On September 16, 2015, the SEC adopted amendments to remove references to credit ratings from Rule 2a-7 and eliminate an exclusion from Rule 2a-7’s issuer diversification provisions. The amendment removing credit rating references implements a requirement of the Dodd-Frank Act, which directed each federal agency, including the SEC, to review its rules and replace any reference to or requirement of reliance on credit ratings with a standard of credit-worthiness that the agency determines is appropriate for its regulations.
Determination of Eligible Securities
Currently, Rule 2a-7 requires money market funds to limit portfolio investments to securities that are “eligible securities,” as defined generally by reference to credit ratings provided by “nationally recognized statistical rating organizations” (each, an “NRSRO”), and that have been determined by the fund’s board (or its delegate) to pose “minimal credit risks” to the fund. Since minimal credit risk is not defined in Rule 2a-7, the money market fund industry has relied on SEC staff guidance regarding the credit quality factors that may be used to determine that a security presents minimal credit risks.
As amended, Rule 2a-7 codifies this guidance and adopts a revised standard for eligible securities requiring a single uniform minimal credit risk finding. Consequently, in making its minimal credit risk determinations, a money market fund’s board (or its delegate) will be required to consider “the capacity of each security’s issuer, guarantor, or provider of a demand feature, to meet its financial obligations, and in doing so, consider, to the extent appropriate, the following factors: (1) financial condition; (2) sources of liquidity; (3) ability to react to future market-wide and issuer- or guarantor-specific events, including ability to repay debt in a highly adverse situation; and (4) strength of the issuer or guarantor’s industry within the economy and relative to economic trends, and issuer or guarantor’s competitive position within its industry.”
The adopting release advises that the financial condition factor generally should include examination of recent financial statements, including consideration of trends relating to cash flow, revenue, expenses, profitability, short-term and total debt service coverage, and leverage. As to sources of liquidity, bank lines of credit and alternative sources of liquidity should be considered. The third factor, involving marketwide events, generally should include analysis of risk from “various scenarios, including changes to the yield curve or spreads, especially in a changing interest rate environment.” The fourth factor, the competitive position of the firm and its industry, generally should include “consideration of diversification of sources of revenue, if applicable.” Finally, the adopting release adds that a minimal credit risk evaluation also may include “consideration of whether the price and/or yield of the security itself is similar to that of other securities in the fund’s portfolio.”
Monitoring Minimal Credit Risks
Rule 2a-7 currently requires a money market fund board (or its delegate) to promptly reassess whether a security that has been downgraded by an NRSRO continues to present minimal credit risks. As amended, Rule 2a-7 will require a money market fund to adopt written procedures requiring the fund’s adviser to provide ongoing review of each portfolio security to determine that the issuer continues to present minimal credit risks.
The SEC adopted a conforming change to the recordkeeping requirements under Rule 2a-7 to reflect that funds must retain a written record of the determination that a portfolio security is an eligible security, including the determination that it presents minimal credit risks, at the time the fund acquires the security, or at such later times (or upon such events) that the fund’s board determines the investment adviser must reassess whether the security presents minimal credit risks.
Exclusion from the Issuer Diversification Requirement
Under current Rule 2a-7, a money market fund’s portfolio must be diversified both as to the issuers of the securities it acquires and providers of guarantees (and demand features) related to those securities. Generally, money market funds must limit their investments in the securities of any one issuer of a “first tier security” to no more than 5% of total assets, other than with respect to government securities and securities subject to a guarantee by a non-controlled person. Thus, Rule 2a-7 currently does not require a money market fund to be diversified with respect to issuers of securities that are subject to a guarantee by a non-controlled person. The Rule amendments adopted by the SEC eliminate the current exclusion to the issuer diversification requirement for such securities.
The effective date of the Rule amendments is October 26, 2015. The compliance date is October 14, 2016. The adopting release is available at: http://www.sec.gov/rules/final/2015/ic-31828.pdf.