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SEC's Proposed Rule Change Panned by Firms

WASHINGTON - The Securities and Exchange Commission's proposed rule changes that would limit the influence of credit rating agencies and boost the role of analysts at investment firms are being strongly criticized by the four firms that have commented on them so far.

In comment letters sent to the SEC, several funds, including Valley Forge, Pa.-based Vanguard Group Inc., which has over $1 trillion in managed assets, warned about the potential harmful effects of the proposed changes, particularly ones that would strip credit rating references from the SEC's Rule 2a-7 on money market funds. The rule generally requires such funds to hold debt rated double-A or higher.

"Ratings - even if occasionally imperfect - protect investors by establishing a uniform minimum credit quality for all money market funds," John J. Brennan, chairman and chief executive officer of Vanguard, wrote in an Aug. 1 letter to the SEC. "Removing that investor protection is akin to outlawing seat belts with the hope that drivers will be less likely to be injured if a defective belt fails in a crash."

In late June, the commission voted in favor of stripping references to "nationally recognized statistical rating organizations" from 38 of its rules, including 2a-7, which governs tax-exempt and other money market funds.

Tax-exempt money market funds held $528.4 billion in the week ending Aug. 18, according to the Money Fund Report, a service of iMoneyNet.com of Westborough, Mass.

The SEC's proposal, which is officially open for public comment through Sept. 5, is the latest response from the commission to record losses reported by Wall Street firms with investments in tainted sub-prime mortgage bonds, which were rated triple-A despite their poor credit quality. Earlier in June, the SEC proposed two sets of rules designed to limit rating agencies' conflicts of interest, increase their disclosure, and better differentiate between the ratings of structured, corporate and municipal securities.

SEC officials have said for months that, in addition to avoiding over-reliance on credit rating agencies, stripping references to NRSRO ratings from the commission rules is necessary to avoid creating a so-called moral hazard caused by the commission's seeming endorsement of the ratings.

But Brennan argued that even if some funds are unduly reliant on ratings and, as a result, may be vulnerable to failures in the ratings process, those funds "failed to meet their obligations to their investors." Good credit analysis can catch the failures in the ratings process, he added.

Brennan warned that if the rule changes are implemented as proposed, they will pose a risk to the stability of the $3.5 trillion money market fund industry because they may inadvertently allow funds to select investments that may not have met the standards of the NRSROs.

"NRSRO ratings serve as an objective and necessary, but not sufficient, qualification for buying a security," Brennan wrote. "If the ratings are eliminated from Rule 2a-7, a common standard for investment quality upon which money market fund investors can rely will be eliminated, to the detriment of those investors."

In a separate Aug. 14 comment letter, Horsham, Pa.-based Realpoint LLC, which rates structured products and was recently designated by the SEC as an NRSRO, was even more direct, warning: "There are no advantages to relying solely on money market fund boards of directors to make minimum credit risk determinations. Existing Rule 2a-7 requires a money market fund's board of directors to determine whether an investment presents minimal credit risks. Existing Rule 2a-7 was never intended to permit NRSRO credit ratings to supersede or obviate board obligations."

Instead of eliminating the rule's reference to NRSRO ratings, the commission should consider revising the rule to require fund boards to separately consider the credit ratings of NRSROs and to document or publish when the board's analyses deviate from the NRSROs, Realpoint said.

Realpoint also noted that a money market fund's board of directors and investment advisers have a conflict of interest "when simultaneously considering and evaluating yields and credit risk." As such, the 2a-7 proposal runs counter to the commission's goals of reducing conflicts of interests in the rating of securities, promoting unsolicited credit ratings and increasing the transparency of credit ratings and the processes by which they are developed, Realpoint said.

Meanwhile, two additional comment letters from funds managed by subsidiaries of Prudential Financial Inc. strongly urge the commission to reconsider its proposal and "relieve fund directors of any direct responsibilities for final determinations as to the credit-worthiness of specific securities."

"If NRSROs are indeed broken, then we ask the commission to do all that it can to fix them so that those institutions can continue to play a pivotal role under Rule 2a-7," said an Aug. 14 comment letter sent to the commission on behalf of the board of directors of the Advanced Series Trust, Prudential Series Fund, and Prudential Gibraltar Fund Inc. "If, though, the commission decides that NRSROs are beyond repair, the commission, in our view, should expressly provide that the fund board would have only a general oversight duty to establish and monitor procedures relating to credit assessments. Actual credit determinations themselves would continue to be delegated to the investment adviser, who could take into account ratings provided by the NRSROs, as well as research provided by financial services firms and any other input that the adviser deems appropriate."

A second letter dated Aug. 22 was written on behalf of the board of the Jennison/Dryden fund, which is managed by Prudential Financial, and Target Mutual Funds. The letter makes a similar point in nearly identical language.

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