By: Roger Binggeli
The new Rule 2a-7 language
In 2014, the SEC announced the first significant changes to Rule 2a-7 since the comprehensive post-financial crisis revisions announced in 2010 (see our blog post from earlier this year, entitled “Preparing for the 2016 Rule 2a7 Requirements”). At that time, the SEC also announced that they were “re-proposing” the elimination of credit rating requirements, a change that would be in line with section 939A of the Dodd-Frank Act. This section called for amending rules that pertain to the reliance on ratings from credit rating agencies. Just this past September, the Commission announced that the removal of the language in Rule 2a-7 pertaining to the relied upon NRSRO* credit ratings would have a compliance date of October 14, 2016. This means the revision takes effect the same time as the majority of the changes that were announced in 2014.
A second major change, announced this past September that has the same October 2016 compliance date, is the removal of the 5% issuer test exemption for securities for which a fund is relying upon the credit quality of guarantors. Previously, funds were able to invest up to 10% of their assets in securities that had the same issuer and were backed by the same guarantor. As of October 2016, however, funds will only be able to invest up to 5% of their assets in any one issuer, regardless of whether they are relying upon a guarantor or not. This means that instead of being able to invest up to 10% in any one position that is backed by the same guarantor, should a fund want to maintain a guarantor position close to 10% of assets, it will need to invest in at least two separate issuers.
The impact on money market fund managers
What do these regulatory changes mean to asset managers? Rule 2a-7 eligibility is now defined as a security that is deemed to present minimal credit risk. Funds will no longer be able to rely solely on ratings from NRSROs to determine Rule 2a-7 eligibility. Firms should continue to monitor the ratings that NRSROs provide because they will still be helpful.
In the same SEC release that announced the revisions to Rule 2a-7, changes to Form N-MFP were also made public. These rule changes involve the addition of new items to the form, including one where the security ratings considered in evaluating whether a security is eligible or not, must be reported.
Additionally, regarding the 10% guarantor and the 5% issuer tests, fund managers will need to remove any clause which permit issuers to exceed 5% of assets from their automated compliance system’s current test setups by the October 2016 compliance date. Although there is no guidance in updates to Rule 2a-7 around grandfathering in existing issuers that are above the threshold, there is also no language specifically stating that an existing issuer over 5% of assets must be brought into compliance through a sale.
What you should be doing now
Given that the effective date of the changes mentioned above was in October of 2015, fund managers should consider managing their funds as if the compliance date for the new rules has also already passed. Current in-house procedures should be re-written in order to match the rule changes, and particular thought should be given to how the eligible securities rule will be monitored on a day-to-day basis. Since the eligible security rule now requires an additional level of analysis, fund managers will no longer be able to leverage automated tests which include ratings, to the extent that they have been. Possible compliance guideline monitoring systems include creating customized lists that contain all eligible securities on your systems, or maintaining a “Rule 2a-7 Eligible Security” field on the security setup screen. Since both of these solutions require extensive manual maintenance, procedures that include multiple checks by different parties should be employed.
For the 10% guarantor test, it is also advisable that fund managers begin managing to the new rule as soon as possible. Any issuers currently over 5% due to the reliance on a guarantor should be examined in order to determine whether the position will fall below 5% ahead of the October 2016 compliance date (given the nature of money market securities, the likelihood of this is high). Should there be issuers that will not come into compliance due to maturity ahead of next October, a legal opinion should be sought as to whether a sale should be made to bring the position below the threshold level. Since the SEC requires that a sale should not be made to bring a fund into compliance if that sale would harm the interests of shareholders, careful consideration will need to be made ahead of a decision to sell down a position.
With the additional, previously announced 2a7 rule changes also having an October 2016 compliance date, your firm should have a committee in place dedicated to assessing how your particular money market funds are impacted by all of the rule changes. Although the fall of 2016 may seem to be far off, it is imperative to take steps now to ensure you are as prepared as possible on that compliance date.
*Nationally Recognized Statistical Rating Organizations
This article was authored by Roger Binggeli, Senior Compliance Consultant. For more information, please contact Roger at email@example.com or Jane Stabile at firstname.lastname@example.org. Roger can also be reached at 617-314-7415 x118.