The Securities and Exchange Commission today proposed rule amendments to remove references to credit ratings in certain rules and forms under the Investment Company Act of 1940, including rule 2a-7 governing the operations of money market funds.
Credit ratings are often considered by investors when they evaluate whether to purchase securities. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires every federal agency to review rules that use credit ratings as an assessment of creditworthiness, and replace those credit-rating references with other appropriate standards.
“The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors, and encourage an independent assessment of creditworthiness,” said SEC Chairman Mary L. Schapiro.
Under the SEC’s proposal, a rating would no longer be a required element in determining which securities are permissible investments for a money market fund. A security would instead be an eligible investment for a money market fund if the fund’s board or its delegate determines that the security presents minimal credit risks. As under the current rule, funds would have to invest at least 97 percent of their assets in securities that the board has determined are issued by an issuer that has the highest capacity to meet its short-term financial obligations. This latter standard is intended to be consistent with the highest credit rating category.
The SEC’s proposed rule amendments also would remove credit ratings in three other areas: repurchase agreements, certain business and industrial development company (BIDCO) investments, and shareholder reports.
Public comments on the proposed rule amendments should be received by April 25, 2011.
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Fact Sheet
Removal of Credit Rating References from Certain Investment Company Act Rules and Forms
Background
Credit rating agencies are organizations that rate the credit-worthiness of a company or a financial product, such as a debt security or money market instrument. These credit ratings are often considered by investors evaluating whether to purchase securities. In many cases during the financial crisis, securities with high ratings performed poorly.
Congress included a provision in Section 939A of the Dodd-Frank Act that requires every federal agency to review rules that use credit ratings as an assessment of credit-worthiness. The Act further requires the agencies to replace those credit-rating references with other appropriate standards.
The SEC is one such agency that has adopted rules over the years that reference credit ratings in assessing the credit-worthiness of a security. For example, under existing rules, money market funds may only invest in securities that have received one of the two highest categories of short-term credit ratings (or if not rated, are of comparable credit quality).
The amendments would make changes to the money market fund rule among others.
The Proposals
Removing References to Credit Ratings of Money-Market Fund Investments
Current Rule: Rule 2a-7 under the Investment Company Act governs the operations of money market funds and requires these funds to invest only in highly liquid short-term investments of the highest quality. To ensure that the funds are invested in high-quality, short-term securities, Rule 2a-7 sets forth several requirements:
First, money market funds can only invest in securities that:
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• Are “first tier”– meaning they have received the highest short-term rating; or
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• Are “second tier” – meaning they have received the second highest short-term rating.
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At least 97 percent of a money market fund’s portfolio must be invested in “first tier” securities. If a security is not rated, the funds must evaluate the credit quality of the security and deem it to be of comparable quality to a security receiving one of the two highest short-term ratings.
Second, a money market fund’s board of directors (or its delegate) must determine that the security presents minimal credit risks, based on factors relating to credit quality, in addition to any rating the security may have received.
Proposed Amendments: The proposed amendments would eliminate the credit ratings requirements for money market fund investments. The amended rule would set forth new requirements:
First, money market funds would have to assess the credit quality of the security and determine that each portfolio security presents minimal credit risks.
Second, money market funds would have to determine whether the portfolio security is a “first tier” or “second tier” security, using new definitions for those terms.
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• A security would be first tier only if the fund’s board of directors (or its delegate) has determined that the security’s issuer has the highest capacity to meet its short term financial obligations. Like the current rule, a money market fund would be required to invest at least 97 percent of its assets in first tier securities.
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• A security would be second tier if the board (or its delegate) has determined the security presents minimal credit risks, even if it is not a first tier security.
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Some debt securities have a feature that allows an investor to sell the security (at cost plus accrued interest) back to the issuer or to a third party. Some of these “demand features” limit an investor’s ability to demand payment for the security under certain circumstances. Under existing Rule 2a-7, a money market fund may invest in a security subject to such a “conditional demand feature” only if, among other things, the underlying security has received one of the two highest ratings.
The proposed rules would eliminate the credit rating requirement. Instead, the fund’s board (or its delegate) would be required to determine that the underlying security is of high quality and subject to very low credit risk.
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The Commission also proposed amendments to Form N-MFP, which money market funds use to report their portfolio schedules to the SEC each month. The proposed amendments would eliminate items in the form that require disclosure of the ratings of the securities in the portfolio.
Removing References to Credit Ratings Regarding Securities Collateralizing Repurchase Agreements
Some funds invest in “repurchase agreements,” under which a party sells securities to the fund and agrees to repurchase the securities at a later date for a price higher than the original sales price. In some circumstances, funds entering into repurchase agreements do not look to the credit-worthiness of the issuer of the repurchase agreement (the counterparty), but instead “look through” to the value and liquidity of the securities that collateralize the agreement for satisfaction of payment.
Current Rule: Rule 5b-3 under the Investment Company Act allows funds – seeking to meet certain diversification requirements – to “look through” repurchase agreements in which they invest to the securities collateralizing the agreements. However, such look throughs are only permitted if, among other things, the collateral securities have received the highest credit rating, are unrated securities of comparable quality, or are government securities.
Proposed Rule: Under the proposed amendments, the board of directors of the fund (or its delegate) 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.
Removing References to Credit Ratings Regarding BIDCOs
Business and industrial development companies (BIDCOs) are state-regulated companies that provide direct investment, loan financing and managerial assistance to state and local enterprises.
Because BIDCOs invest in securities, they may meet the definition of “investment company” under the Investment Company Act. The Investment Company Act exempts BIDCOs from most provisions of the Act subject to certain conditions.
Current Provision: Section 6(a)(5) of the Investment Company Act permits BIDCOS relying on this exemption to purchase debt securities issued by investment companies and private funds only if these debt securities are rated “investment grade” by a credit rating agency.
Proposed Rule: Under proposed new rule 6a-5, BIDCOs relying on the statutory exemption could purchase debt securities issued by investment companies and private funds if the BIDCO’s board of directors (or its delegate) determines, at the time of acquisition, that the debt security meets specific credit risk and liquidity criteria.
Shareholder Reports
Current Form: Forms N-1A, N-2 and N-3 each require shareholder reports to include a table, chart or graph depicting portfolio holdings by reasonably identifiable categories, such as industry sector, geographic region or credit quality. If credit quality is used, the forms require that credit quality be depicted using credit ratings.
Proposed Amendments: The forms would be amended to eliminate the required use of credit ratings by funds that choose to use credit quality categorizations in the table, chart or graph.
What’s Next
The proposal seeks public comment through April 25, 2011.
http://www.sec.gov/news/press/2011/2011-59.htm
