greater than moderate credit risk; or (ii) if they are less seasoned securities, subject to a minimal or low amount of credit risk.

The amendments do not include a requirement that the fund's board of directors make a determination regarding credit risk and liquidity, because Rule 10f-3 already requires a fund's directors to review purchases of municipal securities made in reliance on the rule. In addition, pursuant to its oversight role, a board would be required to approve procedures for ensuring that the municipal securities meet the proposed conditions for credit quality and liquidity. Although the rule would no longer require municipal securities to be rated, a board would still be able to rely on the assessments that Rating Agencies have issued.

Conflicts of Interest of Investment Advisers—Rule 206(3)

Section 206(3) of the Advisers Act prohibits any investment adviser from engaging in or effecting a transaction on behalf of a client while acting either as principal for its own account, or as a broker for a person other than the client, without disclosing in writing to the client, before the completion of the transaction, the adviser's role in the transaction and obtaining the client's consent. Rule 206(3)-3T provides a temporary alternative for registered broker-dealers acting as a principal in transactions with certain clients.4 Generally, an adviser may not rely on Rule 206(3)-3T if the adviser or a person who controls, is controlled by, or is under common control with the adviser is the issuer or is an underwriter of the security. However, if the adviser or a control person is an underwriter of nonconvertible investment-grade debt securities, the exclusion does not apply. Currently, an investment grade debt security is a nonconvertible debt security that, at the time of sale, is rated in one of the four highest rating categories of at least two Rating Agencies.

The SEC has proposed to amend Rule 206(3)-3T to prevent an adviser from relying exclusively on credit ratings to determine whether a security is investment grade. Instead, the adviser would have to make its own assessment, taking into account specified criteria, including that the security: (i) has no greater than moderate credit risk; and (ii) is sufficiently liquid to be sold at or near its carrying value within a reasonably short period of time. An adviser seeking to rely on Rule 206(3)-3T would have to adopt and implement policies and procedures that address the adviser's methodology for determining whether a security is investment grade.

Questions

Any person who has a question regarding the issues raised in this Corporate and Securities Update may obtain additional guidance from a member of our Public Companies Group.

Footnotes

1. A "liquid security" is a security that can be sold or disposed of in the ordinary course of business, within seven days, at approximately the value that the money market fund has ascribed to it.

2. A security is "eligible" if the board of directors of a money market fund has determined that the security presents minimal credit risks. The determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations.

3. A repurchase agreement may otherwise be considered an acquisition of an interest in a counterparty, which a fund is not permitted to do under Section 12(d)(3) of the Investment Company Act. A fund would also be limited in the number and principal amounts of repurchase agreements due to the diversification requirements of Section 5(b)(1).

4. Rule 206(3)-3T requires an adviser to: (1) disclose to its client the conflicts of interest involved in principal transactions; (2) inform the client of the circumstances when the adviser may affect a trade on a principal basis; and (3) provide the client with meaningful opportunities to refuse to consent to a particular transaction or revoke prospective general consent.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.