SEC Proposes Rule Changes Removing References to Credit Ratings from Exchange Act Rules and Forms | Practical Law

SEC Proposes Rule Changes Removing References to Credit Ratings from Exchange Act Rules and Forms | Practical Law

An update on the SEC proposal under the Dodd-Frank Act that would amend certain Exchange Act rules and forms to remove references to credit ratings.

SEC Proposes Rule Changes Removing References to Credit Ratings from Exchange Act Rules and Forms

by PLC Corporate & Securities
Published on 28 Apr 2011 • USA (National/Federal)
An update on the SEC proposal under the Dodd-Frank Act that would amend certain Exchange Act rules and forms to remove references to credit ratings.
On April 27, 2011, the SEC proposed rule amendments that would replace references to credit ratings with alternative evaluations of creditworthiness in Exchange Act rules and forms applicable to distributions of securities, broker-dealer financial responsibility and confirmations of transactions. The proposal is made under Section 939A of the Dodd-Frank Act, which requires federal agencies to review how existing rules rely on credit ratings and replace the ratings with alternative criteria where appropriate.
The proposal would remove references to Nationally Recognized Statistical Rating Organization (NRSRO) ratings as a means for entities to evaluate creditworthiness and risk from certain Exchange Act rules, including:
  • Regulation M. Rules 101 and 102 of Regulation M prohibit issuers and underwriters from bidding for, purchasing or inducing others to bid for or purchase "covered securities" for a period of time. Currently, these rules exclude investment grade nonconvertible and asset-backed securities from the definition of covered securities. The proposed rule would eliminate the reference to investment grade ratings and instead exempt nonconvertible and asset-backed securities if these are:
    • liquid relative to the market for their asset class;
    • traded in relation to general market interest rates and yield spreads; and
    • relatively fungible with securities of similar characteristics and interest rate spreads.
  • Rule 15c3-1 (The Net Capital Rule). The proposal eliminates the option of relying on NRSRO credit ratings in determining counterparty and credit risk, and would instead encourage firms to develop and use internal policies and procedures for evaluating risk. The Net Capital Rule requires broker-dealers to maintain minimum levels of liquid assets (net capital). Currently, the rule applies a lower deduction from net capital (haircut) to certain types of securities held by a broker-dealer if those securities are rated higher by NRSROs. The proposal would amend the Net Capital Rule to require broker-dealers to take a 15% haircut on certain types of securities unless they have an adequate process for determining creditworthiness. However, broker-dealers could apply a lower haircut on those securities if:
    • they establish, maintain and enforce written policies and procedures to assess credit and liquidity risk by evaluating a range of security-specific factors (such as credit spreads, securities-related research and default statistics); and
    • based on these processes, they determine that the investment has only a "minimal amount of credit risk."
  • Appendix A to the Net Capital Rule. The proposal would replace the credit rating requirement in the definition of "major market foreign currency" with the requirement that a substantial inter-bank forward currency market exist for a currency.
  • Appendices E, F and G to the Net Capital Rule. Currently, the Net Capital Rule requires a broker-dealer using the alternative net capital method for computing capital (contained in Appendix E) to deduct from its net capital certain credit risk charges for counterparty risk based on either an NRSRO rating or that broker-dealer's internal counterparty credit rating. The proposed rule would eliminate the option to base this calculation on an NRSRO rating. The proposal rule would also make a similar change to Appendix F, which governs net capital deductions by OTC derivatives dealers, and conforming changes to Appendix G.
  • Rule 15c3-3 (The Customer Protection Rule). Exhibit A to the Customer Protection Rule allows broker-dealers to include required customer margin for transactions in security futures products in calculating reserve requirements. The customer margin can be included if it is on deposit at a clearing agency or derivatives clearing organization that satisfies one of four criteria, including whether the agency or organization maintains the highest investment-grade rating from an NRSRO. The proposal would eliminate the criteria based on credit ratings, but keep the three remaining criteria in place (such as whether the agency maintains at least $3 billion in margin deposits).
  • Rule 10b-10 (The Customer Confirmation Rule). Under the proposed rule, broker-dealers would no longer be required to include in a customer confirmation when a debt security is unrated by an NRSRO.
The proposal also requests public comment on the standards of creditworthiness that should apply to the definition of mortgage related security (Section 3(a)(41), Exchange Act) and small business related security (Section 3(a)(53), Exchange Act). Section 939(e) of the Dodd-Frank Act removed credit rating references from these definitions effective July 2012. Starting on July 21, 2012, securities that are intended to satisfy these definitions will have to meet new standards of creditworthiness established by the SEC. One alternative the SEC is considering, subject to public comment, would be based on the "minimal amount of credit risk" standard proposed for purposes of the Net Capital Rule.
For more information on the treatment of credit rating agencies in the Dodd-Frank Act, see Practice Note, Summary of the Dodd-Frank Act: Credit Rating Agencies.
For more information on SEC rulemaking activities regarding credit rating agencies, see Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Credit Rating Agencies.