March 2, 2011

As FD went to press, the Securities and Exchange Commission voted to issue a proposal to eliminate credit rating references from Rule 2a-7, which governs money market funds, and to replace them with alternative criteria. Under the new proposal, a fund board or its delegate would determine that the issuer has the “highest capacity to meet its short-term financial obligations” in order for a security to be an eligible investment and a rating would no longer be required when determining in which securities money market funds can invest.

Under the current rule, money market funds must invest in securities rated in the two highest tiers and the fund’s board or its delegate must determine that every security a money market fund purchases presents minimal credit risks, regardless of the rating. The SEC is weighing this proposal now after being mandated by the Dodd-Frank Act to remove references to credit ratings in its regulations.

“In 2008, a similar proposal was put out for comment that was roundly disapproved in the industry,” said Joan Ohlbaum Swirsky, of counsel at Stradley Ronon. She added that this proposal will most likely be opposed by the industry as well. “Dodd-Frank is trying to move away from reliance on ratings but Rule 2a-7 is really a different case because there isn’t a reliance on ratings alone,” she said.

Under the 2008 proposal, the SEC sought to require boards overseeing money market funds to determine that each security presents minimal credit risk without expressly using credit ratings, leaving boards to determine whether a security is eligible based on factors relating to the issuer’s ability to meet its short-term financial obligations (FD, August 2008).

Commissioner Luis Aguilar, although eventually voting in favor of the proposal to give a chance for industry comments, also raised concerns because of what he called a lack of an appropriate substitute and the implementation costs outweighing the benefits of the proposal. He further asked Congress to reconsider its “blanket ban” on credit rating references and suggested instead that ratings-based determinations be confirmed by additional risk analysis.

Swirsky noted that boards might feel more vulnerable to an advisor chasing yield under the new proposal because there is no longer a floor provided by the credit ratings and that boards will want to know what criteria the advisor is using under the new credit standard.