Last summer, the SEC proposed controversial amendments that would remove all references to nationally recognized statistical rating organization (NRSRO) credit ratings in its rules – including Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment Company Act of 1940 (the 1940 Act), and Rule 206(3)-3T under the Investment Advisers Act of 1940 (the Advisers Act). Comment letters received by the SEC generally opposed the proposed amendments, expressing concern that the amendments would replace an objective standard of an NRSRO rating with a riskier, subjective determination by boards of directors that would be difficult to apply and increase the burden on mutual fund boards. Now, over a year later, the SEC has adopted certain of its proposed amendments to Rule 5b-3 and Rule 10f-3.

The amendments to Rule 5b-3 require funds that seek to treat refunded securities they hold as government securities (for diversification purposes) to confirm that an independent accountant certification has been provided for these securities. The amendment eliminates a previous exception for securities with a credit rating in the highest rating category of an NRSRO. The SEC has explained that the accountant certification requirement of Rule 5b-3 may be satisfied without separately obtaining an independent accountant certification. That is, funds and their advisers may satisfy amended Rule 5b-3 by determining that a third party such as an NRSRO, in the course of evaluating an offering of refunded securities, already has determined that an independent accountant provided the required certification.

The amendments to Rule 10f-3 no longer permit funds to rely solely on NRSRO ratings to define eligible municipal securities (i.e., securities from affiliated underwritings that mutual funds may purchase). The new definition defines these securities as those that are sufficiently liquid to be able to be sold at or near their carrying value within a reasonably short period of time, and are either: (1) subject to no greater than moderate credit risk; or (2) if the securities are less seasoned securities, subject to a minimal or low amount of credit risk.

Practice Points. The amendments will likely result in changes to most funds’ current 10f-3 procedures. In the rule’s adopting release, the SEC commented that, in developing procedures under the amended rule, fund boards may incorporate ratings, reports, analyses, opinions and other assessments issued by third parties – including NRSROs – although an NRSRO rating by itself could not substitute for the evaluation performed by the board. Although the release is silent with regard to a board’s ability to delegate this new evaluation, clearly, boards will need to rely to some extent on the adviser’s analysis of the credit risk. That, in turn, may require some advisers to enhance their credit risk functions. Accordingly, fund advisers will need to work closely with boards and counsel to provide them with the additional information relevant to the boards’ evaluation of third-party assessments.