A Small Entity Compliance Guide¹

Introduction

On December 27, 2013, the Securities and Exchange Commission (“Commission”) adopted amendments to rule 5b-3 and Forms N-1A, N-2, and N-3 under the Investment Company Act of 1940 to: (1) replace the reference to credit ratings in rule 5b-3 with an alternative standard designed to retain a similar degree of credit quality to that in current rule 5b-3; and (2) eliminate in the Forms the required use of nationally recognized statistical rating organizations (“NRSROs”) credit ratings when a fund chooses to depict its portfolio holdings by credit quality. The amendments are designed to implement a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act and effectuate Congressional intent to reduce reliance on NRSRO credit ratings.  Investment companies (or “funds”) that rely on rule 5b-3 and funds that prepare shareholder reports in accordance with the instructions contained in Forms N-1A, N-2, and N-3 will be required to comply with the amended rule and forms beginning on July 7, 2014.

Amendment to Rule 5b-3 under the Investment Company Act

Rule 5b-3 allows a fund to look through repurchase agreements to the underlying collateral securities for certain counterparty limitation and diversification purposes if the collateral meets certain credit quality standards.  One of the former rule’s conditions was that, in order to use the look through provision, the collateral securities (other than government securities) must have received the highest credit rating from an NRSRO (or be unrated securities of comparable quality).  The amendment to rule 5b-3 replaces this reference to NRSRO credit ratings with a requirement that the fund’s board of directors (or its delegate) determine that non-governmental collateral securities be issued by an issuer that has an exceptionally strong capacity to meet its financial obligations and are highly liquid.  The replacement standard is designed to retain a similar degree of credit quality to that in current rule 5b-3. 

Amendments to Forms N-1A, N-2, and N-3 under the Investment Company Act and Securities Act of 1933

Forms N-1A, N-2, and N-3 require shareholder reports to include a table, chart or graph depicting portfolio holdings by reasonably identifiable categories, such as industry sector, geographic region or credit quality.  The pre-amended forms required, if credit quality was used, that credit quality be depicted using credit ratings from a single NRSRO.  The amended forms no longer require the use of credit ratings by funds that choose to use credit quality categorizations in the table, chart or graph.  In addition, funds that choose to use credit ratings may use credit ratings from more than one credit rating agency (e.g., split-rated securities).  Funds must also describe in the shareholder report how the credit quality of the portfolio holdings was determined and, if credit ratings are used, describe how they were identified and selected.

Other Resources

The adopting release for the amendments to rule 5b-3 and Forms N-1A, N-2, and N-3 can be found on the Commission’s website at http://www.sec.gov/rules/final/2013/33-9506.pdf.

The text of rule 5b-3 and Forms N-1A, N-2, and N-3 can be accessed through the “Investment Management” section of the Commission’s website at http://www.sec.gov/divisions/investment.shtml.

Contacting the Securities and Exchange Commission

The Commission’s Division of Investment Management is happy to assist small funds with questions regarding the amendments to rule 5b-3 and Forms N-1A, N-2, and N-3.  The Division’s Office of Chief Counsel answers questions submitted by email and telephone.  You can submit a question by e-mail to imocc@sec.gov and a staff member of the office will call you to discuss your question.  You can also contact the Office of Chief Counsel at (202) 551-6825.

¹ This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended.  The guide summarizes and explains rule and form amendments adopted by the SEC, but is not a substitute for any rule or form itself.  Only the rule or form itself can provide complete and definitive information regarding its requirements.