Driven by a provision of the Dodd-Frank Act that requires federal agencies to remove references to credit rating agencies in regulations, the Securities and Exchange Commission re-proposed eliminating these references from the rules governing money market funds. The proposed rules would give fund boards ultimate responsibility for the credit quality of the securities in their funds’ portfolios. The Commission was careful to note, however, that fund boards and advisers could still utilize credit agency ratings in their analysis.
The proposal revises the definition of “eligible security” to 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.” As a result of eliminating the references to credit ratings, the proposed rule would also eliminate the existing distinction between first and second tier securities. The Commission noted that the proposed standard “is designed to preserve the current degree of risk limitation in rule 2a-7 without reference to credit ratings” and that “only the highest quality” second-tier securities would meet the standard. The Commission expressed the view that third-tier rated securities would not meet the “exceptionally strong capacity” standard in the proposed rule. The proposal would make similar revisions to the review of the conditional demand feature of a security.
In addition to credit risk considerations based on the type of investment, the Commission offered a non-exhaustive list of general considerations:
(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).
While the proposal would eliminate the obligation to monitor for a security’s credit rating downgrade, the adviser’s obligation to provide ongoing monitoring would, practically speaking, still require monitoring for ratings downgrades. The Commission acknowledges that the proposal could allow an adviser to choose to keep a downgraded security without involving the board in the decision; however, the proposal states that fund boards “generally should establish procedures for the adviser to notify the board of such circumstances.”
The Commission seemed to struggle with the directive to remove credit rating references from stress testing requirements as commenters “uniformly advocated” against such a removal. Under the proposed amendments, money market funds would stress test against an “event indicating or evidencing credit deterioration of particular portfolio security positions.” Such an event could include, but would not be limited to, a downgrade of a credit rating.
These proposed rules are subject to comment, and thus are not yet final. However, given the statutory requirements, the Commission likely has limited ability to adopt a fundamentally different approach. The Forum previously filed a comment letter on the original proposal.