Fidelity Management & Research Company
Eric D. Roiter
Senior Vice President and General Counsel
82 Devonshire Street
Boston, MA 02109-3614
July 31, 2000
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Attention: Jonathan Katz, Secretary
Re: Proposed Regulation FD Regarding Selective Disclosure, SEC Release Nos. 33-7787, 34-42259, File no. S7-31-99
Ladies and Gentlemen:
On behalf of Fidelity Investments, I am writing to address some of the adverse consequences for money market funds that Fidelity believes are likely to follow if the Commission adopts proposed Regulation FD in its current form. At the outset, we wish to state our support for the twin purposes of the Commission's proposal -- to promote the timely dissemination by issuers of information that investors may consider important in making investment decisions and to foster fairness in the markets for all investors, both retail and institutional. We would emphasize that these two categories of investors are not mutually exclusive, particularly in regard to the mutual fund industry. Millions of retail investors participate in the market by commingling their savings in mutual funds, thereby gaining the benefit of the investment management expertise of advisers to those funds. Fidelity takes seriously its fiduciary responsibilities to provide that expertise to its shareholders and, because we believe strongly that fundamental, "bottoms up" investment research is the best approach, we devote substantial resources toward that end.
The Commission has heard from a number of commentators that Reg. FD, if adopted in its current form, will have a harmful effect on the markets. Rather than promoting more timely, and broader, disclosure, the rule is likely to have precisely the opposite effect. The rule offers no safe harbor for issuers, no precision on what may or may not be said to any investor or shareholder in the absence of a contemporaneous press release or webcast, and no incentive for issuers' management to stray from prepared scripts in one-on-one discussions with investment managers. On the contrary, the proposed rule contains powerful disincentives for issuers and their management to be forthcoming in any discussions with individual investment managers and their analysts, including the loss of privileges to use short-form registration statements and shelf offerings and possible enforcement proceedings for disclosures deemed, in hindsight, to have been "material." For these reasons, Fidelity urges the Commission to reconsider the scope of the proposed rule, as well as the consequences for issuers in the event of inadvertent non-compliance.
Virtually all of the commentators that have voiced concerns over the proposal have spoken broadly about its adverse implications for the markets as a whole or (at least implicitly) for the equity markets. We concur generally with the concerns that have been raised, particularly as set forth by the comment letter of the Investment Company Institute, but are taking this opportunity to address specifically the adverse implications for money market funds and the managers of these funds, who are seeking to fulfill their Rule 2a-7 obligations by carrying out independent credit research. The proposed rule's chilling effect on credit-related analysis is also likely to extend to the fixed-income and derivatives markets generally, unsettling well-established research procedures crucial to credit and counterparty risk management.
Impact on Money Market Funds
Affirmative Credit Research Obligations under Rule 2a-7
Money market funds differ from equity funds in one crucial respect: because money market funds must maintain a stable net asset value, they must avoid downside risk. This core restriction is reinforced by the terms of Rule 2a-7, which permit money market funds to invest in any given issuer's money market instruments only after the fund or its adviser makes an independent assessment of the creditworthiness of the issuer and determines that the instrument represents "minimal credit risk." Downgraded securities and securities that cease to represent "minimal credit risk" must be promptly sold unless a determination is made by the directors of the fund that sale is not in the best interests of shareholders. Assignment of the highest ratings by an NRSRO is only the starting point for the assessment of minimal credit risk, as the Commission's rules themselves make clear. 1
The Commission has emphasized that "[w]here the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor considered in determining whether a security has minimal credit risk."2 Not only must money market fund analysts carefully probe an issuer's credit quality at the time of an initial investment, they must continually monitor that credit quality.3
Although minimal credit risk is not defined in Rule 2a-7, the Commission in its pronouncements has stressed the searching analysis that mutual fund managers must undertake:
"The board of directors must determine that a security presents minimal credit risk whether or not the security has been rated by a NRSRO. The board cannot merely conclude that, because the security is rated high quality, it presents minimal credit risk. Rather, in our view, a board of directors can only make this determination based upon an analysis of the issuer's capacity to repay its short-term debt. Examples of elements of such an analysis include: (i) a cash flow analysis; (ii) an assessment of the issuer's ability to react to future events, including a review of the issuer's competitive position, cost structure and capital intensiveness; (iii) an assessment of the issuer's liquidity, including bank lines of credit and alternative sources of liquidity to support its commercial paper; and (iv) a `worst case scenario' evaluation of the issuer's ability to repay its short-term debt from cash sources or assets liquidations in the event that the issuer's backup credit facilities are unavailable."4
"In making its determination concerning the credit risk presented by each instrument, the board should take into account, as appropriate, [such] factors [as] ... the issuer's or guarantor's current and future credit quality; the strength of the issuer's or guarantor's industry within the economy and relative to economic trends; the issuer's or guarantor's market position within its industry; cash flow adequacy; the level and nature of earnings; financial leverage; asset protection; the quality of the issuer's or guarantor's accounting practices and management; the likelihood and nature of event risks, etc."5
The Commission has made clear that credit risk analysis is not a matter of "best practice," but is an affirmative legal obligation under Rule 2a-7. 6 While periodic reports filed under the Securities Exchange Act are obviously important in this regard, quite plainly that statute's reporting scheme (and the relatively extended periods between reporting dates) renders these reports less useful to the money markets than to the equity markets. Detailed (and often technical) points regarding features of an issuer's cash flow or short term borrowing arrangements and other sources of liquidity, for example, are typically not addressed in the MD&A discussion in a company's 10-K or 10-Q filings, because these matters are of lesser concern to the equity markets. And, even if an issuer goes to unusual lengths in its periodic reports to address these points in detail, there is significant risk that those details may well change prior to the next Exchange Act report. In the money market context, therefore, ongoing discussions between credit analysts and an issuer's senior management, particularly those in the comptroller or treasurer's office, take on a critical role in regard to the ability of money market funds to make minimal credit risk determinations.
Apart from requirements governing minimal credit risk determinations, Rule 2a-7 also imposes stringent limitations on the ability of a money market fund to purchase unrated securities. These securities must be comparable in quality to securities rated within the top two tiers by an NRSRO. Comparable quality determinations are typically made by investment managers by applying comparable research criteria and methodologies to those that are used by NRSROs, and, of necessity, involve meetings and discussions with corporate management to secure the necessary data for a finding of comparability. The adverse effect that proposed Reg. FD would have on credit analysis generally would be particularly acute with regard to comparable quality determinations for unrated securities.
Credit Research for Fidelity Money Market Funds
Our concerns over the likely deterioration in credit research for money market funds if proposed Reg. FD is adopted in its present form may be better understood by describing how that research is now conducted for the Fidelity money market funds. Typically, the money market fund manager, with the help of analysts, carries out credit research by gathering data from primary and secondary sources, and routinely meeting with corporate management to "kick the tires," understand operational as well as management priorities and take a measure of management's competence. If circumstances arise that suggest that a monitored credit needs a fresh, close look, the investment manager is likely to call or visit the issuer to confirm the issuer's creditworthiness or to determine that new information must be added to the mix to determine if holdings should be rolled over, put or sold and to determine new limits on exposure (as to maturity and size).
Both the taxable and tax-exempt money market funds for which Fidelity serves as investment adviser employ extensive procedures for making and monitoring minimal credit risk determinations. All issuers, rated and unrated, are subject to the same independent credit analysis. Fidelity analysts look beyond the published financial information of each issuer, and management's discussion and analysis thereof, to analyze cash flow adequacy, financial leverage and asset protection. Fidelity analysts also measure the quality of the issuer's management, review its accounting practices and assess its ability to cope with adversity or capitalize on opportunity. Fidelity analysts are also mindful of event risk for issuers, knowing that many of the financial attributes that lead to strong credit quality also make an issuer an attractive candidate for acquisition or restructuring, which may adversely affect its financial condition.
Evaluation of back-up lines of credit is a key factor in considering the strength of commercial paper issuers. Certain securities involve complex legal structures, for which Fidelity analysts review underlying documentation to evaluate the soundness of the security from a legal and credit perspective. Fidelity analysts and their attorneys often contact issuers and their counsel to discuss certain provisions of these complex instruments in order to better understand both the operation of the contractual provisions and the business rationale behind the provisions. It is important to note that Fidelity regularly discusses issuers and credit issues with analysts at the NRSROs as part of our credit analysis process in order to verify the basis for the NRSRO rating and to test the reliability of Fidelity's own assessments of particular data.
Fidelity has 17 analysts and 8 research associates supporting both taxable and tax-exempt money market issuers. In addition, there are over 230 fixed income and equity analysts and research associates within Fidelity who provide important insights from different perspectives to our credit analysis of money market issuers. Interaction with investment analysts in other parts of Fidelity is a critical part of the money market group's research process and is a necessary part of minimal credit risk analysis. While specialization of function is important, the quality of research is improved by the cross-fertilization of multiple disciplines, and the costs of maintaining a strong research process are better controlled.
While Fidelity reviews with care the written information supplied to us by issuers, determining that an issuer presents minimal credit risk is simply not possible based on that written information alone. Analysts must be able to ask issuers specific questions about their finances and their business. This additional information allows for a more complete understanding of each issuer, and in times of market stress, provides us with the ability to more accurately and promptly judge credit quality.
Thorough analysis and constant surveillance of money market issuers is critical to ensure liquidity and stability in times of financial stress. With a sound understanding of the details of an issuer's cash flow and liquidity, investors are in a far better position to assess the impact of volatile markets on that issuer. Particularly in the short-term debt markets, where loss of confidence and simultaneous actions by investors can have a domino effect on the deterioration of an issuer's credit, it is essential for money market funds to maintain their ability to probe issuer's management on issues that relate to credit quality.
Municipal Money Market Funds
Our concerns are not limited to taxable money market funds, but extend to municipal money market funds as well. Given the increasingly greater role that structured products and credit enhanced products play in the portfolio of municipal money market funds, proposed Reg. FD, in its present form, would do significant harm to credit analysis for those funds. In the case of municipal money market funds, many portfolio instruments are supported by the credit of corporations, in the case of conduit issuers, or by letters of credit, insurance or guarantees of banks, broker-dealers, insurance companies or other highly creditworthy non-governmental entities. At any given time, between 40% to 80% of a typical Fidelity municipal money market fund's portfolio might consist of structured or credit enhanced products.
Municipal money market research starts with an understanding of the structural aspects of the instrument. After determining which credit or credits must pay principal and interest and which credit source provides liquidity or effective maturity, the municipal analyst draws on the credit research of the taxable analyst to complete the minimal credit risk analysis. Thus, many of the same institutional and corporate credits that are found in a taxable money market fund make up many of the true credits in a municipal money market fund as well.
Additionally, although true municipal issuers, who do not avail themselves of private credit enhancers, would not be subject to proposed Reg. FD, the likely result of the rule's adoption, in its present state, would be a further clouding of the opaque markets in which municipal issuers currently issue their debt. The Office of Municipal Securities has expressed the view that a municipal issuer should be free to communicate accurate and material information to an investor and prospective investor without fear of violating Rule 10b-5, as long as the issuer is prepared to provide the same information to any person who asks for it. We are concerned that the adoption of Proposed Regulation FD is likely to eliminate the ability of municipal asset managers to obtain relevant information about the general obligation debt that they hold, because Reg. FD, by implication, denigrates one-on-one discussions between issuers and investors. 7
A Proposed Solution For Money Market Funds
In regard to proposed Regulation FD, any proposed solution addressing concerns that are particular to money market funds should be considered against the backdrop of existing factors that currently mitigate the risks of unfairness or abuse in the mutual fund industry.
Investment advisers of mutual funds have a large reputational and financial stake in preventing their personnel from trading on material, nonpublic information. First and foremost, fund advisers risk the public trust that is vital to their business if they fail to implement robust procedures designed to ensure compliance with all applicable laws, including the insider trading provisions of the federal securities laws. Even if a commitment to high standards of fiduciary duty were insufficient incentives, the treble damages penalties for the misuse of material nonpublic information has promoted the development of strong internal control procedures within the investment management industry. All of the foregoing considerations apply to money market fund investment managers and credit analysts. But as we have seen, proposed Reg. FD is likely to have a particularly disruptive and unhelpful effect on the conduct of credit research for money market funds, without any commensurate benefits for investors.
One solution would be to create a safe-harbor that excludes from the reach of Regulation FD communications by an issuer if the issuer or its management (i) in good faith (ii) communicates information in the ordinary course of business (iii) to a person who has responsibility for managing investments of a money market fund or conducting research for the purpose of making minimal credit risk or comparable quality determinations under Rule 2a-7 of the Investment Company Act of 1940.
In the adopting release, the Commission could make clear that the safe harbor exception applies only in the limited context of an issuer's reporting requirements under Regulation FD and that no inference (positive or negative) should be drawn as to the applicability of other rules and requirements of the federal securities laws, including Section 10(b) and Rule 10b-5 of the Securities Exchange Act to any given communication by an issuer or its management.
Adverse Impact on Other Fixed Income Markets
While the primary purpose of this letter is to address the difficulties that proposed Regulation FD poses for money market funds, it seems clear that other fixed income markets will also be adversely affected, including the asset-backed, high yield and fixed-income derivatives markets.
Asset Backed Securities
More than half of the new issuance of debt securities in the United States is in the form of asset backed securities. The value and performance of these securities is determined by analyzing the legal structure of the specific security and the cash flows of the assets that are held by the special purpose issuer. Most analysts of these securities use sophisticated computer models and computational methods to analyze projected cash flows under various economic and interest rate scenarios. The data that is necessary for credit surveillance and relative value analysis (and sometimes the computer models) are often supplied in electronic formats by issuers. This interchange between credit analysts and issuers simply does not lend itself to press conferences or press releases. A limited number of institutions request the information (and the information is generally available to all who request) that is required to monitor the performance of these issuers.
If adopted, Regulation FD would likely interfere with arrangements that have worked relatively well to date, with little or no evidence of unfairness or abuse toward any group of investors. The dangers of chilling credit-related research in this specialized market are ominous: Lack of information about complex asset backed and mortgage backed securities was a major contributing factor to problems experienced by several money market and bond fund managers in 1994 in the wake of Federal Reserve Board interest rate moves. As with the money markets, the asset backed markets depend on direct information flows between issuers and present and/or prospective holders. Lack of information will impair market liquidity and reduce market acceptance of new issuances.
High Yield Debt
The markets for high yield debt, particularly lower quality and distressed debt, also require effective and timely direct communications between issuers and investors. Managing troubled credits and assessing the possibility of a turn-around or successful reorganization sometimes requires the holder to voluntarily accept material, nonpublic information with respect to the issuer under information blocking control procedures designed to prevent violations of the federal securities and bankruptcy laws. Proposed Regulation FD, if adopted, would impair effective management of lower quality and distressed credits
The Derivative Markets
Counterparty credit research is at the heart of all professional management of derivatives, including swaps, forwards and repurchase agreements. Managers of these instruments must constantly assess the ability of a counterparty to assume its obligations under these types of instruments. As is the case with the money markets, proposed Regulation FD will introduce serious obstacles to the conduct of credit research in the derivatives markets. Constant surveillance of credit and establishing exposure limits based on up-to-date credit information is essential if losses are to be avoided. Because of the interlocking nature of derivative positions (most firms run a so-called matched book and end the day with a very limited net long or short position), significant systemic risk is present whenever a single participant gets into financial difficulty. Accordingly, market participants carefully police each other's credit and wind down exposures if a particular participant evidences signs of stress or credit deterioration. Proposed Regulation FD would likely weaken the counterparty credit research operations of most professional asset managers who use derivatives by deterring an essential tool of credit research: the one-on-one meeting with company management.
Summary and Conclusion
While the purposes of proposed Regulation FD are laudable, the rule, if adopted in its proposed form, is likely seriously to harm the quality of credit research for money market funds, without producing any appreciable benefits for investors. We urge the Commission to reconsider the practical difficulties that the proposed rule would engender for the markets generally, and for money market funds in particular. At the least, the Commission should consider some form of safe harbor provision or exemption for money market funds along the lines proposed above.
Eric D. Roiter
cc: Mike Eisenberg, Esquire
Douglas Scheidt, Esquire
Robert Plaze, Esquire
1 "The money market fund shall limit its portfolio investments to those United States Dollar Denominated securities that the fund's board of directors determines present minimal credit risks (which determination must be based on factors pertaining to credit quality in addition to any rating assigned to such securities by an NRSRO) and that are at the time of Acquisition Eligible Securities." 17 CFR 270.2a-7(c)(3).
2 Revisions to Rules Regulation Money Market Funds, February 27, 1991, at pg. 7.
3 See, e.g., Revisions to Rules Regulating Money Market Funds, December 17, 1993, at pg. 7 ("The amendments would require credit risks to be reviewed on an ongoing basis to assure that the securities continue to present minimal credit risk.").
4 Letter to Registrants (pub. avail. May 8, 1990).
5 Letter to Investment Company Institute (pub. avail. Dec. 6, 1989).
6 See Revisions to Rules Regulating Money Market Funds, December 17, 1993, at pg. 3 ("The amendments would require credit risk to be reviewed on an ongoing basis to assure that the securities continue to present minimal credit risk. The amendments would require funds to establish written procedures designed to assure that they have access to sufficient financial and other pertinent information concerning the issuer of the underlying security to permit the fund to perform a credit analysis of the issuer in certain circumstances. If this information cannot be obtained in these circumstances, the fund would be required to dispose of the security.").
7 The reporting requirements for companies that are registered under the Exchange Act are significantly more rigorous than the reporting requirements under Rule 15c2-12 and, accordingly, the information gaps for municipal securities are particularly problematic.