Speech by SEC Commissioner:
Statement at SEC Open Meeting: Allow the Regulators to Regulate
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
March 2, 2011
I join my colleagues in thanking our staff. This proposal tasked our staff with the impossible challenge of creating an appropriate substitute for the credit rating references in Investment Company Act Rules 2a-7 and 5b-3. On prior occasions, the Commission has publicly considered this exact issue and was told repeatedly by staff and public commenters that no appropriate substitute exists.1 In February 2010, the Commission agreed as to Rule 2a-7 and reached the conclusion to retain the reference to the credit rating as an initial threshold requirement.2
The Dodd-Frank Act requires that the Commission, and other federal regulators, review their regulations for any references to credit ratings and replace those references with an appropriate substitute.3 The key question is what do regulators do when no appropriate substitute exists?
I have previously supported initiatives to remove credit rating rule references because I believed that the Commission’s proposal replaced the references with an appropriate substitute. Our proposal regarding certain “short-form” registration statements is a recent example. 4
However, although I will support publication of this proposal, I have serious misgivings because it appears no appropriate substitute has been identified. The costs of implementing today’s proposal seem to far outweigh the benefits for industry participants and investors alike.
Let’s take Rule 2a-7, the rule allowing money market funds to be exempted from the requirement that funds calculate current net asset value per share by valuing portfolio instruments at market value. In exchange for this exemptive relief, Rule 2a-7 contains strong "risk-limiting conditions" that protect investors and funds from excessive exposure to certain risks, such as credit, currency and interest rate risks.
In particular, Rule 2a-7 currently requires a money market fund to hold top quality securities in its portfolio. The board of directors of the fund (which typically relies on the fund's adviser) is charged with determining that the portfolio investments present "minimal credit risk," based on factors pertaining to credit quality, in addition to any credit ratings on a security. This means that money market portfolio securities must pass two tests: (1) be highly rated securities, and (2) in addition, pass the scrutiny of the board of directors (or of the delegated adviser). In short, the current rule contains both an external, objective determination — which is the credit rating — and an internal, subjective determination — which is the board's independent evaluation.
The use of credit ratings in Rule 2a-7 was designed to provide a clear reference point to regulators and to market participants, but it was not designed as a substitute for reasoned analysis and judgment by the fund's board or adviser (as the Board's delegate). The board has an express duty under the rule to independently evaluate the credit risk of portfolio securities. Under the current requirements of the rule, both ratings and judgment are currently required. Thus, it seems this is a reference that has no effective substitute and is already accompanied by a requirement to conduct analysis above and beyond ascertaining the credit rating.
Today the Commission proposes to delete the external, objective evaluation. Deleting the external evaluation, that is, the credit rating, will remove the baseline protection provided by third-party credit ratings and will re-fashion 2a-7 to be solely dependent on the internal evaluation.
Eliminating the credit rating requirement and leaving only the internal, subjective standard is to take away a vital investor protection. Removing this objective, external determination will create an opportunity for those that will chase yield at the expense of investing in the highest quality securities.
And, in fact, the Commission has not been able to find or develop an acceptable substitute. Instead, today’s proposal removes the baseline, objective standard and expands the subjective determination. Frankly, each previous time that the Commission has asked for comment as to removing this credit rating protection and implementing this proposal, we have been told frankly and directly that serious harm would flow from such an ill-advised action.
I am also concerned about the uncertainty a proposal like this creates for market participants. This proposal is designed to reduce reliance on ratings but the Commission’s proposal is explicit that the Board of Directors can continue to rely on credit ratings. Here’s an example of what the release repeatedly states: “In making these credit quality determinations, money market funds would continue to be able to use analyses provided by third parties, including ratings provided by ratings agencies, that the funds conclude are reliable for such purposes.”5
It is clear that the Commission contemplates that money market funds boards will continue to use credit ratings as currently required. Of course, without the requirement, there can be no guarantee that will be the case. This is a contradiction on its face and sends fund boards a mixed message. Moreover, eliminating the objective baseline determination exposes investors to more rather than less risk – this runs counter to the entire philosophy of Rule 2a-7.
It will also be much harder for the Commission to monitor and insure that all money market funds are holding top quality securities. It is difficult, to near impossible, to oversee a purely subjective determination. In its report on the SEC’s NRSRO program, the United States General Accountability Office (GAO), in speaking specifically to the rules that govern money market fund investments, highlighted its concern that that the Commission may “develop alternative standards of creditworthiness that are not effective in supporting the purpose of a particular rule.” I fear that is the path the Commission is taking.6
I believe that an absolute and inflexible requirement to remove a reference - even when the primary regulator is not able to find an appropriate substitute - will ultimately harm investors. I join John Walsh, the Acting Comptroller of the Currency, in his statements to Congress that removing all references in regulation goes too far and instead Congress should amend the law to direct regulators to require that, instead of removing the reference, ratings-based determinations be confirmed by additional risk analysis. In particular, he recommends that “rating-based determination be confirmed by additional risk analysis in circumstances where ratings are likely to present an incomplete picture of the risks presented to an institution, or where those risks are heightened due to concentrations in particular asset classes.”7
I ask Congress to reconsider its blanket ban on any credit rating reference in our regulations because some of these ratings requirements, in fact, ably serve investor protection and have no effective substitute.
Given these concerns, I am particularly interested in public comment addressing the following questions:
(1) What is the appropriate substitute for credit rating references in Rule 2a-7 that constitutes an objective, baseline determination?
(2) Upon adoption, how can the Commission make a finding that these rule amendments are in the public interest given that it creates opportunities for gaming and increases risks for investors?
1 See References to Ratings of Nationally Recognize Statistical Rating Organizations, Investment Company Act Release No. 28327 (Jul. 1, 2008) [73 FR 40124]. See also References to Ratings of Nationally Recognized Statistical Organizations, Investment Company Act Release No. 28939 (Oct. 5, 2009) [74 FR 52358]. The Commission also sought comment on removing credit rating references in Rule 2a-7 in its 2009 proposal for certain reforms for money market funds. See Money Market Fund Proposing Release, Investment Company Act Relase No. 28807, (June 30, 2009) [74 FR 32688].
2 See Money Market Fund Reform, Investment Company Release No. 29132 (Feb. 23, 2010) [75 FR 10060].
3 Dodd-Frank Wall Street Reform and Consumer Protection Act, § 939A, “Review of Reliance On Ratings.
(a) Agency Review.—Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review—
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(b) Modifications Required.—Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(c) Report.Upon conclusion of the review required under subsection (a), each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection (b).”
4 See Release No. 33-9186; 34-63874; File No. S7-18-08 17 CFR Parts 200, 229, 230, 232, 239, 240, and 249 http://www.sec.gov/rules/proposed/2011/33-9186.pdf.
5 References to Credit Ratings in Certain Investment Company Act Rules and Forms, Investment Company Act Release, March 2, 2011.
6 United States General Accountability Office, Study: Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures, September 2010, pages 47-56.
7 Testimony of John Walsh before the Senate Committee on Banking, Housing, and Urban Affairs, September 30, 2010.