The SEC recently (Mar. 2, 2011) proposed rule amendments (PDF) to remove references to credit ratings in rules and forms under the Investment Company Act of 1940. The SEC announced the rule amendments in furtherance of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Specifically, the Dodd-Frank Act requires federal agencies to review rules that use credit ratings as an assessment of creditworthiness and to replace those credit-rating preferences with other appropriate standards in an effort to eliminate the over-reliance on credit ratings by both regulators and investors.

The rule proposal would amend Rule 2a-7 by eliminating a minimum credit rating as a required element in determining which securities are permissible investments for a money market fund. In its place, the proposed amendment empowers the money market fund’s board (or its delegate) to make the determination regarding whether a security presents minimal credit risks and thus constitutes an eligible security for the fund. Consistent with the current rule, money market funds will be required to invest at least 97% of their assets in securities that the board has determined present minimal credit risks from issuers with the highest capacity to meet their short term financial obligations.

The rule proposal also would remove credit ratings in three other areas: repurchase agreements (Rule 5b-3); certain business and industrial development company (BIDCO) investments (New Rule 6a-5); and shareholder reports (Forms N-1A, N-2 and N-3).

Comments to the proposed amendments must be submitted by Apr. 25, 2011.

OUR TAKE: Similar to other efforts by the SEC to amend its rules in order to comply with the Dodd-Frank Act, these proposed rules address the perceived complacency of both regulators and investors in accepting the ratings provided by credit rating organizations as a substitute for more thorough evaluations. By providing boards with a subjective measure of the creditworthiness of a security as opposed to an objective one that relies on the determination of a credit rating organization, boards should better understand the securities in which their fund invests and the risks that such securities present.