July 23, 2010

The new Dodd-Frank reform law touches virtually every corner of the financial landscape, and money market funds are not excluded.

The regulation, which was signed into law Wednesday by President Barack Obama, mandates the elimination of references to credit ratings in numerous securities laws, including the Investment Company Act of 1940.

It also will require the Securities and Exchange Commission and other governmental agencies to establish alternative standards for determining creditworthiness, rather than relying on ratings provided by credit rating agencies. The agencies have one year to complete what many see as a rather daunting task.

Under current regulation, money funds must adhere to a two-part test in order to determine whether they can purchase a given security. The security must be within the top two rating categories, or, if the security isn’t rated, it must be deemed of comparable quality. Separately, the fund must determine that the security represents a minimal credit risk, independent of credit ratings.

Ratings represent a “floor” in terms of the creditworthiness of a security, says Joan Ohblaum Swirsky, of counsel at Stradley Ronon. They are not a substitute for an independent credit analysis of securities by fund advisors, she says.

Yet, while funds are not required to buy securities that are rated or to rely on credit ratings (other than as a floor), there’s a strong preference within the industry for using them. In fact, when the SEC requested comment last year on whether it should eliminate or alter the use of credit ratings for Rule 2a-7, which governs money funds, the industry vehemently objected.

The use of credit ratings validates the advisor’s judgment that a security represents minimal credit risk and also helps ensure that it’s a liquid security, says Stephen Keen, partner at Reed Smith.

“The real consequence of this change is the ability of the SEC to enforce Rule 2a-7,” says Keen. “In essence, it deregulates credit risk because the regulator is going to have a harder time making [fund advisors] adhere to a credit standard if you can’t use ratings.”

The big question, Keen says, is how will the SEC express the standard of creditworthiness for securities that money funds hold? What are their alternatives?

Instead of using actual credit ratings, the agency could use the words that the credit rating agencies use to describe the credit ratings.

For example, instead of requiring that money funds purchase securities with the highest credit ratings, the agency could require that the securities have “the highest capacity to honor short-term financial obligations,” Keen says.

“I understand the words,” Keen says, “but in terms of real-life examples of securities, what does this mean?”

The flip side of the coin is that without being able to rely on credit ratings, it may become more difficult for fund firms to defend the purchase of a given security if SEC examiners or even the Division of Enforcement comes calling, says Arthur Delibert, partner at K&L Gates. And that’s especially the case if a portfolio security has suffered problems, he adds.

Delibert also notes that a number of fund firms have left the business altogether, largely due to the difficult rate environment, coupled with a heightened awareness of the potential risks.

“I would think that regulation that makes the whole credit evaluation process more difficult will encourage that move,” he says.

The new law also raises some questions about whether recent SEC amendments to Rule 2a-7 should be delayed or suspended before they go into effect. Specifically, the amendments call for fund boards to designate at least four credit rating agencies (or NRSROs — nationally recognized statistical rating organizations) that can be relied on to determine whether securities can be held by the funds. This goes into effect at the end of December.

“It seems that the SEC should at least delay or suspend the effective date, pending the decision on what will be done to respond to the Dodd-Frank directives [on credit ratings],” says Swirsky.

Regarding the requirement of designating at least four NRSROs, Robert Plaze, associate director of the SEC’s Division of Investment Management, says, “The staff understands the issue and we will provide some guidance to the industry.”

Plaze also notes that while the ink on the statute is barely dry, in the coming year the commission will address interpretive issues arising from it.