Early yesterday, the SEC issued a press release entitled, "Removal of Credit Rating References from Certain Investment Company Act Rules and Forms," and held an Open Meeting on the topic of changing the definition of "First Tier" (among other things). The release says, "The Commission will consider whether to propose amendments that would remove references to credit ratings in two rules and four forms under the Investment Company Act of 1940. The proposals stem from the Dodd-Frank Wall Street Reform and Consumer Protection Act.... The amendments would make changes to the money market fund rule among others."

SEC Chairman Mary Shapiro comments in her "Opening Statement Regarding Proposal to Remove Credit Rating References from Investment Company Act Rules and Forms," "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."

The Proposal, "Removing References to Credit Ratings of Money-Market Fund Investments," was passed by the Commission. The release comments on the "Current Rule," "Rule 2a-7 under the Investment Company Act governs the operations of money market funds and requires these funds to invest only in highly liquid short-term investments of the highest quality. To ensure that the funds are invested in high-quality, short-term securities, Rule 2a-7 sets forth several requirements: First, money market funds can only invest in securities that: Are 'first tier' -- meaning they have received the highest short-term rating or are 'second tier' -- meaning they have received the second highest short-term rating. At least 97 percent of a money market fund's portfolio must be invested in 'first tier' securities. If a security is not rated, the funds must evaluate the credit quality of the security and deem it be of comparable quality to a security receiving one of the two highest short-term ratings. Second, a money market fund's board of directors (or its delegate) must determine that the security presents minimal credit risks, based on factors relating to credit quality, in addition to any rating the security may have received."

It continues, "Proposed Amendments: The proposed amendments would eliminate the credit ratings requirements for money market fund investments. The amended rule would set forth new requirements: First, money market funds would have to assess the credit quality of the security and determine that each portfolio security presents minimal credit risks. Second, money market funds would have to determine whether the portfolio security is a 'first tier' or 'second tier' security, using new definitions for those terms. A security would be first tier only if the fund's board of directors (or its delegate) has determined that the security's issuer has the highest capacity to meet its short term financial obligations. Like the current rule, a money market fund would be required to invest at least 97 percent of its assets in first tier securities. A security would be second tier if the board (or its delegate) has determined the security presents minimal credit risks, even if it is not a first tier security."

It adds, "Some debt securities have a feature that allows an investor to sell the security (at cost plus accrued interest) back to the issuer or to a third party. Some of these 'demand features' limit an investor's ability to demand payment for the security under certain circumstances. Under existing Rule 2a-7, a money market fund may invest in a security subject to such a 'conditional demand feature' only if, among other things, the underlying security has received one of the two highest ratings. The proposed rules would eliminate the credit rating requirement. Instead, the fund's board (or its delegate) would be required to determine that the underlying security is of high quality and subject to very low credit risk.... The Commission also will consider proposing amendments to Form N-MFP, which money market funds use to report their portfolio schedules to the SEC each month. The proposed amendments would eliminate items in the form that require disclosure of the ratings of the securities in the portfolio."

Both SEC Commissioner Luis Aguilar and Commissioner Troy Paredes expressed reservations. Aguilar's Speech says, "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." Paredes' speech adds, "I support the proposal but do have questions about its practical effect, particularly insofar as rule 2a-7 is concerned. I look forward to the comments we will receive." Public comments on the proposed amendments should be received by April 25, 2011.

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