On Wednesday, March 2, 2011, the Securities and Exchange Commission voted unanimously to propose rule amendments that would remove references to credit ratings from Rule 2a-7 and certain other rules and forms under the Investment Company Act of 1940. The proposals, which were made in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act, were not unexpected. The proposals would require investment company boards and advisers to change the way they evaluate securities, even if they have relied less on credit ratings recently.
The proposed rule amendments would eliminate credit ratings as a required element in determining whether a security is a permissible investment for a money market fund and require the fund’s board and/or adviser to make subjective determinations with respect to a security’s credit quality. Fund boards and advisers would still be able to use ratings in assessing a security’s credit quality, provided that boards and advisers “understand the method for determining the rating and make an independent judgment of credit risks, and…consider an outside source’s record with respect to evaluating the types of securities in which the fund invests.” The Commission noted that the proposed rule amendments are designed to offer protections comparable to those provided by credit ratings in the current rules and steer money market funds toward only the highest quality short-term securities, while removing the impression that money market fund securities may be selected solely because of their credit ratings.
The proposed rule amendments are similar to those proposed by the Commission in 2008, which generally were not supported by the industry and were never adopted. Implementation of the proposed rule amendments may have uncertain consequences for funds, issuers and the short-term credit markets. As a result, those that may be affected will want to review the proposals carefully and consider making their views known through the comment process (the Commission requested public comments on the proposed rule amendments by April 25, 2011). In addition, there may be more changes in money market fund regulation yet to come, as the report of the President’s Working Group on Financial Markets, issued on October 21, 2010, left out on the table a number of additional options for money market fund reform.1
Eligible Securities for Money Market Funds
Currently, a money market fund may invest only in securities that have received credit ratings in one of the two highest short-term rating categories or comparable unrated securities (“eligible securities”). Money market funds are required to invest at least 97% of their total assets in “eligible securities” that are “first tier securities” (generally, those securities that have received the highest short-term rating, comparable unrated securities, securities issued by money market mutual funds or government securities) and no more than 3% of their total assets in “eligible securities” that are “second tier securities” (generally, securities that have received the second highest short-term rating). In addition, a money market fund’s board or its delegate (generally, the fund’s adviser) also must determine at the time of purchase that the security presents minimal credit risks, based on factors pertaining to credit quality.
Under the proposed rule amendments, money market funds still would be required to invest at least 97% of their total assets in “eligible securities” that are “first tier securities,” and no more than 3% of their total assets in “eligible securities” that are “second tier securities,” and the fund’s board or its delegate still would be required to assess the credit quality of each portfolio security and determine that the security presents minimal credit risks. However, the determination that a security presents minimal credit risks would have to be based on factors pertaining to credit quality and the issuer’s ability to meet its short-term financial obligations. In addition, a security would be a “first tier security” if the board or its delegate has determined that the security’s issuer has the “highest capacity to meet its short-term financial obligations” (a security would continue to be a “first tier security” if the security is issued by a money market mutual fund or is a government security). A security would be a “second tier security” if the board or its delegate has determined that, although it does not meet the criteria for a “first tier security,” the security presents minimal credit risks.
While determining the eligibility of securities for purchase by a money market fund is and would remain a responsibility of the fund’s board or its delegate, issuers (including asset-backed issuers) would have somewhat less certainty that their securities will be accepted by funds as “first tier securities,” given the replacement of an objective criterion of the highest short-term rating with a more subjective requirement that the fund’s board or its delegate determine that the issuer has the “highest capacity to meet its short-term financial obligations.” A rating in the highest short-term category may still inform such a determination, but it will not be a foregone conclusion, and different funds may make different determinations with regard to the same security.
Securities With a Conditional Demand Feature
The proposed rule amendments also would remove the credit rating requirement from the provision of Rule 2a-7 relating to securities subject to a “conditional demand feature.” A “demand feature” is a feature of a debt security that allows an investor to sell the security back to the issuer or to a third party. A “conditional demand feature” is a “demand feature” that limits an investor’s ability to demand payment for the security under certain circumstances. Currently, Rule 2a-7 provides that a money market fund may invest in a security subject to a “conditional demand feature” only if, among other things, the underlying security has received one of the two highest ratings. Under the proposed rule amendments, the credit rating requirement would be replaced by a requirement that the board or its delegate determine that the underlying security is “of high quality and subject to very low credit risk.”
Monitoring Minimal Credit Risk
The proposed rule amendments also would affect requirements for monitoring securities for ratings downgrades and other credit events. Currently, the board or its delegate is required promptly to reassess whether a security continues to present minimal credit risks if the security’s credit rating has been downgraded. Under the proposed amendments, the adviser would be required to reassess whether a security continues to present minimal credit risks if the adviser becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a “first tier security” or “second tier security,” as the case may be.
Stress Testing
The proposed rule amendments also would affect stress testing. Currently, money market funds are required to test the fund’s ability to maintain a stable net asset value per share based on certain hypothetical events, including a downgrade of portfolio securities. This reference to ratings downgrades would be replaced with a requirement to stress test for an adverse change in the ability of a portfolio security issuer to meet its short-term financial obligations.
Form N-MFP and Shareholder Reports
The Commission also proposed amendments to Form N-MFP, the form used by money market funds to report their portfolio holdings to the Commission each month, in order to eliminate items requiring disclosure of the ratings of the securities in the portfolio. Amendments to Forms N-1A, N-2 and N-3 to eliminate required disclosure of credit ratings in shareholder reports also were proposed.
Securities Collateralizing Repurchase Agreements
In addition to the proposals specifically affecting money market funds, the Commission also proposed amendments to Rule 5b-3 under the Investment Company Act that would remove references to credit ratings with respect to securities collateralizing repurchase agreements. Currently, funds seeking to meet certain diversification requirements under the Investment Company Act are permitted to “look through” to the value and liquidity of the securities that collateralize a repurchase agreement rather than looking to the creditworthiness of the counterparty to the agreement if, among other things, the collateral securities have received the highest credit rating (or are unrated securities of comparable quality), or are government securities. Under the proposed rule amendments, the board or its delegate instead would be required to determine that non-governmental collateral securities are issued by an issuer that has the highest capacity to meet its financial obligations and are highly liquid.
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The proposed elimination of credit ratings from Rule 2a-7 and Rule 5b-3 will change the way money market fund boards and advisers evaluate securities, and increase the sizable burden fund boards and advisers already bear. If the rule amendments are adopted in the proposed form, fund boards and advisers will need to look closely at their policies and procedures, and tailor them to comply with the proposed requirements.
For assistance, please contact any of the following lawyers:
Reed D. Auerbach, Partner, Structured Transactions
reed.auerbach@bingham.com, 212.705.7400
Lea Anne Copenhefer, Partner, Investment Management
leaanne.copenhefer@bingham.com, 617.951.8515, 213.680.6592
Barry N. Hurwitz, Partner, Investment Management
barry.hurwitz@bingham.com, 617.951.8267
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services
roger.joseph@bingham.com, 617-951-8247
Charles A. Sweet, Partner, Corporate M&A and Securities
charles.sweet@bingham.com, 202.373.6777
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
This article was originally published by Bingham McCutchen LLP.