Speech by SEC Chairman:
Opening Statement Regarding Proposal to Remove Credit Rating References from Investment Company Act Rules and Forms
Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
SEC Open Meeting
March 2, 2011
The final item on our agenda relates to proposals to eliminate credit rating references from rules and forms under the Investment Company Act.
Today’s proposals represent the next step in a series of actions we have taken to remove references to credit ratings contained within our rules, and to replace them with alternative criteria.
Under the Dodd-Frank Act, federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness. At the conclusion of this review, each agency is required to remove these references and replace them with alternative standards that the agency determines to be appropriate.
The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors – and to encourage an independent assessment of creditworthiness rather than a potentially misguided reliance on a credit rating.
One of the more significant rules we are considering today is Rule 2a-7. This rule plays a critical role in protecting investors in money market funds by imposing risk-limiting conditions on the investments a money market fund can make. The core use of ratings under Rule 2a-7 relates to determining which securities are eligible for purchase by a money market fund.
Currently, under this rule, if a money market fund invests in a security that is rated, then the rating must be in one of the two highest rating categories. And, no more than 3 percent of the fund’s assets may be invested in securities in the second highest rating category. In addition, the fund’s board of directors or its delegate – such as the fund’s manager – must determine that every security a money market fund purchases presents minimal credit risks, regardless of the rating.
Under the proposal we are considering today, a rating would no longer be a required element in determining which securities are permissible investments for a money market fund. Instead, a security would be an eligible investment for a money market fund if the fund’s board or its delegate determines that the issuer has the “highest capacity to meet its short-term financial obligations.” This is a standard that is intended to be consistent with the highest credit rating category.
Alternatively, a security would be an eligible investment if the board or its delegate determines that it presents minimal credit risks, but does not meet the criteria for a first tier security. As with the current rule, such second tier investments cannot make up more than 3 percent of the fund’s assets.
It is our intention that this approach would continue to steer money market funds toward only the highest quality short-term issues. Additionally, funds will have to continue to meet existing maturity limits and liquidity standards – further limiting a fund’s portfolio risks.
At the same time, the proposal would remove the impression that money market fund securities may be selected solely because of their ratings.
Coinciding with this rule, we are proposing corresponding amendments to the form on which we collect money market fund data, to eliminate required disclosure of ratings.
In addition, today we also are considering removing credit ratings in three other areas:
First, we are considering a proposal to remove references to credit ratings in Investment Company Act rule 5b-3. That rule currently allows funds – seeking to meet certain diversification requirements – to “look through” the repurchase agreements in which they invest to the securities collateralizing the agreement. But, such “look throughs” are only permitted if, among other things, the non-government securities have received the highest credit rating or are a comparable unrated security.
Under the proposed standard, a fund board or its delegate would instead have to determine that the issuer of the collateral securities has the highest capacity to meet its financial obligations. The fund also must determine that the securities are sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days.
Second, we are considering proposing a rule to establish a standard of creditworthiness for certain debt securities purchased by business and industrial development companies (BIDCOs) that the Investment Company Act exempts from many of that Act’s provisions.
Under the proposals, BIDCOs would no longer be able to rely on an NRSRO to determine whether a debt security is investment grade. Instead, the company’s board or its delegate would have to determine that the debt security is subject to no greater than moderate credit risk and sufficient liquidity that it can be sold at or near its carrying value within a reasonably short period of time.
Third, we are considering a proposal that would eliminate required disclosure of credit ratings in registration statements and shareholder reports. A final Investment Company Act rule referencing credit ratings, rule 3a-7 regarding asset backed securities issuers, will be considered in a later rule proposal.
I look forward to the comments on today’s proposals to remove credit ratings. I am particularly interested in whether the alternatives to credit ratings that we propose are meaningful, effective and workable.
Before asking the staff to elaborate on the substance of the proposals, I would first like to welcome the new Director of the Division of Investment Management, Eileen Rominger. Today marks the end of her second week on the job – and we have already benefitted from the expertise, knowledge and focus that she brings to her new role.
I also would like to acknowledge the staff that prepared the rules we are considering for proposal today: From the Division of Investment Management, Bob Plaze, Penelope Saltzman, Anu Dubey, Susan Nash, Mark Uyeda, and Jane Kim; from the Office of the General Counsel, Lori Price and Vincent Meehan; from the Division of Risk, Strategy and Financial Innovation, Harvey Westbrook, John Niarhos, and Charles Dale; from the Division of Trading and Markets, Randall Roy and Mark Attar; and from the Office of Compliance Inspections and Examinations, Zee Johnson and Ehv DeArmas.