SEC Proposes Amendments to Rule 2a-7

By Joan Ohlbaum Swirsky

Executive Summary

A money market fund (a “fund”) would not be required to limit its investments to those rated within the top two categories by rating agencies (or to unrated securities of comparable quality) under amendments to Rule 2a-7 (the “Rule”) under the Investment Company Act of 1940, as amended (the “Act”), proposed by the Securities and Exchange Commission (“SEC”) on June 25, 2008, and made public on July 1, 2008 (the “Proposal”).¹ Rather, the fund’s Board or its delegate would be required to determine whether each security presents minimal credit risk based on “factors pertaining to credit quality” and also based on “the issuer’s ability to meet its short-term financial obligations.” The minimal credit risk determination is required under the Rule currently, but the only basis for that determination is “factors pertaining to credit quality.”

The Proposal would retain the defined terms in the current Rule for “First Tier Security” and “Second Tier Security.”² Currently such definitions are based predominantly on ratings by rating agencies. (The Rule, as proposed to be amended, would continue to limit the percentage exposure of a Fund to second tier holdings.) But, rather than requiring that those categories be defined by ratings assigned by rating agencies, they now would be defined by whether the fund Board or its delegate has determined that the issuer has the “highest capacity to meet its short-term financial obligations.” This more subjective criterion for determining the “tier” of a security would be substituted in each of the other provisions of the Rule governing credit quality that currently are governed by rating categories.

The Proposal also would revise the provisions of the Rule that require reassessment of whether a portfolio security poses minimal credit risks following a downgrade, by substituting a more subjective requirement for reassessment when the Board’s delegate “becomes aware of any information about a portfolio security or an issuer of a portfolio security that may suggest that the security may not continue to present minimal credit risks.”

Fund Boards typically delegate most of the responsibility for credit-quality determinations under the Rule to the investment adviser. The Proposal does not impose any new duties on fund Boards that may not be delegated to the investment adviser.³ But if the Proposal is adopted, advisers and Boards will need to consider whether their procedures reflect the revised standards and whether reports to the Board need to be modified to reflect the revised standards.⁴

The Proposal also would codify in the Rule a limit on illiquid holdings of no more than 10 percent of a fund’s total assets and a definition of “Liquid Securities.” Currently, both are included in SEC releases but not in a rule. Further, the Rule would impose a subjective standard for fund liquidity in addition to the 10 percent test: A fund must “hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of the fund’s obligations” to honor redemptions under the Act “and any commitments it has made to shareholders.”⁵

In addition to amending the Rule, the Proposal would amend Rule 5b-3 under the Act to eliminate requirements relating to ratings in the definitions of “Collateralized Fully” and “Refunded Security.” These definitions set forth the criteria for determining how to apply issuer diversification requirements under the Rule. The definition of “Collateralized Fully” also governs whether the repurchase agreement is considered to be an interest in the repurchase agreement counterparty or an interest in the issuer of the underlying assets. If the repurchase agreement is an interest in the counterparty, and the counterparty is a broker, dealer or underwriter, a fund must limit its interest in the repurchase agreement under Section 12(d)(3) of the 1940 Act. If the repurchase agreement is an interest in the issuer of the underlying asset, generally the limits of Section 12(d)(3) do not apply.

Last, the Proposal would require a fund to report promptly to the SEC Director of the Division of Investment Management the purchase of a security from the fund by certain affiliated persons under Rule 17a-9, the exemptive rule that permits these affiliated transactions. Currently, transactions under that rule need not be reported to the SEC.

A further description of each of these proposed changes follows.⁶

Main Proposals Relating to Ratings

Introduction. The Proposal is part of a group of proposed amendments to various SEC rules designed to eliminate or minimize references to rating agencies. SEC Chairman Christopher Cox stated that the “package of reforms is born of the subprime mortgage crisis, [which has caused regulators] . . . to re-examine every aspect of the regulatory framework governing credit rating agencies.” In a separate rule proposal on June 21, 2008, the SEC noted that widespread downgrades of mortgage-related securities by rating agencies had “caused a loss of confidence among investors in the reliability” of ratings. Chairman Cox said, “To the extent that the marketplace views the SEC’s references to credit ratings in our rules as giving those ratings an implied official seal of approval, [some] have argued, our own rules may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation.” The proposed amendments to the Rule are “designed to offer similar protections to the current rule’s reliance on” ratings, according to the proposing release.

Credit ratings referred to under the Rule are provided by “NRSROs,” which are, in summary, nationally recognized statistical rating organizations recognized as such by the SEC under the Securities Exchange Act of 1934.

Current Quality Requirements and Proposed Amendments. Currently, the Rule imposes two separate principal tests of quality on each investment – one test that does not involve credit ratings and one that does. Each investment must present “minimal credit risks” and must be an “Eligible Security.” Whether a security presents minimal credit risks requires a judgment based on review of “factors pertaining to credit quality in addition to any ratings assigned” to the security. The requirement that each security present minimal credit risks based on factors pertaining to credit quality will remain in effect, with the addition of a requirement that minimal credit risk must also be based on the “issuer’s ability to meet its short-term financial obligations.” This revised test would also be the standard for an “Eligible Security” under the Proposal.

Under the current Rule, an Eligible Security is (in summary of the relevant part of the definition) rated in the top two rating categories (“first tier” or “second tier”) by the “Requisite NRSROs,”⁷ or is an unrated security⁸ determined by the adviser to be of comparable quality⁹ to a security with such ratings.¹⁰ The Proposal eliminates this definition that relies on ratings (or a determination of comparability) and states that an Eligible Security is one that presents minimal credit risk based on the two factors noted above.

Under the current Rule, a First Tier Security has ratings within the highest short-term category or is unrated but determined by the adviser to be of comparable quality. Under the Proposal, the definition of First Tier Security would not be based on first tier ratings by NRSROs, but rather upon a determination by the adviser that the issuer “has the highest capacity to meet its short-term financial obligations.”¹¹ A Second Tier Security has the same definition under both the current Rule and the Proposal: an “Eligible Security that is not a First Tier Security.” But the criteria for determining that a security is eligible, but not first tier, differ under the current Rule and the Proposal. Under the current Rule, a Second Tier Security is an Eligible Security (a security that has ratings in the top two tiers (or comparable quality unrated security)) that does not have ratings in the top tier (and is not a comparable-quality unrated security). Under the Proposal, a Second Tier Security is a security that meets the new subjective definition of “Eligible Security” but does not satisfy the new subjective definition of “First Tier Security.”

Under the Proposal, the status of a security as an Eligible Security – either first tier or second tier – would not necessarily depend on NRSRO ratings (or, for an unrated security, it would not depend on a determination that the unrated security is of comparable quality to a security with such ratings). But in commentary included in the Proposal, the SEC said that advisers “would still be able to use quality determinations prepared by outside sources, including NRSRO ratings that they conclude are credible, in making credit risk determinations. We expect that the boards of directors (or their delegates) would understand the basis for the rating and make an independent judgment of credit risks.” (Emphasis added.)



These changes substitute a subjective determination for a review of ratings that (in the case of rated securities) had been objective, and permit the adviser to determine whether ratings are credible.

Effect of Amendment to Eligible Security Quality Requirement. For advisers that invest their funds only in rated securities, thereby avoiding the need to perform analysis under the existing “Eligible Security” standard other than review the ratings, it is possible that the new standard substituted for the Eligible Security test may require changed or additional procedures. For advisers that purchase unrated securities and therefore already analyze whether the securities are of comparable quality to rated securities with the requisite ratings (as required under the definition of “Eligible Security” for an unrated security), the Proposal to eliminate reliance on ratings may not require any unaccustomed type of analysis. (Even these advisers, however, may wish to consider whether any changed analysis is necessary due to the changed standard (“issuer’s ability to meet its short-term financial obligations” rather than “comparable quality” to a rated security with the requisite ratings).)

By requiring the adviser to determine the criteria for evaluating the “issuer’s ability to meet its short-term financial obligations,” the Proposal in effect requires the adviser to evaluate the credibility of NRSRO ratings, and to determine whether the NRSRO ratings are the appropriate basis for a determination of Eligible Security quality. This contrasts with the SEC’s approach to NRSRO ratings in 1997, when advisers were invited to rely on the special expertise of NRSROs, specifically as related to evaluation of asset backed securities. At that time, the SEC added to the Rule a requirement (that the Proposal eliminates) that asset backed securities must be rated by an NRSRO (other than asset backed securities backed by municipal securities). At that time, the SEC explained that the independent evaluation of credit quality provided by the NRSRO was necessary because advisers are not experienced with the actuarial analysis required to evaluate asset backed securities backed by a large pool of assets (such as credit card receivables).¹²

In contrast, currently, in a separate recent release, the SEC is proposing that industry participants scrutinize the data behind NRSRO ratings. The SEC recently has proposed rules that would require that NRSROs make available substantial and detailed information relating to the criteria the NRSRO uses to assign and to change ratings and information about changes the NRSRO makes to its ratings.¹³ Advisers to funds may consider the extent to which they will need, and have the capability, to evaluate the additional information if these other proposals are adopted.

At the open meeting at which the SEC issued the Proposal, SEC Commissioner Kathleen Casey asked whether it was expected that, if the Proposal were adopted, funds would need to perform significantly greater analysis than currently is performed for credit evaluation under the Rule. Robert Plaze, the Associate Director of the SEC Division of Investment Management, responded, “We do not expect that.” However, he noted that advisers vary in their level of expertise and said that it is possible that smaller advisers may hire third parties (which Mr. Plaze referred to as “turnkey” operations) to perform analyses on their behalf. Mr. Plaze noted that if a smaller adviser allowed a compliance lapse, the result could taint the entire industry, so it is important that each adviser to a money market fund comply adequately. Each adviser will need to consider whether it needs to perform additional analysis to review an issuer’s “ability to meet . . . short-term financial obligations,” to identify issuers that have the “highest capacity to meet . . . short-term financial obligations” and (if ratings are the basis for identification of “First Tier Securities” or “Second Tier Securities”) to determine whether ratings are “credible.”

In the section of the Proposal addressing costs that the amendments would entail, the SEC states that “[f]unds and investment advisers may incur additional costs if they perform a more detailed and comprehensive analysis before making an investment decision . . . In general, we expect that money market fund boards of directors (or their delegates) would incur no additional costs in making credit and liquidity risk determinations regarding portfolio securities, because the proposed rules would codify the determinations regarding credit risk and liquidity that we believe boards (or their delegates) make under the current rule.”

In a section of the Proposal addressing efficiencies to be achieved by the amendments, the SEC states that “[t]he proposed amendments to rule 2a-7 may slightly decrease the efficiency of certain money market funds, to the extent that any funds may be relying exclusively on credit ratings to make current minimal credit risk determinations. We believe that independently generated assessments of credit risks are important, however, and a slight decrease in efficiency may be warranted.” Even under the current version of the Rule, however, funds are not permitted to rely exclusively on credit ratings to make the minimal credit risk determinations. So decreased efficiency should not result from generating independent assessments of credit risk for advisers that already currently comply with the requirement for independent assessment, unless an adviser concludes that the assessment process must be enhanced or expanded in order to address the new standards requiring analysis of “the issuer’s ability to meet its short-term financial obligations” and of whether an issuer has the “highest capacity to meet . . . short-term financial obligations.”

It is not clear whether, in practice, funds would stop using ratings by NRSROs as a standard in money market fund quality evaluation. Some managers, for example, may choose to continue to self-impose a ratings standard if shareholder investment guidelines incorporate the requirements and make them a prerequisite for investment in the fund.

Downgrades

Currently under the Rule, a fund must re-evaluate whether a security presents minimal credit risk upon certain downgrades by an NRSRO (or upon determinations that an unrated security is no longer of comparable quality to securities rated first tier). Specifically, if a portfolio security ceases to be a First Tier Security (or an unrated security ceases to be of comparable quality to a First Tier Security) or the adviser becomes aware that any Unrated Security or Second Tier Security has been given an NRSRO rating below second tier, the adviser must reassess promptly whether such security continues to present minimal credit risks (except that the reassessment is not required if the security is disposed of (or matures) under fund procedures within five business days of the event and, in the case of a rating below second tier, the Board is subsequently notified). This duty to reassess is a Board duty that can be delegated to the adviser. Further, if a security has been determined to no longer present minimal credit risks, the fund must dispose of the security (absent a Board finding that disposal would not be in the best interests of the fund). This determination by the Board may not be delegated. The Proposal would eliminate the foregoing requirements.

In contrast to the current requirement for reassessment upon downgrades (or loss of comparable quality), under the Proposal, if an adviser becomes aware of “any information about a portfolio security or an issuer of a portfolio security that may suggest that the security may not continue to present minimal credit risks” (emphasis added), the adviser must reassess promptly whether the security continues to present minimal credit risks and shall cause the fund to take such action as the adviser determines is in the best interests of the fund and its shareholders. This requirement is not limited to information about ratings changes. In the commentary included in the Proposal, the SEC said,

We do not believe that the proposed amendments would require investment advisers to subscribe to every rating service publication in order to comply with this proposal. However, we would expect an investment adviser to exercise reasonable diligence in keeping abreast of new information about a portfolio security that is reported in the national financial press or in publications to which the investment adviser subscribes.

Under the Proposal, the reassessment and action are activities that a fund Board may delegate to the adviser. The Rule as currently in effect, but not the Proposal, allows the reassessment to be avoided if the security is disposed of (or matures) within five business days of the event.

The Proposal also eliminates the current requirement that a fund exercise Demand Features to reduce exposure in excess of 5 percent of total assets to securities issued by or subject to Demand Features that are Second Tier Securities, following a rating downgrade. (Under the current Rule, a decision to retain securities following such a downgrade requires a Board finding that the disposal would not be in the best interests of the fund. Again, this determination by the Board may not be delegated.)

The Rule currently requires that an adviser dispose of a security that ceases to be an Eligible Security, absent a non-delegable Board finding that disposal would not be in the best interests of the fund. Under the Proposal, this requirement would remain in effect, except that the loss of Eligible Security status under the revised definition would trigger the requirement to dispose.

The Proposal changes to electronic mail the method for notifying the SEC staff of defaults and events of insolvency affecting assets constituting ½ of 1 percent or more of total assets. (Under the current Rule, the method is telephonic, or by means of facsimile transmission or electronic mail, followed by letter sent by first-class mail.)

Proposals Relating to Liquidity

Current SEC policy, but no rule, limits illiquid securities in a money market fund to no more than 10 percent of total assets. Under the Proposal, a fund would be prohibited from investing more than 10 percent of its total assets in securities that are not “Liquid Securities,” measured immediately after the acquisition of any security. In addition to the foregoing objective standard, a fund would be required to satisfy a subjective standard with regard to liquidity: It must “hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of the fund’s obligations under Section 22(e) of the Act [limiting the right to suspend redemptions; citation omitted] and any commitment it has made to shareholders . . .”

Under the Proposal, a definition of a “Liquid Security” would be added to the Rule: “a security that can be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the money market fund.” This definition and the 10 percent limit are consistent with current SEC policy. The SEC also reconfirms its existing position that if changes in the fund’s portfolio or other external events cause the fund’s investments in illiquid instruments to exceed the 10 percent limit, the fund would have to “take steps to bring the aggregate amount of illiquid securities back within the proposed limitations as soon as reasonably practicable. However, . . . this requirement generally would not force the money market fund to liquidate any portfolio security where the fund would suffer a loss on the sale of that instrument.”

Rating Requirements Eliminated

The Proposal would eliminate each of the following three requirements from the Rule. The fourth change listed below is a conforming change to the record-keeping requirements under the Rule.

• Long-term Rating of Stub Security. Under the current Rule, a security that is unrated and that is a “stub period” security (that is, at the time of issuance it had a remaining maturity of more than 397 calendar days but is acquired with a remaining maturity of 397 calendar days or less) may not have a long-term rating from any NRSRO that is lower than the NRSRO’s three highest long-term ratings categories (unless the security has received a long-term rating from the Requisite NRSROs in one of the three highest rating categories).

• Rating for Asset Backed Security. Under the current Rule, an Asset Backed Security, other than an Asset Backed Security substantially all of whose qualifying assets consist of obligations of one or more Municipal Issuers, must have a rating from an NRSRO.

• Rating for Guarantee. Under the current Rule, subject to certain exceptions, a Guarantee must be rated, or the provider of the Guarantee must have received a rating from an NRSRO with respect to a class of debt obligations (or any debt obligation within that class) that is comparable in priority and security to the Guarantee.

• Records of Ratings. Under the current Rule, a fund must maintain and preserve for not less than three years a written record of the determination that a portfolio security presents minimal credit risks and the NRSRO ratings (if any) used to determine the status of the security as an Eligible Security, First Tier Security or Second Tier Security. Under the Proposal, the requirement to maintain and preserve a record of the NRSRO ratings would be eliminated.

Eligibility or Tier Requirements Retained, but With Revised Definitions

Under the Proposal, each of the requirements summarized below would continue in effect, but the revised definition of “Eligible Security,” “First Tier Security” and “Second Tier Security,” as the case may be, would apply (that is, the definition relating to credit quality and ability to meet short-term financial obligations, rather than the definition relating to ratings).

• Rating Requirement for Security With a Conditional Demand Feature. Under the Rule as currently in effect, a security that is subject to a Conditional Demand Feature must satisfy two quality tests that depend on NRSRO ratings. First, the Conditional Demand Feature must be an Eligible Security or a First Tier Security. Second, in summary, the underlying security or any guarantee of the security (or the guarantor itself) must have ratings within the top two tiers from the Requisite NRSROs or be determined to be of comparable quality. Under the Proposal, the requirement applicable to the Conditional Demand Feature would be unchanged, except that the revised definitions of “Eligible Security” and “First Tier Security” would apply. The requirement relating to the underlying security or its guarantee or guarantor would be revised to require that the underlying security or any guarantee present “minimal credit risks.”

• Limit on Second Tier Securities. Under the Rule, in summary, a fund is limited to no more than 5 percent of total assets in Second Tier Securities in the aggregate and no more than 1 percent of total assets in any one issuer’s Second Tier Securities. For a taxable fund, in general, these limits apply to all assets. For a tax-exempt fund, these limits apply only to “Conduit Securities.”

• Three-Day Safe Harbor for Taxable and National Tax-Exempt Funds and 25 percent Basket for Single State Tax-Exempt Funds. Under the Rule, a taxable fund or national tax-exempt fund is permitted to exceed the regular issuer diversification limit of the Rule by using the “three-day safe harbor,” which permits the fund to invest up to 25 percent of its total assets in the First Tier Securities of a single issuer for a period of up to three business days. A single state tax-exempt fund has a 25 percent basket for First Tier Securities, with no three-business-day limit and no limit to a single issuer.

• Second Tier Demand Features and Guarantees. Under the Rule, in summary, a fund may invest no more than 5 percent of total assets in any provider of a Demand Feature or Guarantee that is a Second Tier Security.

• Guarantees as the Basis for Eligible or First Tier Security Quality. Under the Rule, a security that is subject to a Guarantee may be determined to be an Eligible Security or a First Tier Security based solely on whether the Guarantee is an Eligible Security or First Tier Security, as the case may be.

Proposals Relating to Rules Other than Rule 2a-7 that Affect Money Market Funds

Collateralized Fully Repurchase Agreements. In addition to the proposed revisions to the Rule, the Proposal would revise the definition of “Collateralized Fully,” which is included in Rule 5b-3 under the 1940 Act. This definition governs how a fund tests issuer diversification for a repurchase agreement. If the repurchase obligation is “Collateralized Fully,” the fund may treat the issuer of the security collateralizing the repurchase agreement as the issuer of the repurchase agreement, rather than treating the counterparty as the issuer, for purposes of issuer diversification testing. The definition of Collateralized Fully is intended to help ensure that if a fund treats the repurchase agreement as an obligation of the issuer of the underlying collateral, the collateral will be available to the fund in the event of a default by the counterparty and will be sufficient to maintain the value of the repurchase agreement. One of the requirements for a repurchase agreement to be Collateralized Fully is that the collateral consists of, among other things, “securities that at the time the repurchase agreement is entered into are rated in the highest rating category by the Requisite NRSROs; or . . . Unrated Securities that are of comparable quality to securities that are rated in the highest rating category by the Requisite NRSROs, as determined by the investment company’s board of directors or its delegate . . .”

Under the Proposal, this requirement has been replaced by the requirement that the collateral consist of (among other things) “securities that the investment company’s board of directors, or its delegate, determines at the time the repurchase agreement is entered into:

• are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time;

• are subject to no greater than minimal credit risk; and

• the issuer of which has the highest capacity to meet its financial obligations . . .”

Refunded Securities. A Refunded Security, in general, is a security the principal and interest payments of which are to be paid by escrowed U.S. Government Securities. The Rule permits a fund to treat as the issuer of the Refunded Security the U.S. government entity whose securities have been placed in escrow, provided that the Refunded Security satisfies certain conditions. One of the conditions for a Refunded Security is that a certified public accountant has certified that the deposited securities will satisfy scheduled payments of principal and interest – except that no certification is required if the Refunded Security has met certain rating requirements. Under the Proposal, the exception has been eliminated, and an accountant’s certification is required for any Refunded Security.

Proposal Relating to Rule 17a-9. Under the Proposal, a fund would be required to report promptly to the SEC staff by electronic mail the purchase of a security from the fund by “an affiliated person or promoter of or principal underwriter for the fund or an affiliated person of such person in reliance on” Rule 17a-9. Rule 17a-9 permits an affiliate of a money market fund to purchase from the fund a security that is no longer an “Eligible Security” for cash in an amount equal to the greater of the amortized cost of the security or its market price (including accrued interest). The Rule currently does not require a report to the SEC of a transaction under Rule 17a-9.

The Rule currently does require prompt notification to the SEC in the event of a default with respect to one or more portfolio securities (other than immaterial defaults unrelated to the financial condition of the issuer) or, in the event of insolvency of portfolio securities, where immediately before the default the securities accounted for ½ of 1 percent or more of total assets. This requirement would continue to apply if the Proposal were adopted. But Mr. Andrew (“Buddy”) Donohue, Director of the SEC Division of Investment Management, said that this requirement to report defaults provides the SEC incomplete information about a money market fund’s holdings of distressed securities.

Comments

Comments on the Proposal are due by Sept. 5, 2008.

If the Proposal is adopted, funds may need to update their procedures, compliance policies and systems, disclosure, and Board reporting practices.


¹ See References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. IC-28327 (July 1, 2008).
² Capitalized terms in this Alert are used with their definitions under current Rule 2a-7, except where otherwise indicated.
³ Indeed, the Proposal eliminates two non-delegable determinations that the current Rule requires to be made by the fund Board following reductions in credit quality, as described under the caption “Downgrades.”
⁴ This Alert refers to duties typically delegated to the adviser as being performed by the adviser rather than by the fund or the fund’s Board.
⁵ Rule 2a-7(c)(5) as proposed to be amended.
⁶ The Proposal also would revise two other rules under the Act to eliminate references to rating agencies: Rule 3a-7 (exemption from
registration for issuers of asset backed securities) and Rule 10f-3 (exemption from affiliated transaction prohibition to allow the acquisition of securities during the existence of an underwriting syndicate of which an affiliate is a member). In addition, the Proposal would revise Rule 206(3)-3T under the Investment Advisers Act of 1940 to eliminate references to rating agencies (temporary alternative means for investment advisers who are registered with the SEC as broker-dealers to meet the requirements of section 206(3) of the Advisers Act when they act in a principal capacity in transactions with certain advisory clients). This Alert does not address these amendments.
⁷ “Requisite NRSROs” are (i) “any two NRSROs that have issued a rating with respect to a security or class of debt obligations of an issuer; or (ii) if only one NRSRO has issued a rating with respect to such security or class of debt obligations of an issuer at the time the fund acquires the security, that NRSRO.”
⁸ The definitions of Rated Security and Unrated Security would be deleted under the Proposal.
⁹ The SEC staff has said that the determination that an unrated security is of comparable quality to a security with the requisite ratings would require “an analysis of the unrated security and its issuer similar, to the extent possible, to that performed by an NRSRO in rating similar securities and issuers.” See letter to registrants dated May 8, 1990, from Kathryn McGrath, Director of the SEC Division of Investment Management.
¹⁰ An Eligible Security also must mature in no more than 397 days under the current Rule and the Proposal.
¹¹ The Proposal eliminates the provision that securities issued by a registered money market fund and U.S. Government Securities are “First Tier Securities.” Apparently, a determination of capacity to repay short-term financial obligations would be required for these entities, as for any other issuer.
¹² See Amending Release No. IC-2291 (Dec. 2, 1997; published in Federal Register Dec. 9, 1997).
¹³ On June 11, 2008, the SEC proposed reforming the operation of rating agencies to significantly increase the amount of information available to funds and others relating to ratings (the “June 11 Proposals”). The Proposal does not specifically require that funds or advisers review this information. Much of the additional information will be reported on Form NRSRO, the form rating agencies use to apply to the SEC for registration as an “NRSRO,” which must be updated periodically and filed publicly. Under the June 11 Proposals, changes in ratings reported on Form NRSRO would be required to be disclosed by asset class, to make it easier for users of credit ratings to compare the accuracy of ratings on a class-by-class basis. Form NRSRO would be required to include information on whether and how information about verification of assets underlying an asset pool or asset backed or mortgage-backed transaction is relied upon in issuing a rating, and whether and how assessments of the quality of originators of assets play a part in ratings. The Form would be required to disclose how frequently credit ratings are reviewed, whether different models or criteria are used for ratings surveillance than for determining initial ratings, whether changes to models and criteria for determining initial ratings are applied retroactively to existing ratings, and whether changes to models and criteria for surveillance are incorporated into the models and criteria for initial ratings. Further, the June 11 Proposals would require the disclosure of all information provided to the NRSRO by certain parties to determine initial ratings and to perform surveillance of the rated instrument. The SEC has said that these disclosures would make it more difficult for those who arrange for NRSRO ratings to exert influence on the NRSROs they hire and would have “an ancillary benefit” of operating as a “check on inaccuracy and incompetence” in the rating process.