Alert March 08, 2011

SEC Proposes Rules Removing Credit Rating References from Rule 2a-7 and Other Rules and Forms and Establishing Alternative Standards of Credit-Worthiness

The SEC issued proposed amendments and a proposed new rule (the “Proposed Rulemaking”) that removes references to credit ratings in certain rules and forms under the Investment Company Act of 1940 (the “1940 Act”), including Rule 2a-7 governing the operations of money market funds, and establishes alternative standards of credit‑worthiness.  The amendments reflected in the Proposed Rulemaking respond to Section 939A of the Dodd-Frank Act, which requires that each Federal agency, including the SEC, remove from its regulations “any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.”  In light of the role of ratings issued by nationally recognized statistical rating organizations (each, an “NRSRO”) in the regulatory framework applicable to money market funds, the Proposed Rulemaking, if adopted, would involve a fundamental shift in the determination and classification of eligible money market fund investments.

Money Market Funds - Background and Current Role of NRSRO Ratings

A mutual fund that holds itself out as a money market fund must comply with various substantive and procedural requirements set forth in Rule 2a-7 under the 1940 Act.  Among other requirements, Rule 2a-7 limits a money market fund to investing in securities that meet certain credit quality, maturity and liquidity thresholds.  The following is a brief summary of those provisions of Rule 2a-7 that reference NRSRO ratings. 

As a general matter, a money market fund only may acquire a security if the fund’s board (or the board’s delegate, often the fund’s investment adviser) determines that the security “presents minimal credit risks” and, at the time of acquisition, is an “eligible security.”  Rule 2a-7 requires that the minimal credit determination “be based on factors pertaining to credit quality in addition to any ratings assigned to such securities by an NRSRO.”  Moreover, substantially all of a money market fund’s portfolio (i.e., 97%) must be comprised of eligible securities that are classified as “first tier” securities, with the remainder being comprised of “second tier” securities.  Each of these classifications reference NRSRO ratings in its definition.  In addition, an unrated security (i.e., a security that has not been assigned a short-term credit rating by an NRSRO) must be of comparable quality to a rated eligible security.  Thus, NRSRO ratings play a central role in determining whether a security presents minimal credit risks, as well as if the security is an eligible security, and, if so, if the security is a first tier security or a second tier security. 

Existing Rule 2a-7 also requires the board (or its delegate) to reassess whether a portfolio security continues to present minimal credit risks in the event of a downgrade in its credit rating.  In addition, under existing Rule 2a-7, 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 by an NRSRO.

Proposed Amendments to Rule 2a-7 and Form N-MFP

Under the Proposed Rulemaking, references to NRSRO ratings would be removed from Rule 2a-7 in favor of “alternative standards of credit-worthiness designed to appropriately achieve the same purposes as the ratings requirements.”  This would impact (i) the determination of “eligible securities” under Rule 2a-7 and whether such securities are characterized as first tier securities or second tier securities, (ii) credit quality standards for securities with a conditional demand feature, (iii) monitoring requirements in connection with NRSRO ratings downgrades and (iv) the new “stress testing” requirements that were added to Rule 2a-7 as part of the 2010 amendments to money market fund regulations (as outlined in the March 5, 2010 Alert). 

Specifically, the Proposed Rulemaking would eliminate the requirement that an “eligible security” be rated by an NRSRO in one of the top two categories (or, in the case of unrated securities, be of comparable quality) while maintaining the first tier and second tier structure and the related aggregate holdings limitations set forth in existing Rule 2a-7.  Under the Proposed Rulemaking, an eligible security would be categorized as a first tier security if the issuer has the “highest capacity to meet its short-term financial obligations.”  A security would be a second tier security if it is an eligible security but is not a first tier security.  As a separate, but related, matter, the board (or its delegate) would still be required to determine that an eligible security 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.  Under the Proposed Rulemaking, however, the rule would no longer require the board (or its delegate) to reassess whether a security continues to present minimal credit risks following a downgrade in credit rating; rather, the board (or its delegate) would be required to reassess whether the security continues to present minimal credit risks if it becomes aware of any credible information regarding the security or its issuer suggesting that the security is no longer a first tier security or a second tier security, as the case may be.  An NRSRO rating downgrade could require the board (or its delegate) to engage in such a reassessment, but the Proposed Rulemaking would remove any objective standard in this regard.

In addition, the Proposed Rulemaking would replace references to NRSRO ratings with respect to conditional demand features with a requirement that a board (or its delegate) determine that the underlying security is of high quality and subject to low credit risk.  The Proposed Rulemaking would also remove references to NRSRO ratings from the “stress test” requirements, replacing them with a standard that the adviser stress test for hypothetical events that could have a detrimental impact on a money market fund’s portfolio.  Furthermore, the Proposed Rulemaking would remove references to NRSRO ratings from Form N-MFP.

Proposed Amendments to Rule 5b-3 and 1940 Act Forms and Proposed Rule 6a-5

In addition to their impact on money market fund regulations, the Proposed Rulemaking would remove references to credit ratings in other 1940 Act rules and forms.  Under existing Rule 5b-3, a fund may treat a repurchase agreement as an acquisition of the securities collateralizing such repurchase agreement under certain conditions, including the condition that the repurchase agreement is “collateralized fully.”  Under the existing rule, for the repurchase agreement to be “collateralized fully”, among other things, the underlying securities must consist of: (i) cash items; (ii) government securities; (iii) securities that have received the highest rating category by the “requisite NRSROs”; or (iv) unrated securities that are of comparable quality.  The Proposed Rulemaking would replace the requirement that collateral other than cash or government securities be rated in the highest category by the requisite NRSROs with a requirement that the collateral consist of securities that the board (or its delegate) determines at the time the repurchase agreement is entered into are: “(i) issued by an issuer that has the highest capacity to meet its financial obligations; and (ii) sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days.”  The Proposed Rulemaking would also remove references to NRSRO ratings from Forms N-1A, N-2 and N-3.

Finally, under the Proposed Rulemaking, new Rule 6a-5 would be adopted.  Under Rule 6a‑5, a “business and industrial development company” (“BIDCO”) relying on the statutory exemption from various provisions of the 1940 Act could purchase debt securities issued by investment companies and private funds if such BIDCO’s board (or its delegate) determines, at the time of purchase, that the security meets specific credit risk and liquidity criteria (which would replace existing references to “investment grade” ratings by a credit rating agency in Section 6(a)(5) of the 1940 Act).

Comments on the Proposed Rulemaking must be received on or before April 25, 2011.