SEC Approves Amendments Limiting Use of Credit Ratings

The Securities and Exchange Commission finalized amendments to Regulation M on Wednesday by a unanimous vote. The amendments will remove references to credit ratings and ratings agencies from the definition of what are “investment grade” securities.

Regulation M is designed to prevent issuers and underwriters from performing certain actions that could manipulate the price of a security in which they have an interest. Amy Caiazza, a partner in the Wilson Sonsini law firm, says that, as an example, a firm underwriting an IPO cannot buy and sell its own securities at the same time in order to create a market.

The regulation contains an exemption for investment-grade securities. Caiazza explains that they are exempt because they have such a low risk of default and, therefore, less risk of market manipulation. Under the previous rule, in order to qualify as investment grade for this purpose, a security must be rated as such by a credit rating agency.

Under the new rules, instead of a credit rating, issuers have to use alternative models of credit worthiness using a structural risk model designed to calculate the risk of default, as outlined in the final rule.

The rule removes references to credit ratings for “nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities and substitute(s) in their place new exceptions that are based on alternative standards of creditworthiness.”

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The finalized amendments are a long time coming: The reforms stem from the Dodd–Frank Wall Street Reform and Consumer Protection Act, enacted in 2010 following the financial crisis of 2008, that ordered the SEC to remove credit ratings from its rules, including the criteria for investment grade products, says Caiazza. Carlo di Florio, the global advisory leader at compliance advisory firm ACA Group, explains that after the financial crisis, credit ratings agencies were seen as having a conflict of interest and would “stamp things AAA when they were junk in order to get more business,” and “Congress wanted to send a strong signal.”

The final rule has a compliance date of 60 days after its entry into the Federal Register. Di Florio says this should not be a huge lift because Dodd-Frank was in 2010, and so many firms have already been moving away from ratings and toward internal credit worthiness models.

Tags: credit rating, credit rating agencies, Dodd-Frank, investment grade, SEC

Private debt is burgeoning, reaching $1.3 trillion in 2022, up from $230 billion in 2008, and Moody’s Investors Service estimates the alternative asset class will hit $2 trillion in 2027. Public pensions are big contributors to the boom, and the latest entrant is San Diego’s.

The San Diego City Employees’ Retirement System exemplifies the trend: At the May meeting of its board of administration, the plan committed to increasing its allocation to private credit to 5% of its $10 billion-plus portfolio, from nothing before.

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The move is part of a rejiggering of the SDCERS’s asset allocation under CIO Carina Coleman, who assumed the plan’s investing helm last year. “Timing is particularly attractive with this asset class,” she told the board. Private debt has particularly lush payouts, often yielding 10% to 12% annually, she said. Plus it carries less risk than stocks and offers firm covenants to protect the new debt holdings, Coleman said.

By a 4 to 1 vote, the board approved the new asset allocation, which includes trimming its equities position to 36% from 39%. The money from the reduction in stocks will mostly go toward private credit, she explained, adding, “This diversifies our equity risk.”

Private debt is increasingly in vogue among investors, according to a March survey from Preqin: 44% of respondents indicated they would invest in private credit over the next year, with 40% saying they would stand pat and only 16% intending to reduce their allocation. Further, 37% expect private debt to perform better in 2023 than it did in 2022, exceeded only by hedge funds (38%).

Coleman noted that San Diego was joining other California pension funds in moving into private debt. The nation’s two largest public pension plans, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, have a 5% and a 2% allocation target, respectively, for private debt.