On December 27, 2013, the SEC adopted amendments to eliminate references to credit ratings by nationally recognized statistical rating organizations (“NRSRO”) in Rule 5b-3 under the Investment Company Act of 1940 (the “1940 Act”) and Forms N-1A, N-2, and N-3 under the 1940 Act and the 1933 Act.1 The amendments were adopted to implement Section 939A of the Dodd-Frank Act and effectuate Congressional intent to reduce reliance on NRSRO credit ratings. The amendments have an effective date of February 7, 2014 and a compliance date of July 7, 2014.
Rule 5b-3 permits a fund to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for diversification and certain broker-dealer counterparty limit purposes, provided that the obligation of the seller to repurchase the securities is “collateralized fully.” Under the previous definition of “collateralized fully,” securities that served as collateral for the repurchase agreement (other than cash or government securities) were required, at the time the agreement was entered into, to be rated in the highest rating category by the “requisite NRSROs” or, if unrated, to be of a comparable quality to securities rated in the highest category by the requisite NRSROs. The amendments to Rule 5b-3 have revised this definition by replacing the reference to NRSRO credit ratings with a requirement that a fund’s board of directors (or its delegate) determine that the securities, at the time the agreement is entered into, are: (i) issued by an issuer that has an exceptionally strong capacity to meet its financial obligations on the securities collateralizing the repurchase agreement; and (ii) sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days. The amended rule does not include any specific factors to be considered in performing this credit analysis, although the SEC indicated that the analysis may incorporate third-party assessments such as ratings, reports, and opinions, including those of NRSROs. However, the determination may not be made solely in reliance on the NRSRO rating as a standard without evaluating the quality of each NRSRO’s assessment. Note that the amendments to Rule 5b-3 do not affect money market fund diversification requirements under Rule 2a-7.
The SEC also amended Forms N-1A, N-2, and N-3 (the “Forms”) to remove the required use of credit ratings assigned by an NRSRO in connection with the inclusion of a table, chart, or graph depicting portfolio holdings by reasonably identifiable categories (e.g., type of security, industry sector, geographic region, credit quality, or maturity). Previously, if credit quality was used to present portfolio holdings, the Forms required that securities be categorized by ratings assigned by a single NRSRO. The amended Forms eliminate this requirement and provide that if a fund chooses to depict portfolio holdings based on credit quality, it may use alternative categorizations that are not based on NRSRO credit ratings, and, if a fund continues to use credit ratings, it is no longer restricted to using the credit ratings assigned by a single NRSRO. Any fund that chooses to depict portfolio holdings based on credit quality must include a description of how the credit quality of the holdings was determined, and, if credit ratings are used, a description of how such ratings were identified and selected.
Funds that invest in repurchase agreements may wish to review their compliance policies and procedures and disclosures in light of the changes to Rule 5b-3 and the Forms. The SEC’s final rule release can be found here.