In response to credit rating agencies’ influence on the credit crisis, Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires each federal agency to review its rules and replace provisions that require reliance on credit ratings as an assessment of creditworthiness. To meet this requirement, on September 16, 2015, the Securities and Exchange Commission (SEC) adopted amendments to remove references to credit ratings from Rule 2a-7 under the Investment Company Act of 1940 (the principal rule governing money market funds) and to modify the requirements related to credit rating disclosures on Form N-MFP (the form that money market funds use to report their portfolio holdings each month). At the same time, the SEC adopted amendments to Rule 2a-7 that will remove exclusions from issuer diversification provisions for securities subject to a guarantee issued by a non-controlled person.
Rule 2a-7 Credit Rating Amendments
Existing Rule 2a-7
Prior to the amendments, Rule 2a-7 generally requires each money market fund to invest at least 97 percent of its assets in securities rated in the top short-term credit quality category (referred to as “first tier” securities) by nationally recognized statistical rating organizations (NRSROs), and the remainder of its assets in securities categorized as “second tier” by NRSROs. Under the existing rule, money market funds are permitted to invest in securities that are not rated by NRSROs, but such securities must be of comparable quality. The existing rule requires that a money market fund board or its delegate then reassess whether a security continues to present minimal credit risk promptly after being downgraded by an NRSRO.
Amended Rule 2a-7
Amended Rule 2a-7 will remove all references to NRSROs and instead require a minimal credit risk finding by the fund’s board or delegate based on the capacity of the security’s issuer or guarantor to meet its financial obligations. The adopting release makes it clear that, in making this finding, the overall impact of adding the security to the fund (in light of the fund’s other holdings) should be considered, along with the security’s individual risks.
To facilitate such minimal credit risk findings, amended Rule 2a-7 provides the following list of factors that may be considered in determining the capacity of each security’s issuer, guarantor or provider of a demand feature to meet its financial obligations:
- Financial condition
- Sources of liquidity
- Ability to react to future market-wide and issuer- or guarantor-specific events, including the ability to repay debt in a highly adverse situation
- Strength of the issuer’s or guarantor’s industry within the economy and relative to economic trends, and the issuer’s or guarantor’s competitive position within its industry
The SEC staff recognized that the amount and types of analysis in a minimal credit risk finding will vary based on a variety of circumstances, so amended Rule 2a-7 will afford significant discretion to the board or its delegate in arriving at a minimal risk finding. Amended Rule 2a-7 will also require that the written record of the minimal credit risk determination address any factors considered, along with an analysis of those factors.
Amended Rule 2a-7 avoids specifying a periodic basis for monitoring whether a security continues to present minimal credit risk, but the SEC staff noted that regular and frequent monitoring should occur. The SEC staff indicated that daily, or even hourly, monitoring is consistent with amended Rule 2a-7’s requirements.
Form N-MFP Credit Rating Amendments
Existing Form N-MFP
Under the current rules for Form N-MFP, the information that money market funds must disclose with respect to each portfolio security (and any associated guarantee, demand feature or other enhancement) includes the name of each designated NRSRO for the portfolio security and the rating assigned to the security.
Amended Form N-MFP
The amended rule requires that funds disclose on Form N-MFP any NRSRO rating that the fund’s board or delegate considered in making its minimal credit risk determination for that particular security, as well as the name of the agency providing the rating. The crucial difference between the existing rule and the amended rule is that the amended rule only requires disclosure of NRSRO ratings that were considered by the board or its delegate, instead of disclosing ratings for all securities regardless of whether such ratings were considered.
Rule 2a-7 Issuer Diversification Requirement Amendments
Existing Rule 2a-7
Under the current Rule 2a-7, a money market fund’s portfolio is required to be diversified both as to the issuers of the securities it acquires and the providers of guarantees related to those securities to reduce the impact of any single issuer’s or guarantor’s financial distress on a fund. Money market funds must limit their investments:
- In securities of any one issuer of a first tier security to no more than 5 percent of total assets (5% Issuer Diversification Requirement), except with respect to securities subject to a guarantee by a non-controlled person
Note: If the money market fund is a single-state money market fund, it may instead invest up to 25 percent of its total assets in the securities of any single issuer.
- In securities subject to a guarantee (or demand feature) to no more than 10 percent of total assets from any one provider (10% Guarantee Provider Requirement)
Amended Rule 2a-7
The SEC staff indicated its concern that under the existing Rule 2a-7, a fund could avoid the 5% Issuer Diversification Requirement by investing the entire value of its portfolio in securities issued by the same issuer, as long as such securities were subject to a guarantee by a large enough number of separate providers to avoid violating the 10% Guarantee Provider Requirement. As a result, the amended rule will remove from the 5% Issuer Diversification Requirement the exclusion for securities subject to a guarantee issued by a non-controlled person.
The rule amendments listed above will be effective 30 days after their publication in the Federal Register and the compliance date will be October 14, 2016, which is the compliance date for the floating net asset value, liquidity fee and redemption gate provisions of the 2014 money market fund rule amendments.