The U.S. Securities and Exchange Commission (SEC) recently adopted amendments (Amendments) to remove references to credit ratings in Rule 2a-7 under the Investment Company Act of 1940, as amended (1940 Act), the primary rule governing registered money market funds.1 In addition, the Amendments revise the issuer diversification requirements under Rule 2a-7, by removing the exclusion that is currently available for securities subject to a guarantee issued by a non-controlled person. As part of the Amendments, the SEC also revised the forms required to be filed by money market funds and provided certain other clarifications. The compliance date for the Amendments is October 14, 2016, although money market funds can begin complying with some or all of the Amendments prior to that date.
This Dechert OnPoint provides background on the Amendments and discusses the changes adopted by the SEC.
The SEC adopted the Amendments in response to requirements set forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). In particular, Section 939A of the Dodd-Frank Act requires federal agencies, including the SEC, to “review any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument and any references to or requirements in such regulations regarding credit ratings.” In response to this requirement of the Dodd-Frank Act, the SEC initially proposed the elimination of credit ratings of nationally recognized statistical rating organizations (NRSROs) from Rule 2a-7 in March 2011 and then re-proposed the rule changes in July 2014. On September 16, 2015, the SEC adopted the Amendments.
The Amendments remove the references in Rule 2a-7 to NRSRO ratings, which described the securities eligible to be held by money market funds – replacing those references with an alternative standard that is intended to “retain a similar degree of credit quality.” Under the Amendments, money market funds will be required to apply a four-pronged test, discussed below, to measure the credit quality of securities eligible to be held by the funds. In a departure from the proposing release for the Amendments, the SEC did not adopt the “exceptionally strong” standard described in the Proposing Release.2
In addition, the Amendments: eliminate an exclusion to the issuer diversification requirements under Rule 2a-7; alter the Rule’s treatment of conditional demand features; and amend the Rule’s monitoring and stress testing requirements.
Removal of Credit Ratings from the Definition of “Eligible Security”
Under Rule 2a-7, a money market fund must limit its investments to securities that qualify as an “eligible security” as defined in the Rule, and which have been determined by the fund’s board to pose “minimal credit risks” to the fund. Historically, Rule 2a-7 defined eligible security (and related terms) by reference to NRSRO ratings. Reliance on such ratings, in one form or another, had been part of Rule 2a-7 since it was originally adopted in 1983.3
The Amendments change the definition of an eligible security to eliminate all references to NRSRO ratings, instead defining the term to mean a security that has a remaining maturity of no more than 397 calendar days, and which has been determined by a money market fund’s board of directors (which may delegate to an entity such as the fund’s investment adviser) to present minimal credit risks to the fund.4
The amended definition requires a fund board (or its delegate) to analyze the ability of the issuer or guarantor of the security to meet its financial obligations and mandates consideration of a series of factors that money market funds traditionally have used to evaluate the creditworthiness of a portfolio security.5 Specifically, the analysis of a security will be required to include the consideration of a number of factors, including the issuer’s or guarantor’s:
- Financial Condition. This should include an examination of recent financial statements of the issuer or guarantor, including consideration of trends relating to cash flow, revenue, expenses, profitability, short-term and total debt service coverage and leverage (including financial and operating leverage).
- Sources of Liquidity. This should include consideration of bank lines of credit and alternative sources of liquidity that would be available to the issuer or guarantor.
- Ability to React to Market-Wide and Issuer- or Guarantor-Specific Events, including the Ability to Repay Debt in a Highly Adverse Situation. This should include an analysis of risks in various scenarios, including changes to the yield curve or spreads in a changing interest rate environment.
- Position within its Industry, as well as Industry Strength within the Economy and Relative to Economic Trends. This should include consideration of diversification of sources of revenue, if applicable.
In addition to the factors described above, which were incorporated into the text of the Rule, the SEC included in the Adopting Release the following asset-specific factors that a board (or its delegate) could evaluate in making determinations regarding minimal credit risk:
- Municipal Securities: (i) the sources of repayment; (ii) issuer demographics (favorable or unfavorable); (iii) the issuer’s autonomy in raising taxes and revenue; (iv) the issuer’s reliance on outside revenue sources, such as revenue from a state or federal government entity; and (v) the strength and stability of the supporting economy.
- Conduit Securities: analysis of the underlying obligor for all securities other than asset-backed securities (including asset-backed commercial paper).
- Asset-Backed Securities (including Asset-Backed Commercial Paper): (i) analysis of the terms of any liquidity or other support provided; and (ii) legal and structural analyses to determine whether the particular asset-backed security presents no more than minimal credit risks for the money market fund.
- Other Structured Securities (such as Variable Rate Demand Notes, Tender Option Bonds, Extendible Bonds or “Step Up” Securities or Other Structures): in addition to analysis of the issuer or obligor’s financial condition, analysis of the protections for the money market fund provided by the legal structure of the security.
- Repurchase Agreements: (i) a financial analysis and assessment of the minimal credit risk of the counterparty; (ii) an assessment as to whether the haircut level is appropriate for the particular type of collateral, based upon price volatility in the market for such collateral type; and (iii) a legal analysis of the protections for the money market fund provided by the terms of the repurchase agreements.
The SEC indicated that the “list of the factors in the [Rule] and the additional factors discussed in [the Adopting Release] as guidance are not meant to be exhaustive, and there may be additional factors that could be relevant depending on the type of security analyzed.”6 The SEC also stated in the Adopting Release that, in determining whether a security presents minimal credit risks, a board (or its delegate) should consider not only the individual risks of the security, but also the overall impact of investing in the security in light of the fund’s other portfolio holdings.
Elimination of the Exclusion for Certain Guarantees from the Issuer Diversification Requirement
Rule 2a-7 requires a money market fund to be diversified, both as to the issuers of the securities it acquires and the providers of guarantees (and demand features) regarding those securities. Money market funds must limit their investments in securities of any issuer to no more than five percent of total assets, other than with respect to government securities and securities subject to a guarantee by a non-controlled person. While Rule 2a-7 has not required money market funds to be diversified with respect to issuers of securities that are subject to a guarantee by a non-controlled person, money market funds currently are prohibited from investing more than 10 percent of their total assets in securities subject to a guarantee or demand feature from any one provider.
Under the Amendments, the SEC removed from the issuer diversification requirement the current exclusion for securities that are subject to a guarantee by a non-controlled person. Accordingly, going forward, a money market fund will be required to limit its investments in securities of a non-governmental issuer to no more than five percent of the fund’s total assets, regardless of whether or not the security is subject to a guarantee by a non-controlled person. The SEC stated its expectation that the impact of this change would be minimal and likely affect only “a small number of all money market funds,” particularly tax-exempt or single-state money market funds.
Amendments to Form M-NFP
As part of reforms made to money market funds in 2010, Form N-MFP was created to provide the SEC with a monthly electronic filing of portfolio holdings from each money market fund. The current Form requires money market funds to provide the name of the designated NRSRO for each portfolio security and the rating assigned to the respective security by the designated NRSRO. The Proposing Release would have revised the Form to require money market funds to provide “each rating assigned by any NRSRO if the fund or its adviser subscribes to the NRSRO’s services” and “any other NRSRO rating that the fund’s board of directors (or its delegate)” took into account, when making its credit risk determination, as well as the name of the respective agency that provided the rating.
In response to comments received on the Proposing Release, the SEC did not adopt the requirement for money market funds to report each rating of an NRSRO to which the fund or its adviser subscribes. However, the SEC did adopt as proposed the requirement that money market funds disclose the NRSRO ratings that the fund’s board (or its delegate) considered, if any, in making its minimal credit risk determination for a security, along with the name of the rating agency that provided the rating. Accordingly, if a money market fund’s board (or its delegate) uses NRSRO credit ratings in determining the minimal credit risk of a security, those ratings will need to be disclosed on Form N-MFP.
Treatment of Conditional Demand Features
Currently, Rule 2a-7 provides that a security subject to a conditional demand feature may be considered an “eligible security” if the conditional demand feature itself is an “eligible security” and the underlying security (or guarantee) received a credit rating within the highest two categories from a NRSRO. Under the Proposing Release, the references to credit ratings would have been eliminated from this requirement and a money market fund’s board (or its delegate) would have been required to determine that the underlying security or its guarantee “[had] a very strong capacity for payment of its financial commitment.”
As a result of comments received on the Proposing Release, the SEC did not adopt this “very strong capacity” standard, instead adopting a “uniform minimal credit risk standard.” Therefore, under the Amendments, a money market fund’s board (or its delegate) must determine that both the conditional demand feature and the underlying security (or guarantee) are eligible securities as defined in the Rule.
Under Rule 2a-7, currently a money market fund’s board (or its delegate) has to promptly reassess whether a security that has been downgraded by an NRSRO continues to present minimal credit risks, and take such action as it determines is in the best interests of the fund and its shareholders. Under the Amendments, as proposed, this requirement has been changed to require the adoption of written procedures that require the money market fund’s adviser to “provide an ongoing review of the credit quality of each portfolio security to determine that the security continues to present minimal credit risks.”7 Although the SEC did not provide a specific requirement with respect to the frequency for the monitoring, it stated that “monitoring efforts should occur on a regular and frequent basis.” The SEC noted that most money market funds engage in daily monitoring of changes in credit quality, and that some even do so on an hourly basis in certain situations, which is in the SEC’s view “consistent with the ongoing monitoring requirement adopted.”
Rule 2a-7 currently requires a money market fund to adopt procedures to conduct periodic stress testing of the fund’s portfolio. These stress tests must assess specific hypothetical events, including a downgrade in the credit rating of a portfolio security or its guarantee. As part of the Amendments, the SEC adopted changes to Rule 2a-7 to replace references to credit rating downgrades in the stress testing provisions with references to an event indicating or evidencing credit deterioration of a particular portfolio security or its guarantee. Accordingly, although money market funds may continue to test their portfolios against possible credit rating downgrades, such Funds must also test securities against “any other indication or evidence of credit deterioration they determine appropriate.”
The Amendments will require revisions and additions to money market fund procedures and will require increased oversight of the process for determining the credit quality of portfolio securities. The Amendments also will impact the diversification requirements under Rule 2a-7. A money market fund will need to be in compliance with the Amendments on or before October 14, 2016, but it can begin complying with the Amendments before such time.