At an open meeting held on June 25, 2008, the SEC unanimously voted to propose changes to Rule 2a-7 relating to the use of ratings issued by nationally recognized statistical rating organizations ("NRSROs"). Money market funds subject to Rule 2a-7 under the Investment Company Act of 1940 ("1940 Act") currently hold approximately $3.7 trillion of investor assets.
In a prepared statement, Buddy Donohue, Director of the Division of Investment Management, noted that while the use made of NRSRO ratings in SEC rules is "laudatory . . . the trust and confidence that the industry and investors place in those ratings may be misplaced."
For funds that hold themselves out as money market funds, Rule 2a-7 uses credit ratings to ensure quality controls. Currently, Rule 2a-7 limits money market fund portfolio investments to securities that have received credit ratings from the "Requisite NRSROs" in one of the two highest short-term rating categories or comparable unrated securities.
The proposed amendments to Rule 2a-7 would eliminate the reference to credit ratings in the rule and instead would require what Mr. Donohue referred to as a "subjective" determination of the quality of the instruments at issue. Specifically, the proposed amendments would require an investment company or investment adviser to make a determination that securities, which under the current rule would be required to carry particular credit ratings, present "minimal credit risks and are sufficiently liquid so that they may be sold at or near their carrying value within a short period of time."
The proposed amendments to Rule 2a-7 would:
- require money market funds to make a determination that each portfolio instrument presents minimal credit risks, and whether the security is a "First Tier Security" or a "Second Tier Security" for purposes of the rule;
- require a money market fund to hold securities that are sufficiently liquid to meet reasonably foreseeable redemptions in light of the fund's obligations under Section 22(e) of the 1940 Act and any commitments the fund has made to shareholders;
- revise Rule 2a-7's downgrade and default provisions so that in the event the money market fund's investment adviser becomes aware of any information about a portfolio security or an issuer of a portfolio security that suggests that the security may not continue to present minimal credit risks, the money market fund's board of directors would have to reassess promptly whether the portfolio security continues to present minimal credit risks; and
- require money market funds to provide prompt notice to the Commission when an affiliate of the money market fund (or its promoter or principal underwriter) purchases from the fund a security that is no longer an Eligible Security, pursuant to Rule 17a-9 under the 1940 Act.
The SEC also voted to propose changes to two other rules under the 1940 Act and one rule under the Investment Advisers Act of 1940 to eliminate references to credit ratings and to require a substantive determination of quality. These rules include 1940 Act Rule 5b-3 (Acquisition of Repurchase Agreement or Refunded Security Treated as Acquisition of Underlying Securities), 1940 Act Rule 10f-3 (Exemption for the Acquisition of Securities During the Existence of an Underwriting or Selling Syndicate) and Investment Advisers Act Rule 206(3)-3T (Temporary Rule for Principal Trades With Certain Advisory Clients). In addition, the SEC proposed to amend 1940 Act Rule 3a-7 (Issuers of Asset Backed Securities) to limit the type of investors that may participate in offerings of securities of structured finance vehicles to accredited investors and qualified institutional buyers "to make the rule consistent marketing practices relating to those vehicles."
The SEC anticipates that it will receive many comments on the proposal.
PRELIMINARY OBSERVATIONS ON PROPOSED CHANGES TO RULE 2a-7
The SEC is proposing the changes to Rule 2a-7 as a result of the current sub-prime situation that has raised questions about the processes of NRSROs.
The proposed changes could increase expenses for fund investment advisers who will have to make a so-called "subjective" determination of the quality of portfolio money market instruments, rather than rely on the "objective" determinations made by NRSROs. On the other hand, investment advisers, in making subjective determinations, would be able to take into account of, among other factors, the quality ratings determined by NRSROs.
There was no discussion of whether the proposed changes could lead to higher investment advisory fees. However, an SEC staff member, who was involved in recommending the proposed changes, said afterwards that this was "a good question."
The proposed changes also could place an increased workload on fund directors. Fund directors will have an increased oversight responsibility in monitoring the quality determinations that investment advisers make regarding the quality of portfolio money market instruments.
Copies of the proposed rule amendments were not made available at yesterday's meeting, so this description is based on oral remarks made at the meeting. The SEC release proposing the amended rules is anticipated to be published on the SEC website within one week. We will provide our clients and friends a thorough review once the proposed amended rules are published.