~
 ., 

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UNITE~STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON. D.C. 20549
 

~IVISION OF
 

.iENT MANAGEMENT 

May 10, 1994 

ACT -:Cll - '10 

Mr. Sean J. Egan BE-eTION 

Director of Reserch RULE :; tl -- '7 Red Flag Reseach Inc.
 

300 Berwyn Pak PUBLIC
 

Suite i 20 A V AIL.ILIT
 fi1/fY

Berwyn, Pennsylvana 19312 , 

Dear Mr. Egan:
 

This is in respnse to your letter of Apri 7, i 994 in which you reuest guidace 

regarding the proper use by money market funds and their advisers of credit analys~s 

prepared by unaffùiated rins.
 

Rule 2a- 7 reuires a money market fund to liit its portolio investments to United
 

States dollaT-denominated instruments that its board of directors or adviser determines 

present minimal creit risks. i Ths determination must be based on factors pertg to
 

credit quality "in addition to the rating assigned to such instruments by a NRRO. ,,2 You 

represent that Red Flag gathers, organies, and provides analytica support regarding 

seurities issuers for use by money market funds when makg the creit qualty 

determinations reuir by the role.
 

You have asked for clarication of whether it is permissible under role 2a-7 for a fund or its adviser' to use creit reports prepar by rins such as Red Flg ("creit

inormation services") when makg creit determinations, or whether the fund's adviser

must gather all the inormation pertg to the seurity's creit analysis independently. 

Rule 2a-7 does not spify the sources of inormation which a money market fund or its
 

adviser may consult when evaluating securities' creitworthiess, and we believe the use of 

rerts prear by creit inormation services is consistent with the role.
 

J Pargraph (c)(3) of role 2a-7. 

~. The term "NRRO" is dermed in the role to mea any nationaly regn 

statistica rating organition, as that term is use in role 15c3-1 under the Securities
 

Exchange Act of 1934. Pargraph (a)(10) of role 2a-7. 

, A money market fund may delegate the mial creit risk determination to the 

fund's investmeut advisei or offcers provided cert conditions ar met. Pargraph 

(e)(l) of role 2a-7. For purpses of this letter, Wl- have assumed that the fund's


board of directors has delegated the respnsibilty of makng minal creit risk 

determinations to the fund's adviser in accrdance with pargraph (e) of role 2a-7. 

2 
.~ 

- 2 ­

The conclusions presented to a fund by a creit inormation service may not provide
 

the sole basis for the fund's decision whether to purchase a security. 
 4 The responsibilty for 

reching a conclusion as to whether the seurity presents minal creit risks and meets role
 

2a-7's other reuirments remais at al times with the fund's adviser and may not be
 

delegated to a creit inormation service. Therefore, inormation reived from the creit

inormation service must be cafully reviewed by the adviser in the course of its overa

review of the creitworthiess of the seurity describe. S When relying on inormation 

provided by a creit inormation service, the adviser must not have any reson to believe 

that the inormation is inaccurate. 

We emphasize that a rert by a creit inormation service is not a substitute for the 

minimal credit risk analysis by the fund's investment adviser. Durig an insption of a
 

money market fund, the Commission sta wil not accpt a fund's possession of a rert on
 

a security (or its issuer) from a creit inormation service as demonstrating that the fund's 

ad vi seT has pedormed a minial credit risk analysis with respt to the security. The fund should present documentation to substantiate that it has pedormed a minal creit risk 

analysis and reached its own conclusion about whether the security presents such risks. 

Sincerely,

~~ 

Robert E. Plaz 

Assistat Dirtor 

4	 You reresent that Red Flg provides inormation for a fund to use when makg a 

creit determination regarding a seurity but does not present a conclusion regarg 

whether a seurity presents mial creit riks for a money market fund.
 

S	 See Investment Company Act ReI. No. 18005 (Feb. 20, 1991) (56 FR 8113 (Feb. 

27, 1991)) at nn. 17-19 and accmpanying text for a discussion of what the minal 

creit risk analysis should enta. We !iave not evaluated the qualty or adeqacy 'Jf
 

the sample report included with your reuest to determine 
 whether it presents suffcient inormation that would alow an adviser to pedorm a minal creit risk
 

analysis. 

.
 
Red Flag Research Ioe.
 

April 7, 1994
 

Mr. Kenneth J. Berman (mailstop 10~) 

Deputy Office Chief 

The Securities and Exchange Commission 

450 Fifth Street NW 

Washington, DC 20549 

Dear Mr. Berman: 

Thank you for speaking with me regarding Rule 2a-7 questions on the collection and 

formatting of data used in the creditworthiness evaluations. 

We have found that some fund managers are confused about whether they must assemble 

all the data themselves (prior to their reaching a creditworthiness decision), or if they can 

use an outside service for gathering, organizing, and providing analytical support for the 

data. Because of the 'time and labor intensive process in gathering the necessary financial 

and peer group data, we have observed that managers spend 80-90% of their research 

time ~athering and organizing the information, and only 10-20% (or less) time assessing 

credit qualiy under various economic, industry and financial conditions as required by 2a7. In some cases. manaaers do almost no analysis. claimina lack of information. A firm' 

such as ours attempts to enable managers to perform more and higher quality analysis (by 

gathering, organizing, and providing analytical support on issuer information) and thereby 

do a better job of protecting money fund investors. We were hoping to obtain some 

clarification on manaaers' usina outside services to aather and oraanize information on 

various issuers. The responsibility for ultimately determinina whether the issuer is of "hiah 

Quality and possesses minimal credit risks" as required by 2a-7 remains with the money 

fund manaaer. 

I have enclosed a copy of an opinion from Willkie Farr & Gallagher which supports the use 

of outside services for gathering and organizing information, provided the managers remain 

responsible for determining. creditworthiness (see the last paragraph). I have also 

enclosed a copy of a typical research report which was generated from softare purchased 

from a "Big 6" accounting firm. The managers can change the assumptions used in the 

report to "stress test" the issuer's credit quality. 

Thank you for your time, and I 
 look forward to speaking further with you. 

Sincerely, ;; c(~

se:-an 

Director of Research 

300 Berw Park, Suite 120, Berw, PA 19312; Tel: 215-648-0220 Fax: 215-648-0777
 
'VILLKIE PARR & GALLAGHER :\..10 York 

Uashington. DC 

London 

Paris 

January 31, 1994
 

Republic New York Securities Corporation
 

452 Fifth Avenue
 

New York, New York 1001e
 

Ladies and Gentlemen:
 

You have asked for advice concerning the
 standards that would apply pursuant to Rule 2a-7 (the 

"Rule") under the Investment Company Act of 1940, as
 

amended (the "1940 Act"), with respect to determinations of
 

the credit quality of investment grade portfolio
 

investments proposed to be made by a money market fund.


Your question was raised in connection' with a research 

service that Republic New York Securities Corporation
 

proposes to distribute to its institutional customers. The
 

research service is prepared by Red Flag Research, Inc.
 

("Red Flag"). You have informed us that it consists of
 

detailed analytical research concerning the creditworthiness of an issuer of eligible securities (as such term is
 

defined in the Rule). It also provides, you noted, a basis


on which a determination can reasonably be made that. a 

particular proposed investment presents minimal credit
 risks wi thin the meaning of paragraph (c) (3) of the Rule. 

In that regard, you have asked what the portfolio
 

manager's review of the Red Flag research would have to
 

entail to satisfy the standard of the Rule. For the
 

reasons set forth below, we believe that an adviser may use
 

and rely on research reports such as those prepared by Red
 

Flag, pursuant to delegated authority and subject to
 

ratification by the fund's board of directors. In
 

reviewing the reports, the adviser should draw his or her
 

own conclusions as to whether the information presented in
 

the report is sufficiently comprehensive in scope to
 

support the proposed determination on credit risk and other
 

relevant factors identified by the fund's board and whether
 

the information and analysis in the report would lend
 

reasonable support to that determination.
 

One Citicorp Center 212 821 8000 

153 Eat 5.1rd Stret Fax: 212 821 811
 

t\elO York..:-Y l0022--iõ77 
Republic New York Securities Corporation
 

January 31, 1994
 

Page 2
 

Paragraph (c) (3) of the Rule provides that a
 

money market fund must limit its portfolio investments,


incl uding puts and repurchase agreements, to those U. S. 

dollar-denominated instruments that its board of directors
 

determines present minimal credit risks (which
 

determination must be based on factors pertaining to credit
 

quality in addition to the rating assigned to such


instruments by one or more nationally recognized
 

statistical rating organizations (each, an "NRSRO")) and
 

that are, at the time of acquisition, "eligible securities"
 

as that term is defined in the Rule.
 

Presumably, an NRSRO reporting a credit rating
 

for a security will already have undertaken a rigorous
 

analysis of the customary factors that affect
 creditworthiness of an issuer and the quality of. a 

particular security. Indeed, the rating itself should
 

represent the result of an elaborate process of review and
 

analysis. Nevertheless, the Rule's requirement that the
 

fund's own analysis go beyond the rating implies the need
 

for additional review.
 

The Commission noted in the release adopting the
 

Rule some illustrative examples of the further review a
 

money market fund's board (and, by extension, the
 

investment adviser acting on its behalf) would be expected
 

to exercise:
 

" 

The requirement that a security have a high


quali ty rating provides protection by ensuring

input into the quality determination by an
 

outside source. However, the mere fact that an
 

instrument has or would receive a high quality
 

rating may not be sufficient to ensure stability.
 

The Commission believes that the instrument must
 

be evaluated for the credit risk that it presents
 

to the particular fund at that time in light of
 

the risks attendant to the use of amortized cost
 

valuation or penny-rounding. Moreover, the board
 

may look at some aspects when evaluating the risk
 

of an investment that would not be considered by
 

the rating services.
 

1940 Act Release No. 13880 (July 11, 1983) in text
 

following n. 31.
 

The factors a fund's board of directors sh~uld
 

take into account in that regard are further described in
 
," 

Republic New York Securities Corporation
 

January 31, 1994
 

Page 3
 

an interpretive letter from the Director of the Securities
 

and Exchange Commission' s Division of Investment Management
 

to the General Counsel of the Investment Company Institute


. (December 6, 1989), 1898 SEe No-Act. LEXIS 1185. The 

Director stated in that letter that the board should take
 

into account, as appropriate, among other things, macroeconomic factors which might affect 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; and the


likelihood and nature of event risks. See also letter from
 

the Director, Division of Investment Management re: Credit
 

Analysis of Portfolio Securities (May 8, 1990), 1990 SEe
 

No-Act. LEXIS 753.
 

Paragraph (e) of the Rule provides that a fund's
 board of directors may 
 delegate to the fund's investment
 

adviser or officers the responsibility to make the
 

determination that a proposed investment presents minimal
 

credit risks as long as the adviser's determination is
 sub' e t to mone mar un's oard of
 

directors and provided that the board: (1) establishes an
 

periodically reviews written guidelines (including
 

guidelines for determining whether instruments present
 minimal credit risks as provided in paragraph (c) (3) of the 

Rule) and procedures under which the person to whom the
 

authority is delegated by the fund's board makes such
 determinations; and (2) exercises' adequate oversight 

through periodic review of fund investments and the
 

delegated person's procedures in connection with, among
 

other things, the making of credit determinations to assure
 

that the guidelines and procedures are being followed.
 

Our research has not uncovered any interpretations by the Commission or its staff that bear on the
 

extent to which a fund's adviser can rely on credit
 

information and analysis provided by third parties in
 

making the determination contemplated by 
 paragraph (c) (3) of the Rule. Nevertheless, we believe that a fund's
 

adviser may reasonably conclude that he or she can use and
 

rely on a research report such as the one prepared by Red
 

Flag in performing the analysis contemplated by Rule 2a-7.
 

In that regard, the fund adviser should read and review
 

carefully the information presented in the report and
 
Republic New York Securities Corporation
 

January 31, 1994
 

Page 4
 

should reach his or her own conclusions as to whether the
 

information presented in the report is sufficiently
 

comprehensive in scope to support a determination that the
 

proposed investment presents minimal credit risks and such
 

other factors as the board has determined affect the
 

suitability of the security for the fund and whether the
 

information and analysis in the report in fact would lend
 

reasonable support to that determination.
 

ve~ truly yours, 

1~i9.~_. w

Roger D. Blanc
 

RDB : em 

03830355