Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”)2 requires that the Commission review any references to credit ratings in its regulations and either remove those references or substitute alternate standards of credit-worthiness. Rule 3a-7 under the Investment Company Act, which specifically excludes from the definition of “investment company” certain asset-backed issuers, contains several conditions that refer to credit ratings by nationally recognized statistical rating organizations (“NRSROs”). While the Commission concedes that the ratings provisions of Rule 3a-7 generally were not intended to serve as standards of credit-worthiness, the Commission uses Section 939A of the Dodd-Frank Act as an opportunity to review Rule 3a-7 in light of market developments in the two decades since the rule was adopted. The Commission asks questions regarding the role that credit ratings should continue to play under Rule 3a-7, and whether Rule 3a-7 should be amended to replace the references to credit ratings with other conditions tailored to address Investment Company Act concerns.
Among the possible new conditions discussed by the Commission are prescriptive or principles-based conditions addressing the issuer’s structure and operations, a review of the securitized assets by and an opinion from an “independent evaluator,” conditions imposing additional requirements for preservation and safekeeping of the assets, and requirements that the issuer meet standards set by a variety of other federal securities laws and rules (including the recently proposed shelf eligibility requirement for a “credit risk manager” and the pending credit risk retention rules required by the Dodd-Frank Act). The Commission notes it had earlier requested comment on whether an asset-backed issuer should be required to meet the requirements of Rule 3a-7 in order to be eligible for shelf registration, and now also asks whether an asset-backed issuer should be required to be shelf-eligible in order to use Rule 3a-7.
The Commission requests comment on whether a holder of a Rule 3a-7 issuer's securities should be required to treat those securities as investment company securities for purposes of determining its own status under the Investment Company Act, whether an asset-backed issuer relying on Rule 3a-7 should be considered an investment company for purposes of the definition of "eligible portfolio company" (meaning that a business development company could not invest primarily in such securities), and whether asset-backed issuers should be precluded from relying on the exclusion from the definition of "investment company" provided by Section 3(c)(5) under the Investment Company Act.
The Commission approved the issuance of the ANPR at an open meeting held on August 31, 2011. At that meeting, the Commission also approved issuance of a pair of companion concept releases discussing the status under the Investment Company Act of mortgage REITs and other mortgage-related pools,3 and the use of derivatives by investment companies.4
Revisiting Rule 3a-7
The Commission cites five concerns that the extensive regulatory scheme imposed by the Investment Company Act was intended to address:
According to the ANPR, asset-backed issuers typically meet the definition of “investment company” but cannot operate under the constraints of the Investment Company Act’s regulatory scheme.6 Therefore, asset-backed issuers generally must rely on an exclusion from the definition of “investment company” such as Rule 3a-7. Rule 3a-7, which was adopted in 1992, excludes from the definition of “investment company” asset-backed issuers that satisfy certain conditions. According to the Commission, these conditions were “intended to reflect the structural and operational distinctions between registered investment companies and asset-backed issuers” and reflected “then-existing practices in the asset-backed securities market that addressed investor protection. . .and promoted capital formation.”7
Three of the conditions of Rule 3a-7 contain references to credit ratings: an asset-backed issuer generally must have fixed income securities rated by at least one NRSRO in one of its four highest rating categories (i.e., an investment grade rating); any acquisition or disposition of eligible assets may not result in a downgrade of the credit ratings on the issuer’s fixed income securities; and cash flows from the assets must be deposited into a segregated account maintained or controlled by an independent trustee, consistent with the ratings of the issuer’s fixed income securities. The Commission states that these references were intended to serve as a proxy for the investor protection concerns addressed by the Investment Company Act, but now questions whether they have effectively done so.
The Commission requests comment on, among other things:
Possible New Conditions
The Commission notes that the Investment Company Act generally is intended to address the structural and operational integrity of an issuer. With regard to an asset-backed issuer, specific concerns include abusive practices (such as self-dealing by insiders), misvaluation of assets (such as “dumping” assets insufficient to produce the cash flows needed to make payments on the issuer’s securities), and inadequate asset coverage. Post-issuance, the Commission is concerned that someone involved with the issuer could substitute lower quality assets in the pool, invest cash flow in a speculative manner, or act in a manner that presents some other conflict of interest.10
The Commission suggests that Rule 3a-7 could be amended to impose specific requirements on the structure and operations of an asset-backed issuer, such as specifying the manner in which assets are selected and valued, the manner in which the issuer may be structured, and prohibiting activities that could adversely affect payment on the issuer’s securities. Alternatively, the Commission suggests that it could take a principles-based approach that requires the parameters of the issuer’s organization and operations to be included in its organizational documents, including the specific responsibilities of transaction parties, conditions for the acquisition or disposition of eligible assets, and policies designed to prevent insiders from engaging in activities that could adversely affect payments on the issuer’s securities.11 The Commission requests comment on which of these two approaches is preferable and more consistent with investor protection, whether other approaches should be considered, and whether Rule 3a-7 should address concerns besides self-dealing, misvaluation and inadequate asset coverage.12
The Commission also is considering whether to replace the rating conditions of Rule 3a-7, in part, with a requirement that an asset-backed issuer obtain an opinion from an “independent evaluator.” The opinion would state that the evaluator reasonably believes that the asset-backed issuer is structured and operated in a manner such that the expected cash flow generated from the underlying assets would likely allow the issuer to have the cash flow at times and amounts sufficient to service payments on the securities. This opinion would not serve as a guarantee. Alternatively, the Commission suggests that the rule could require an issuer certification to this effect, after considering the views of an independent evaluator.13 Among the Commission’s requests for comment on this proposal are:
Rule 3a-7 already contains several conditions designed to address the safekeeping of the issuer’s assets and cash flows, including: the requirement that an issuer take reasonable steps to cause an independent trustee to have a perfected security interest or ownership interest in the assets; the requirement that cash flows be deposited periodically in a segregated account maintained or controlled by an independent trustee, consistent with the ratings of the issuer’s fixed income securities; and the requirement that fixed income securities generally receive an investment grade rating. The Commission asks for a variety of comments on current practices with respect to safekeeping of assets and whether Rule 3a-7 should include stronger safekeeping provisions, including:
The Commission asks whether the requirements of a variety of other existing and proposed federal securities laws and rules regarding asset-backed issuers should be incorporated into Rule 3a-7 to mitigate Investment Company Act-related concerns, possibly in lieu of the rating condition. These include:
Finally, the Commission notes that it earlier had requested comment in the 2011 ABS Re-Proposal on whether asset-backed issuers should be required to meet the requirements of Rule 3a-7 as a condition of shelf eligibility.20 If such a requirement were adopted, it would preclude public shelf ABS issuers from relying on Section 3(c)(5)(C) or any other exclusion from the definition of “investment company” under the Investment Company Act. The Commission now asks whether the requirements of Regulation AB or the shelf eligibility requirements for ABS, including those re-proposed in the recent 2011 ABS Re-Proposal, might serve to address some or all of the Investment Company Act concerns of Rule 3a-7. If such a requirement were adopted, it would preclude the issuance of ABS by any asset-backed issuer that is not eligible to register its ABS for the shelf. The Commission goes on to ask if its “understanding [is] correct that some [ABS] issuers that privately offer their securities rely on Rule 3a-7” and whether “certain of those issuers would no longer be able to rely on Rule 3a-7 if the rule was limited in this manner.”21
Acquisition and Disposition of Eligible Assets
Rule 3a-7 permits acquisitions and dispositions of eligible assets only in accordance with the terms of the transaction documents, in a manner that does not result in a downgrade of the ratings of its fixed income securities, and not for the primary purpose of recognizing gains or decreasing losses from market value changes. The Commission states that the rule was originally intended not to permit the type of active asset management engaged in typically by registered investment companies, only activities such as “selling or substituting eligible assets when documentation is defective or for nonconformity with representations or warranties, disposing of assets in default or in imminent default, and removing excess credit support.”22 The Commission requests comment on whether any changes should be made to the rule’s conditions for the acquisition and disposition of eligible assets, whether the rule adequately precludes active management, and whether additional conditions should be added to limit the acquisition and disposition of eligible assets.23
The Effect of the Exclusion Provided by Rule 3a-7
Rule 3a-7 currently provides simply that an issuer that meets its conditions is not an investment company; it does not contain any provision requiring a holder of securities issued by an asset-backed issuer meeting its requirements to treat them in any other manner.24
Holders of ABS Issued by an Asset-Backed Issuer
A company’s status under the Investment Company Act may depend on the investment company status of the securities it owns. For example, any company that owns 50% or more of the outstanding voting securities of a company may treat it as a “majority-owned subsidiary,” and securities of a majority-owned subsidiary that is not an investment company are not “investment securities” for purposes of determining whether the parent meets the statutory definition of “investment company.”25 Currently, because a Rule 3a-7 issuer is not an investment company, a company that holds 50% or more of its outstanding voting securities may treat it as a majority-owned subsidiary, and those voting securities generally would not constitute investment securities for the purpose of determining the parent’s status as an investment company under Section 3(a)(1)(c) of the Investment Company Act.26 According to the Commission, the activities of some companies that focus on purchasing equity and residual interests in collateralized loan obligations and collateralized debt obligations of issuers that relied on Rule 3a-7 suggest that they are in the business of investing in securities, even though they might not fall within the definition of "investment company" due to the broad exclusion contained in Rule 3a-7.
The Commission therefore requests comment on the possibility of modifying Rule 3a-7 either to provide that its exclusion from the definition of “investment company” does not extend to the definition of “investment securities,” or to recast it so that a Rule 3a-7 issuer would be an investment company but instead be exempted from all the requirements of the Investment Company Act.27
Eligible Portfolio Company for Business Development Companies
A “business development company” (a “BDC”) generally is prohibited from making any investment unless at least 70% of its total assets are invested in securities of certain specified issuers, including “eligible portfolio companies.” An eligible portfolio company must not meet the definition of “investment company” or be excluded from that definition by any of the exemptions contained in Section 3(c) of the Investment Company Act.28
The Commission notes that a BDC might seek to treat a Rule 3a-7 issuer as an eligible portfolio company, but notes that it “does not believe that Rule 3a-7 issuers are the type of small, developing and financially troubled businesses in which Congress intended BDCs primarily to invest.”29 Therefore, the Commission asks whether Rule 3a-7 should be amended to provide that a Rule 3a-7 issuer is an investment company for purposes of the definition of “eligible portfolio company," which would result in BDCs not being permitted to invest primarily in securities of Rule 3a-7 issuers.30
Reliance by Asset-Backed Issuers on Section 3(c)(5)
Not all asset-backed issuers rely on Rule 3a-7 in order to avoid investment company treatment. Some issuers of ABS rely on Section 3(c)(5) of the Investment Company Act, which exempts any person who is not engaged in the business of issuing redeemable securities or certain other types of securities and is primarily engaged in the business of: purchasing or acquiring obligations representing part or all of the sales price of merchandise, insurance and services; making loans to manufacturers, wholesalers, retailers, and prospective purchasers of specified merchandise, insurance and services; and/or purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. According to the Commission, these asset-backed issuers include issuers that securitize retail automobile installment contracts, credit card receivables, trade receivables, boat loans, equipment leases, whole residential mortgage loans, home equity loans, whole commercial mortgages, participated mortgage interests, and whole pool certificates issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Other types of asset-backed issuers that sometimes rely on Section 3(c)(5)(C) include issuers that securitize student loans and automobile leases.
The Commission notes that Section 3(c)(5) did not specifically contemplate asset-backed issuers, which did not exist when Congress enacted the Investment Company Act. When the Commission originally adopted Rule 3a-7, it requested comment on whether it should seek statutory amendments that would preclude Section 3(c)(5) from being used by asset-backed issuers. In the ANPR, the Commission states that it believes it is now appropriate to revisit this issue. The Commission asks whether Section 3(c)(5) should be so amended, or the Commission should adopt rules limiting the availability of Section 3(c)(5) to issuers that were “intended” to be encompassed by Section 3(c)(5).31
The Commission has issued a companion concept release indicating that it may be fundamentally re-thinking the Section 3(c)(5)(C) exemption for companies purchasing or acquiring mortgages and liens and interests in real estate, particularly as it applies to mortgage REITs and other mortgage-related pools that appear to the Commission to be similar in operation and structure to traditional investment companies.32
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1. Treatment of Asset-Backed Issuers under the Investment Company Act, SEC Rel. No. IC-29779 (Aug. 31, 2011), available at http://sec.gov/rules/concept/2011/ic-29779.pdf.
2. The Dodd-Frank Act is available at http://banking.senate.gov/public/_files/Rept111517DoddFrankWallStreetReformandConsumerProtectionAct.pdf. Our summary of the Dodd-Frank Act is available at /Media.aspx?MediaID=10963.
3. Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments, SEC Rel. No. IC-29778 (Aug. 31, 2011), available at http://sec.gov/rules/concept/2011/ic-29776.pdf. We expect to issue a client alert on this release in the near future.
4. Use of Derivatives by Investment Companies under the Investment Company Act of 1940, SEC Rel. No. IC-29776, available at http://sec.gov/rules/concept/2011/ic-29776.pdf. Our client alert on this release is available at /Media.aspx?MediaId=12823.
5. ANPR, at 9.
6. Id., at 3.
7. Id., at 11.
8. Id., at 16.
9. Id., at 15-17.
10. Id., at 19.
11. The Commission notes that the latter approach may be more or less consistent with current market practice.
12. ANPR, at 19-20.
13. The Commission notes its proposal to replace the current investment grade rating criterion for shelf eligibility of ABS with a certification by the CEO (or executive officer in charge of securitization) of the depositor in its recent re-proposed changes to Regulation AB (the “2011 ABS Re-Proposal”). The content of the independent evaluator’s opinion or issuer certification suggested here is very similar to that proposed form of certification. The proposing release for the 2011 ABS Re-Proposal, SEC Reg. No. 33-9244, 76 Fed Reg. 47948 (Aug. 5, 2011) (the “2011 ABS Re-Proposing Release”), is available at http://sec.gov/rules/proposed/2011/33-9244fr.pdf. Our client alert on 2011 ABS Re-Proposal is available at /Media.aspx?MediaID=12705.
14. ANPR, at 22-27.
15. Such as two business days, consistent with the annual assessment requirement in Item 1121(d) of Regulation AB, which requires assessment of whether servicers deposited payments into the appropriate accounts no more than two business days of receipt or such other number of days specified in the transaction documents.
16. ANPR, at 27-32.
17. Our client alert on the adoption of Rule 193 is available at /Media.aspx?MediaID=11901.
18. This provision is not effective until the Commission prescribes implementing rules, which the Commission has not yet proposed or adopted.
19. ANPR, at 32-35. The credit risk retention rules have been proposed by the Commission and the other applicable banking regulators, but have not yet been adopted. The proposing release for the credit risk retention rules, Credit Risk Retention, SEC Rel. No. 33-6418, 76 Fed. Reg. 24090 (Apr. 29, 2011), is available at http://sec.gov/rules/proposed/2011/34-64603fr.pdf. Our guide to the proposed credit risk retention rules is available at /Media.aspx?MediaID=12273.
20. ANPR, at 6; 2011 ABS Re-Proposing Release, 76 Fed. Reg. at 46963-64.
21. ANPR, at 35.
22. Id., at 37.
23. Id., at 37-38.
24. Id., at 38.
25. ANPR, at 50; Investment Company Act §§ 2(a)(24), 2(a)(42), 3(a)(1), 3(a)(2).
26. Such a company might be deemed to be an investment company under some other provision of the Investment Company Act, however.
27. ANPR, at 38-42.
28. ANPR, at 43; Investment Company Act §§ 2(a)(46), 55(a),
29. ANPR, at 44.
30. Id., at 42-44.
31. Id., at 44-47.
32. See footnote 3 above.
This article was originally published by Bingham McCutchen LLP.