On June 21, 2013, the Department of Labor (DOL) published proposed amendments to certain class exemptions required by Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which directs federal agencies to remove from their regulations any references to, or requirements of reliance on, credit ratings and to replace those requirements with substitute standards of creditworthiness.

DOL has determined that its class exemptions constitute regulations for this purpose and has proposed amendments to applicable exemptions. As described in more detail in the attached overview, the proposal affects six existing class exemptions dealing with financial and investment transactions.1 DOL proposes to substitute for the credit rating previously specified in the exemption a comparable standard of credit quality to be determined, generally, by a responsible fiduciary for the plan that is engaging in the exempted transaction. For example, an existing requirement that a debt security be rated in the four highest categories by a national credit rating firm would become a determination that the security is subject to no more than moderate credit risk and is reasonably liquid. According to the preamble:

  • DOL sees this determination as a fiduciary act subject to the standards of Section 404 of the Employee Retirement Income Security Act of 1974, as amended (ERISA).
  • That determination can take into account, but apparently cannot exclusively rely on, credit ratings.
  • To the extent a fiduciary lacks the time or expertise to make that determination, as a matter of prudence the fiduciary may need to consult an expert third-party.

DOL outlined in the preamble (but did not incorporate in the exemptions themselves) a number of factors, derived from Securities and Exchange Commission (SEC) regulations for implementing Section 939A, that fiduciaries may consider “helpful” in making the credit determinations required by the proposed amendments. Because these factors came from guidance designed for financial professionals, they are quite sophisticated in certain respects. Depending on the nature of the security at issue, the listed factors include:

  • Credit spreads (i.e., the amount of credit risk a position in commercial paper and/or nonconvertible debt is subject to, based on the spread between the security’s yield and the yield of Treasury or other securities, or based on credit default swap spreads that reference the security);
  • Securities-related research (i.e., to what extent providers of securities-related research believe the issuer of the security will be able to meet its financial commitments, generally, or specifically, with respect to securities held);
  • Internal or external credit risk assessments (i.e., whether credit assessments developed internally by a broker-dealer, or externally by a credit rating agency, express a view as to the credit risk associated with a particular security);
  • Default statistics (i.e., whether providers of credit information relating to securities express a view that specific securities have a probability of default consistent with other securities with a determined amount of credit risk);
  • Inclusion on an index (i.e., whether a security, or issuer of the security, is included as a component of a recognized index of instruments that are subject to a determined amount of credit risk);
  • Priorities and enhancements (i.e., the extent to which a security is covered by credit enhancements, such as overcollateralization and reserve accounts, or has priority under applicable bankruptcy or creditors’ rights provisions);
  • Price, yield and/or volume (i.e., whether the price and yield of a security or a credit default swap that references the security are consistent with other securities that the broker-dealer has determined are subject to a certain amount of credit risk and whether the price resulted from active trading); and
  • Asset class-specific factors (e.g., in the case of structured finance products, the quality of the underlying assets).

Written comments and requests for a public hearing must be received by the DOL by August 20. The DOL has specifically requested comments on the cost to comply with the proposed amendments and has invited proposed alternatives.

  • The exemptions, by their current terms, tend to reference credit ratings for relatively narrow purposes.
  • In carrying out this Congressional mandate to change those references, DOL followed its usual precepts about the operation of and the nature of responsibilities under the fiduciary standards of ERISA. This is perhaps to be expected.
    • For example, the proposal may foreshadow the approach DOL will take in its pending project to provide tools for fiduciaries evaluating the lifetime income solutions for defined contribution plans.
  • Nonetheless, that Congressional mandate may well have unintended consequences. For example:
    • The proposal converts a ministerial element under the existing terms of the exemptions into a fiduciary determination and explicitly institutes a prudence component for prohibited transaction relief.
    • To qualify for the exemptive relief under the proposed amendments, plan fiduciaries generally would take on the role of mini-credit rating agencies. There will be a cost to serving in that role – often, predictably, in fees for third-party providers performing the same analyses as credit rating agencies, on which the exemptions currently rely at no incremental out-of-pocket cost to the plan – and that cost, as always, will affect the value of plan benefits provided to participants.
    • Moreover, prior experience has shown that attempts by DOL to describe the elements of a particular fiduciary process, while intended to be helpful, often have a perverse behavioral effect. Specifically, such a process, when reduced to writing by a regulator, appears so daunting and fraught with risk that fiduciaries are discouraged rather than assisted.
  • As a result, the helpful transactions permitted by these exemptions may occur with less frequency or on more limited terms than in the past, as described in the attached overview.

Accordingly, it may be worthwhile to consider whether there are alternative ways to implement Section 939A in these exemptions that can be proposed to DOL – for example, a presumption that conclusively adopts for purposes of the exemption the creditworthiness determinations of a recognized expert (which could include but need not be limited to a credit rating agency) unless the plan fiduciary has reason to doubt that determination – that would be less disruptive and less expensive in practice.