Strong Opposition Voiced on SEC Proposal to Drop Ratings Requirement from Rule 2a-7 on Money Market Funds

The mutual fund industry strongly opposes the SEC’s proposal to remove references to credit ratings from the rule governing money market funds and what securities they can invest in. Under Investment Company Act Rule 2a-7, money market funds must limit purchases to securities that have eligible ratings, or are of comparable quality, from nationally recognized statistical ratings organizations (NRSROs). In a comment letter urging the SEC not to take this ``draconian’’ step, the Investment Company Institute said that the ratings requirement in Rule 2a-7 constructs a floor below which investments may not be made, which provides an important layer of protection for investors. The removal of this floor, continued the ICI, would weaken the investor protections embedded in Rule 2a-7 and erode market confidence in the money market fund industry, which has operated effectively under Rule 2a-7 for 25 years.

For example, money market funds may only invest in securities either rated by the NRSROs in one of the two highest short-term rating categories or, if unrated, as determined by the fund's board to be of comparable quality. In general, money market funds also cannot invest in certain securities, including most asset-backed securities, unless they have been rated. Finally, Rule 2a-7 requires money market fund advisers to take certain actions in the event a security is downgraded. While Rule 2a-7 does not completely limit money market funds to investments in rated securities, it effectively requires fund advisers to incorporate any available ratings into the analysis of appropriate securities to be held by these funds.

Noting that Rule 2a-7 has worked remarkably well since its adoption in 1983, Fidelity Investments commented that a large part of investor confidence in money market funds stems from the rule’s requirements with regard to credit quality, maturity and diversification. Thus, Fidelity urged the Commission to keep this effective regulation in place in its current form. Similarly, Vanguard argued that NRSRO ratings provide an independently established baseline for money market fund investments and are a valuable assurance to investors that such investments are not subject to unnecessary risks.

The ICI also noted that Rule 2a-7 requires that a fund's board independently evaluate the credit quality of each portfolio investment and determine that each investment presents minimal credit risks. NRSRO ratings complement this determination by providing a third-party's evaluation of credit quality for the instruments in which money market funds may invest. In this important if limited way, said the ICI, they are an integral part of the protections designed to manage the overall credit risks of a fund's holdings.

One reason for dropping the ratings requirement is the SEC’s belief that the current rule's reliance on credit ratings discourages fund directors and investment advisers from performing independent credit risk assessments. The SEC said that the proposal is intended to reduce undue reliance on credit ratings and improve the analysis underlying investment decisions.
But the ICI pointed out that the objective ratings test is but one prong of a two-prong test to determine the eligibility of portfolio securities. Removing the objective prong would weaken the rule, said the ICI. Similarly, the subjective judgments that would replace the two-prong test would require, among other things, a determination that an issuer has the highest capacity to meet its short-term financial obligations. The factors used for this determination are not listed in the proposal, said the ICI, and thus will vary from fund to fund and from adviser to adviser.

Further, accompanying this expanded discretion is a risk that a fund may invest in a security that would not have qualified under the rule's current standards, thereby raising the potential for harm to not only the shareholders in that particular fund, but also to the entire money market fund industry.

Removing ratings from Rule 2a-7 would also raise broader regulatory concerns for fund directors. For example, the proposal would require boards to determine whether a security is a First Tier Security. In order to make this determination, the board would need to determine whether an issuer meets the standard of having the highest capacity to meet its short-term financial obligations. This standard would be difficult for a fund board to administer, posited the ICI, and determinations made pursuant to such standard could be subject to significant second-guessing. In contrast, a fund board currently is responsible for making a determination of First Tier Security status only with respect to unrated securities, which is based on the more readily ascertainable standard of comparability to a rated security. The proposal therefore would make fund boards responsible for additional investment-related determinations that do not appear to involve conflicts of interest, contrary to the Commission's stated intent to reduce the everyday burdens of fund directors in these situations.

The proposal also would present significant compliance challenges, in the view of the ICI. For example, the proposal would establish a new standard for monitoring credit risk that would put fund boards and investment advisers in the untenable position of having to monitor for any information about a portfolio security or an issuer of a portfolio security that may suggest that the security may not continue to present minimal credit risks.

By removing the objective trigger of ratings and setting the standard for reassessment of a security's eligibility under the rule to the mere suggestion of an adverse credit development, reasoned the ICI, the proposal would require investment advisers to monitor and maintain records of any new potentially relevant information about a portfolio security or an issuer, including numerous changes to credit assessments, which in many instances would not provide indications of true adverse developments.