On July 23, 2014, in connection with the adoption of final rules governing the structure and operation of money market funds, the Securities and Exchange Commission (SEC) re-proposed amendments to Rule 2a-7 to implement Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which requires the SEC to remove references to or requirements of reliance on credit ratings and to establish appropriate creditworthiness standards.[1] As a step toward implementing these mandates, in March 2011 the SEC proposed to replace references to credit ratings issued by nationally recognized statistical rating agencies (NRSROs) in two rules and four forms under the Securities Act of 1933, as amended and the Investment Company Act of 1940, as amended (the Investment Company Act), including Rule 2a-7 and Form N-MFP under the Investment Company Act. [2]
The 2011 proposal preceded other amendments to Rule 2a-7 and Form N-MFP that were proposed in June 2013[3] and adopted in July 2014.[4] In light of comments received to the 2011 Proposing Release and the Money Market Fund Reform Proposing Release, the SEC determined to propose or re-propose: (1) amendments to replace credit rating references in Rule 2a-7; (2) modifications to the provisions in Form N-MFP that reference credit ratings; and (3) amendments that would eliminate the exclusion from the issuer diversification requirement of Rule 2a-7 for securities subject to a guarantee issued by a non-controlled person.
Credit Rating References in Rule 2a-7
The re-proposed amendments would affect five elements of Rule 2a-7: (i) determination of whether a security is an eligible security; (ii) determination of whether a security is a first tier security; (iii) credit quality standards for securities with a conditional demand feature; (iv) requirements for monitoring securities for ratings downgrades and other credit events; and (v) stress testing. Each of these elements is discussed below.
Determinations Regarding Eligible Securities and First Tier Securities
In the 2011 Proposing Release, the SEC proposed to eliminate the requirement that eligible securities be rated. Instead of ratings, the SEC proposed that money market fund boards be required to: (i) determine whether securities are eligible securities based on minimal credit risks; and (ii) distinguish between first and second tier securities based on subjective standards similar to those the ratings agencies have developed to describe their ratings. In its re-proposal, the SEC seeks to combine the two criteria into a single standard, which would be included as part of Rule 2a-7’s definition of eligible security. As re-proposed, an eligible security would be a security with a remaining maturity of 397 calendar days or less that the fund’s board of directors (or its delegate) determines presents minimal credit risks, which determination includes a finding that the security’s issuer has an exceptionally strong capacity to meet its short-term obligations.[5] As re-proposed, a money market fund would be limited to investing in securities that the fund’s board (or its delegate) has determined present minimal credit risks, notwithstanding any rating the security may have received. In addition, fund boards would no longer be required to designate nationally recognized statistical rating organizations (NRSROs). In connection with these changes, the SEC also is re-proposing to remove the current prohibition on funds investing more than 3% of their portfolios in second tier securities.
The Credit Rating Release states that Rule 2a-7 does not set forth specific factors that a board (or its delegate) should consider in determining minimal credit risks but notes that an assessment of the strength of any issuer’s or guarantor’s ability to satisfy its obligations generally should include an analysis of the following factors, to the extent appropriate: (i) the issuer or guarantor’s financial condition (i.e., analysis of recent financial statements, including trends relating to cash flow, revenue, expenses, profitability, short-term and total debt service coverage, and leverage (including financial leverage and operating leverage); (ii) the issuer or guarantor’s liquidity, including bank lines of credit and alternative sources of liquidity; (iii) the issuer or guarantor’s ability to react to future events, including a discussion of a “worst case scenario,” and its ability to repay debt in a highly adverse situation; and (iv) the strength of the issuer or guarantor’s industry within the economy and relative to economic trends as well as the issuer or guarantor’s competitive position within its industry (including diversification in sources of profitability, if applicable). The Credit Rating Release notes that a minimal credit risk evaluation could also include an analysis of whether the price and/or yield of a security are similar to that of other securities in the fund’s portfolio.
Conditional Demand Features
Rule 2a-7 restricts money market funds to investing in securities with remaining maturities of no more than 397 days. However, a long-term security subject to a conditional demand feature (“underlying security”), may be determined to be an eligible security (or a first tier security) if, among other features, the: (i) the conditional demand feature is an eligible security or a first tier security; and (ii) the underlying security (or its guarantee) has received either a short-term rating or a long-term rating, as the case may be, within the highest two categories from the requisite NRSROs or is a comparable unrated security. Currently, Rule 2a-7 requires this analysis of both the short-term and long-term credit aspects of the demand instrument because a security subject to a conditional demand feature combines both short-term and long-term credit risks. The re-proposal would require a similar analysis, but would remove the requirement that the fund board (or its delegate) consider credit ratings of underlying securities. As re-proposed, a fund would have to determine, as with any short-term security, that the conditional demand feature is an eligible security. In addition, a fund’s board of directors (or its delegate) would have to evaluate the long-term risk of the underlying security and determine that it (or its guarantor) “has a very strong capacity for payment of its financial commitments.” An issuer that the board determines has a very low risk of default and a capacity for payment of its financial commitments that is not significantly vulnerable to reasonably foreseeable events would satisfy the proposed standard.
Monitoring Minimal Credit Risks
Rule 2a-7 currently requires a money market fund board (or its delegate) promptly to reassess whether a security that has been downgraded by an NRSRO continues to present minimal credit risks, and to take such action as it determines is in the best interests of the fund and its shareholders. In addition, Rule 2a-7 requires ongoing review of the minimal credit risks associated with securities for which maturity is determined by reference to a demand feature.
In 2011, the SEC proposed to amend Rule 2a-7 to require that, in the event the money market fund’s adviser (or any person to whom the board has delegated portfolio management responsibilities) becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier security or a second tier security, as the case may be, the board (or its delegate) would have to reassess promptly whether the portfolio security continues to present minimal credit risks.
In the Credit Rating Release, the SEC re-proposed a different standard - namely, to eliminate the requirement that a money market fund re-assess the credit risks of an issuer when a security is downgraded by an NRSRO and to re-propose a requirement that money market funds adopt written procedures that require the adviser to provide ongoing review of the credit quality of each portfolio security (including any guarantee or demand feature on which the fund relies to determine portfolio quality, maturity, or liquidity) to determine that the security continues to present minimal credit risks. The Release notes that ongoing monitoring of minimal credit risks would include the determination of whether the issuer of the portfolio security, and the guarantor or provider of a demand feature, to the extent relied upon by the fund to determine portfolio quality, maturity or liquidity, continues to have an exceptionally strong capacity to repay its short-term financial obligations. It further states that such review would typically update the information that was used to make the initial minimal credit risk determination and would have to be based on, among other factors, financial data of the issuer or provider of the guarantee or demand feature.
Ratings Downgrades in Stress Testing Requirements
The SEC re-proposed to replace the reference to ratings downgrades in the stress testing requirement with a hypothetical event that is designed to have a similar impact on a money market fund’s portfolio. The re-proposed stress testing amendments would require that money market funds stress test for an event indicating or evidencing credit deterioration of particular portfolio security positions, each representing various exposures in a fund’s portfolio. The re-proposed amendments would also describe the type of hypothetical event that funds should use for testing and include a downgrade or default as examples of that type of event. Thus, funds could continue to test their portfolios against a potential downgrade or default in addition to any other indication or evidence of credit deterioration they determine appropriate (and that might adversely affect the value or liquidity of a portfolio security).
Credit Rating References in Form N-MFP
The SEC re-proposed disclosures relating to credit ratings in Form N-MFP. As part of the money market fund reforms adopted in 2010, money market funds must file portfolio holdings information on Form N-MFP on a monthly basis. The information that money market funds must disclose with respect to each portfolio security (and any guarantee, demand feature, or other enhancement associated with the portfolio security) includes the name of each designated NRSRO for the portfolio security and the rating assigned to the security. In the 2011 Proposing Release, the SEC proposed to eliminate the form items that currently require a fund to identify whether a portfolio security is a first tier or second tier security or is an unrated security, and that require the fund to identify the “requisite NRSROs” for each security (and for each demand feature, guarantee or other credit enhancement). In response to comments received, the SEC is re-proposing instead to require that each money market fund disclose, for each portfolio security, (i) each rating assigned by any NRSRO if the fund or its adviser subscribes to that NRSRO’s services, as well as the name of the agency providing the rating, and (ii) any other NRSRO rating that the fund’s board of directors (or its delegate) considered in making its minimal credit risk determination, as well as the name of the agency providing the rating.
Issuer Diversification Exclusion for Securities Subject to a Guarantee Issued by a Non-Controlled Person
The SEC adopted amendments to Rule 2a-7 as part of the broader money market fund reforms relating to the Rule’s diversification provisions, which require a money market fund to diversify investments with respect to the issuers of the securities it acquires, as well as providers of demand features and guarantees related to those securities.[6] Specifically, the amendments require that money market funds treat certain entities that are affiliated with each other as single issuers when applying the 5% issuer diversification test and treat the sponsors of asset-backed securities as guarantors subject to the 10% limit applicable to guarantees and demand features, unless the fund’s board makes certain findings. In the Credit Rating Release, the SEC requests comment on proposed amendments that would require a money market fund that invests in securities subject to a guarantee (whether or not the guarantor is a non-controlled person) to comply with both the 10% diversification limitation for the guarantor as well as the 5% diversification requirement for the issuer. The Credit Rating Release notes that these proposed amendments are designed to reduce risk in money market funds by limiting their ability to concentrate investments in a single economic enterprise.
Comment Period and Proposed Compliance Dates
Comments to the proposed and re-proposed amendments are due 60 days after publication of the Credit Rating Release in the Federal Register. The Credit Rating Release notes that the SEC anticipates that the compliance date for the re-proposed amendments to Rule 2a-7 and Form N-MFP and the proposed amendments to the issuer diversification requirements would be 18 months after the effective date of the rules adopted on July 23, 2014.
Notes:
[1] See Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification
Requirement in Money Market Fund Rule, Investment Company Act Release No. 31184 (July 23, 2014) ( Credit Rating Release).
[2] See References to Credit Ratings in Certain Investment Company Act Rules and Forms, Investment Company Act Release No. 29592 (Mar. 3, 2011) (2011 Proposing Release).
[3] See Money Market Fund Reform; Amendments to Form P-F, Investment Company Act Release No .30551
(June 5, 2013) (Money Market Fund Reform Proposing Release).
[4] See Money Market Fund Reform; Amendments to Form P-F, Investment Company Act Release No. 31166
(July 23, 2014) (Money Market Fund Reform Adopting Release).
[5] Re-proposed Rule 2a-7(a)(11).
[6] See Money Market Fund Reform Adopting Release, supra, at section III.I.l.d.
