The Department of Labor has announced a final notice of amendments to six class exemptions from the prohibited transaction rules in the Employee Retirement Income Security Act and the Internal Revenue Code.
The amendments relate to the use of credit ratings as conditions in these class exemptions. Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the DOL to remove any references to or requirements of reliance on credit ratings from its class exemptions and to substitute standards of creditworthiness as the department determines to be appropriate.
The DOL explains that in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress included provisions designed to reduce federal regulatory reliance on credit ratings, finding that in the financial crisis of 2008, certain credit ratings had been inaccurate, and that they “contributed significantly to the mismanagement of risks by financial institutions and investors, which in turn adversely impacted the health of the economy in the United States and around the world.” The DOL’s review of its class exemptions determined that Prohibited Transaction Exemptions 75-1 Parts III and IV, 80-83, 81-8, 95-60, 97-41 and 2006-16 include references to, or require reliance on, credit ratings.
Each class exemption provides relief for a transaction involving a financial instrument, and in each of them, the DOL conditioned exemptive relief on the financial instrument, or its issuer, receiving a specified minimum credit rating. PTEs 75-1 and 80-83, which provide exemptions for securities transactions with retirement plans and individual retirement accounts, required any non-convertible debt securities involved in a transaction to be rated in “one of the four highest rating categories from a nationally recognized statistical rating organization.” PTE 81-8 required commercial paper sold to plans or IRAs to possess a rating in “one of the three highest rating categories by at least one nationally recognized statistical rating service.” PTE 2006-16, which applies to securities lending transactions, included the following credit ratings requirements applicable to the loan’s collateral: for letters of credit, the issuer must receive a credit rating of at least “investment grade,” while foreign sovereign debt securities must be rated in “one of the two highest rating categories.” PTEs 95-60 and 97-41 do not require specific credit ratings, but instead refer generally to the credit ratings of certain financial instruments.
In 2013, the DOL proposed to amend the PTEs to remove references to and requirements to rely on credit ratings. The DOL proposed to replace the requirement in each of PTE 75-1 Parts III and IV, PTE 80-83 and PTE 2016-06 for a security to be “investment grade” or in one of the four highest rating categories from a nationally recognized statistical rating organizations, or NRSRO, with a new standard requiring the securities to be subject to no greater than moderate credit risk and sufficiently liquid that such securities can be sold at or near their fair market value within a reasonably short period of time. For PTE 81-8, the DOL proposed to substitute “subject to a minimal or low amount of credit risk and sufficiently liquid that such securities can be sold at or near their fair market value within a reasonably short period of time” for a credit rating in one of the three highest rating categories.
PTE 2006-16 required foreign sovereign debt securities for foreign collateral used in securities lending transactions to be rated in one of the two highest categories of at least one NRSRO. The DOL proposed to replace this requirement in PTE 2006-16 Section V(f)(4) with a requirement that the security be “subject to a minimal amount of credit risk and sufficiently liquid that such securities can be sold at or near their fair market value in the ordinary course of business within seven calendar days.”
The DOL says it is adopting the amendments as proposed in 2013, with minor changes to address comments received. It notes that a fiduciary may consider a variety of factors in making a determination of credit quality. “While credit ratings may no longer serve as specific exemption requirements, fiduciaries are not prohibited from using them as an element or data point to analyze credit quality,” the DOL’s notice says. “The Department is not suggesting that fiduciaries consider any specific financial ratios when analyzing credit quality, as suggested by one commenter, but it notes that fiduciaries have broad discretion in evaluating investments and may choose to incorporate financial ratios into their review of investment options.”
The DOL declined to provide a definition of “minimal credit risk,” because, it says, “fiduciaries should be able to determine whether a security satisfies this standard based its analysis of the issuer’s ability to repay its debt obligations.”
The text of the DOL’s notice of amendments to class exemptions is here.