SEC Proposes Revisions to Limit Reliance on Credit Ratings in SEC Rules

At its open meeting on June 25, 2008, the SEC voted to propose revisions to the SEC’s rules and forms that refer to and rely upon credit ratings. The proposed revisions are the third part of a three-part proposal relating to the regulation of credit rating agencies in response to the subprime mortgage crisis. The first two parts, proposed on June 11, consisted of rule changes that address conflicts of interest in the ratings process, mandate public disclosure of specified ratings-related information, and require nationally recognized statistical rating organizations (“NRSROs”) to differentiate their ratings of structured products from their ratings of corporate debt.

The new rule and form changes are intended to avoid encouraging “undue reliance” on NRSRO ratings and instead emphasize the need for investors to make independent investment judgments. The changes affect rules and forms across a broad range of statutes, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act, the Investment Advisers Act, and Regulation M. The most significant of the proposed changes are summarized below.

Securities Act

•   Form S-3/F-3 Eligibility for Primary Offerings of Non-Convertible Securities. Currently, an issuer is eligible to register offerings of non-convertible securities that are rated investment grade by at least one NRSRO on Form S-3 or F-3 whether or not that issuer has a market capitalization of $75 million or more as is otherwise generally required. The SEC proposes to replace this investment grade eligibility criterion and instead permit use of Form S-3 or F-3 by issuers that have made registered primary offerings of at least $1 billion of non-convertible securities other than common equity during the prior three years. (Foreign private issuers meeting the new requirement would be permitted to reconcile their financial statements to U.S. GAAP under the more lenient provisions of Form 20-F Item 17 rather than Item 18, as issuers meeting the investment grade requirement currently may do.) The SEC staff stated that they expect this change (which would conform this eligibility criterion to one of the criteria under which a registrant can qualify as a “well-known seasoned issuer” under the SEC’s securities offering reform rules) to eliminate six issuers from Form S-3/F-3 eligibility and to permit an unspecified number of “junk bond” issuers to qualify that were not previously eligible. The staff suggested that this approach, like the “well-known seasoned issuer” definition, uses size of market issuances as a proxy for the availability of market information on an issuer.

•   Form S-3 Eligibility for ABS Transactions. Currently, Form S-3 may be used to register offerings of asset-backed securities (“ABS”) as long as the ABS are rated investment grade by at least one NRSRO and meet certain other requirements. The SEC proposes to replace the ABS rating requirement with a requirement that the ABS may be initially sold only to “qualified institutional buyers” (which are generally limited to entities with $100 million of securities investments) and may be initially sold or subsequently transferred only in denominations of at least $250,000. This approach is intended to limit sales to sophisticated investors. Commissioner Atkins urged the staff to consider permitting ABS registered on Form S-3 to be sold to sophisticated investors that may not qualify as “qualified institutional buyers,” perhaps adopting the Exchange Act’s “qualified investor” standard (which generally requires $25 million in investments) in order to foster greater liquidity in such securities. The staff emphasized that ABS issuers who fail to qualify for Form S-3 may still conduct a registered offering on Form S-1, although in practice that has not proven an attractive option, and instead such issuers have generally relied on Rule 144A.

Securities Exchange Act

•   Broker-Dealer Net Capital Rule “Haircut” Provisions. Currently, Exchange Act Rule 15c3-1 requires broker-dealers to deduct certain “haircuts” from the value of their securities positions when calculating their net capital. For purposes of determining the required “haircut,” the current rule defines certain classes of securities, including three categories that are defined in part by reference to NRSRO ratings: commercial paper, nonconvertible debt securities and preferred stock. In lieu of these ratings requirements, the SEC proposes to require the broker-dealer to determine that the security’s credit risk is no more than minimal (in the case of commercial paper) or moderate (in the case of debt and preferred stock) and that it is sufficiently liquid that it can be sold for approximately its carrying value almost immediately (in the case of commercial paper) or in a reasonable period of time (in the case of debt and preferred stock). The SEC staff said they expect to take the position that broker-dealers may use ratings as one method of making these credit and liquidity determinations, and that the ratings now required for the respective classes of securities would justify a determination that those securities met the requirements of the revised rule, but that broker-dealers could also make independent determinations based on internal credit analysis or other third-party information. In questioning by Commissioner Casey, the staff stated that they expect that there will be significant variations in how broker-dealers make determinations under the revised rule, with the largest relying on in-house credit analysts, the smallest continuing to rely solely on ratings, and others perhaps using third-party service providers.

Investment Company and Investment Advisers Acts

•   Investment Company Act Rule 2a-7. The SEC proposes to revise Rule 2a-7, which exempts money market funds with approximately $3.5 trillion in assets from the valuation requirements that otherwise apply to registered investment companies as long as their asset portfolios meet certain maturity, quality and diversification requirements. The SEC is proposing to replace the portion of the rule’s quality requirements that now require NRSRO ratings with a subjective requirement that the portfolio securities have minimal credit risk and sufficient liquidity to meet reasonably foreseeable redemptions and commitments to shareholders; investments in illiquid securities would be limited to 10% of total assets and a fund’s board of directors would be required to reassess any security that the adviser believes may no longer meet the credit and liquidity criteria. As with the broker-dealer net capital determinations discussed above, the SEC staff said that they expect the largest funds to rely on the teams of in-house credit analysts that they already have to make the required determinations, while smaller funds may need to obtain third-party assistance.

•   Investment Company Act Rule 3a-7. Rule 3a-7 under the Investment Company Act provides an exemption from Investment Company Act registration for issuers of asset-backed securities that meet certain requirements, one of which is currently that such issuers may sell only investment-grade fixed-income securities to investors who are not either institutional “accredited investors” or “qualified institutional buyers.” The SEC is proposing replacing this restriction with a prohibition on Rule 3a-7 issuers selling any securities to persons that are not either “accredited investors” or “qualified institutional buyers,” as well as requiring such issuers to adopt specified procedures to protect payments to be made to investors.

Click here for the SEC Chairman Cox’s statement on the new proposals: http://sec.gov/news/speech/2008/spch062508cc_credit.htm 

Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under the “Structured Finance” or “Capital Markets” sections of this website if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP