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What You Need to Know About Money Market Fund Reform - Ratings

September 11, 2014
Client Alert

SEC Reproposes Removal of Credit Ratings From Rule 2a-7; Proposes to Tighten Issuer Diversification Requirements and to Provide Relief From Immediate Delivery of Confirmations for Floating Net Asset Value Money Market Funds

On July 23, the U.S. Securities and Exchange Commission (SEC) reproposed amendments (the Reproposal) removing the requirement that a money market fund (a fund) limit its investments to those rated within the top two categories by rating agencies (or to unrated securities of comparable quality).1 In place of that requirement, the fund’s board of directors or its delegate (such as the investment adviser) must determine whether each security presents minimal credit risks. In making that determination, the board of directors or its delegate must find that the security’s issuer has an exceptionally strong capacity to meet its short-term obligations. While the minimal credit risks determination is currently required by Rule 2a-7 (the Rule) under the Investment Company Act of 1940, as amended (the 1940 Act), the only basis for that determination is “factors pertaining to credit quality.” The current limit on securities rated in the second-tier short-term rating category to three percent of the portfolio (1/2 percent in any one second-tier issuer) would be eliminated, as there would be no distinction between first-tier and second-tier securities under the Rule.

The SEC also proposes to tighten issuer diversification requirements and to provide exemptive relief from the requirement that a broker deliver a confirmation immediately following each transaction for floating net asset value funds.

The Reproposal is part of the SEC’s process to implement Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which became law in July 2010. Section 939A directs the SEC, “to the extent applicable, [to] review any regulation that requires an assessment of credit-worthiness,” to “modify any such regulations identified by the review” in order 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.

The release setting forth the Reproposal (the Release) provides guidance regarding some of the factors that a fund may consider in its minimal credit risk determinations, including specific guidance relating to municipal securities, conduit securities, asset-backed securities, other structured securities and repurchase agreements. Click here for a list of these factors.

The Reproposal also revises certain requirements to list ratings on portfolio securities in Form N-MFP, which funds file monthly with the SEC to report portfolio holdings and other information.

Commissioner Expresses Misgivings
The SEC considered the role of ratings in the Rule on four occasions in the past, most recently in 2011 (the 2011 Proposal), and each time many industry commentators opposed eliminating the ratings standard from the Rule.2 Indeed, at the open meeting at which the SEC approved the 2011 Proposal, SEC Commissioner Luis A. Aguilar expressed misgivings about the removal of credit ratings 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,3 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 a subjective standard to replace ratings would be difficult to oversee. Commissioner Aguilar reiterated his doubts when discussing the Reproposal, noting that the amendments could encourage funds to invest in riskier portfolios.

Possible Effects of the Reproposal to Remove References to Ratings
The SEC points out that, in many respects, the practical effects of the Reproposal to remove ratings from the Rule may not be significant. On the other hand, certain aspects of portfolio management may change. Some limited effects and some possible changes are summarized below.

Ratings still important? The Reproposal would eliminate the requirement that a fund determine the credit ratings of portfolio securities (or determine that the quality of an unrated security is comparable to the quality of a security with the requisite ratings). However, boards, advisers and shareholders may continue to consider ratings an important component of credit quality assessment. The SEC says, “we believe that the majority of funds would continue to refer to credit ratings in making minimal credit risk determinations.” In addition, although the Rule will not reference ratings, funds may, in effect, limit themselves to securities rated within the top two short-term tiers, as the SEC says it does not believe that securities rated in the third-highest category for short-term ratings (or comparable unrated securities) would satisfy the reproposed “exceptionally strong capacity” standard in the amended Rule. The SEC says that the new standard “is designed to preserve the current degree of risk limitation in Rule 2a-7.”

Possible change: Due diligence regarding ratings methodologies. The SEC states that in assessing credit risk, a fund adviser could take into account credit quality determinations prepared by outside sources, including rating agencies, that the adviser considers are reliable. If a fund continues to consider ratings, the adviser may need to engage in some due diligence regarding the ratings that some advisers may not have undertaken in the past. Specifically, the SEC states that “[i]n considering such sources [as ratings], an adviser should understand the particular [rating agency]’s methodology for determining the rating at issue and make an independent judgment of credit risks, and it should consider any outside source’s record with respect to evaluating the types of securities in which the fund invests.”

Reassessment on downgrade replaced by “ongoing” monitoring, but current practices may continue? The Reproposal also would revise the provision of the Rule that requires reassessment upon downgrade of a security, by substituting a more general requirement for ongoing review of minimal credit risk. This new requirement is broader than the existing requirement to monitor for a specific event – a downgrade. But the SEC states that it does not believe the changed provision will significantly change current portfolio monitoring practices. The SEC states that “[a]lthough Rule 2a-7 does not explicitly require ongoing monitoring of whether a security presents minimal credit risks, as a practical matter, we believe most fund advisers currently engage in similar types of ongoing monitoring” for several reasons. Specifically, advisers may perform ongoing credit monitoring already because:

  • Funds regularly roll over securities, which triggers the obligation to make a new minimal credit risk determination.
  • The Rule requires funds to reassess whether a security presents minimal credit risks upon the occurrence of certain events.
  • Events such as downgrades can decrease the shadow price of a security.
  • Rated funds may need to monitor downgrades to maintain their own ratings.
  • Shareholders may be more likely to redeem if credit quality of a holding declines.

The SEC says that “as a practical matter, [an adviser’s obligation to monitor risks to which a fund is exposed would] require the adviser to monitor for downgrades by relevant credit rating agencies.” “Relevant” rating agencies are those agencies whose downgrades would likely affect the value of a portfolio security.

Board still involved in certain downgrades? The Reproposal also eliminates the requirement to inform the board regarding ratings on portfolio holdings below second tier. The SEC points out that “one consequence of our proposal would be that a fund adviser could decide to keep a portfolio security that has been downgraded from second tier status without involving the fund’s board in that decision.” However, this change may not have a significant impact on fund practices. The SEC says, “[a]s part of its oversight of the adviser’s investment decisions, however, we would expect that a fund board generally should establish procedures for the adviser to notify the board in such circumstances.”

Stress testing similar? The Reproposal replaces the requirement to stress test for a downgrade or default of portfolio holdings with a requirement to stress test for an event indicating or evidencing credit deterioration of particular portfolio security positions. But the amendment states that a downgrade or default is an example of the type of event that a fund may test for. Accordingly, some funds that stress test for downgrades may continue to do so.

Form N-MFP reporting may be the same for some funds. In 2011, the SEC had proposed to remove from Form N-MFP questions that asked the ratings of portfolio holdings. The Reproposal abandons that approach and instead revises the questions to require disclosure of only those ratings assigned by any rating agency to which the fund or its adviser subscribes and of any other rating that the adviser considered in making its minimal credit risk determination. Accordingly, for some funds the ratings information in Form N-MFP may not be significantly reduced.

Ratings underlying Conditional Demand Features – existing practices may continue? The amendments eliminate the rating requirement for securities that provide a particular type of “put” right, known as a “Conditional Demand Feature.” The requirement that such securities be rated in one of the top two ratings tiers is replaced by a more subjective quality standard. Although the rating standard has been removed, the SEC states that it does not believe that securities rated in the third-highest category for long-term ratings (or comparable unrated securities) would satisfy the proposed subjective standard.

Minimal credit risk factors – advisers may wish to determine whether any changes are necessary. The Reproposal includes a list of some of the factors the adviser may consider in its minimal credit risk determinations, further detailed below in the link titled “Some Factors Which Might Be Included in a Minimal Credit Risk Determinations.” Advisers may want to consider whether their credit procedures cover the appropriate factors on this list.

Actions to Comply
No new nondelegable board duties, though procedures and board reports may change. Fund boards typically delegate the day-to-day responsibility for credit quality determinations under the Rule to the investment adviser. The Reproposal does not impose any new duties on fund boards that may not be delegated to the investment adviser.

If the Reproposal is adopted, several actions will be necessary to comply
:

  • 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.
  • An adviser should take steps to understand the rating agencies’ methodology if the adviser takes ratings into account.
  • Funds may need to update their amortized cost and stress-testing procedures, compliance policies and systems, disclosure, and board reports. Among other things,
    • Funds should ensure they have written policies to keep written records of their minimal credit determination that includes the factors considered and an analysis of such factors.
    • Funds must ensure they have written procedures requiring the fund adviser to undertake ongoing review of the credit quality of each portfolio security to determine that the security continues to present minimal credit risks.
    • Funds may establish procedures for the adviser to notify the board should the adviser decide to keep a portfolio security that has been downgraded from second-tier status.
    • 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.
  • Funds will need to reconsider their reporting of ratings on portfolio securities on Form N-MFP.

To assist you in understanding the proposed changes, we have prepared a marked copy of Rule 2a-7 as it would appear if the proposals are adopted. Click here to view this marked copy.

Comment Due Date
Comments on the Reproposal and Diversification Proposal are due by October 14, 2014.

Board Designation of Rating Agencies Put to Rest
Amendments to the Rule that became effective during 2010 included a provision requiring 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 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.4 If the Reproposal is 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 Reproposal is not adopted, the SEC staff’s suspension of implementation of the designation requirement presumably will remain in effect until the SEC implements Section 939A of the Dodd-Frank Act with respect to Rule 2a-7.

SEC Proposes Amendments to the Issuer Diversification Requirement of the Rule
The July 2014 Money Market Fund Reform included changes relating to the Rule’s diversification provisions,5 including requiring that a fund treat certain entities that are affiliated with each other as single issuers when applying the five percent issuer diversification provision of the Rule and treat sponsors of asset-backed securities as guarantors subject to the 10 percent diversification provisions of the Rule. In the same release as the Reproposal, the SEC proposed a further tightening of the Rule’s diversification testing.

Currently under the Rule, there are two separate diversification tests – one that limits a fund’s exposure to any one issuer of portfolio securities, and another that limits a fund’s exposure to any one provider of credit support on portfolio securities (such as a guarantor). The issuer diversification test generally limits exposure to any one issuer to five percent of the portfolio and exposure to any one guarantor to 10 percent of the portfolio. The rule does not require the first diversification test – the issuer diversification test – to be applied to a security that has a guarantee by a noncontrolled person of the issuer. Such a security is tested only under the second test – the guarantee test. The reason for this exception from testing of the fund’s exposure to the issuer is that the fund may be relying only on the credit quality of the guarantor, rather than the credit quality of the issuer, for a security with a guarantee. If so, exposure to the issuer is less important to risk in the fund. However, the SEC is concerned that this exception may allow a fund to have a portfolio highly concentrated in one issuer.

Accordingly, the proposals would remove the exception to the five percent issuer diversification provision with respect to issuers of securities that are subject to a guarantee by a noncontrolled person (the Diversification Proposal). Accordingly, under the Diversification Proposal, each fund that invests in securities subject to a guarantee would have to comply with both the 10 percent diversification requirement for the guarantor and the five percent diversification requirement for the issuer (the issuer test would apply whether or not the guarantor is a noncontrolled person).

If the Diversification Proposal is adopted:

  • Advisers should review their compliance programs and portfolio management systems to ensure their programs and systems adequately reflect the new diversification requirements.
  • Boards will need to adopt revised amortized cost procedures to reflect the new requirements.

SEC Files Notice of Proposed Exemptive Order Under Rule 10b-10
Rule 10b-10(b) permits broker-dealers to provide transaction information (confirmations) for transactions in stable net asset value money market shares on a monthly basis. On July 23, the SEC also filed a Notice of Proposed Exemptive Order (the Notice) that would permit broker-dealers to continue to rely on the current exception under Rule 10b-10(b) with respect to transactions in floating net asset value fund shares instead of sending immediate confirmations for all purchases and redemptions of shares.6

Comments on the Notice were due by August 19, 2014.

Implementation Timeline
The SEC anticipates that the compliance date for the Reproposal and Diversification Proposal would be April 14, 2016 (18 months after the effective date of the July 2014 Money Market Fund Reform).

If you would like further detail on the Reproposal to remove ratings from Rule 2a-7, click here.

1 See Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule, Investment Company Act Release No. 31184, 79 Fed. Reg. 47986 (proposed July 23, 2014). The SEC also adopted amendments to the Rule on July 23, 2014, as part of its broader money market fund reform (“July 2014 Money Market Fund Reform”). These amendments are discussed in the Fund Alert titled “What You Need to Know About Money Market Fund Reform.”

2 The SEC considered the ratings standard in the Rule in a 2003 concept release, in a 2008 proposal to remove the ratings standard from the Rule, in proposed amendments to the Rule in 2009 and again in proposed amendments to the Rule in 2011. See References to Credit Ratings in Certain Investment Company Act Rules and Forms, Securities Act Release No. 9193, Investment Company Act Release No. 29592, 76 Fed. Reg. 12896 (proposed Mar. 3, 2011); Money Market Reform, Investment Company Act Release No. 28807, 74 Fed. Reg. 32688 (proposed June 30, 2009); References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28327, Advisers Act Release No. 2751, 73 Fed. Reg. 40124 (proposed July 1, 2008); Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws, Investment Company Act Release No. 26066 (June 4, 2003) (concept release).

The 2011 proposal proposed to (i) replace references to credit ratings in the Rule and Rule 5b-3 under the 1940 Act with alternative standards of creditworthiness; (ii) adopt new Rule 6a-5 under the 1940 Act, which would establish a creditworthiness standard (for purchase of certain debt securities by business and industrial development companies) to replace the credit rating reference in Section 6(a)(5) removed by the Dodd-Frank Act; (iii) eliminate required disclosures of credit ratings in Form N-MFP; and (iv) remove the requirement that credit ratings be used when portraying credit quality in shareholder reports from forms N-1A, N-2 and N-3 under the Securities Act of 1933, as amended, and the 1940 Act. The SEC has already adopted certain of these proposals. See Removal of Certain References to Credit Ratings Under the Investment Company Act, Securities Act Release No. 9506, Investment Company Act Release No. 30847, 79 Fed. Reg. 1316 (Dec. 27, 2013) (adopting amendments removing references to credit ratings in Rule 5b-3 and eliminating the required use of credit ratings in forms N-1A, N-2 and N-3); Purchase of Certain Debt Securities by Business and Industrial Development Companies Relying on an Investment Company Act Exemption, Investment Company Act Release No. 30268, 77 Fed. Reg. 70117 (Nov. 19, 2012) (adopting new Rule 6a-5). The remaining proposals are considered in the Reproposal – elimination of certain references to ratings in the Rule and Form N-MFP.

3 The board may delegate the credit quality determination to the investment adviser and typically does so. This Fund Alert refers to duties typically delegated to the adviser as being performed by the adviser rather than by the fund or the fund’s board.

4 See Karrie McMillan, General Counsel, Investment Company Institute, SEC No-Action Letter (Aug. 9, 2010).

5 Generally, funds must limit their investments in the securities of any one issuer of a first-tier security (other than U.S. government securities) to no more than five percent of total assets and limit their investments in securities subject to demand feature or a guarantee to no more than 10 percent of total assets from any one provider.

6 This permission is subject to certain conditions set forth in Rule 10b-10(b)(2) and (3). Specifically, Rule 10b-10(b)(2) requires a broker-dealer to send to a customer, within five business days after the end of each monthly period, a written statement disclosing each purchase or redemption effected for or with, and each dividend or distribution credited to or reinvested for, the account of such customer during the month; the date of such transaction; the identity, number and price of any securities purchased or redeemed by such customer in each such transaction; the total number of shares of such securities in such customer’s account; and any remuneration received or to be received by the broker or dealer in connection therewith. Rule 10b-10(b)(2) also requires that any other information required by Rule 10b-10(a) be furnished upon written request. The written statement required by Rule 10b-10(b)(2) may be delivered to some other person designated by the customer for distribution to the customer. Rule 10b-10(b)(3) requires that such customer is provided with prior notification in writing disclosing the intention to send the written information referred to in Rule 10b-10(b)(1) in lieu of an immediate confirmation.


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