Wednesday, August 31, 2011

SEC Questions Use of Credit Ratings in Rule Excluding Issuers of Asset-Backed Securities from 1940 Act

The SEC plans to issue an Advance Notice of Proposed Rulemaking on possible amendments to regulations excluding issuers of asset-backed securities from having to comply with the requirements of the Investment Company Act. While issuers of asset-backed securities typically meet the 1940 Act definition of investment company, SEC Rule 3a-7 excludes some asset-backed issuers from the definition of investment company provided they meet specified conditions, one of which is that the asset-backed securities be rated by a nationally recognized statistical ratings organization, but the SEC says that condition was not primarily intended as a measure of credit-worthiness of the issuer.

Rather, the Commission included the credit rating condition because it believed that as part of the ratings process, the rating agencies assessed the issuer’s investor protection measures. In the aftermath of the recent financial crisis, the Commission has engaged in various regulatory initiatives to address concerns raised by credit rating procedures and methodologies.

The Advance Notice of Proposed Rulemaking would solicit public comment on possible amendments to Rule 3a-7 including the role, if any, that credit ratings should continue to play in the rule. In order to use Rule 3a-7, an issuer must meet the rule’s conditions including the existing rating condition.

The ANPR posits removing the rating condition and replacing it with new conditions. Rather than rely on rating agencies to assess the issuer’s structure and operations, such new conditions could address the structure and operations of asset-backed issuers. Possible new conditions also could require the issuer to undergo an independent review to protect investors in the asset-backed securities from self-dealing and overreaching by insiders. Additional possible conditions could help ensure that the issuer preserves and safeguards its assets and cash flow.

The ANPR also asks whether Rule 3a-7 issuers should still be considered investment companies for the limited purpose of determining whether an entity investing in Rule 3a-7 issuers is itself an investment company that should comply with the requirements of the 1940 Act.


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