SEC Adopts Amendments to Remove Certain NRSRO References in Investment Company Rules and Forms

January 15, 2014


Mutual fund shareholder reports currently contain tables showing holdings of fixed-income securities that may be categorized by credit ratings from Standard & Poor’s, Dow Jones, Fitch and other nationally recognized statistical rating organizations (“NRSROs”). In addition, mutual funds presently are required to consider credit ratings of repurchase agreement collateral when they enter into such transactions. The Securities and Exchange Commission (“SEC”) recently adopted final amendments (the “Amendments”) to remove references to NRSROs in Rule 5b-3 under the Investment Company Act of 1940 (the “1940 Act”) and in requirements set forth in forms under the 1940 Act (the “Release”).1 The Amendments were prompted by Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires that Federal agencies remove from their regulations requirements for reliance on credit ratings and substitute alternative standards of credit worthiness.

The Amendments

Rule 5b-3

Rule 5b-3 permits funds to look through repurchase agreements to the underlying collateral securities for certain counterparty limitation and diversification purposes if such agreements are collateralized fully. Under current requirements, a repurchase agreement is collateralized fully if, among other things, the collateral consists only of: (A) cash items; (B) government securities; (C) securities that at the time of the repurchase agreement are rated in the highest category by “requisite NRSROs”; or (D) unrated securities that are of comparable quality to the securities that are rated in the highest rating category by the requisite NRSROs, as determined by a fund’s board of directors (“Board”) or its delegate (typically, the fund’s investment adviser).

The Amendments provide a new standard designed to reflect a similar degree of credit quality as the NRSRO credit rating standards currently in use. Under the Amendments, categories (C) and (D) above are removed from Rule 5b-3 and replaced by the following: securities that a Board, or its delegate, determines at the time of the repurchase agreement 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 such that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days.

As a result of the Amendments, a Board or its delegate must make credit quality determinations for all collateral securities that are not cash items or government securities.

The Amendments do not define “exceptionally strong capacity” or include specific factors or tests that must be applied in performing a credit analysis. Rather the Release states that in determining credit quality, a fund may incorporate into its analysis ratings, reports, opinions and other assessments issued by third parties, including NRSROs. A Board or its delegate should evaluate the basis for using any third-party assessment, including NRSRO ratings, in determining whether collateral meets the standard. However, a Board or its delegate cannot rely solely on the credit ratings of an NRSRO without performing additional due diligence. This due diligence entails, in part, a determination that the ratings meet the standard and that the agencies providing the ratings are credible and reliable for that use. A fund may establish its own additional criteria for what a fund may accept as collateral for repurchase agreements.

Fund Registration Forms

The Amendments revise certain requirements in SEC Forms N-1A, N-2 and N-3, pursuant to which funds must present a table, chart or graph in shareholder reports depicting fixed-income portfolio holdings by a reasonably identifiable category, such as credit quality. The Amendments remove the requirements under which funds that organize their portfolio holdings based on credit quality categorizations must use NRSRO ratings for that purpose.

A fund must provide near, or as part of, the portfolio holdings presentation, a description of how the credit quality of holdings was determined, and if credit ratings assigned by a credit rating agency are used, an explanation of how they were identified and selected. The Release cautions that it may be misleading for a fund that does not use credit ratings to describe its portfolio holdings with similar descriptions to the ratings nomenclature or to characterize securities as rated.

Effective and Compliance Dates

Mutual funds and their investment advisers should review, and modify where necessary, their repurchase agreement policies and procedures and corresponding repurchase agreement disclosures in fund prospectuses and SAIs and portfolio holding categorizations in shareholder reports to determine the impact of these Amendments on those policies and disclosures.

The Amendments become effective as of February 7, 2014. The SEC has established a compliance date of July 7, 2014.


If you have any questions concerning the matters discussed in this memorandum, please contact an attorney in the Investment Management Group at Seward & Kissel.


1 See Investment Company Act Release No. IC-30847 (Dec. 27, 2013).