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SEC Proposes Amendments to Remove Credit Ratings References in Several Rules Under the Exchange Act

In keeping with its ongoing crackdown on the credit ratings agencies, the Securities and Exchange Commission (SEC) has this week voted unanimously to propose amendments that would remove references to credit ratings in several rules under the Exchange Act. This is all part of the requirements contained in Dodd Frank to remove references to credit ratings within agency rules and, where appropriate, replace them with alternative criteria, such as the notion of new “standards of credit-worthiness”.

Under Dodd Frank, US regulators must review how their existing regulations rely on credit ratings as an assessment of creditworthiness. At the conclusion of this review, each agency is required to report to Congress on how they have modified these references to replace them with alternative standards that the agency determined to be appropriate.

“We are proposing to remove references to credit ratings in rule 2a-7, which would affect five elements of the rule: determination of whether a security is an eligible security; determination of whether a security is a first tier security; credit quality standards for securities with a conditional demand feature; requirements for monitoring securities for ratings downgrades and other credit events; and stress testing,” states the regulator in the proposals.

By taking the mandatory credit rating element out of the equation, firms will have to put in place new standards in order to determine factors such as the eligibility of securities. The details of the new standards for credit-worthiness include new data checks, limits and requirements by which securities must be judged. Credit risk evaluations will therefore need to be strengthened in order to take into account these changes and firms will need to ensure the data on which these judgements are made is of sufficiently high quality; yet another compelling argument for investment in data management solutions going forward.

For example, the SEC is proposing to remove from the net capital rule all references to credit ratings and substitute an alternative standard of creditworthiness. Under the proposal, a broker-dealer would be required to take a 15% haircut on its proprietary positions in commercial paper, non-convertible debt, and preferred stock unless the broker-dealer has a process for determining creditworthiness that satisfies the criteria set out by the regulator.

In its assessments, the broker-dealer will therefore need to take into account: credit spreads; securities related research; internal or external credit risk assessments; default statistics; inclusion on an index; priorities and enhancements; price, yield and/or volume; and asset class specific factors. A whole host of additional data items must therefore be stored and made easily accessible for a period of “not less than three years”.

These proposals follow on from last month’s proposed amendments to the Investment Company Act of 1940 with regards to removing credit ratings references. There has been some pushback from the industry with regards to the removal of ratings references altogether in Rule 2a-7 of the Investment Company Act in particular, which relates to money markets and was proposed last month. Sifma has sent a letter to the SEC asking it to review the proposals related to 2a-7, stating: “These provisions benefit shareholders and serve an important purpose as a quality floor, different from ratings provisions in other regulations.”

The association elaborates: “Under the current rule, each security purchased by a money market mutual fund must present minimal credit risks as determined by the board or its delegate. Additionally, at the time each holding is acquired, it must have short term ratings from the requisite nationally recognised statistical rating organisations of at least second tier quality, or, if unrated, be determined by the fund board or its delegate to be of comparable quality. In effect, the rating requirement creates a quality ‘floor’, separate from and in addition to the minimal credit risks requirement.”

The SEC’s own commissioner Luis Aguilar has also voiced some concerns about the removal of ratings references from regulation because of the lack of a sufficiently robust alternative. “I am troubled about the proposed amendments to Rule 15c3-1, the net capital rule, because it does not appear that we have been able to identify an appropriate substitute for credit ratings,” he noted recently during a speech at an SEC meeting in Washington.

Public comments on the rule amendments related to the Exchange Act proposals must be submitted to the regulator within 60 days after they are published in the Federal Register.

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