(The article featured below is a selection from SEC No-Action Letter Weekly, which is available to subscribers of that publication.)

Vanguard Urges SEC to Keep Rule 2a-7 Reliance on Credit Ratings

The Vanguard Group, one of the world's largest mutual fund complexes, has written in opposition to the SEC's proposal to eliminate references to credit ratings in Investment Company Act rule 2a-7. The SEC has proposed to eliminate the references in other rules as well, but Vanguard said the removal from rule 2a-7 caused the greatest concern. The elimination of nationally recognized statistical rating organization ratings from rule 2a-7 would remove an important investor protection, weaken investment standards and potentially pose a risk to the stability of the money market fund industry, according to Vanguard. Vanguard provides 10 money market mutual funds with assets of $190 billion.

Vanguard believes that NRSRO ratings provide an important baseline for money market fund investments. Vanguard recognizes the SEC's concerns about the integrity of the ratings and the potentially misplaced reliance on flawed ratings in the recent market turmoil. However, Vanguard called for a greater emphasis on the requirement under rule 2a-7 for an independent risk analysis. Even if the ratings are not perfect, Vanguard said they protect investors by establishing a uniform, minimum credit quality for all money market funds.

If certain funds unduly relied on credit ratings and were more vulnerable to the failures of the ratings process, Vanguard said those funds failed to meet their obligations to investors. The SEC should demand that all fund managers and boards of directors comply with the minimal credit risk standard under rule 2a-7 rather than lower the minimum threshold for eligible instruments. Vanguard believes the SEC's initiative to improve the transparency of the ratings process will make it easier for funds to detect any flaws in the ratings.

Deficient ratings pose a danger to money market funds, but Vanguard emphasized that not all ratings are dangerous. Properly generated ratings that are understood by the market are valuable safeguards against the temptation to invest in higher yielding but more risky investments, according to Vanguard. The SEC should address the reliability of ratings and the transparency of the process rather than throw out all ratings, in Vanguard's view.

The SEC's original view was that NRSRO ratings play an integral role in rule 2a-7 by establishing an independent floor for money market investments. Vanguard said that view is still valid. Independent third-party credit ratings protect investors by limiting a fund's ability to seek higher yields with riskier investments based on its own assessments, Vanguard explained. Vanguard characterized NRSRO ratings as an objective and necessary, but not a sufficient qualification, when buying a security.

If the SEC eliminates the NRSRO baseline, Vanguard warned that funds may do what the SEC tried to prevent them from doing when it adopted the rule 2a-7 requirements. Money market fund credit analysts would be free to disagree with the judgment of the rating agencies and approve instruments that to not meet the NRSROs' standards of credit quality and liquidity. Vanguard noted that the SEC did not believe this was wise when it adopted rule 2a-7, nor when it reconsidered the rule on various occasions.

Vanguard urged the SEC to continue to support a regulatory framework for money market funds that protects investors from the loosening of credit standards. This framework can be achieved by enhancing the transparency of the ratings process and through compliance examinations and sanctions against those who fail to meet the rule 2a-7 requirements, according to Vanguard.