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Rule 3a-7 under the Investment Company Act of 1940 (the Act) excludes issuers of asset-backed securities (ABS) from the definition of "investment company" upon the satisfaction of certain conditions.  One of those conditions is that, at the time of the initial sale, the securities are rated in 1 of the 4 highest categories assigned to long-term debt, or an equivalent for short-term debt, by at least one nationally-recongized statistical rating agency or are sold to "accredited investors" or "qualified institutional buyers" as such terms are defined in the Securities Act of 1933.

On August 31, 2011, the SEC issued an advanced notice of proposed rulemaking (the ANPR) on possible amendments to Rule 3a-7.  The proposed amendments are designed to implement Dodd-Frank Section 939A, which generally requires the SEC to replace requirements linked to credit ratings with other standards of credit-worthiness.  In the ANPR, the SEC requests comment regarding conditions that should be added to Rule 3a-7 to address investor protection in lieu of the credit ratings condition.  More specifically, the SEC proposed the following alternative conditions:

  • Structure and Operation of the Issuer:  Prevent a sponsor from dumping assets into an ABS issuer and prevent self-dealing by insiders either (a) by prescribing the particular manner in which such activities must be conducted; or (b) by taking a principles-based approach by, for example, requiring that the parameters of the issuer's organization and operation be set forth in its organizational documents in a way that addresses the activities the Act was designed to address.
  • Independent Review:  Ensure the quality of the issuer and its operations either (a) by requiring that an independent evaluator give an opinion that it reasonably believes that the issuer is structured and would be operated in a manner such that excepted cash flows from its assets would likely be sufficient to service expected payments on the issuer's fixed-income securities; or (b) by requiring the issuers to give a similar certification in its offering documents after considering the views of an independent evaluator.

Because many ABS issuers currently rely on Rule 3a-7 for their exclusion from the definition of "investment company" and in light of other regulatory initiatives (including the Volcker Rule), any conditions added to Rule 3a-7 could limit the availability of its exclusion.

Comments were due on November 7, 2011 and is unclear what the SEC's next steps will be.


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