On November 19, 2012, the SEC adopted Rule 6a-5 under the Investment Company Act, which establishes a credit quality standard for debt securities issued by investment companies or private funds (i.e., 3(c)(1) and 3(c)(7) funds) that business and industrial development companies (“BIDCOs”) may purchase. Rule 6a-5 becomes effective December 24, 2012.

Background. BIDCOs are companies that operate under state statutes to provide direct investment and loan financing, as well as managerial assistance, to state and local enterprises. Under Section 6(a)(5) of the Investment Company Act, BIDCOs are exempt from most provisions of the Investment Company Act as long as they comply with certain conditions set forth therein. Prior to the enactment of the Dodd-Frank Act, one of these conditions was that a BIDCO could not purchase securities issued by investment companies and private funds except for (i) debt securities that were rated as investment grade by at least one nationally recognized statistical rating organization (“NRSRO”) and (ii) securities issued by a registered open-end investment company that invests at least 65% of its assets in debt securities described in clause (i) or securities that such registered investment company determines to be comparable in quality. The Dodd-Frank Act eliminated the investment grade rating requirement in Section 6(a)(5) and replaced it with a reference to “such standards of credit-worthiness as the [SEC] shall adopt.” Rule 6a-5 was adopted in response to this Dodd-Frank Act mandate.  

Rule 6a-5. Under Rule 6a-5, a debt security issued by an investment company or a private fund will be deemed to meet the credit-worthiness standard if the board of directors or members of a BIDCO (or its or their delegate) determines that the debt security, at the time of purchase, is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time. Rule 6a-5 also limits a BIDCO’s investments in registered openend investment companies to those companies that invest at least 65% of their assets in debt securities meeting this standard. According to the SEC’s adopting release, Rule 6a-5 establishes a standard of credit-worthiness designed “to achieve the same degree of risk limitation as the credit rating it replaces” and “to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities.”  

Notably, Rule 6a-5 does not enumerate specific factors or establish a bright-line test for making this credit-worthiness determination. According to the adopting release, the credit-worthiness standard established by Rule 6a-5 is “clear enough for a BIDCO’s board or members . . . to understand the risks acceptable under the rule.” The adopting release also notes that the number and scope of factors that may be appropriate to making a credit-worthiness determination may vary significantly depending on the particular debt security. In addition, according to the adopting release, in evaluating an issuer’s creditworthiness, boards of directors or members of BIDCOs may consider credit quality reports prepared by NRSROs or other outside sources that are deemed reliable for making such credit-worthiness determination.