At an open meeting on March 2, 2011, the SEC voted unanimously to propose that a money market fund (a fund) would no longer be required to limit its investments to those rated within the top two categories by rating agencies (or to unrated securities of comparable quality). Rather, the fund's board or its delegate would be required to determine whether each security presents minimal credit risks based on "factors pertaining to credit quality" and on "the issuer's ability to meet its short-term financial obligations." The minimal credit risks determination is required under Rule 2a-7 (the Rule) currently, but the only basis for that determination is "factors pertaining to credit quality."1
The SEC proposed the amendments (the Proposals) to the Rule under the Investment Company Act of 1940, as amended (the 1940 Act), to implement Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which became law in July. Section 939A directs the SEC, "to the extent applicable, [to] review any regulation that requires an assessment of creditworthiness," to "modify any such regulations identified by the review" to remove references to or requirements for reliance on ratings, and to substitute a standard of creditworthiness as the SEC determines to be appropriate. This directive addresses the concern that investors and regulators may have relied too heavily on rating agency ratings rather than on independent credit analysis - particularly in light of perceived errors by rating agencies during the financial crisis of 2008, when rating agencies rapidly downgraded highly rated structured investment vehicle securities.
Misgivings; Suggestion That Congress Revisit The Issue
The SEC considered the role of ratings in Rule 2a-7 on three occasions in the past, and each time many industry commentators opposed eliminating the ratings standard from the Rule.2Indeed, at the open meeting at which the SEC approved the Proposals, SEC Commissioner Luis Aguilar expressed misgivings about them and said that Congress should amend the Dodd-Frank Act to eliminate the requirement to remove ratings, and instead require that ratings-based determinations be confirmed by additional risk analysis. He pointed out, as many industry commentators have noted, that the Rule already includes a requirement that each security present "minimal credit risks," as determined by the fund's board, in addition to the credit rating requirement. Accordingly, the rating is a quality floor rather than a safe harbor, and removing the floor "runs counter to the entire philosophy of Rule 2a-7." Further, Commissioner Aguilar stated that the subjective standard that would replace ratings would be difficult to oversee.
At the open meeting, Commissioner Troy Paredes posed pointed questions about the Proposals, including whether funds would attempt to "reach for yield" in the absence of the ratings floor (or, alternatively, become over-conservative in making credit quality determinations on their own). Commissioner Aguilar noted that the SEC's commentary in the proposing release states that money market funds could continue to use their current policies and procedures to comply with the proposed amendments. Commissioner Aguilar observed that the language in the release setting forth the Proposals (the Release) "contemplates that money market funds boards will continue to use credit ratings as currently required[which] is a contradiction on its face and sends fund boards a mixed message." He questioned whether the fund board's role would change appreciably under the Proposals. Each of Commissioner Aguilar and Commissioner Paredes invited those who comment on the Proposals to address his specific inquiries.
Muted enthusiasm for the amendments appears to be reflected in the cost-benefit analysis of the Proposals (which is routinely included in SEC rule proposals and is included in the Release). Among the costs noted in the Release are the "increased risks to money market funds and their shareholders" that may result from a money market fund board (or its delegate) using the proposed subjective standard to "disregard a second tier rating in order to invest a larger portion of the fund's portfolio in lower quality securities that it classifies as first tier securities." In addition, the Release noted that "it could be difficult for the Commission to challenge the determination of a money market fund board (or its delegate) in those circumstances." Among the "benefits" is the anticipation that funds may find a way to incorporate third-party input into credit quality determinations, in spite of the Proposals. Specifically, the analysis states, "Although some money market funds may eliminate the specific use of ratings in their credit risk determinations, we anticipate that many of those funds are likely to consider some outside analyses in evaluating the credit quality of, and minimal credit risks presented by, portfolio securities." (It appears to be faint praise that a "benefit" of the Proposals is that some funds may find a way to work around them.)
Executive Summary Of Some Effects Of The Proposals
The SEC's commentary in the Release indicates that if a money market fund does continue to consider ratings, the adviser may need to do some due diligence regarding the ratings. Specifically, the Release indicates that in order for fund boards to continue to rely on ratings, the SEC would expect the fund advisers to conclude that the ratings are "credible and reliable," 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."
The Proposals would retain the defined terms in the current Rule for "First Tier Security" and "Second Tier Security." Currently such definitions are based predominantly on ratings by rating agencies. (The Rule, as proposed to be amended, would continue to limit the percentage exposure of a fund to second tier holdings.) But rather than requiring that those categories be defined by ratings assigned by rating agencies, the Proposals would now define those categories by whether the fund board or its delegate had determined that the issuer had the "highest capacity to meet its short-term financial obligations." This more subjective criterion for determining the "tier" of a security would be substituted in each of the other provisions of the Rule concerning credit quality that currently is governed by rating categories. The SEC states that this criterion is similar to that articulated by rating agencies. The SEC observed that "an issuer of a first tier security that would satisfy our proposed standard should have an exceptionally strong ability to repay its short-term debt obligations and the lowest expectation of default." The SEC also noted, "The issuer of a second tier security that would satisfy our proposed standard should have a very strong ability to repay its short-term debt obligations, and a very low vulnerability to default."
The Proposals also would revise the provisions of the Rule that require reassessment of whether a portfolio security poses minimal credit risks following a downgrade by substituting a more subjective requirement for reassessment when the board's delegate "becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that may suggest that the security is no longer a First Tier Security or a Second Tier Security." This new, subjective standard appears to expand and complicate the adviser's responsibility to monitor for negative credit information regarding rated securities, as opposed to monitoring for a specific event - a downgrade.
Fund boards typically delegate the day-to-day responsibility for credit quality determinations under the Rule to the investment adviser. The Proposals do not impose any new duties on fund boards that may not be delegated to the investment adviser.3If the Proposals are adopted, however, advisers and boards will need to consider whether their procedures reflect the revised standards and whether reports to the board need to be modified to reflect the revised standards.
In addition to amending the Rule, the Proposals would amend Rule 5b-3 under the 1940 Act to eliminate requirements relating to ratings in the definition of "Collateralized Fully." This definition, in addition to setting forth the criteria for determining how to apply issuer diversification requirements, is used to determine whether a repurchase agreement is Collateralized Fully for purposes of Section 12(d)(3) of the 1940 Act. The particular paragraph that is proposed for revision does not affect diversification testing for money market funds. The revised paragraph, however, introduces a subjective standard for determining whether repurchase agreement collateral, other than cash and U.S. government securities, qualifies the repurchase agreement as collateralized fully for purposes of Section 12(d)(3). The revision to the definition of "Collateralized Fully" is significant because it governs whether a repurchase agreement is considered to be an interest in a repurchase agreement counterparty or an interest in the issuer of the underlying assets for purposes of Section 12(d)(3). If the repurchase agreement is an interest in the counterparty, and the counterparty is a broker, dealer or underwriter, a fund must limit its interest in the repurchase agreement under Section 12(d)(3). If the repurchase agreement is an interest in the issuer of the underlying asset, generally the limits of Section 12(d)(3) do not apply.
Board Designation Of Rating Agencies To Be Put To Rest?
Amendments to Rule 2a-7 that became effective during 2010 included a provision requiring money market fund boards to designate at least four rating agencies as having ratings that are sufficiently reliable as the basis for certain credit quality determinations under the Rule. Boards were to have made this designation and disclosed it in the fund's statement of additional information by December 31, 2010. But the SEC staff has permitted money market funds to delay implementing this requirement, pending the SEC's implementation of the Dodd-Frank Act's directive to eliminate reference to ratings from rules. If the Proposals are adopted, the requirement that boards designate rating agencies will be eliminated from the Rule and will not become effective. Some boards might welcome that result, as it would free them of the task of designating rating agencies as "reliable." If the Proposals are not adopted, the SEC staff presumably will need to set a new compliance date for the requirement that boards designate rating agencies.
Comments; Actions To Comply
Comments on the Proposals are due by April 25, 2011.
If the Proposals are adopted, boards and advisers will need to consider whether they will excise ratings from their credit analysis or continue to consider ratings as an independent third-party viewpoint that may bring to bear expertise not otherwise readily available to each adviser. Funds may need to update their amortized cost and stress-testing procedures, compliance policies and systems, disclosure, and board reporting practices. Advisers may wish to consider whether it is necessary for them to perform additional credit analysis to satisfy the new subjective credit quality standard based on ability to meet short-term financial obligations.
1The definition of "Eligible Security" relating to ratings will be replaced, in relevant part, by a requirement that an "Eligible Security" is one "that the fund's board of directors determines presents minimal credit risk (which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations)."
2The SEC considered the ratings standard in Rule 2a-7 in a 2003 concept release, in a 2008 proposal to remove the ratings standard from Rule 2a-7, and again in proposed amendments to Rule 2a-7 in 2009. See Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws , Investment Company Act Release IC- 26066 (June 4, 2003); References to Ratings of Nationally Recognized Statistical Rating Organizations , Investment Company Act Release IC-28327 (July 1, 2008); and Money Market Reform , Investment Company Act Release IC- 28807 (June 30, 2009).
3In fact, the Proposals eliminate a non-delegable determination that the current Rule requires to be made by the fund board following loss by a portfolio security of status as "minimal credit risk," as described under the caption "Downgrades" in the detailed analysis of the Proposals.
As Of Counsel in Stradley Ronon's investment management/mutual funds practice group, Joan Ohlbaum Swirsky has counseled clients for more than 25 years, including more than 15 years advising investment companies on regulatory compliance and general corporate matters under the Investment Company Act of 1940, with a focus on money market funds and Rule 2a-7. She is the author of The Guide to Rule 2a-7: A Map Through the Maze for the Money Market Professional.