Purchase of Certain Debt Securities by Business and Industrial Development Companies Relying on an Investment Company Act Exemption

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is adopting a new rule under the Investment Company Act of 1940 (“Investment Company Act”) to establish a standard of credit-worthiness in place of a statutory reference to credit ratings that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) removes. The rule will establish the standard of credit quality that must be met by certain debt securities purchased by entities relying on the Investment Company Act exemption for business and industrial development companies.

DATES:

Effective date: December 24, 2012.

FOR FURTHER INFORMATION CONTACT:

Anu Dubey, Senior Counsel, or Penelope Saltzman, Assistant Director (202) 551-6792, Office of Regulatory Policy, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is adopting new rule 6a-5 [17 CFR 270.6a-5] under the Investment Company Act.

Table of Contents

I. Background

II. Discussion

III. Paperwork Reduction Act

IV. Economic Analysis

V. Final Regulatory Flexibility Analysis

Statutory Authority

Text of Rule

I. Background

The Dodd-Frank Act was enacted on July 21, 2010. Section 939(c) of the Dodd-Frank Act removes a reference to credit ratings from section 6(a)(5) of the Investment Company Act and replaces it with a reference to “such standards of credit-worthiness as the Commission shall adopt.” To implement this mandate, last year the Commission proposed new rule 6a-5 under the Investment Company Act that would establish a credit-worthiness standard to replace the credit rating reference in section 6(a)(5) of that Act that the Dodd-Frank Act eliminates. We received one comment letter regarding proposed rule 6a-5, which we discuss below. Today, we are adopting new rule 6a-5, which implements section 939(c) of the Dodd-Frank Act.

II. Discussion

Business and industrial development companies (“BIDCOs”) are companies that operate under state statutes that provide direct investment and loan financing, as well as managerial assistance, to state and local enterprises. Because they invest in securities, BIDCOs frequently meet the definition of “investment company” under the Investment Company Act. In 1996, the Investment Company Act was amended to add section 6(a)(5) to exempt these companies from most provisions of the Act subject to certain conditions. The statutory exemption was premised on states having a strong interest in overseeing the structure and operations of these companies, thus rendering regulation under the Investment Company Act largely duplicative and unnecessary.

BIDCOs that seek to rely on the exemption in section 6(a)(5) are limited with respect to the types of securities issued by investment companies and companies exempt from the definition of investment company under section 3(c)(1) or 3(c)(7) of the Investment Company Act (“private funds”) that they may purchase. Specifically, section 6(a)(5)(A)(iv) prohibits these BIDCOs from purchasing securities issued by investment companies and private funds other than debt securities that are rated investment grade by at least one NRSRO and securities issued by registered open-end investment companies that invest at least 65 percent of their assets in investment grade securities or securities that the fund determines are comparable in quality. This provision was intended to provide limited flexibility to invest capital not immediately needed for the company's long-term commitments. Although the legislative history of the provision does not specifically explain why Congress restricted BIDCOs to acquiring “investment grade” debt of investment companies and private funds, as we noted in the 2011 Proposing Release, it may have been designed to limit BIDCOs to investing in debt securities of sufficiently high credit quality that they are likely to maintain a fairly stable market value and that could be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities.

As described above, section 939(c) of the Dodd-Frank Act eliminates the credit rating reference in section 6(a)(5)(A)(iv) of the Investment Company Act. Instead of limiting BIDCOs to purchasing debt securities issued by investment companies and private funds that are rated “investment grade,” the amendment requires such debt securities to meet “such standards of credit-worthiness as the Commission shall adopt.”

We do not understand that the statutory amendment was intended to change the standard of credit quality represented by an investment grade rating. Accordingly, we are adopting rule 6a-5, as proposed, to establish a standard of credit-worthiness designed to achieve the same degree of risk limitation as the credit rating it replaces. Rule 6a-5 deems a BIDCO to have met the requirements for credit-worthiness of certain debt securities under section 6(a)(5)(A)(iv)(I) if the board of directors or members of the company (or its or their delegate) determines, at the time of purchase, that the debt security is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time. The board of directors or members of a BIDCO (or its or their delegate) would have to make this determination at the time of acquisition of the securities. As a result of rule 6a-5, section 6(a)(5) of the Investment Company Act will also limit a BIDCO's investments in registered open-end funds to those funds that invest at least 65 percent of their assets in debt securities that meet our standard.

The final rule does not, as one commenter suggested, include specific factors or tests that the board must apply in performing its credit analysis. We believe that the new credit quality standards (that the debt security be subject to no greater than moderate credit risk and be sufficiently liquid that it can be sold at or near its carrying value within a reasonably short period of time) are clear enough for a BIDCO's board or members (or its or their delegate) to understand the risks acceptable under the rule. We note that the number and scope of factors that may be appropriate to making a credit quality determination with respect to a security may vary significantly depending on the particular security. We are concerned that prescribing a list of specific factors in a rule today might function as a limit to the credit quality analysis that boards or members would undertake and may not address information that would be relevant to credit quality determinations regarding new types of debt securities that investment companies or private funds may issue and in which BIDCOs may invest in the future.

The standard we are adopting is designed to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities. Debt securities (or their issuers) subject to a moderate level of credit risk would demonstrate at least average credit-worthiness relative to other similar debt issues (or issuers of similar debt). Moderate credit risk would denote current low expectations of default risk associated with the security, with an adequate capacity for payment by the issuer of principal and interest. In making their credit quality determinations, a BIDCO's board of directors or members (or its or their delegate) can also consider credit quality reports prepared by outside sources, including NRSRO ratings, that the BIDCO board or members conclude are credible and reliable for this purpose.

III. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (“PRA”) imposes certain requirements on federal agencies in connection with their conducting or sponsoring any collection of information as defined by the PRA. Rule 6a-5 does not create any new collections of information.

IV. Economic Analysis

As discussed above, we are adopting a new rule to implement section 939(c) of the Dodd-Frank Act to replace a statutory reference to a credit rating with an alternative credit-worthiness standard. We considered the economic effects, including costs and benefits, of our proposed new rule in the 2011 Proposing Release and we discuss below the comment received related to our analysis.

The Commission has discretion in adopting the alternative standard of credit-worthiness, and we undertake below to discuss the economic effects of the new rule that are within our discretion under the Dodd-Frank Act, in addition to the economic effects of removing rating references from statutory provisions, as mandated by the Dodd-Frank Act itself. The two types of costs and benefits may not be entirely separable to the extent that our discretion is exercised to realize the benefits intended by the Dodd-Frank Act. In evaluating the economic effects of new rule 6a-5, we compare section 6(a)(5) of the Investment Company Act, as currently in effect (which includes a reference to a rating), with the new rule we are adopting.

Rule 6a-5 establishes a credit-worthiness standard under section 6(a)(5)(A)(iv)(I) of the Investment Company Act. BIDCOs that seek to rely on the exemption in section 6(a)(5) of the Act are limited to investing in debt securities issued by investment companies and private funds if, at the time of purchase, the board of directors or members of the BIDCO (or its or their delegate) determines that the debt security is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time.

We anticipate that the adoption of rule 6a-5 may result in certain benefits. First, we do not understand that by amending section 6(a)(5), Congress intended to change the credit quality of the debt securities that BIDCOs may purchase and our rule is designed to establish a similar credit quality standard in order to achieve the same limitation on risk as the credit rating it replaces. In particular, the amended standard is designed to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities. Second, the subjective credit quality standard in amended rule 6a-5 may provide BIDCOs greater flexibility in determining the pool of eligible debt securities in which they may invest. Finally, the credit quality standard in new rule 6a-5 may further Congress' stated purpose of reducing reliance on ratings in the context of a BIDCO's purchase of certain debt securities.

We also recognize that BIDCOs may incur some costs as a result of the adoption of new rule 6a-5. These may be internal costs or costs to consult outside legal counsel to evaluate whether changes to any policies and procedures the BIDCOs may have currently for acquiring debt securities issued by investment companies or private funds may be appropriate in light of the new rule. We expect that, although not required by the Investment Company Act, as a matter of good business practice, directors or members of most BIDCOs that do not currently have them may prepare policies and procedures to make the credit quality and liquidity determinations required by the new rule. Staff estimates that BIDCOs will incur the costs of preparing the procedures for making determinations of credit quality and liquidity under the rule once, and directors and members of BIDCOs (or their delegates) will be able to follow these procedures for purposes of making future determinations under the rule. Commission staff estimated in the 2011 Proposing Release that each BIDCO would incur, on average, an initial one-time cost of $1000 to prepare policies and procedures and an average of $1000 in annual costs for making credit determinations with respect to the acquisition of debt securities. We received no comments on those estimates. We note however, that under rule 6a-5, in evaluating whether debt securities issued by investment companies and private funds present moderate credit risk, boards of directors and members of BIDCOs (or its or their delegates) can consider credit quality determinations prepared by outside sources, including NRSRO ratings, that they conclude are credible and reliable for purposes of making these determinations, and we anticipate that many BIDCOs that invest cash in these types of debt securities will continue to do so. We expect that the ability to consider outside assessments will help minimize the burden on BIDCOs and contribute to a BIDCO's ability to make consistent and reliable credit quality determinations. Nevertheless, we recognize that some BIDCO boards or members may choose to hire consultants to assist in developing procedures and to make or oversee the determinations. Staff estimated in the 2011 Proposing Release that the cost to hire such consultants would be, on average, $8000 for each BIDCO. We received no comments on this estimate.

Adopting a new credit quality standard in place of the ratings requirement in section 6(a)(5)(A)(iv) of the Investment Company Act may result in other costs for BIDCOs and their investors. The minimum rating requirement in section 6(a)(5)(A)(iv) of the Act, before it was amended by the Dodd-Frank Act, established an objective standard that is easy to apply and may have limited BIDCOs from investing in securities that posed greater credit risks. The new rule instead requires BIDCO boards or members to assess credit quality by applying a subjective standard. We acknowledge that a BIDCO could invest in lower quality debt securities that it determines meets the standard in new rule 6a-5, and that it may be difficult for the Commission to challenge the determination of a BIDCO's directors or members (or their delegates). In addition, because credit quality assessments could differ across BIDCOs, the range of risk of investments may be broader than it is currently. We do not, however, believe that the new rule is likely to lead BIDCOs to invest in riskier securities because the standard we are adopting is very similar to the standard articulated by the rating agencies for investment grade securities.

As part of our economic analysis, we considered alternatives to the standard that we are adopting in rule 6a-5. In particular, we considered including specific factors or tests that a fund board must apply in performing its credit analysis in the rule. As noted above, we believe that this alternative could function as a limit to a fund's credit quality analysis and thus might result in a less effective credit quality determination than a BIDCO would perform under the credit quality standard in the new rule, which could result in investments that expose the BIDCO to greater risk.

V. Final Regulatory Flexibility Analysis

The Commission has prepared the following Final Regulatory Flexibility Analysis (“FRFA”) in accordance with section 4(a) of the Regulatory Flexibility Act regarding new rule 6a-5, which we are adopting today to give effect to provisions of the Dodd-Frank Act. We prepared an Initial Regulatory Flexibility Analysis (“IRFA”) in conjunction with the 2011 Proposing Release in March 2011.

A. Need for and Objectives of the Rule and Form Amendments and New Rule

As described more fully in Sections I and II of this Release, the Commission is adopting new rule 6a-5 to set forth a standard of credit-worthiness for purposes of section 6(a)(5)(A)(iv) of the Investment Company Act, as anticipated by section 939(c) the Dodd Frank Act, which eliminates the investment grade standard from section 6(a)(5) of the Investment Company Act.

B. Significant Issues Raised by Public Comment

In the Proposing Release, we requested comment on the IRFA. In particular, we sought comment on how many small entities would be subject to the proposed new rule and whether the effect of the proposed new rule on small entities subject to it would be economically significant. None of the comment letters we received specifically addressed the IRFA. None of the comment letters specifically addressed the effect of the new rule on small BIDCOs.

C. Small Entities Subject to the Rule and Form Amendments and New Rule

New rule 6a-5 under the Investment Company Act would affect BIDCOs, including entities that are considered to be a small business or small organization (collectively, “small entity”) for purposes of the Regulatory Flexibility Act. Under the standards adopted by the Small Business Administration, small entities in the financial investment industry include entities with $7 million or less in annual receipts. We do not have any data and are not aware of any databases that compile information regarding how many BIDCOs would be small entities under this definition. We also did not receive any comments from BIDCOs.

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

Rule 6a-5 imposes no reporting, recordkeeping or other compliance requirements.

E. Agency Action To Minimize Effect on Small Entities

The Regulatory Flexibility Act directs us to consider significant alternatives that would accomplish our stated objectives, while minimizing any significant adverse effect on small entities. In connection with the new rule, the Commission considered the following alternatives: (i) Establishing different compliance standards or timetables that take into account the resources available to small entities; (ii) clarifying, consolidating, or simplifying compliance and reporting requirements under the rule for small entities; (iii) use of performance rather than design standards; and (iv) exempting small entities from all or part of the requirements.

We believe that special compliance or reporting requirements for small entities, or an exemption from coverage for small entities, is not appropriate or consistent with investor protection or section 939(c) of the Dodd-Frank Act, which rule 6a-5 implements. With respect to rule 6a-5, we believe that special compliance requirements or timetables for small entities, or an exemption from coverage for small entities, may create a risk that those BIDCOs could acquire debt securities that are not of sufficiently high credit quality that they would be likely to maintain a fairly stable market value or be liquidated easily, as we believe may have been intended for the BIDCO to support its long-term commitments. Further consolidation or simplification of rule 6a-5 for BIDCOs that are small entities is inconsistent with the Commission's goals of fostering investor protection. Finally, rule 6a-5 uses performance rather than design standards for determining the credit quality of specific debt securities.

Statutory Authority

The Commission is adopting new rule 6a-5 under the authority set forth in section 38(a) of the Investment Company Act [15 U.S.C. 80a-37(a)] and section 939 of the Dodd-Frank Act, to be codified at section 6(a)(5)(A)(iv)(I) of the Investment Company Act [15 U.S.C. 80a-6(a)(5)(A)(iv)(I)].

List of Subjects in 17 CFR Part 270

• Investment companies
• Reporting and recordkeeping requirements
• Securities

Text of Rule

PART 270—RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

1. The authority citation for part 270 is amended by adding a sub-authority in numerical order to read as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-39, unless otherwise noted.

Section 270.6a-5 is also issued under 15 U.S.C. 80a-6(a)(5)(A)(iv)(I).

2. Section 270.6a-5 is added to read as follows: