SEC Removes References to NRSRO Ratings in Certain Rules and Forms (with Lofchie Comment)

The SEC has adopted amendments that remove references to nationally recognized statistical rating organizations ("NRSROs") credit ratings in certain rules and forms.The changes were required by Dodd-Frank, and remove credit rating references from:

• Investment Company Act Rule 5b-3 ("Acquisition of Repurchase Agreement or Refunded Security Treated as Acquisition of Underlying Securities"): a rule that permits funds to look through repurchase agreements to the underlying collateral securities for certain counterparty limitation and diversification purposes provided the collateral meets certain credit quality standards;
• Forms N-1A, N-2, and N-3: forms that contain requirements for funds to report information about their activities to shareholders, including information about the credit quality of their portfolios;
• Securities Exchange Act Rule 15c3-1 ("Net Capital Requirements for Brokers or Dealers") (and certain appendices): this rule establishes the amount of regulatory capital that broker-dealers are required to maintain and are maintaining; among other things, the rule requires broker-dealers to take "haircuts" from the market value of securities positions to take account of the risk and volatility in the position; certain debt securities with high ratings are subject to very low haircuts; and in the absence of a rating system, broker-dealers will have to make individualized determinations as per the SEC's statement that each: "broker or dealer must assess the creditworthiness of the security or money market instrument pursuant to policies and procedures for assessing and monitoring creditworthiness that the broker or dealer establishes, documents, maintains, and enforces. The policies and procedures must be reasonably designed for the purpose of determining whether a security or money market instrument has only a minimal amount of credit risk. Policies and procedures that are reasonably designed for this purpose should result in assessments of creditworthiness that typically are consistent with market data";
• Securities Exchange Act Rule 15c3-3 ("Customer Protection--Reserves and Custody of Securities"); and
• Securities Exchange Act Rule 10b-10 ("Confirmation of Transactions"): the SEC's confirmation rule has generally required broker-dealers effecting transactions for customers in debt securities provide their customers with information including as to the ratings of the securities.

SEC Commissioner Daniel M. Gallagher released a statement regarding the rule amendments, stating that the removal of NRSRO credit rating references is "a very important step towards addressing a key cause of the 2008 Financial Crisis." According to Commissioner Gallagher, the "NRSROs failed miserably in their ratings of asset-backed securities, especially residential mortgage backed securities, in the years leading up to the crisis," and the incorporation of references to credit ratings into SEC rules "exacerbated the problem."

Lofchie Comment: These rule changes were mandated by Congress, so the SEC was required to implement them. While they may seem positive, it is not obvious that they are. For example, while the rating agencies may have been subject to conflicts of interest in producing their ratings, broker-dealers holding securities positions are also subject to a conflict of interest in that they will want to take a lower haircut on their positions. There are also potential inefficiencies in requiring that each broker-dealer assess the creditworthiness of each debt security, rather than effectively allowing for economies of scale by having the ratings work done by a third party for the industry as a whole. One potential concern is that smaller issuers might find it harder to get financing if firms do not want the expense of assessing these issuers' creditworthiness. It will also be interesting to see whether the regulators will drive various firms to adopt essentially identical credit evaluation measures or whether the regulators will permit a meaningful divergence in standards between firms.Leaving aside these policy questions, firms will now have to implement individualized credit rating procedures. This will require consideration of, for example, certain objective measures and, in most cases, allowing for exceptions. Firms should also consider the extent to which it is possible to "wall off" the credit evaluation function from the individuals who make trading decisions, so that the traders do not unduly influence the credit groups.

See: SEC Press Release; Rule Text of Securities Exchange Act Amendments; Rule Text of Investment Company Act Amendments. See also: Commissioner Gallagher's Statement. Related news: SEC Issues Annual Staff Reports on Credit Rating Agencies (December 24, 2013).