The Securities and Exchange Commission (SEC) recently proposed rule amendments that would eliminate references to credit ratings in Rules 2a-7 and 5b-3 under the Investment Company Act of 1940. Rule 2a-7 governs money market funds and Rule 5b-3 provides a look-through to certain repurchase agreements for purposes of meeting diversification requirements. The SEC reviewed these rules in response to the requirement of the Dodd- Frank Wall Street Reform and Consumer Protection Act that agencies review rules that use credit ratings as an assessment of creditworthiness, and replace those credit-rating references with other appropriate standards. In 2008, the Commission had proposed to similarly eliminate references to credit ratings in Rule 2a-7. That proposal was not adopted.

Rule 2a-7

Under current regulations, money market funds can invest only in securities that are “eligible securities” – either first tier (securities that have received the highest short-term ratings from requisite Nationally Recognized Securities Rating Organizations (NRSROs)) or second tier (securities have received the second highest short-term ratings from requisite NRSROs). Additionally, a money market fund can invest only in securities that the fund’s board of directors, or its delegate (usually the fund’s adviser), determines has minimal credit risks. This determination must be based on factors in addition to ratings assigned by an NRSRO.  

The SEC’s rule proposal would eliminate the objective standard provided by credit ratings in the definition of “eligible security” and “first tier” security and instead require a subjective determination of both eligible securities and first tier securities.  

Eligible Security. As proposed, an eligible security would be a security that the money market fund’s board of directors, or its delegate, determines presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer’s ability to meet its short-term financial obligations. This determination is similar to that which a money market fund’s board or delegate is currently required to make (which must be based on factors in addition to NRSRO ratings). Unlike the determination currently required to be made, the SEC makes clear in its proposing release that a fund board or its delegate, in making its determination of whether a security presents minimal credit risks, would be able to consider quality determinations prepared by outside sources, including NRSRO ratings, for purposes of determining eligible securities. However, the SEC explained that it would expect fund advisers to understand the method for determining the rating and make an independent judgment of credit risks, and to consider an outside source’s record with respect to evaluating the types of securities in which the fund invests.  

First Tier Security. A security would be a first tier security if the fund’s board or its delegate determines that the issuer (or in the case of a security subject to a guarantee, the guarantor) has the “highest capacity to meet its short-term financial obligations.” The SEC’s proposing release notes that an issuer of a first tier security should have an “exceptionally strong ability” to repay its short-term debt obligations and the lowest expectation of default.

Second Tier Security. A security would be a second tier if it is an eligible security but not a first tier security. The SEC differentiates a second tier security as a security that would have a “very strong ability” to repay its short-term debt and a very low vulnerability to default. The limitation on investment in second tier securities is unchanged at 3 percent of the fund’s assets.  

Downgrades. Currently, a money market fund’s board or its delegate must promptly reassess whether a security whose credit rating has been downgraded continues to present minimal credit risks. Under the SEC’s rule proposal, if the fund’s adviser becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier security or a second tier security, as the case may be, the board or its delegate would be required to reassess promptly whether the portfolio security continues to present minimal credit risks. The SEC expects that an investment adviser would be required to exercise reasonable diligence in keeping up with new information about a portfolio security that the adviser believes is credible.  

The SEC also proposed to eliminate references to credit ratings in several other places in Rule 2a-7.  

Conditional Demand Features. The rule proposal would eliminate the credit rating requirement for securities with a conditional demand feature. A money market fund would be able to invest in a security subject to a conditional demand feature only if, among other things, the fund’s board or its delegate had determined that the underlying security is of high quality and subject to very low credit risk. A fund board or its delegate could continue to rely on analyses provided by third parties, including ratings provided by ratings agencies, if it concluded the ratings were credible and reliable for such purposes.

Stress Testing. Money market funds would be required to stress test for an adverse change in the ability of a portfolio security issuer to meet its short-term financial obligations. The SEC’s release states that under the proposed rule, funds could continue to test their portfolios by treating a downgrade as a credit event that might adversely affect the value or liquidity of the portfolio security.  

The Commission also proposed to eliminate required disclosure of credit ratings in Form N-MFP and remove the requirement that credit ratings be used when showing credit quality in shareholder reports and fund registration forms.  

Criticisms of Proposed Rule Amendments. Although the proposed amendments were approved by the SEC by unanimous vote, some of the SEC commissioners expressed concerns. For example, SEC Commissioner Luis Aguilar said in his remarks at the SEC open meeting that he had “serious misgivings because it appears that no appropriate substitute has been identified” for credit ratings. Another criticism made by him and others is that, under the proposed amendments, money market funds could invest in riskier securities to increase returns because they could disregard credit ratings and instead rely on a subjective determination of creditworthiness. Commissioner Aguilar stated subjective determinations would be more difficult for regulators to oversee. On the other hand, some have criticized the SEC’s proposal because it would make no practical difference in how money market funds invest because funds would still be able to consider credit ratings.

Rule 5b-3

Repurchase Agreements. Funds currently can rely on Rule 5b-3 to look through repurchase agreements for diversification purposes to the securities collateralizing the agreements if, among other things, the collateral securities have received the highest credit rating, are unrated securities of comparable quality, or are government securities. Under the proposed amendment, a fund would be able to look though repurchase agreements to the underlying collateral only if the fund’s board or its delegate determines that any non-governmental collateral securities are issued by an issuer that has the highest capacity to meet its financial obligations and are sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days. This proposal does not affect money market funds because money market funds can only look through repurchase agreements to the underlying collateral if the underlying collateral is limited to cash items and government securities.

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The SEC has asked for comments on numerous aspects of the proposed rule amendments. Some of the SEC Commissioners also asked for specific comments in their remarks at the SEC open meeting. The deadline for submitting comments is April 25, 2011.