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11 July 2008
Three notices.
[Federal Register: July 11, 2008 (Volume 73, Number 134)][Proposed Rules] [Page 40087-40106] From the Federal Register Online via GPO Access [wais.access.gpo.gov] [DOCID:fr11jy08-16] [[Page 40087]] ----------------------------------------------------------------------- Part IV Securities and Exchange Commission ----------------------------------------------------------------------- 17 CFR Parts 229, 230, et al. References to Ratings of Nationally Recognized Statistical Rating Organizations; Security Ratings; Proposed Rules [[Page 40088]] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240, 242, and 249 [Release No. 34-58070; File No. S7-17-08] RIN 3235-AK17 References to Ratings of Nationally Recognized Statistical Rating Organizations AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. ----------------------------------------------------------------------- SUMMARY: This is one of three releases that the Securities and Exchange Commission (``Commission'') is publishing simultaneously relating to the use in its rules and forms of credit ratings issued by nationally recognized statistical rating organizations (``NRSROs''). In this release, the Commission proposes to amend various rules and forms under the Securities Exchange Act of 1934 (``Exchange Act'') that rely on NRSRO ratings. The proposed amendments are designed to address concerns that the reference to NRSRO ratings in Commission rules and forms may have contributed to an undue reliance on NRSRO ratings by market participants. DATES: Comments should be received on or before September 5, 2008. ADDRESSES: Comments may be submitted by any of the following methods: Electronic CommentsUse the Commission's Internet comment form (http:// www.sec.gov/rules/proposed.shtml); or Send an e-mail to rule-comments@sec.gov. Please include File Number S7-17-08 on the subject line; or Use the Federal eRulemaking Portal (http:// www.regulations.gov). Follow the instructions for submitting comments. Paper Comments Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number S7-17-08. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available. FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate Director, Thomas K. McGowan, Assistant Director, Randall W. Roy, Branch Chief, and Joseph I. Levinson, Attorney (Net Capital Requirements and Customer Protection) at (202) 551-5510; Michael Gaw, Assistant Director, Brian Trackman, Special Counsel, and Sarah Albertson, Attorney (Alternative Trading Systems) at (202) 551-5602; Paula Jenson, Deputy Chief Counsel, Joshua Kans, Senior Special Counsel, Linda Stamp Sundberg, Senior Special Counsel (Confirmation of Transactions) at (202) 551-5550; Josephine J. Tao, Assistant Director, Elizabeth A. Sandoe, Branch Chief, and Bradley Gude, Special Counsel (Regulation M) at (202) 551-5720; or Catherine Moore, Counsel to the Director at (202) 551-5710, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-6628. SUPPLEMENTARY INFORMATION: I. Introduction On June 16, 2008, in furtherance of the Credit Rating Agency Reform Act of 2006,\1\ the Commission published for notice and comment two rulemaking initiatives.\2\ The first proposes additional requirements for NRSROs \3\ that were directed at reducing conflicts of interests in the credit rating process, fostering competition and comparability among credit rating agencies, and increasing transparency of the credit rating process.\4\ The second is designed to improve investor understanding of the risk characteristics of structured finance products. Those proposals address concerns about the integrity of the credit rating procedures and methodologies of NRSROs in light of the role they played in determining the credit ratings for securities that were the subject of the recent turmoil in the credit markets. --------------------------------------------------------------------------- \1\ Public Law 109-291, 120 Stat. 1327 (2006). \2\ Proposed Rules for Nationally Recognized Statistical Rating Organizations, Securities Exchange Act Release No. 57967 (June 16, 2008), 73 FR 36212 (June 25, 2008). \3\ As described in more detail below, an NRSRO is an organization that issues ratings that assess the creditworthiness of an obligor itself or with regard to specific securities or money market instruments, has been in existence as a credit rating agency for at least three years, and meets certain other criteria. The term is defined in section 3(a)(62) of the Securities Exchange Act. A credit rating agency must apply with the Commission to register as an NRSRO, and currently there are nine registered NRSROs. \4\ See Press Release No. 2008-110 (June 11, 2008). --------------------------------------------------------------------------- Today's proposals comprise the third of these three rulemaking initiatives relating to credit ratings by an NRSRO that the Commission is proposing. This release, together with two companion releases, sets forth the results of the Commission's review of the requirements in its rules and forms that rely on credit ratings by an NRSRO. The proposals also address recent recommendations issued by the President's Working Group on Financial Markets (``PWG''), the Financial Stability Forum (``FSF''), and the Technical Committee of the International Organization of Securities Commissions (``IOSCO'').\5\ Consistent with these recommendations, the Commission is considering whether the inclusion of requirements related to ratings in its rules and forms has, in effect, placed an ``official seal of approval'' on ratings that could adversely affect the quality of due diligence and investment analysis. The Commission believes that today's proposals could reduce undue reliance on credit ratings and result in improvements in the analysis that underlies investment decisions. --------------------------------------------------------------------------- \5\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments (March 2008), available at http://www.ustreas.gov (``PWG Statement''); The Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 2008), available at http://www.fsforum.org (``FSF Report''); Technical Committee of the International Organization of Securities Commissions, Consultation Report: The Role of Credit Rating Agencies in Structured Finance Markets (March 2008), page 9, available at http://www.iosco.org. --------------------------------------------------------------------------- II. Background The Commission first used the term NRSRO in our rules in 1975 in the net capital rule for broker-dealers, Rule 15c3-1 under the Exchange Act (``Net Capital Rule'') \6\ as an objective benchmark to prescribe capital charges for different types of debt securities. Since then, we have used the designation in a number of regulations under the federal securities laws. Although we originated the use of the term NRSRO for a narrow purpose in our own regulations, ratings by NRSROs today are used widely as benchmarks in federal and state legislation, rules issued by other financial regulators, in the United States and abroad, and private financial contracts. --------------------------------------------------------------------------- \6\ 17 CFR 240.15c3-1. --------------------------------------------------------------------------- [[Page 40089]] Referring to NRSRO ratings in regulations was intended to provide a clear reference point to both regulators and market participants. Increasingly, we have seen clear disadvantages of using the term in many of our regulations. Foremost, there is a risk that investors interpret the use of the term in laws and regulations as an endorsement of the quality of the credit ratings issued by NRSROs, which may have encouraged investors to place undue reliance on the credit ratings issued by these entities. In addition, as demonstrated by recent events,\7\ there has been increasing concern about ratings and the ratings process. Further, by referencing ratings in the Commission's rules, market participants operating pursuant to these rules may be vulnerable to failures in the ratings process. In light of this, the Commission proposes to amend the regulations. --------------------------------------------------------------------------- \7\ See Proposed Rules for National Recognized Statistical Rating Organizations, Securities Exchange Act Release No. 57967. --------------------------------------------------------------------------- We have identified a small number of rules and forms, however, where we believe it is appropriate to retain the reference to NRSRO ratings. These rules and forms generally relate to non-public reporting or recordkeeping requirements we use to evaluate the financial stability of large brokers or dealers or their counterparties and are unlikely to contribute to any undue reliance on NRSRO ratings by market participants.\8\ --------------------------------------------------------------------------- \8\ These include Rules 15c3-1g(c)(1)(i), 15c3-1g(e)(2)(i), 17i- 5, and 17i-8, which impose certain recordkeeping and reporting requirements for ultimate holding companies of broker-dealers and of supervised investment bank holding companies, and Forms 17-H and X- 17A-5 Part IIB, which require reports regarding the risk exposures of large broker-dealers and OTC derivatives dealers. --------------------------------------------------------------------------- III. Proposed Amendments We are proposing to remove references to NRSROs in the following rules and forms: Rule 3a1-1, Rule 10b-10, Rule 15c3-1, Rule 15c3-3, Rules 101 and 102 of Regulation M, Regulation ATS, Form ATS-R, Form PILOT, and Form X-17A-5 Part IIB. A. Proposed Amendments to Rule 3a1-1, Regulation ATS, Form ATS-R, and Form PILOT In 1998, we established a new framework for the regulation of exchanges and alternative trading systems (``ATSs'').\9\ That framework allowed an ATS to choose whether to register as a national securities exchange or to register as a broker-dealer and comply with the requirements of Regulation ATS. As part of this framework, we adopted Rule 3a1-1 under the Exchange Act,\10\ Regulation ATS,\11\ and Forms ATS and ATS-R. --------------------------------------------------------------------------- \9\ See Securities Exchange Act Release No. 40760 (December 8, 1998), 63 FR 70844 (December 22, 1998) (``Regulation ATS Adopting Release''). \10\ 17 CFR 240.3a1-1. \11\ 17 CFR 242.300 to 242.303. --------------------------------------------------------------------------- Rule 3a1-1(a) provides an exemption from the Exchange Act definition of ``exchange''--and thus the requirement to register as an exchange--for a trading system that, among other things, is in compliance with Regulation ATS.\12\ Rule 3a1-1(b) contains an exception to the exemption from the exchange definition. Under this exception, the Commission may require a trading system that is a ``substantial market'' to register as a national securities exchange if it finds that such action is necessary or appropriate in the public interest or consistent with the protection of investors.\13\ Specifically, the Commission may--after notice to an ATS and an opportunity for it to respond--require the ATS to register as an exchange if, during three of the preceding four calendar quarters, the ATS had: (1) 50% or more of the average daily dollar trading volume in any security and 5% or more of the average daily dollar trading volume in any class of securities; or (2) 40% or more of the average daily dollar volume in any class of securities.\14\ --------------------------------------------------------------------------- \12\ See 17 CFR 240.3a1-1(a)(2). \13\ See 17 CFR 240.3a1-1(b); Regulation ATS Adopting Release, 63 FR at 70857. \14\ See 17 CFR 240.3a1-1(b)(1). --------------------------------------------------------------------------- As the Commission explained in the Regulation ATS Adopting Release, it was reserving the right to require a ``dominant'' ATS to register as an exchange.\15\ The Commission noted, for example, that ``it may not be consistent with the protection of investors or in the public interest for a trading system that is the dominant market, in some important segment of the securities market, to be exempt from registration as an exchange if competition cannot be relied upon to ensure fair and efficient trading structures.'' \16\ The Commission also stated that it might be necessary to require an ATS to register as an exchange if it ``would create systemic risk or lead to instability in the securities markets' infrastructure.'' \17\ The Commission made clear that its authority under Rule 3a1-1 was discretionary: ``Although the standard for denying or withholding the exemption is based on objective factors, the Commission has discretion to initiate any process to consider whether to revoke a particular entity's exemption under the rule.'' \18\ Thus, while observing that some ATSs likely were above the volume thresholds of Rule 3a1-1, the Commission did not at the time believe it was appropriate to revoke the exemption for any such ATS.\19\ --------------------------------------------------------------------------- \15\ See 63 FR at 70857. \16\ Id. at 70858. \17\ Id. \18\ Id. at 70857-58. \19\ See id. at 70858. --------------------------------------------------------------------------- The Commission set forth eight classes of securities in any one of which an ATS might achieve ``dominant'' status: (1) Equity securities; (2) listed options; (3) unlisted options; (4) municipal securities; (5) investment grade corporate debt securities; (6) non-investment grade corporate debt securities; (7) foreign corporate debt securities; and (8) foreign sovereign debt securities.\20\ Under the definitions provided in Rule 3a1-1, investment grade and non-investment grade corporate debt securities have three elements in common. They are securities that: (1) Evidence a liability of the issuer of such security; (2) have a fixed maturity date that is at least one year following the date of issuance; and (3) are not exempted securities, as defined in Section 3(a)(12) of the Exchange Act.\21\ The distinguishing characteristic of an investment grade corporate debt security under our current rules is that it has been rated in one of the four highest categories by at least one NRSRO. A non-investment grade corporate debt security under our current rules is a corporate debt security that has not received such a rating. --------------------------------------------------------------------------- \20\ See 17 CFR 240.3a1-1(b)(3). \21\ Compare 17 CFR 240.3a1-1(b)(3)(v) with 17 CFR 240.3a1- 1(b)(3)(vi). --------------------------------------------------------------------------- We preliminarily believe that distinguishing investment grade corporate debt securities and non-investment grade corporate debt securities as separate classes of securities under Rule 3a1-1 is not necessary to fulfill the purposes of that rule. We preliminary believe instead that combining all corporate debt securities into a single class for purposes of assessing whether an alternative trading system is ``dominant'' is appropriate. Accordingly, we propose to amend Rule 3a1-1 by replacing paragraphs (b)(3)(v) and (b)(3)(vi) which define investment grade corporate debt securities and non-investment grade debt securities, respectively, with a single category ``corporate debt securities'' in paragraph (b)(3)(v).\22\ This new definition would retain verbatim the three elements common to the existing definitions of investment grade and non-investment grade debt securities. The 5% and 40% thresholds also would remain [[Page 40090]] unchanged. Under the proposed amendment to Rule 3a1-1, the Commission could, for example, determine that an ATS must register as an exchange if the system had--during three of the preceding four calendar quarters--50% or more of the average daily dollar trading volume in any security and 5% or more of the average daily dollar trading volume in corporate debt securities, or 40% of the average daily dollar trading volume in corporate debt securities.\23\ --------------------------------------------------------------------------- \22\ Existing paragraphs (b)(3)(vii) and (b)(3)(viii) would be unchanged but redesignated as paragraphs (b)(3)(vi) and (b)(3)(vii), respectively. \23\ The other six classes of securities--equity securities, listed options, unlisted options, municipal securities, foreign corporate debt securities, and foreign sovereign debt securities-- would remain unchanged. Therefore, as under existing Rule 3a1-1, the Commission also could determine that an ATS must register as an exchange if the system exceeded either volume threshold in any of these other classes of securities. --------------------------------------------------------------------------- The Commission preliminarily believes that exceeding a volume threshold for a combined class of all corporate debt securities would be a sufficient indication that an ATS should be required to register as an exchange, and that it is not necessary or appropriate to assess trading volumes in the narrower segments of investment grade and non- investment grade corporate debt securities. While the proposed amendment could reduce the likelihood that an ATS could be required to register as an exchange,\24\ we preliminarily believe that this change would nevertheless be appropriate. At this time, there does not appear to be a continuing need to analyze ``dominance'' in separate classes of investment grade and non-investment grade corporate debt securities, particularly in view of the fact that the Commission would continue to analyze for dominance in six other classes of securities (in addition to the new single class for corporate debt securities). The Commission notes that, in over nine years since the adoption of Rule 3a1-1, the Commission has never determined to require an ATS to register as an exchange because it had become ``dominant.'' Moreover, the Commission would continue to be able to exercise discretion about whether to revoke the exemption for any ATS that exceeded either threshold in Rule 3a1-1. The Commission seeks comment on whether, in light of the proposed combination of investment grade and non-investment grade corporate debt securities into a single class, it should adopt lower thresholds at which an ATS that trades corporate debt securities should be required to register as an exchange. If so, what should those thresholds be and why? --------------------------------------------------------------------------- \24\ For example, under existing Rule 3a1-1, an ATS that has 40% of the average daily dollar trading volume in non-investment grade corporate debt securities and 0% of the average daily dollar trading volume in investment grade corporate debt securities for three consecutive months could be required by the Commission to register as an exchange. Under the proposed amendment, the Commission could not do so because the ATS's combined average daily dollar trading volume in corporate debt securities would be less than 40%. --------------------------------------------------------------------------- We are proposing similar changes to Regulation ATS, which establishes certain requirements applicable to ATSs that choose to register as broker-dealers and comply with Regulation ATS in lieu of exchange registration. Rule 301(b)(5) of Regulation ATS imposes a ``fair access'' requirement, whereby an ATS that exceeds certain volume thresholds in any class of securities must establish written standards for granting access to trading on its system and not unreasonably prohibit or limit any person in respect to access to the services it offers.\25\ The fair access standard applies if an ATS has 5% or more of the average daily volume during at least four of the preceding six calendar months in any of the following: (1) Any individual NMS stock; \26\ (2) any individual equity security that is not an NMS stock and for which transactions are reported to a self-regulatory organization; (3) municipal securities; (4) investment grade corporate debt securities; and (5) non-investment grade corporate debt securities.\27\ The terms investment grade and non-investment grade debt security are defined in Rule 300 of Regulation ATS. --------------------------------------------------------------------------- \25\ See 17 CFR 242.301(b)(5). \26\ See 17 CFR 240.600(a)(47) (defining ``NMS stock''). \27\ In proposing Regulation ATS, the Commission requested comment ``on whether categories of debt securities should be further divided based on an instrument's maturity, credit rating, or other criteria.'' Securities Exchange Act Release No. 39884 (April 21, 1998), 63 FR 23504, 23519 (April 29, 1998). However, in adopting Regulation ATS, the Commission did not employ these narrower classes of debt securities. See Regulation ATS Adopting Release, 63 FR at 70873. --------------------------------------------------------------------------- We propose to amend Rules 300 and 301(b)(5) to establish a single class of corporate debt securities and to eliminate the existing separate classes of investment grade and non-investment grade corporate debt securities. Accordingly, paragraphs (i) and (j) of Rule 300 would be replaced with a new paragraph (i) defining ``corporate debt security'' to mean any security that: (1) Evidences a liability of the issuer of such security; (2) has a fixed maturity date that is at least one year following the date of issuance; and (3) is not an exempted security, as defined in Section 3(a)(12) of the Exchange Act. Existing paragraphs (i)(D) and (i)(E) of Rule 301(b)(5) would be replaced with a new paragraph (i)(D) providing that an ATS must comply with the access requirements set out in Rule 301(b)(5) if, with respect to corporate debt securities, such system accounts for 5% or more of the average daily volume traded in the United States for the requisite number of months. The 5% threshold at which an ATS would have to grant fair access to its system also would remain unchanged.\28\ As with the proposed changes to Rule 3a1-1, the other classes of securities would remain unchanged. --------------------------------------------------------------------------- \28\ When the Commission originally adopted Regulation ATS, it set the fair access threshold at 20%. It later lowered the threshold to 5% in connection with the adoption of Regulation NMS. See Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496, 37550 (June 29, 2005). --------------------------------------------------------------------------- In addition, Rule 301(b)(6) of Regulation ATS \29\ requires an ATS that exceeds certain volume thresholds in any class of securities to comply with standards regarding the capacity, integrity, and security of its automated systems. Five classes of securities are currently identified in Rule 301(b)(6): (1) NMS stocks; (2) equity securities that are not NMS stocks and for which transactions are reported to a self-regulatory organization; (3) municipal securities; (4) investment grade corporate debt securities; and (5) non-investment grade corporate debt securities.\30\ Consistent with the other proposed changes to Regulation ATS, the Commission also proposes to eliminate separate classes for investment grade and non-investment grade debt securities in Rule 301(b)(6) and replace them with a single category for ``corporate debt securities,'' which would be defined in Rule 300. Existing paragraphs (i)(D) and (i)(E) of Rule 301(b)(6) would be replaced with a new paragraph (i)(D) providing that an ATS must comply with the capacity, integrity, and security requirements of Rule 301(b)(6) if, with respect to corporate debt securities, such system accounts for 20% or more of the average daily volume traded in the United States for the requisite number of months. The 20% threshold and the other three classes of securities would remain unchanged. --------------------------------------------------------------------------- \29\ 17 CFR 242.301(b)(6). \30\ 17 CFR 242.301(b)(6)(i). --------------------------------------------------------------------------- For the same reasons we are proposing to amend Rule 3a1-1, we preliminarily believe that these proposed amendments to Regulation ATS would be appropriate, and that a volume threshold for a combined class of all corporate debt securities would be sufficient for the fair access requirement and the capacity, integrity, and security requirements. The Commission preliminarily believes that the purposes of Regulation ATS would still be [[Page 40091]] fulfilled if investment grade and non-investment grade corporate debt securities were combined into a single class. ATSs would continue to be subject to the fair access requirements and the capacity, integrity, and security requirements with respect to the other existing classes of securities and at the same volume thresholds (5% and 20%, respectively). The Commission seeks comment on whether, in light of the proposed combination of investment grade and non-investment grade corporate debt securities into a single class, it should adopt lower thresholds for fair access and the capacity, security, and integrity requirements under Regulation ATS. If so, what should those thresholds be and why? We are also proposing revisions to Form ATS-R, which is used by ATSs to report certain information about their activities on a quarterly basis.\31\ Currently, Form ATS-R requires each ATS to report the total unit volume and total dollar volume in the previous quarter for various categories of securities, including investment grade and non-investment grade corporate debt securities. Consistent with the proposed amendments to Regulation ATS described above, we also propose to revise Form ATS-R to eliminate the separate categories for investment grade and non-investment grade corporate debt securities, and instead create a single category for ``corporate debt securities.'' As with the proposed changes to Regulation ATS, ``corporate debt securities'' would be defined in the instructions to Form ATS-R to mean any security that: (1) Evidences a liability of the issuer of such security; (2) has a fixed maturity date that is at least one year following the date of issuance; and (3) is not an exempted security, as defined in Section 3(a)(12) of the Exchange Act. Because separate classes for investment grade and non-investment grade corporate debt securities are proposed to be eliminated for purposes of the thresholds in Rule 3a1-1 and Rules 301(b)(5) and 301(b)(6) of Regulation NMS, no purpose would be served by requiring ATSs to separately report their trading volumes for investment grade and non-investment grade debt securities on Form ATS-R. The figures for the separate classes would be added together and reported as a single item on the amended form. The Commission is not proposing any other changes to Form ATS-R. --------------------------------------------------------------------------- \31\ Each ATS must file a Form ATS-R within 30 days of the end of each calendar quarter, and within ten days of a cessation of operations. See 17 CFR 242.301(b)(9). --------------------------------------------------------------------------- We are also proposing to revise Form PILOT consistent with the proposed changes to Form ATS-R. Ordinarily, Section 19 of the Exchange Act \32\ and Rule 19-4 thereunder \33\ require a self-regulatory organization (``SRO'') to file with the Commission proposed rule changes on Form 19b-4 regarding any changes to any material aspect of its operations, including any trading system. Rule 19b-5 under the Exchange Act \34\ sets forth a limited exception to that requirement by permitting an SRO to operate a pilot trading system without filing proposed rule changes with respect to that system if certain criteria are met. One of those criteria is that the SRO file a Form PILOT in accordance with the instructions on that form. Like Form ATS-R, Form PILOT currently requires quarterly reporting of trading activity by classes of securities, including investment grade and non-investment grade corporate debt securities. For the same reasons we propose to amend Rule 3a1-1 and Regulation ATS, we also propose to revise Form PILOT to eliminate these two categories, replacing them with a single category of ``corporate debt securities.'' Corporate debt securities would be defined identically in Form PILOT and Form ATS-R. The Commission preliminarily believes that it is appropriate to obtain trading volumes from pilot trading systems for the combined class of corporate debt securities, and that separate reporting of the two classes is not necessary to adequately monitor the development of pilot trading systems. The Commission notes that, in over nine years since Rule 19b-5 and Form PILOT were adopted, no SRO has ever established a pilot trading system pursuant to Rule 19b-5 to trade corporate debt securities. --------------------------------------------------------------------------- \32\ 15 U.S.C. 78s. \33\ 17 CFR 240.19b-4. \34\ 17 CFR 240.19b-5. --------------------------------------------------------------------------- We generally request comment on all aspects of the proposed elimination of the reference to NRSRO ratings in Rule 3a1-1, Regulation ATS, Form ATS-R, and Form PILOT. In addition, we request comment on the following specific questions: Would the proposed amendments to Rule 3a1-1 have any significant impact on investors, market participants, the national market system, or the public interest? Would the proposed amendments to Regulation ATS have any significant impact on investors, market participants, the national market system, or the public interest? Would the proposed amendments affecting the fair access standards have other consequences, whether on investors, market participants, the national market system, or the public interest? Have investors experienced difficulty obtaining access to ATSs trading corporate debt securities? Would the proposed amendments impair or limit current investor access to ATSs? Would the proposed changes to Regulation ATS as they relate to the capacity, integrity, and security requirements have any adverse impact on investors, market participants, or the national market system as a whole? In view of the proposed combination of investment grade and non-investment grade corporate debt securities into a single class for purposes of Rule 3a1-1 and Regulation ATS, should the Commission also lower the thresholds in those rules for the combined class of corporate debt securities? If so, what should those thresholds be? Why are those suggested thresholds appropriate? Should the Commission retain investment grade and non- investment grade corporate debt securities as separate classes of securities under Rule 3a1-1 and Regulation ATS and instead use different definitions of those terms that do not rely on NRSRO ratings? If so, how should investment grade and non-investment grade be defined? Would the proposed amendments to Form ATS-R or Form PILOT have any significant impact on investors, market participants, the national market system, or the public interest? B. Proposed Amendments to Rule 10b-10 We propose to amend Rule 10b-10,\35\ the transaction confirmation rule for broker-dealers, to delete paragraph (a)(8) of that rule.\36\ Rule 10b-10 generally requires broker-dealers that effect transactions for customers in securities, other than U.S. savings bonds or municipal securities, which are covered by Municipal Securities Rulemaking Board rule G-15 (which applies to all municipal securities brokers and dealers), to provide customers with written notification, at or before the completion of each transaction, of certain basic transaction terms. This transaction confirmation must disclose, among other information: the date of the transaction; the identity, price, and [[Page 40092]] number of shares bought or sold; \37\ the capacity of the broker- dealer; \38\ the dollar price or yield at which a transaction in a debt security was effected; \39\ and, under specified circumstances, the amount of compensation paid to the broker-dealer and whether the broker-dealer receives payment for order flow.\40\ --------------------------------------------------------------------------- \35\ 17 CFR 240.10b-10. \36\ Consistent with that change, we also are proposing to redesignate paragraph (a)(9) of the rule, related to broker-dealers that are not members of the Securities Investor Protection Corporation (``SIPC''), as paragraph (a)(8). \37\ See 17 CFR 240.10b-10(a)(1) (the confirmation must also include either the time of the transaction or the fact that it will be furnished upon written request). \38\ See 17 CFR 240.10b-10(a)(2). \39\ See 17 CFR 240.10b-10(a)(5) and (6). \40\ See, e.g., 17 CFR 240.10b-10(a)(2)(i)(B), (C) and (D). --------------------------------------------------------------------------- The rule's requirements, portions of which have been in effect for over 60 years, provide basic investor protections by conveying information that allows investors to verify the terms of their transactions, alerts investors to potential conflicts of interest with their broker-dealers, acts as a safeguard against fraud, and provides investors a means to evaluate the costs of their transactions and the execution quality.\41\ --------------------------------------------------------------------------- \41\ See Securities Exchange Act Release No. 34962 (November 10, 1994), 59 FR 59612, 59613 (November 17, 1994). --------------------------------------------------------------------------- Paragraph (a)(8) of Rule 10b-10 requires transaction confirmations for debt securities, other than government securities, to inform the customer if the security is unrated by an NRSRO. When we adopted paragraph (a)(8) in 1994, it was intended to prompt a dialogue between the customer and the broker-dealer if the customer had not previously been informed of the unrated status of the debt security. We stated that this disclosure was not intended to suggest that an unrated security is inherently riskier than a rated security.\42\ Upon further consideration and in light of present concerns regarding undue reliance on NRSRO ratings and confusion about the significance of those ratings, we believe it would be appropriate to delete this requirement. However, in proposing to no longer require broker-dealers to include in transaction confirmations the information that a debt security is unrated, we do not mean to suggest that information about an issuer's creditworthiness is not a relevant subject for discussion and consideration prior to purchasing a debt security. We would encourage investors to seek to understand all of the risks of securities, including credit-related risks, before buying. In addition, we note that deleting this requirement would not prevent broker-dealers from voluntarily continuing to include this information in transaction confirmations. --------------------------------------------------------------------------- \42\ See Securities Exchange Act Release No. 34962 (November 10, 1994), 59 FR 59612 (November 17, 1994) (File No. S7-6-94). --------------------------------------------------------------------------- We generally request comment on all aspects of the proposed elimination of the NRSRO reference in Rule 10b-10. In addition, we request comment on the following specific questions: Have investors found confirmation disclosure about the fact that a debt security is not rated by an NRSRO to be useful? Are there any possible alternatives to deletion that would address concerns about undue reliance on NRSRO ratings or avoid confusion about the significance of those ratings? For example, should the confirmation disclose that the security is rated or not rated by an NRSRO, as the case may be, instead of just that the security is not rated? C. Proposed Amendments to Rule 15c3-1 Under the Net Capital Rule, broker-dealers are required to maintain, at all times, a minimum amount of net capital. The rule generally defines ``net capital'' as a broker-dealer's net worth (assets minus liabilities), plus certain subordinated liabilities, less certain assets that are not readily convertible into cash (e.g., fixed assets), and less a percentage (haircut) of certain other liquid assets (e.g., securities).\43\ Broker-dealers are required to calculate net worth using generally accepted accounting principles. --------------------------------------------------------------------------- \43\ See 17 CFR 240.15c3-1(c)(2). --------------------------------------------------------------------------- In computing their net capital under the provisions of the Net Capital Rule, broker-dealers are required to deduct from their net worth certain percentages of the market value of their proprietary securities positions. A primary purpose of these ``haircuts'' is to provide a margin of safety against losses that might be incurred by broker-dealers as a result of market fluctuations in the prices of, or lack of liquidity in, their proprietary positions. We apply a lower haircut to certain types of securities held by a broker-dealer that were rated investment grade by a credit rating agency of national repute since those securities typically were more liquid and less volatile in price than securities that were not so highly rated.\44\ --------------------------------------------------------------------------- \44\ See 17 CFR 240.15c3-1(c)(2)(vi)(E) (haircuts applicable to commercial paper), 17 CFR 240.15c3-1(c)(2)(vi)(F) (haircuts applicable to nonconvertible debt securities), and 17 CFR 240.15c3- 1(c)(2)(vi)(H) (haircuts applicable to cumulative nonconvertible preferred stock). The term NRSRO is also used in appendices to the Net Capital Rule. See 17 CFR 240.15c3-1a(b)(1)(i)(C) (defining the term ``major market foreign currency'') and 17 CFR 240.15c3-1f(d) (determining the capital charge for credit risk arising from certain OTC derivatives transactions). --------------------------------------------------------------------------- We are proposing to remove, with limited exceptions, all references to NRSROs from the Net Capital Rule.\45\ The broker-dealers subject to the Net Capital Rule are sophisticated market participants regulated by at least one SRO.\46\ As regulated entities, broker-dealers must meet certain financial responsibility requirements, including maintaining minimum amounts of liquid assets as net capital, safeguarding customer funds and securities, and making and preserving accurate books and records. Accordingly, we preliminarily believe that broker-dealers would be able to assess the creditworthiness of the securities they hold without undue hardship and, therefore, that exclusive reliance on NRSRO ratings for the purposes of the Net Capital Rule is no longer necessary, although broker-dealers that wish to continue to rely on such ratings may do so. --------------------------------------------------------------------------- \45\ In 2003, the Commission published a concept release in which we sought comment on the use of NRSRO ratings in our rules, and specifically sought comment on eliminating the minimum quality standards established with the use of NRSRO ratings in Exchange Act Rule 15c3-1. See Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws, Securities Exchange Act Release No. 47972 (June 4, 2003), 68 FR 35258 (June 12, 2003). (Comments on the concept release are available at: http://www.sec.gov/rules/concept/ s71203.shtml.) As discussed above, recent events have highlighted the need to revisit our reliance on NRSRO ratings in the context of these developments. See also the extensive discussion of market developments in the Release No. 57967. \46\ The SROs regulating broker-dealers include the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, and the national securities exchanges. --------------------------------------------------------------------------- We are proposing the substitution of two new subjective standards for the NRSRO ratings currently relied upon under the Net Capital Rule. For the purposes of determining the haircut on commercial paper,\47\ we propose to replace the current NRSRO ratings-based criterion--being rated in one of the three highest rating categories by at least two NRSROs--with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For the purposes of determining haircuts on nonconvertible debt securities as well as on preferred stock,\48\ we propose to replace the current NRSRO ratings- based criterion--being rated in one of the four highest rating categories by at least two NRSROs--with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or [[Page 40093]] near its carrying value within a reasonably short period of time. This latter formulation would apply as well to long or short positions that are hedged with short or long positions in securities issued by the United States or any agency thereof or nonconvertible debt securities having a fixed interest rate and a fixed maturity date and which are not traded flat or in default as to principal or interest.\49\ --------------------------------------------------------------------------- \47\ See 17 CFR 240.15c3-1(c)(2)(vi)(E). \48\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(1) and (c)(2)(vi)(H). \49\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(2). --------------------------------------------------------------------------- We preliminarily believe that these new standards would continue to advance the purpose the NRSRO ratings-based standards were designed to advance, which is to enable broker-dealers to make net capital computations that reflect the market risk inherent in the positioning of those particular types of securities. The prior standards--being rated in one of the three or four highest rating categories by at least two NRSROs--were designed based on the practice of many credit rating agencies to have at least eight categories for their debt securities with the top four commonly referred to as ``investment grade.'' \50\ While the proposed standards, like the prior standards, do not use the term ``investment grade,'' they are meant to serve the same purpose as the prior standards. As such, the category of securities that have ``no greater than moderate credit risk'' and can be sold at or near their carrying value within a reasonably short period of time should encompass all investment grade securities. The proposed new criteria for commercial paper to be used for net capital purposes are securities that are ``subject to a minimal amount of credit risk'' and can be sold at or near their carrying value almost immediately. In each case, the proposed liquidity standard would reflect the fact that only liquid assets are relevant for the purposes of the Net Capital Rule. --------------------------------------------------------------------------- \50\ See Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations, Securities Exchange Act Release No. 55857 (June 5, 2007), 72 FR 33564 (June 18, 2007). --------------------------------------------------------------------------- We further believe that broker-dealers have the financial sophistication and the resources necessary to make the basic determinations of whether or not a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments. Notwithstanding our belief that broker-dealers have the financial sophistication and the resources to make these determinations, we believe it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the Net Capital Rule. As such, if we adopt the proposed amendments, after considering comments, we expect to take the view in the adopting release that securities rated in one of the three highest categories by at least two NRSROs would satisfy the requirements of proposed new paragraph (c)(2)(vi)(E) and securities rated in one of the four highest rating categories by at least two NRSROs to satisfy the requirements of proposed new paragraphs (c)(2)(vi)(F) and (c)(2)(vi)(H). We emphasize, however, that references to such NRSRO ratings would be just one means of satisfying the requirements of the proposed amendments but would not the only means of doing so. We are also proposing to remove references to NRSRO ratings from Appendices E and F to Rule 15c3-1 and make conforming changes to Appendix G of Rule 15c3-1 and the General Instructions to Form X-17 A- 5, Part IIB.\51\ Appendix E of the Net Capital Rule sets forth a program that allows a broker-dealer to use an alternative approach to computing net capital deductions, subject to certain conditions, most importantly the broker-dealer's ultimate holding company consenting to group-wide Commission supervision as a consolidated supervised entity (``CSE'').\52\ Appendix F to the Net Capital Rule sets forth a similar program for OTC derivatives dealers. In each case, the program sets forth an alternative means of establishing net capital requirements under the Net Capital Rule by which the broker-dealer or OTC derivatives dealer, as applicable, may elect to determine counterparty risk. This may be done either based on NRSRO ratings by requesting Commission approval to determine credit risk weights based on internal calculations. --------------------------------------------------------------------------- \51\ 17 CFR 240.15c3-1e, 240.15c3-1f, and 240.15c3-1g; see 17 CFR 249.617. \52\ See 17 CFR 240.15c3-1e. --------------------------------------------------------------------------- We are proposing to delete the provisions of Appendices E and F permitting reliance on NRSRO ratings for the purposes of determining counterparty risk. As a result of these deletions, a broker-dealer that is part of a CSE or a OTC derivatives dealer that wished to use the approach set forth Appendix E or F, respectively, to determine counterparty risks would be required, as part of its initial application to use the alternative approach or in an amendment, to request Commission approval to determine credit risk weights based on internal calculations. Based on the strength of the broker-dealer/CSE or OTC derivatives dealer's internal credit risk management system, we may approve the application. A broker-dealer or OTC derivatives dealer that obtained such approval would be required to make and keep current a record of the basis for the credit risk weight of each counterparty. To date, a total of seven entities have applied for and been granted permission to use the methods set forth in Appendix E, while five have applied for and been granted permission to use the methods set forth in Appendix F. We do not currently anticipate that any additional firms will apply for permission to use either Appendix E or Appendix F. All of the approved firms have already developed models to calculate market and credit risk under the alternative net capital calculation methods set forth in the appendices as well as internal risk management control systems.\53\ As such, each firm already employs the non-NRSRO ratings- based method that would, under the proposed amendments, become the only option for determining counterparty credit risk under Appendices E and F. We are also proposing conforming amendments to Appendix G of Rule 15c3-1 and the General Instructions to Form X-17 A-5, Part IIB. The proposed amendments would delete references to the provisions of Appendices E and F, respectively, that are proposed to be deleted. --------------------------------------------------------------------------- \53\ See, e.g., Alternative Net Capital Requirements for Broker- Dealers That Are Part of Consolidated Supervised Entities, Securities Exchange Act Release No. 49830 (June 8, 2004), 69 FR 33428 at 33456 (June 21, 2004). --------------------------------------------------------------------------- We generally request comment on all aspects of the proposed elimination of the use of NRSRO ratings in the Net Capital Rule. In addition, we request comment on the following specific questions: Would internal evaluations of individual debt securities by broker-dealers for purposes of determining the capital charges (``internal processes'') instead of reliance on NRSRO ratings accomplish the stated goals of the Commission's net capital requirements? What are the benefits, other than those we have identified, of the use of internal processes? Besides the use of internal processes by broker-dealers, are there potential alternate means of establishing creditworthiness for the purposes of the Net Capital Rule without reference to NRSRO ratings? Commenters who [[Page 40094]] believe that this is the case should include detailed descriptions of such alternate means. Are we correct in our preliminary belief that broker- dealers have the financial sophistication and the resources necessary to generate internal processes and make the basic determinations of whether or not a security is meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk? If not, how should the proposed rule be modified to address those concerns? What would be the potential consequences of using internal processes for purposes of the net capital rule and how could these be addressed? For example, one concern is that a broker-dealer would have an incentive to downplay the credit risk associated with a particular security in order to minimize capital charges. How could this concern be addressed? If we provided for the use of internal processes, should we require that the persons responsible for developing a broker- dealer's internal processes and applying them to individual securities for the purposes of the Net Capital Rule be separate from employees who perform other functions for the broker-dealer, such as making proprietary investment decisions for the broker-dealer? What would be the appropriate level of regulatory oversight for broker-dealers employing internal processes? Should we require any policies and procedures with regard to the basic determinations as to whether a security meets the standards in the proposed amendments? Should we explicitly define the terms used in the proposed new standards in Rules 15c3-1(c)(2)(vi)(E), (F), and (H)? If we adopt the proposed standards, would broker-dealers find it useful to employ market-based models, including models using credit spreads to satisfy the requirements of the proposed standards? Should we provide guidance about the use of these models? What is the likelihood that small broker-dealers would purchase credit ratings or the models used to develop those ratings from large broker-dealers? If we adopt the proposed amendments after considering comments, should we take the view in the adopting release that securities rated in one of the three highest categories by at least two NRSROs satisfy the requirements of proposed new paragraph (c)(2)(vi)(E) and securities rated in one of the four highest rating categories by at least two NRSROs to satisfy the requirements of proposed new paragraphs (c)(2)(vi)(F) and (c)(2)(vi)(H)? Commenters should include detailed descriptions of any subset of broker-dealers they believe should be able to continue to rely on NRSRO ratings and the rationale therefor. What factors should we take into account when considering the potential regulatory compliance costs of removing references to NRSROs from the Net Capital Rule? Commenters should include detailed descriptions of any potential costs. D. Proposed Amendment to Rule 15c3-3 Note G to Exhibit A of Rule 15c3-3 under the Exchange Act (the ``Customer Protection Rule''), which provides the formula for the determination of broker-dealers' reserve requirements, allows a broker- dealer to include as a debit in the formula the amount of customer margin related to customers' positions in security futures products posted to a registered clearing or derivatives organization that maintains the highest investment grade rating from an NRSRO.\54\ This standard, which is one of four different means by which a registered clearing or derivatives organization can be judged to meet the requirements of paragraph (b)(1) of Note G,\55\ is consistent with the customer protection function of Rule 15c3-3 and is necessary because of the unsecured nature of the customer positions in security futures products margin debit. We propose to replace this standard with a requirement that the registered clearing or derivatives organization to which customers' positions in security futures products are posted has the highest capacity to meet its financial obligations and is subject to no greater than minimal credit risk. --------------------------------------------------------------------------- \54\ 17 CFR 240.15c3-3a(b)(1)(i). \55\ A broker-dealer may also include customer margin related to customers' positions in security futures products posted to a registered clearing or derivatives organization (1) that maintains security deposits from clearing members in connection with regulated options or futures transactions and assessment power over member firms that equal a combined total of at least $2 billion, at least $500 million of which must be in the form of security deposits; (2) that maintains at least $3 billion in margin deposits; or (3) which does not meet the other requirements but which the Commission has agreed, upon a written request from the broker-dealer, that the broker-dealer may utilize. 17 CFR 240.15c3-3a(b)(1)(ii)-(iv). --------------------------------------------------------------------------- We preliminarily believe that these new standards would continue to advance the purpose the NRSRO-ratings standard was designed to advance, namely to ensure both of the long-term financial strength of a clearing organization to which customers' positions in security futures products are posted and its general creditworthiness.\56\ Although the rule was originally designed to provide an indication of long-term financial strength and general creditworthiness from an independent source,\57\ we preliminarily believe that broker-dealers, as sophisticated market participants and regulated entities that are subject to financial responsibility requirements, have the financial sophistication and the resources necessary to make this determination. The broker-dealer would have to be able to explain how the registered clearing or derivatives organization to which customers' positions in security futures products are posted meets the standard in the proposed amendment. --------------------------------------------------------------------------- \56\ See Rule 15c3-3 Reserve Requirements for Margin Related to Security Futures Products, Securities Exchange Act Release No. 50295 (August 31, 2004), 69 FR 54182, 54185 (September 7, 2004). \57\ Id. --------------------------------------------------------------------------- We also believe, however, that it would be appropriate, as one means of complying with the proposed amendment, for broker-dealers to refer to NRSRO ratings for the purposes of paragraph (b) of Note G. As such, if we adopt the proposed amendments after considering comments, we expect to take the view in the adopting release that we would continue to consider a registered clearing agency or derivatives clearing organization that maintains the highest investment-grade rating from an NRSRO to satisfy the requirements of that provision. We emphasize, however, that the references to such NRSRO ratings would be just one means of satisfying the requirements of the proposed amendments and would not be the only means of doing so. We request comment on the following specific questions in connection with Exhibit A to the Customer Protection Rule: As an alternative to relying on an NRSRO rating to distinguish the creditworthiness of a registered clearing agency or derivatives clearing organization, should we prescribe a minimum net worth or asset test for the organizations? Alternatively, should we prescribe a test based on a minimum level of members of the organization or minimum level of clearing deposits held by the organization? Commenters that support any of these proposals should provide details (e.g., the minimum levels in dollar amounts) as to how they should be implemented. Would it be more appropriate to delete current paragraph (b)(1)(i) of Note G to Exhibit A to the Customer [[Page 40095]] Protection Rule in its entirety? Put differently, do the guidelines offered by current paragraphs (b)(1)(ii)-(iv) of Note G in and of themselves provide sufficient means by which a registered clearing or derivatives organization could be judged to meet the requirements of paragraph (b)(1) of Note G? If we adopted the proposed amendment to Note G to Exhibit A of Rule 15c3-3, should we explicitly define the terms used in the proposed new standard? Is it appropriate to allow broker-dealers to make the determination of whether a clearing organization possesses the highest capacity to meet its financial obligations and is subject to no greater than minimal credit risk? If not, what are suggested ways that the proposed rule could be amended to address that concern? Should we require any policies and procedures with regard to the determination whether a registered clearing or derivatives organization meets the standard in the proposed amendment? What would be the potential consequences of allowing broker-dealers to determine whether a clearing organization possessed the highest capacity to meet its financial obligations and was subject to no greater than minimal credit risk and how could these be addressed? For example, one concern is that a broker-dealer would have an incentive to downplay the credit risk associated with a particular clearing organization in order to be able to post customers' positions in security futures products to it. How could this concern be addressed? If we adopt the proposed amendments after considering comments, should we take the view in the adopting release that we would consider a registered clearing agency or derivatives clearing organization that maintains the highest investment-grade rating from an NRSRO to satisfy the requirements of that provision? Commenters should include detailed descriptions of any subset of broker-dealers they believe should be able to continue to rely on NRSRO ratings and the rationale therefore. What factors should we take into account when considering the potential regulatory compliance costs of removing references to NRSROs from paragraph (b)(1) of Note G to Rule 15c-3a? Commenters should include detailed descriptions of any potential costs. E. Proposed Amendments to Rules 101 and 102 of Regulation M 1. Regulation M As a prophylactic, anti-manipulation set of rules, Regulation M is designed to protect the integrity of the securities trading market as an independent pricing mechanism by prohibiting activities that could artificially influence the market for the offered security. Rules 101 and 102 of Regulation M specifically prohibit issuers, selling security holders, underwriters, brokers, dealers, other distribution participants, and any of their affiliated purchasers, from directly or indirectly bidding for, purchasing, or attempting to induce another person to bid for or purchase, a covered security until the applicable restricted period has ended.\58\ --------------------------------------------------------------------------- \58\ ``Covered security'' is defined as ``any security that is the subject of a distribution or any reference security.'' 17 CFR 242.100. --------------------------------------------------------------------------- 2. Current Rule 101(c)(2) and Rule 102(d)(2) Exceptions Both rules currently except ``investment grade nonconvertible and asset-backed securities.'' \59\ These exceptions apply to nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated by at least one NRSRO in one of its generic rating categories that signifies investment grade.\60\ The current exceptions for certain investment grade debt and preferred securities rated by a NRSRO were originally based on the premise that these securities are traded on the basis of their yields and credit ratings, are largely fungible and, thus, are less likely to be subject to manipulation.\61\ With respect to asset-backed securities, the current exceptions were premised on the fact that asset-backed securities also trade primarily on the basis of yield and credit rating and that asset-backed securities investors are concerned with ``the structure of the class of securities and the nature of the assets pooled to serve as collateral for those securities.'' \62\ --------------------------------------------------------------------------- \59\ 17 CFR 242.101(c)(2) and 242.102(d)(2). \60\ Id. \61\ Securities Exchange Act Release No. 19565 (March 4, 1983); 48 FR 10628 (March 14, 1983). See also Securities Exchange Act Release No. 18528 (March 3, 1982); 47 FR 11482 (March 16, 1982). \62\ Securities Exchange Act Release No. 38067 (December 20, 1996); 62 FR 520 (January 3, 1997). --------------------------------------------------------------------------- 3. Proposed Amendments' Elimination of the NRSRO Reference In light of our effort to reduce undue reliance on NRSRO ratings, we believe that it is appropriate to alter the current exceptions in Rules 101 and 102 to eliminate the reference to NRSROs. We propose to remove Rules 101 and 102's current exceptions for investment grade nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities based on NRSRO ratings. In place of those exceptions, we propose new exceptions for nonconvertible debt securities and nonconvertible preferred securities based on the ``well- known seasoned issuer'' (``WKSI'') concept of Securities Act of 1933 (``Securities Act'') Rule 405.\63\ We are also proposing to except asset-backed securities from Rules 101 and 102 if those securities are registered on Form S-3.\64\ --------------------------------------------------------------------------- \63\ 17 CFR 230.405. \64\ Asset-backed securities are defined out of the WKSI standard at subparagraph (1)(iv) of the definition and, further, could not meet the requirements of (1)(i)(A) or (B) of the definition because they are generally one-time issuers. Id. --------------------------------------------------------------------------- The proposed exceptions continue to be based on the premise that these securities are traded on factors such as their yields and are largely fungible. In addition we believe that the marketplace is more likely to have access to a significant amount of useful and high- quality public information concerning these securities that may assist investors in assessing the creditworthiness of the issuer on their own without needing to unduly rely on a NRSRO.\65\ We understand that WKSI and Form S-3 issuers are some of the largest and highest quality issuers of nonconvertible debt, nonconvertible preferred securities and asset-backed securities which makes default generally less likely. But the availability of this information or quality of underlying assets is not enough to justify the exceptions in and of itself, the security must also trade in such a way that it is resistant to manipulation. This is why we are proposing to continue to limit these exceptions to nonconvertible debt, nonconvertible preferred, and asset-backed securities as those securities trade largely on the basis of their yield and are largely fungible. --------------------------------------------------------------------------- \65\ See Securities Exchange Act Release No. 52056 (July 19, 2005); 70 FR 44722 (August 3, 2005). See also Note 61, infra. --------------------------------------------------------------------------- a. Proposed Rules 101(c)(2)(i) and 102(d)(2)(i)--Nonconvertible Debt and Preferred Securities The proposed exceptions for nonconvertible debt and nonconvertible preferred securities would require that the issuer of such securities meet the requirements of the WKSI definition and meet the requirements for nonconvertible securities other than common equity in paragraph (1)(i)(B)(1) [[Page 40096]] of the definition of WKSI in Rule 405. As proposed, the exceptions would be available for nonconvertible debt or nonconvertible preferred securities issued by a WKSI issuer, regardless of the method the issuer used to attain WKSI status. However, in order to rely on the proposed exceptions, the security must be issued by an issuer who also meets the requirements of paragraph (1)(i)(B)(1) of the definition of WKSI in Rule 405.\66\ This would require that the issuer have issued at least $1 billion aggregate principal amount of nonconvertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act.\67\ This would limit the exceptions to securities whose issuers have an existing public market in nonconvertible securities other than common equity that is publicly known and followed and, thus, are less likely to be subject to manipulation. --------------------------------------------------------------------------- \66\ A nonconvertible debt or nonconvertible preferred security issued by an issuer who is a WKSI based on the common equity calculation in paragraph (1)(i)(A) of the definition of WKSI in Rule 405 would still be able to rely on the proposed exception if the issuer can also meet the requirements of paragraph (1)(i)(B)(1) of the definition of WKSI in Rule 405. \67\ 17 CFR 230.405, paragraph (1)(i)(B)(1) of the definition of WKSI. --------------------------------------------------------------------------- With respect to these proposed exceptions for nonconvertible debt and non-convertible preferred securities utilizing a WKSI requirement, we have noted that WKSI issuers: [A]re followed by sophisticated institutional and retail investors, members of the financial press, and numerous sell-side and buy-side analysts that actively seek new information on a continual basis. Unlike smaller or less mature issuers, large seasoned public issuers tend to have a more regular dialogue with investors and market participants through the press and other media. The communications of these well-known seasoned issuers are subject to scrutiny by investors, the financial press, analysts, and others who evaluate disclosure when it is made.\68\ --------------------------------------------------------------------------- \68\ Securities Exchange Act Release No. 52056 (July 19, 2005); 70 FR 44722 (August 3, 2005). Thus, we believe that the nonconvertible debt and nonconvertible preferred securities that fall within the proposed exceptions should be resistant to manipulation because of their fungibility, trading based on yield, and this wide industry following. b. Proposed Rules 101(c)(2)(ii) and 102(d)(2)(ii)--Asset-Backed Securities The proposed changes to the asset-backed securities exceptions would require that the offer and sale of the security is registered using Form S-3.\69\ We believe that the proposed amendments should provide exceptions to only those asset-backed securities that are approximately the equivalent quality of securities that are currently excepted from Rules 101 and 102. Additionally, the proposal is also based on the premise that asset-backed securities trade primarily on the basis of yield and that asset-backed securities investors are primarily concerned with the structure of the class of securities and the nature of the assets pooled to serve as collateral for those securities and, thus, such securities are less likely to be subject to manipulation.\70\ --------------------------------------------------------------------------- \69\ The Commission is also proposing to revise the General Instruction I.B.5 to Form S-3 (which sets the eligibility requirements for asset-backed securities to use that form) to remove references to NRSROs. Securities Act Release No. 8940 (July 1, 2008) (File No. 27-18-08). \70\ These were the reasons that we originally excepted such securities. Securities Exchange Act Release No. 38067 (December 20, 1996); 62 FR 520 (January 3, 1997). --------------------------------------------------------------------------- 4. Bright-Line Alternative/Existing Benchmarks We believe that the proposed amendments are appropriate replacements for the NRSRO investment grade standard for the following reasons. We believe that the proposals will capture securities that are more likely to be resistant to manipulation similar to the current exceptions because they are based on the same premises as the current exceptions (such as high liquidity and fungibility).\71\ Second, the proposals provide a bright line demarcation and objective criteria for the exceptions. As both the WKSI and Form S-3 standards as utilized by this proposal are established benchmarks, they should be familiar to those persons subject to Rules 101 and 102 and easily applied by such persons seeking to rely on the proposed exceptions. Thus, we believe that the proposals are comparable in scope to the existing exceptions but use alternate benchmarks that provide an equally bright line that is not unduly reliant on NRSRO ratings. --------------------------------------------------------------------------- \71\ See Securities Exchange Act Release Number 19565 (March 4, 1983); 48 FR 10628 (March 14, 1983); Securities Exchange Act Release Number 18528 (March 3, 1982); 47 FR 11482 (March 16, 1982); and Securities Exchange Act Release Number 38067 (December 20, 1996); 62 FR 520 (January 3, 1997). --------------------------------------------------------------------------- 5. Comments We solicit comments on all aspects of this proposal. We ask that commenters provide specific reasons and information to support alternative recommendations. Please provide empirical data, when possible, and cite to economic studies, if any, to support alternative approaches. Are the WKSI requirements appropriate for use in a trading (as opposed to disclosure) context? What effect(s) of the proposed exceptions, if any, would you anticipate in the investment grade debt market and the high-yield debt market? Should the Rule 101(c)(2) and 102(d)(2) exceptions be based on criteria other than the WKSI requirements for nonconvertible debt and nonconvertible preferred securities and Form S-3 registration for asset-backed securities? Would the WKSI nonconvertible debt and nonconvertible preferred securities excepted in the proposal be as resistant to manipulation as those same securities that meet the existing investment grade standard? Please provide comment as to whether the proposal would capture the same type and quantity of securities that fall within the current Rule 101(c)(2) and Rule 102(d)(2) exceptions. Do the proposed WKSI and Form S-3 benchmarks adequately identify nonconvertible debt, nonconvertible preferred securities, and asset-backed securities that are of high quality with low default risk? Please distinguish the characteristics of nonconvertible debt, nonconvertible preferred securities, and asset-backed securities that meet these proposed benchmarks and those that do not. Is the proposed WKSI criterion easily applied by all persons subject to Rules 101 and 102 with respect to nonconvertible debt and nonconvertible preferred securities issued by issuers who are WKSI by virtue of $700 million market value of common equity? Would persons other than issuers who are subject to Rules 101 and 102 have access to adequate information to determine if a particular security fits into the exceptions? Should asset-backed securities registered on Form S-3 be excepted from Rules 101 and 102 of Regulation M? Have there been developments in the asset-backed securities market that might indicate whether such securities should be eliminated from the proposed exceptions or should continue to be excepted from Rules 101 and 102? How frequently is the current asset-backed exception from Rules 101 and 102 relied upon? Is it appropriate to also except asset-backed securities registered on Form F-3? If yes, please explain. We ask for specific comment as to any relevant changes to the debt market since Regulation M was adopted in 1996 and the way debt issues are brought to market and trade. Do nonconvertible debt securities continue to trade based on their yield [[Page 40097]] and fungibility? Nonconvertible preferred securities? Asset-backed securities? Are there other factors that influence the trading of such securities? IV. Request for Comment We generally request comment on all aspects of our proposal to end our regulatory reliance on NRSRO credit ratings. In addition, we request comment on the following specific questions: Should we eliminate the NRSRO designation from all our rules or only from select rules? Commenters who believe that certain rules should retain references to NRSROs or NRSRO ratings should identify each rule they believe should retain the use of the NRSRO concept and explain the rationale for doing so. Does the use of the NRSRO designation in our rules cause investors to overly rely on NRSRO credit ratings? Would its elimination mitigate this over reliance? Does the use of the NRSRO designation in our rules adversely impact competition among credit rating agencies by favoring those agencies that are registered as NRSROs? Would its elimination mitigate this negative impact? V. Paperwork Reduction Act Certain provisions of the proposed amendments to the rules and forms contain ``collection of information requirements'' within the meaning of the Paperwork Reduction Act of 1995.\72\ The hours and costs associated with preparing and filing the disclosure, filing the forms and schedules and retaining records required by these regulations constitute reporting and cost burdens imposed by each collection of information. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number. The titles of the affected information forms are Rule 10b-10, ``Confirmation of Transactions,'' (OMB Control Number 3235-0444), Rule 15c3-1 (OMB Control Number 3235- 0200), Rule 15c3-3 (OMB Control Number 3235-0078), Form ATS-R (OMB Control Number 3235-0509), Form PILOT (OMB Control Number 3235-0507), and Form X-17A-5, Financial and Operational Combined Uniform Single Report, Part IIB, OTC Derivatives Dealer (OMB Control Number 3235- 0498). For the reasons discussed below, we do not believe the proposed amendments if adopted would result in a material or substantive revision to these collections of information.\73\ --------------------------------------------------------------------------- \72\ 44 U.S.C. 3501 et seq. \73\ 5 CFR 1320.5(g). --------------------------------------------------------------------------- The proposed amendments to Form ATS-R and Form PILOT would revise the forms to provide that information which is currently reported as separate items, i.e., investment grade debt corporate debt securities and non-investment grade corporate debt securities, would be combined and reported as a single item, i.e., corporate debt securities. In all other respects, the information collected on these forms would remain unchanged. Accordingly, we do not believe the proposed amendment would result in a substantive revision to those collections of information if adopted. The proposed amendment to Rule 10b-10 would eliminate a requirement for transaction confirmations for debt securities (other than government securities) to inform customers if a security is unrated by an NRSRO. This proposed amendment would alter neither the general requirement that broker-dealers generate transaction confirmations and send those confirmations to customers, nor the potential use of information contained in confirmations by the Commission, self- regulatory organizations, and other securities regulatory authorities in the course of examinations, investigations and enforcement proceedings. Moreover, the proposed amendment is not expected to change the cost of generating and sending confirmations, and, we believe that broker-dealers may not need to incur significant costs if they choose not to input information that a debt security is unrated into their existing confirmation systems. Accordingly, we do not believe the proposed amendment would result in a material or substantive revision to these collections of information if adopted. The proposed amendment to Rule 15c3-1 would potentially modify broker-dealers' existing practices to impose additional recordkeeping burdens. The proposed amendment would replace NRSRO ratings-based criteria for evaluating creditworthiness with new subjective standards based on the broker-dealer's own evaluation of creditworthiness, although broker-dealers would still be able to refer to NRSRO ratings for those purposes. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments. As such, we believe that firms would be required to develop (if they have not already) criteria for assessing the creditworthiness of securities to be included in net capital calculations and apply those criteria to such securities. In addition, the expectation that the broker-dealer be able to explain that any securities used for net capital purposes meet the standards set forth in the proposed amendments would result in the creation and maintenance of records of those assessments. We believe that all broker-dealers already have policies and procedures in place for evaluating the overall risk and liquidity levels of the securities they use for the purposes of the Net Capital Rule and that they keep records of the assessments of securities they make for net capital purposes; however, the proposed requirements, which specifically address credit risk, could result in additional burdens. The proposed amendments would apply to the approximately 550 broker-dealers that take haircuts on securities pursuant to the Net Capital Rule. We estimate that on average, broker dealers will spend ten hours developing a system of standards for evaluating creditworthiness for the purposes of the Net Capital Rule, resulting in an aggregate initial burden of 5,500 hours. This estimate is based on our belief that many of these broker-dealers already have their own criteria in place for evaluating creditworthiness, while others would continue to refer to NRSRO ratings as the basis of their creditworthiness decisions. We further estimate that, on average, each broker-dealer will spend an additional ten hours a year reviewing, adjusting, and applying its own standards for evaluating creditworthiness, for a total of 5,500 annual hours across the industry. Once again, this estimate reflects our belief that many of these broker-dealers already have their own criteria in place, while others would continue to refer to NRSRO ratings. We also estimate that firms would employ compliance attorneys, in many cases relying on outside counsel, to review these standards, both initially and on an annual basis. We estimate the per-firm costs of outside counsel to be $2,700 initially and $1,350 on an annual basis, for an aggregate industry cost of $1,485,000 initially and $742,500 on an annual basis.\74\ --------------------------------------------------------------------------- \74\ For the purposes of this analysis, we are using salary data from the Securities Industry and Financial Markets Association (``SIFMA'') Report on Management and Professional Earnings in the Securities Industry 2007, which provides base salary and bonus information for middle management and professional positions within the securities industry, as modified by Commission staff to account for an 1800-hour work-year and multiplied by 5.35 to account for bonuses, firm size, employee benefits and overhead. We believe that the legal reviews required by the proposed amendments would be performed by compliance attorneys at an average rate of $270 per hour. Furthermore, we believe that the review process will entail ten hours of initial work and five hours on an annual basis of $270 x 10 = $2,700 x 550 = $1,485,000; $270 x 5 = $1,350 x 550 = $742,500. --------------------------------------------------------------------------- [[Page 40098]] We generally request comment on all aspects of these proposed estimates. In addition, we request specific comment on the following items related to these estimates: Are we correct in our hours estimates and our belief that many broker-dealers already have their own criteria in place for evaluating creditworthiness? Are we correct in our belief that some broker-dealers would continue to refer to NRSRO ratings as the basis of their creditworthiness decisions? Are we correct in our estimation that broker-dealers would engage outside counsel to review their internally generated standards for creditworthiness? If not, how would firms review such standards and what would be the effect of such differing approaches on our burden estimates? The proposed amendments to the appendices of Rule 15c3-1 include amendments to certain recordkeeping and disclosure requirements that are subject to the PRA. Specifically, the proposed amendments to Appendices E and F of Rule 15c3-1 and conforming amendments to Appendix G would remove the provisions permitting reliance on NRSRO ratings for the purposes of determining counterparty risk. As a result of these deletions, an entity that wished to use the approach set forth in these appendices to determine counterparty risks would be required, as part of its initial application to use the alternative approach or in an amendment, to request Commission approval to determine credit risk weights based on internal calculations and make and keep current a record of the basis for the credit risk weight of each counterparty. We do not believe that the removal of the option permitting reliance on NRSRO ratings would affect the small number of entities that currently elect to compute their net capital deductions pursuant to the alternative methods set forth in Appendix E or F. Although the collection of information obligations imposed by the proposed amendments are mandatory, applying for approval to use the alternative capital calculation is voluntary. To date, a total of seven entities have applied for and been granted permission to use the methods set forth in Appendix E, while five have applied for and been granted permission to use the methods set forth in Appendix F. We do not currently anticipate that any additional firms will apply for permission to use either Appendix E or Appendix F. All of the approved firms have already developed models to calculate market and credit risk under the alternative net capital calculation methods set forth in the appendices as well as internal risk management control systems.\75\ As such, each firm already employs the non-NRSRO ratings-based method that would, under the proposed amendments, become the only option for determining counterparty credit risk under Appendices E and F. Since each entity already employs its own models to calculate market and credit risk and keeps current a record of the basis for the credit risk weight of each counterparty, the proposed amendments would therefore not alter the paperwork burden currently imposed by Appendices E and F. --------------------------------------------------------------------------- \75\ See, e.g., Alternative Net Capital Requirements for Broker- Dealers That Are Part of Consolidated Supervised Entities, Securities Exchange Act Release No. 49830 (June 8, 2004), 69 FR 33428 at 33456 (June 21, 2004). --------------------------------------------------------------------------- The proposed amendment to Note G of Exhibit A to Rule 15c3-3 would potentially modify broker-dealers' existing practices to impose additional recordkeeping burdens. Currently, Note G to Exhibit A of Rule 15c3-3 allows a broker-dealer to include, as a debit in the formula for determining its reserve requirements, the amount of customer margin related to customers' positions in security futures products posted to a registered clearing or derivatives organization that meets one of four standards, including maintaining the highest investment grade rating from an NRSRO.\76\ The proposed amendment would replace the NRSRO ratings-based standard with a requirement that the registered clearing or derivatives organization has the highest capacity to meet its financial obligations and is subject to no greater than minimal credit risk. As such, we believe that firms that previously relied on NRSRO ratings for the purposes of Note G would be required to develop criteria for assessing the creditworthiness of registered clearing or derivatives organizations and apply those criteria to such securities, although one means of complying with the proposed amendment would be for broker-dealers to refer to NRSRO ratings. In addition, the expectation that the broker-dealer be able to explain that any such clearing or derivatives organizations meets the standard set forth in the proposed amendment would result in the creation and maintenance of records of those assessments. --------------------------------------------------------------------------- \76\ See 17 CFR 240.15c3-3a, Note G, (b)(1)(i). A broker-dealer may also include customer margin related to customers' positions in security futures products posted to a registered clearing or derivatives organization (1) that maintains security deposits from clearing members in connection with regulated options or futures transactions and assessment power over member firms that equal a combined total of at least $2 billion, at least $500 million of which must be in the form of security deposits; (2) that maintains at least $3 billion in margin deposits; or (3) which does not meet any of the other criteria but which the Commission has agreed, upon a written request from the broker-dealer, that the broker-dealer may utilize. 17 CFR 240.15c3-3a, Note G, (b)(1)(ii)--(iv). --------------------------------------------------------------------------- In the final release adding Note G to Exhibit A of Rule 15c3-3, we estimated that approximately 102 firms would be required to comply with the provisions of the Note.\77\ In addition, we estimated in that release that under subparagraph (c) to Note G, each broker-dealer would spend approximately 0.25 hours to verify that the clearing organizations they used met the conditions of Note G, for an aggregate one-time total of 25.5 hours; \78\ we believe that this estimate would apply to the verification of that status under the proposed amendment as well. We believe that the proposed amendment would impose an additional one-time burden for broker-dealers that chose to rely on the new standard of proposed Rule 15c3-3a(b)(1)(i). Given the additional options set forth in Note G, we estimate that only half, or 51, of the broker-dealers would choose this option, which we believe would result in the broker-dealer spending, on average, ten hours developing a system of standards for evaluating creditworthiness for the purposes of Note G, resulting in an aggregate initial burden of 510 hours.\79\ We also estimate that firms would employ compliance attorneys, in many cases relying on outside counsel, to review these standards. We estimate the one-time costs of outside counsel to be $1,350 per firm, resulting in an aggregate industry cost of $68,850.\80\ --------------------------------------------------------------------------- \77\ See Reserve Requirements for Margin Related to Security Futures Products, Exchange Act Release No. 34-50295 (August 31, 2004), 69 FR 54182 at 54188 (September 7, 2004). \78\ 0.25 x 102 = 25.5. \79\ 10 x 51 = 510. \80\ For the purposes of this analysis, we are using salary data from the SIFMA Report on Management and Professional Earnings in the Securities Industry 2007. We believe that the legal reviews required by the proposed amendments would be performed by compliance attorneys at an average rate of $270 per hour. Furthermore, we believe that the review process will entail five hours of initial work. $270 x 5 = $1,350 x 51 = $68,850. --------------------------------------------------------------------------- We generally request comment on all aspects of these proposed estimates. In addition, we request specific comment on the following items related to these estimates: [[Page 40099]] Are we correct in our estimate of the number of broker- dealers that would be affected by the proposed amendment to Note G? Are we correct in our estimate of the percentage of such broker-dealers that choose to rely on proposed Rule 15c3-3a(b)(1)(i)? Are we correct in our belief that broker-dealers would engage outside counsel to review their internally generated standards for creditworthiness? If not, how would firms review such standards and what would be the effect of such differing approaches on our burden estimates? The instructions to Form X-17A-5 Part IIB currently include a summary of the credit risk calculation in paragraph (d) of Rule 15c3- 1f. Paragraph (d) of Rule 15c3-1f is proposed to be amended to remove that part of the credit risk calculation that is summarized in Form X- 17A-5 Part IIB. Accordingly, we have proposed a conforming amendment to the form that would remove the summary of the credit risk calculation. The summary in the instructions provides additional information for the benefit of the filer and is not related to the information reported on the forms. Accordingly, we do not believe the proposed amendment would result in a substantive revision to these collections of information if adopted. Pursuant to 44 U.S.C. 3506(c)(2)(B), we solicit comments to: (1) Evaluate whether the proposed collection of information is necessary for the performance of the functions of the agency, including whether the information shall have practical utility; (2) Evaluate and provide relevant data regarding the agency's estimate of the burden of the proposed collection of information, including the validity of the methodology and assumptions used; (3) Enhance the quality, utility and clarity of the information to be collected; and (4) Minimize the burden of collection of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. Persons wishing to submit comments on the collection of information requirements should direct them to the following persons: (1) Desk Officer for the Securities and Exchange Commission, Office of Information and Budget (``OMB''), Room 3208, New Executive Office Building, Washington, DC 20503; and (2) Florence E. Harmon, Acting Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090 with reference to File No. S7-17-08. OMB is required to make a decision concerning the collection of information between 30 and 60 days after publication, so a comment to OMB is best assured of having its full effect if OMB receives it within 30 days of publication. The Commission has submitted the proposed collection of information to OMB for approval. Requests for the materials submitted to OMB by the Commission with regard to this collection of information should be in writing, refer to File No. S7-17-08, and be submitted to the Securities and Exchange Commission, Records Management Office, 100 F Street, NE., Washington, DC 20549-1110. VI. Costs and Benefits of the Proposed Rulemaking The Commission is sensitive to the costs and benefits imposed by its rules. We have identified certain costs and benefits of the proposed amendments and request comment on all aspects of this cost- benefit analysis, including identification and assessment of any costs and benefits not discussed in this analysis. We seek comment and data on the value of the benefits identified. We also welcome comments on the accuracy of the cost estimates in each section of this analysis, and request that commenters provide data that may be relevant to these cost estimates. In addition, we seek estimates and views regarding these costs and benefits for particular covered institutions, including small institutions, as well as any other costs or benefits that may result from the adoption of these proposed amendments. As discussed above, the proposed rule amendments are designed to address the risk that the reference to and use of NRSRO ratings in our rules is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs, and may encourage investors to place undue reliance on the NRSRO ratings. The proposed amendments to Rule 3a1-1, Rule 10b-10, Rule 15c3-1, Rule 15c3-3, Rules 101 and 102 of Regulation M, Rules 300 and 301 of Regulation ATS, and Form ATS-R, Form PILOT, and Form X-17A-5 Part IIB would eliminate the reference to and requirement for the use of NRSRO ratings in these rules. A. Benefits The Commission anticipates that one of the primary benefits of the proposed amendments, if adopted, would be the benefit to investors of reducing their possible undue reliance on NRSRO ratings that could be caused by references to NRSROs in our rules. An over-reliance on ratings can inhibit independent analysis and could possibly lead to investment decisions that are based on incomplete information. The purpose of the proposed rule amendments is to encourage investors to examine more than a single source of information in making an investment decision. Eliminating reliance on ratings in the Commission's rules could also result in greater investor due diligence and investment analysis. In addition, the Commission believes that eliminating the reliance on ratings in its rules would remove any appearance that the Commission has placed its imprimatur on certain ratings. We expect that there would be little effect on broker-dealers or other market participants that are subject to the rules that are proposed to be amended. This is because the references to NRSROs in these rules would be no longer necessary, can be replaced with an alternative bright-line standard, or can be used as one possible interpretation of a subjective standard set forth in a proposed amendment to the rule. The proposed amendments to Rule 3a1-1, Rules 300 and 301 of Regulation ATS, Form ATS-R, and Form PILOT would eliminate the separate definitions of and references to investment grade corporate debt securities and non-investment grade corporate debt securities and would replace them with a single category ``corporate debt securities.'' For reasons discussed above, the Commission preliminarily believes that it is not necessary or appropriate to assess trading volumes in the narrower segments of investment grade and non-investment grade corporate debt securities to fulfill the purposes of those rules. The other classes of securities and the threshold levels themselves would remain unchanged. Therefore, the proposed amendments to Rule 3a1-1 and Regulation ATS are not expected to significantly affect the regulatory treatment of ATSs. With respect to the proposed changes to Form ATS-R and Form PILOT, we expect that combining investment grade and non- investment grade corporate debt securities into a single class for purposes of those two forms would have only minimal impact, because the total units and total dollar volume of corporate debt securities transacted would still have to be reported. The proposed amendments to Rule 10b-10 to eliminate a requirement for transaction confirmations for debt securities (other than government securities) to inform customers if a security is unrated by an NRSRO. The other requirements of Rule 10b-10 would remain unchanged. Eliminating [[Page 40100]] this requirement would avoid giving credit ratings an imprimatur that may inadvertently suggest to investors that an unrated security is inherently riskier than a rated security. Accordingly, we anticipate that investors and the marketplace would benefit from the elimination of this requirement, in light of concerns about promoting over-reliance on securities ratings or creating confusion about the significance of those ratings. More generally, eliminating this requirement is consistent with the goal of promoting a dialogue between broker-dealers and their customers--prior to purchase--regarding the creditworthiness of issuers, and should help avoid promoting the use of credit ratings as an oversimplified shorthand that replaces a more complete discussion of credit quality issues. We preliminarily believe that the proposed amendments to the Net Capital Rule, its appendices, and Exhibit A to the Customer Protection Rule would result in a better overall assessment of the risks associated with securities held by broker-dealers for the purposes of net capital calculations as well as of the long-term financial strength and general creditworthiness of clearing organizations to which customers' positions in security futures products are posted. As the NRSROs themselves have stressed, the ratings they generate focus solely on credit risk, that is, the likelihood that an obligor or financial obligation will repay investors in accordance with the terms on which they made their investment.\81\ Many broker-dealers already conduct their own risk evaluation. However, for those broker-dealers that do not, developing their own means of evaluating risk--including, as would be required by the proposed amendments to the Net Capital Rule, an evaluation of the degree of liquidity--would allow them to better incorporate the overall levels of various categories of risk associated with the securities they hold into their net capital calculations. --------------------------------------------------------------------------- \81\ See, e.g., Inside the Ratings: What Credit Ratings Mean, Fitch, August 2007 (``Inside the Ratings''), p. 1; Testimony of Michael Kanef, Group Managing Director, Moody's Investors Service, Before the United States Senate Committee on Banking, Housing, and Urban Affairs (September 26, 2007), p. 2; Testimony of Vickie A. Tillman, Executive Vice President, Standard & Poor's Credit Market Services, Before the United States Senate Committee on Banking, Housing, and Urban Affairs (September 26, 2007), p. 3. --------------------------------------------------------------------------- A separate evaluation of risk by the broker-dealer should lead to a better understanding of the risks associated with those securities which would, we believe, lead to increased operational efficiency and potentially lowered net capital charges for those broker-dealers that currently do not conduct their own risk evaluation. We believe that allowing broker-dealers to employ their own criteria in determining credit risk for net capital purposes would, by reducing the reliance on NRSRO ratings and therefore more closely aligning a broker-dealer's net capital-related risk assessments with its general internal risk assessments, increase operational efficiency. Furthermore, we believe that the proposed amendments could result in more closely tailored capital charges, and thus lowered costs, for broker-dealers while still being designed to ensure net capital requirements sufficient to require maintenance of capital to achieve the goals of the Net Capital Rule. We believe that the same reasoning applies to the proposed amendment to Exhibit A of the Customer Protection Rule. Broker-dealers that utilize their own means of evaluating the long-term financial strength and general creditworthiness of clearing organizations to which customers' positions in security futures products are posted would better be positioned to incorporate the overall levels of various categories of risk associated with those organizations into their assessments. In the case of the amendments to Rules 101 and 102 of Regulation M, we believe the proposed rule amendments would have benefits that justify any costs, if adopted. Because the exceptions in Rules 101 and 102 are narrowly-tailored, the proposed amendments should continue to promote investor confidence in the offering process and the market as a whole by only excepting those securities that are resistant to manipulation. Market integrity would also continue to be promoted, which benefits the market and all participants. Also, since the proposals would be a bright-line, compliance with the proposed amendments would be easy for issuers and other persons subject to the rules. In fact, this proposal may lower costs for these people by eliminating the need to obtain an investment grade rating from a nationally recognized statistical rating organization. We believe that replacing the NRSRO investment grade requirement with the proposed exceptions should not result in broker-dealers hiring new compliance staff or making extensive systems changes because the proposals utilize existing bright-line benchmarks. B. Costs We anticipate that broker-dealers and other market participants could incur certain costs if the proposed amendments are adopted. Investors could incur additional costs if they perform a more detailed and comprehensive analysis before making an investment decision. Broker-dealers could incur additional costs if they perform their own risk evaluation, if they do not currently do so. Furthermore, the purpose of the proposal is to encourage investors not to place undue reliance on NRSRO ratings in making investment decisions. Investors could still choose to rely solely on NRSRO ratings without incurring additional costs. The proposed amendments to Rule 3a1-1, Rules 300 and 301 of Regulation ATS, Form ATS-R, and Form PILOT would eliminate the separate definitions of and references to investment grade corporate debt securities and non-investment grade debt securities and would replace them with a single category ``corporate debt securities.'' We preliminarily believe that these changes would not impose any significant costs on market participants. The proposed amendments to Rule 3a1-1 and Regulation ATS would marginally reduce the likelihood of an ATS meeting the thresholds in those rules. For example, under existing Rule 3a1-1, an ATS that currently has 40% of the average daily dollar trading volume in non- investment grade corporate debt securities and 0% of the average daily dollar trading volume in investment grade corporate debt securities for at least four of the preceding six calendar months could be required to register as an exchange. Under the proposed amendment to Rule 3a1-1, the Commission would no longer be able to require the ATS to register as an exchange, because its average daily dollar trading volume in corporate debt securities combined would be less than 40%. A potential cost of the proposed amendments to Rule 3a1-1 and Regulation ATS is that an ATS that exceeds one of the existing thresholds and thus becomes subject to additional regulatory requirements (in the case of Regulation ATS) or must register as an exchange (in the case of Rule 3a1-1) would no longer exceed the threshold and would not have to meet the attendant requirements. However, the Commission preliminarily believes that this possibility is remote, and that the proposed amendments are unlikely to impose any costs on investors, market participants, or the national market system generally. We believe that any costs associated with the proposed changes to Form ATS-R and Form PILOT would be minimal. Respondents already determine and report the total units and [[Page 40101]] total trading volume for investment grade and non-investment grade corporate debt securities separately. On the revised forms, respondents would report them together as a single item for ``corporate debt securities.'' The cost of the proposed changes to these forms would be the cost of adding these previously separate items together. We do not expect the proposed amendment to result in any significant changes in the costs associated with Rule 10b-10. Broker- dealers will continue to generate transaction confirmations and send those confirmations to customers, and the proposed amendment if adopted would not be expected to change the cost of generating and sending confirmations. Moreover, we believe that broker-dealers may not need to incur significant costs if they choose not to input information that a debt security is unrated into their existing confirmation systems. We believe that the costs of compliance with the proposed amendments to the Net Capital Rule and its appendices as well as to Note G of Exhibit A of the Rule 15c3-3 would be minimal for entities that already employ their own criteria in determining credit risk for net capital purposes. In the event the broker-dealer inaccurately evaluates the creditworthiness and liquidity of its positions, a potential cost could be that the broker-dealer is required to take a larger haircut on its proprietary positions, and therefore reserve additional capital. This could affect its ability to hold its positions or to add to its positions. As for broker-dealers that do not currently employ such criteria, if the proposed amendments are adopted, after considering comment, we could take the view that securities rated by NRSROs would meet the standards in the rules as amended and this would provide a way for broker-dealers that do not determine credit risk on their own to avoid incurring any additional costs. If we were to adopt the view that NRSRO rated securities meet the standard in the proposed amendments, it would mean that any potential costs would be wholly voluntary. While we encourage broker-dealers that have not yet developed their own credit risk evaluation procedures to do so, such actions would proceed at the time and pace desired by the broker- dealers. We expect the costs of the proposal to modify Rules 101 and 102 of Regulation M to be minimal to most persons subject to those rules who could rely on the proposed amendments as they relate to nonconvertible debt and preferred securities. The proposed exceptions are only triggered when the conditions in the exceptions are met which would only occur in a limited number of situations. It is only when there is an offering of nonconvertible debt or nonconvertible preferred securities which qualifies as a distribution under Regulation M where a covered person bids for, purchases or attempts to induce another person to bid for or purchase the covered security during the applicable restricted period. Thus, there may be offerings of nonconvertible debt or preferred securities that do not constitute a distribution for purposes of Regulation M. In such case, the prohibitions of Regulation M are not triggered and neither the current nor the proposed exceptions would be necessary. Additionally, even if a distribution of the nonconvertible debt or nonconvertible preferred securities exists, a person subject to Regulation M's prohibitions could structure buying activity before or after the applicable restricted period so as not to incur any costs, even if minimal, associated with relying on the proposed exceptions. This holds true for asset-backed securities as well. We believe that many of the issuers of these securities would already know if they are WKSI issuers based on the non-common equity standard because this analysis would have been already done as part of the offering process. Persons other than issuers who would be subject to Rules 101 and 102 should have access to the issuer's WKSI status as well via the issuer's 10K filings. Such persons should also be in a position with the issuer to obtain any other information needed to make a determination as to whether the proposed exception would apply to the security at issue. Thus, we believe that these persons should incur no significant costs under the proposal. There may be, however, costs to any person subject to Rules 101 or 102 to make minor system changes should the Commission adopt this proposal because of the proposed new standard. We do believe, however, that there may be increased costs for issuers and other persons subject to Rules 101 and 102 as they relate to nonconvertible debt and preferred securities if that issuer is WKSI based on the common equity standard.\82\ Since the issuer in that case would not need to determine the aggregate principal amount of their nonconvertible securities other than common equity for purposes of Securities Act disclosure, new analysis would need to be conducted and communicated to other persons subject to Rules 101 and 102 to rely on the exception. This could likely result in increased costs not completely offset by not needing to obtain an investment grade rating. --------------------------------------------------------------------------- \82\ 17 CFR 230.405. The common equity standard is at subparagraph (1)(i)(A) of the definition of ``well-known seasoned issuer.'' --------------------------------------------------------------------------- With respect to asset-backed securities, we believe that there should not be any significant increased costs to persons subject to Rules 101 and 102. All persons who are subject to those rules should know what form the issuer is using to register the offering, including whether Form S-3 is being used. Thus, no new analysis would need to be conducted. We also expect that there could be a small number of securities taken out of this exception as a result of the proposed change. Costs for such issuers, selling shareholders, underwriters, brokers, dealers, any other distribution participants, or affiliated purchasers of any of these persons affected by this change would be more significant, but we do not expect there to be a significant number of these persons. There could also be minimal costs to train broker- dealer and self-regulatory organization staff and to update broker- dealer policies and procedures and make system changes regarding the new exceptions. C. Request for Comment We request data to quantify the costs and the benefits above. We seek estimates of these costs and benefits, as well as any costs and benefits not already described, which could result from the adoption of the proposed amendments. Specifically, would the proposal result in lower costs associated with debt and preferred securities covered by the new exception? What new costs, if any, would be associated with the proposal for persons subject to Rules 101 and 102 where the nonconvertible debt and nonconvertible preferred securities are issued by issuers who are WKSI based on the common equity standard? What costs, if any, would be related to the change for asset-backed securities? For these issues, what is the cost of determining the aggregate principal amount of nonconvertible debt securities other than common equity and then communicating the exception to other persons subject to Rules 101 and 102? Would any securities that currently fall within the existing exceptions not meet the exceptions as proposed? Would the proposal affect the cost to broker dealers of generating transaction confirmations? Do investors benefit from the notification on the transaction confirmation? Does the confirmation help promote conversations about broker-dealers and their customers [[Page 40102]] regarding unrated securities? Are there alternative means to promote such conversations that would not create over-reliance on NRSRO ratings? VII. Consideration of the Burden on Competition, Promotion of Efficiency, and Capital Formation Section 3(f) of the Exchange Act \83\ requires the Commission, whenever it engages in rulemaking and is required to consider or to determine whether an action is necessary or appropriate in the public interest, to consider whether the action will promote efficiency, competition, and capital formation. In addition, Section 23(a)(2) of the Exchange Act \84\ requires the Commission, when promulgating rules under the Exchange Act, to consider the impact any such rules would have on competition. Section 23(a)(2) further provides that the Commission may not adopt a rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. --------------------------------------------------------------------------- \83\ 15 U.S.C. 78c(f). \84\ 15 U.S.C. 78w(a)(2). --------------------------------------------------------------------------- The proposed amendments would remove the reference to NRSRO ratings in several of our rules and forms. These include Rules 3a1-1, 10b-10, 15c3-1, 15c3-3, Rules 101 and 102 of Regulation M, Rules 300 and 301 of Regulation ATS, and Forms ATS-R and PILOT. The purpose of the proposed amendments is to address concerns that the references to NRSRO ratings in our rules and forms contributed to any over-reliance on credit ratings by investors. We preliminarily believe that the proposed amendments to Rule 3a1-1 and Rules 300 and 301 of Regulation ATS would be unlikely to create any adverse impact on efficiency, competition, or capital formation. The Commission preliminarily believes that combining investment grade and non-investment grade corporate debt securities into a single class of securities for purposes of the thresholds in those rules is unlikely to affect whether an ATS crosses one of those thresholds. Moreover, the other classes of securities for which the thresholds are applied--and the levels of the thresholds themselves--would remain unchanged. The proposed changes to Form ATS-R and Form PILOT would simplify reporting for ATSs and self-regulatory systems that operate pilot trading systems. Form ATS-R and Form PILOT respondents are already required to determine and report the volumes of corporate debt securities. A single reporting item for ``corporate debt securities'' would replace the existing separate entries for ``investment grade corporate debt securities'' and ``non-investment grade corporate debt securities.'' Therefore, we preliminarily believe that the changes to Form ATS-R and Form PILOT would be unlikely to have any significant impact on efficiency, competition, or capital formation. We do not believe that the proposed amendment to Rule 10b-10 would result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act. The proposed deletion of paragraph (a)(8) of that rule would not be expected to impose any significant additional costs upon broker-dealers (which in any event would not be prohibited from voluntarily including information that a particular debt security is unrated by an NRSRO). For similar reasons, we do not believe that this proposed amendment would impose any significant adverse effects on efficiency, competition or capital formation. We preliminarily believe that the proposed amendments to the Net Capital Rule and its appendices or to Note G of Exhibit A of the Rule 15c3-3 would serve to promote efficiency and capital formation. As noted above, we believe that by relying on their own means of evaluating risk, broker-dealers would better incorporate the overall levels of risk associated with the securities they hold into their Net Capital Rule. In turn, we believe, this better understanding would more closely align a broker-dealer's net capital-related risk assessments with its general internal risk assessments and lead to increased operational efficiency, potentially lowered net capital charges, and a more efficient allocation of capital. In addition, broker-dealers that developed their own means of evaluating the long-term financial strength and general creditworthiness of clearing organizations to which customers' positions in security futures products are posted for purposes of Note G to Exhibit A of Rule 15c3-3 would better be positioned to incorporate the overall levels of various categories of risk associated with those organizations into their assessments, creating a more efficient means of evaluating those organizations for the sake of the Rule 15c3-3 than simply relying on NRSRO credit ratings alone. We do not anticipate that the proposed amendments to the Net Capital Rule and its appendices or to Note G of Exhibit A of Rule 15c3- 3 would have any impact on competition. We preliminarily believe that the proposed amendments to Rules 101 and 102 of Regulation M are intended to promote capital formation. The proposed amendments should promote continued investor confidence in the offering process by proposing an exception from Regulation M's Rule 101 and 102 prohibitions limited to those securities which are resistant to manipulation. Such investor confidence in our markets should promote continued capital formation. We believe that the proposals should foster continued market integrity which should also translate into capital formation by only allowing for non-manipulative buying activity during distributions. Issuers of nonconvertible debt, nonconvertible preferred securities and asset-backed securities who fall within the proposed exceptions may be encouraged to engage in capital formation knowing that the proposed exceptions are available for their buying activity as well as the buying activity of distribution participants. Because the proposal eliminates the need to obtain an investment grade rating by an NRSRO, a hurdle to both relying on the exception and capital formation would be eliminated, which would also promote capital formation. The proposal would provide an alternative to obtaining an investment grade rating but still would provide clear guidance to all persons subject to those rules. We preliminarily believe that the proposed Regulation M amendments would promote market efficiency by providing continued clarity to issuers, distribution participants, and their affiliated purchasers as to the scope of permissible activity by providing a bright line test for compliance with the proposed exceptions comparable to the existing exception. In addition, the proposals continue to utilize existing benchmarks so as not to trigger inefficiencies that might result from use of a new standard. The proposal would also eliminate the need to obtain an investment grade rating from an NRSRO to rely on the exception, which will eliminate a potential inefficiency in the capital raising process. For these reasons, the Commission preliminarily believes that the proposed exceptions will promote efficient capital formation and competition. We have considered the proposed amendments to Rules 101 and 102 of Regulation M in light of the standards cited in Section 23(a)(2) and believe preliminarily that, if adopted, they would not likely impose any significant burden on competition not necessary or appropriate in furtherance of the Exchange Act. We preliminary believe that the use of the existing WSKI and [[Page 40103]] Form S-3 standards would mean that any additional burdens the proposal may place on market participants should be minimal as market participants are already familiar with and utilize these benchmarks in other contexts. Additionally, the proposals would apply equally to all issuers, distribution participants, and their affiliated issuers. Thus, no person covered by Regulation M should be put at a competitive disadvantage, and the proposal would not impose a significant burden on competition not necessary or appropriate in furtherance of the Act. We generally request comment on the effects of the proposed amendments to Rules 3a1-1, 10b-10, 15c3-1, 15c3-3, Rules 101 and 102 of Regulation M, Rules 300 and 301 of Regulation ATS, and Forms ATS-R and PILOT on efficiency, competition, and capital formation. Commenters should provide analysis and empirical data to support their views. VIII. Regulatory Flexibility Act Certification Section 3(a) of the Regulatory Flexibility Act of 1980 \85\ requires the Commission to undertake an initial regulatory flexibility analysis of the proposed rule on small entities unless the Commission certifies that the rule, if adopted, would not have a significant economic impact on a substantial number of small entities.\86\ Pursuant to Section 605(b) of the Regulatory Flexibility Act (``RFA''), the Commission hereby certifies that the proposed amendments to the rule, would not, if adopted, have a significant economic impact on a substantial number of small entities. --------------------------------------------------------------------------- \85\ 5 U.S.C. 603(a). \86\ 5 U.S.C. 605(b). --------------------------------------------------------------------------- For purposes of Commission rulemaking in connection with the RFA, small entities include broker-dealers with total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared pursuant to Rule 17a-5(d) under the Exchange Act,\87\ or, if not required to file such statements, a broker or dealer that had total capital (net worth plus subordinated liabilities) of less than $500,000 on the last day of the preceding fiscal year (or in the time that it has been in business, if shorter); and is not affiliated with any person (other than a natural person) that is not a small business or small organization.\88\ --------------------------------------------------------------------------- \87\ See 17 CFR 240.17a-5(d). \88\ See 17 CFR 240.0-10(c). --------------------------------------------------------------------------- An alternative trading system that complies with Regulation ATS must, among other things, register as a broker-dealer.\89\ Thus, the Commission's definition of small entity as it relates to broker-dealers also would apply to ATSs. An ATS that approaches the volume thresholds for investment grade or non-investment grade corporate debt securities in Rule 3a1-1 or Regulation ATS would be very large and thus unlikely to be a small entity or small organization. With respect to the proposed changes to Form ATS-R, even if an ATS is a ``small entity'' or ``small organization'' for purposes of the RFA, the only change being proposed to the form is to eliminate the distinction between investment grade and non-investment grade corporate debt securities and to require reporting for the combined class of corporate debt securities. We believe this would impose only negligible costs on ATSs, even if they were small entities or small organizations. --------------------------------------------------------------------------- \89\ See 17 CFR 242.301(b)(1). --------------------------------------------------------------------------- Similarly, SROs are the only respondents to Form PILOT and are not ``small entities'' for purposes of the RFA. Accordingly, no small entities would be affected by the proposed amendments to Form PILOT. We believe that the proposed amendment to Rule 10b-10 will not have a significant economic impact on a substantial number of small entities. While some broker-dealers that effect transactions in the debt securities currently subject to paragraph (a)(8) of that rule may be small entities, the proposed amendment should not result in any significant change to the cost of providing confirmations to customers in connection with those transactions. The proposed amendments to the securities haircut provisions in paragraphs (E), (F), and (H) of Rules 15c3-1(c)(2)(vi), if adopted, would not have a significant economic impact on a small number of entities. If the Commission adopts the proposed amendments, we would take the view in the adopting release that securities rated by NRSROs as currently required would meet the amended standards. Thus, the proposed amendments would allow for compliance without reference to the standards that are currently in the rule (i.e., NRSRO ratings), but broker-dealers that wish to use them would still be accommodated. Accordingly, the rule would not have any economic impact on small entities because they would not have to change their current practices. The proposed amendments to the Appendices E and F to Rule 15c3-1 (which include conforming amendments to Appendix G of Rule 15c3-1 and the General Instructions to Form X-17A-5, Part IIB), if adopted, would not apply to small entities. Appendices E and G apply to broker-dealers that are part of a consolidated supervised entity and Appendix F and Form X-17A-5, Part IIB apply to OTC Derivatives Dealers that have applied to the Commission for authorization to compute capital charges as set forth in Appendix F in lieu of computing securities haircuts pursuant to Rule 15c3-1(c)(2)(vi). All of these brokers or dealers would be larger than the definition of a small broker dealer in Rule 0- 10. The proposed amendments to Rule 15c3-3a, if adopted, would not have a significant economic impact on a substantial number of small entities. The proposed amendments to Rule 15c3-3a would apply only to broker-dealers that clear and carry positions in security futures products in securities accounts for the benefit of customers. None of those broker-dealers affected by the rule is a small entity as defined in Rule 0-10 (confirming this with OEA). With respect to the amendments to Rules 101 and 102 of Regulation M, it is unlikely that any broker-dealer that is defined as a ``small business'' or ``small organization'' as defined in Rule 0-10 \90\ could be an underwriter or other distribution participant as they would not have sufficient capital to participate in underwriting activities. Small business or small organization for purposes of ``issuers'' or ``person'' other than an investment company is defined as a person who, on the last day of its most recent fiscal year, had total assets of $5 million or less.\91\ We believe that none of the various persons that would be affected by this proposal would qualify as a small entity under this definition as it is unlikely that any issuer of that size had investment grade securities that could rely on the existing exception. Therefore, we believe that these amendments would not impose a significant economic impact on a substantial number of small entities. --------------------------------------------------------------------------- \90\ 17 CFR 240.0-10. \91\ 17 CFR 240.0-10(a). --------------------------------------------------------------------------- We encourage written comments regarding this certification. The Commission solicits comment as to whether the proposed amendments to Rules 3a1-1, 10b-10, 15c3-1, 15c3-3, Rules 101 and 102 of Regulation M, Rules 300 and 301 of Regulation ATS, and Forms ATS-R and PILOT could have an effect on small entities that has not been considered. We request that commenters describe the nature of any [[Page 40104]] impact on small entities and provide empirical data to support the extent of such impact. IX. Statutory Basis and Text of the Proposed Amendments The amendments to Rules 3a1-1, 10b-10, 15c3-1, 15c3-3, Rules 101 and 102 of Regulation M, Rules 300 and 301 of Regulation ATS, and Forms ATS-R, Pilot, 17-H, and X-17A-5 Part IIB under the Act are being proposed pursuant to the Sections 7,\92\ 17(a),\93\ 19(a) \94\ of the Securities Act, Sections 2,\95\ 3,\96\ 9(a),\97\ 10,\98\ 11,\99\ 11A(c),\100\ 12,\101\ 13,\102\ 14,\103\ 15,\104\ 15(c),\105\ 15(g),\106\ 17,\107\ 17(a),\108\ 23(a),\109\ 30,\110\ and 36(a)(1) \111\ of the Exchange Act, and Sections 23,\112\ 30,\113\ and 38 \114\ of the Investment Company Act of 1940. --------------------------------------------------------------------------- \92\ 15 U.S.C. 77g. \93\ 15 U.S.C. 77q(a). \94\ 15 U.S.C. 77s(a). \95\ 15 U.S.C. 78b. \96\ 15 U.S.C. 78c. \97\ 15 U.S.C. 78i(a). \98\ 15 U.S.C. 78j. \99\ 15 U.S.C. 78k. \100\ 15 U.S.C. 78k-1(c). \101\ 15 U.S.C. 78l. \102\ 15 U.S.C. 78m. \103\ 15 U.S.C. 78n. \104\ 15 U.S.C. 78o. \105\ 15 U.S.C. 78o(c). \106\ 15 U.S.C. 78o(g). \107\ 15 U.S.C. 78q. \108\ 15 U.S.C. 78q(a). \109\ 15 U.S.C. 78w(a). \110\ 15 U.S.C. 78dd. \111\ 15 U.S.C. 78mm(a)(1). \112\ 15 U.S.C. 80a-23. \113\ 15 U.S.C. 80a-29. \114\ 15 U.S.C. 80a-37. --------------------------------------------------------------------------- List of Subjects in 17 CFR Parts 240, 242, and 249 Broker, Reporting and recordkeeping requirements, Securities. Text of Amendment In accordance with the foregoing, Title 17, Chapter II of the Code of Federal Regulations is proposed to be amended as follows: PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for part 240 continues to read, in part, as follows: Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise noted. * * * * * 2. Amend Sec. 240.3a1-1 by revising paragraphs (b)(3)(v), (b)(3)(vi), and (b)(3)(vii) and by removing (b)(3)(viii) to read as follows: Sec. 240.3a1-1 Exemption from the definition of ``Exchange'' under Section 3(a)(1) of the Act. * * * * * (b) * * * (3) * * * (v) Corporate debt securities, which shall mean any securities that: (A) Evidence a liability of the issuer of such securities; (B) Have a fixed maturity date that is at least one year following the date of issuance; and (C) Are not exempted securities, as defined in section 3(a)(12) of the Act, (15 U.S.C. 78c(a)(12)); (vi) Foreign corporate debt securities, which shall mean any securities that: (A) Evidence a liability of the issuer of such debt securities; (B) Are issued by a corporation or other organization incorporated or organized under the laws of any foreign country; and (C) Have a fixed maturity date that is at least one year following the date of issuance; and (vii) Foreign sovereign debt securities, which shall mean any securities that: (A) Evidence a liability of the issuer of such debt securities; (B) Are issued or guaranteed by the government of a foreign country, any political subdivision of a foreign country, or any supranational entity; and (C) Do not have a maturity date of a year or less following the date of issuance. 3. Section 240.10b-10 is amended by removing paragraph (a)(8) and redesignating paragraph (a)(9) as paragraph (a)(8). 4. Section 240.15c3-1 is amended by revising the introductory text of paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F)(1), and (c)(2)(vi)(F)(2), and by revising paragraph (c)(2)(vi)(H) to read as follows: Sec. 240.15c3-1 Net capital requirements for brokers or dealers. * * * * * (c) * * * (2) * * * (vi) * * * (E) Commercial paper, bankers acceptances and certificates of deposit. In the case of any short term promissory note or evidence of indebtedness which has a fixed rate of interest or is sold at a discount, which has a maturity date at date of issuance not exceeding nine months exclusive of days of grace, or any renewal thereof, the maturity of which is likewise limited, and is subject to a minimal amount of credit risk and has sufficient liquidity such that it can be sold at or near its carrying value almost immediately, or in the case of any negotiable certificates of deposit or bankers acceptance or similar type of instrument issued or guaranteed by any bank as defined in section 3(a)(6) of the Securities Exchange Act of 1934, the applicable percentage of the market value of the greater of the long or short position in each of the categories specified below are: * * * * * (F) (1) Nonconvertible debt securities. In the case of nonconvertible debt securities having a fixed interest rate and a fixed maturity date, which are not traded flat or in default as to principal or interest and which are subject to no greater than moderate credit risk and have sufficient liquidity such that they can be sold at or near their carrying value within a reasonably short period of time, the applicable percentages of the market value of the greater of the long or short position in each of the categories specified below are: * * * * * (2) A broker or dealer may elect to exclude from the above categories long or short positions that are hedged with short or long positions in securities issued by the United States or any agency thereof or nonconvertible debt securities having a fixed interest rate and a fixed maturity date and which are not traded flat or in default as to principal or interest, and which are subject to no greater than moderate credit risk and have sufficient liquidity such that they can be sold at or near their carrying value within a reasonably short period of time, if such securities have maturity dates: * * * * * (H) In the case of cumulative, non-convertible preferred stock ranking prior to all other classes of stock of the same issuer, which is subject to no greater than moderate credit risk and has sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time and which are not in arrears as to dividends, the deduction shall be 10% of the market value of the greater of the long or short position. * * * * * 5. Section 240.15c3-1e is amended by removing paragraphs (c)(4)(vi)(A) through (c)(4)(vi)(D) and redesignating paragraphs (c)(4)(vi)(E), (F), and (G) as paragraphs (c)(4)(vi)(A), (B), and (C). 6. Section 240.15c3-1f is amended by: a. Removing the phrase ``by a nationally recognized statistical rating [[Page 40105]] organization (``NRSRO'')'' in paragraph (d)(2)(i); b. Removing the phrase ``by an NRSRO'' in paragraphs (d)(2)(ii), (d)(3)(i), and (d)(3)(ii); and c. Revising the first and second sentences of paragraph (d)(4). The revision reads as follows: Sec. 240.15c3-1f Optional market and credit risk requirements for OTC derivatives dealers (Appendix F to 17 CFR 240.15c3-1). * * * * * (d) * * * (4) Counterparties may be rated by the OTC derivatives dealer, or by an affiliated bank or affiliated broker-dealer of the OTC derivatives dealer, upon approval by the Commission on application by the OTC derivatives dealer. Based on the strength of the OTC derivatives dealer's internal credit risk management system, the Commission may approve the application. * * * * * * * * 7. Section 240.15c3-1g is amended by revising paragraph (a)(3)(i)(F) to read as follows: Sec. 240.15c3-1g Conditions for ultimate holding companies of certain brokers or dealers (Appendix G to 17 CFR 240.15c3-1). * * * * * (a) * * * (3) * * * (i) * * * (F) Credit risk weights shall be determined according to the provisions of paragraphs (c)(4)(vi)(A) of Sec. 240.15c3-1e. * * * * * 8. Section 15c3-3a is amended by revising Note G paragraph (b)(1)(i) to read as follows: Sec. 240.15c3-3a Exhibit A--formula for determination reserve requirement of brokers and dealers under Sec. 240.15c3-3. * * * * * Note G. * * * (b) * * * (1) * * * (i) Has the highest capacity to meet its financial obligations and is subject to no greater than minimal credit risk; or * * * * * PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS AND CUSTOMER MARGIN REQUIREMENTS FOR SECURITY FUTURES 9. The authority citation for part 242 continues to read as follows: Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2), 78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g), 78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and 80a-37. 10. Section 242.101 is amended by revising paragraph (c)(2) to read as follows: Sec. 242.101 Activities by distribution participants. * * * * * (c) * * * (2) Nonconvertible and asset-backed securities. Nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities, if: (i) For nonconvertible debt securities and nonconvertible preferred securities, the issuer of such securities meets the requirements of ``well-known seasoned issuer'' as that term is used in Sec. 230.405 of this chapter, but only if such issuer also meets the requirements of paragraph (1)(i)(B)(1) of that definition; or (ii) For asset-backed securities, the offer and sale of the security is registered using Form S-3 (Sec. 239.13 of this chapter); or * * * * * 11. Section 242.102 is amended by revising paragraph (d)(2) to read as follows: Sec. 242.102 Activities by issuers and selling security holders during a distribution. * * * * * (d) * * * (2) Nonconvertible and asset-backed securities. Nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities, if: (i) For nonconvertible debt securities and nonconvertible preferred securities, the issuer of such securities meets the requirements of ``well-known seasoned issuer'' as that term is used in Sec. 230.405 of this chapter, but only if such issuer also meets the requirements of paragraph (1)(i)(B)(1) of that definition; or (ii) For asset-backed securities, the offer and sale of the security is registered using Form S-3 (Sec. 239.13 of this chapter); or * * * * * 12. Section 242.300 is amended by revising paragraph (i), removing paragraph (j), and redesignating paragraph (k) as paragraph (j). The revision reads as follows: Sec. 242.300 Definitions. * * * * * (i) Corporate debt security shall mean any security that: (1) Evidences a liability of the issuer of such security; (2) Has a fixed maturity date that is at least one year following the date of issuance; and (3) Is not an exempted security, as defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)). * * * * * 13. Section 242.301 is amended by: a. Adding the word ``or'' to the end of paragraph (b)(5)(i)(C); b. Revising paragraph (b)(5)(i)(D); c. Removing paragraph (b)(5)(i)(E); d. Adding the word ``or'' to the end of paragraph (b)(6)(i)(C); e. Revising paragraph (b)(6)(i)(D); and f. Removing paragraph (b)(6)(i)(E). The revisions read as follows: Sec. 242.301 Requirements for alternative trading systems. * * * * * (b) * * * (5) * * * (i) * * * (D) With respect to corporate debt securities, 5 percent or more of the average daily volume traded in the United States. * * * * * (6) * * * (i) * * * (D) With respect to corporate debt securities, 20 percent or more of the average daily volume traded in the United States. * * * * * PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934 14. The authority citation for part 249 continues to read in part as follows: Authority: 15 U.S.C. 78a et seq., 7202, 7233, 7241, 7262, 7264, and 7265; and 18 U.S.C. 1350, unless otherwise noted. * * * * * 15. Amend Form X-17A-5 Part IIB General Instructions (referenced in Sec. 249.617) by removing the phrase ``by a nationally recognized statistical rating organization (`NRSRO')'' and the phrase ``by an NRSRO'' wherever it appears in the section ``Credit risk exposure'' under the heading ``Computation of Net Capital and Required Net Capital'' and before the heading ``Aggregate Securities and OTC Derivatives Positions.'' Note: The text of Form X-17A-5 Part IIB does not and this amendment will not appear in the Code of Federal Regulations. 16. Form ATS-R (referenced in Sec. 249.638) is amended by: a. In the instructions to the form, Section B, revising the second term and removing the third term; and b. In Section 4 of the form, revising Line L, to read ``Corporate debt securities,'' removing Line M, and redesignating Lines N and O as Lines M and N. [[Page 40106]] Note: The text of Form ATS-R does not and this amendment will not appear in the Code of Federal Regulations. The revision reads as follows: Form ATS-R, Quarterly Report of Alternative Trading System Activities Form ATS-R Instructions B. * * * Corporate Debt Securities--shall mean any securities that (1) evidence a liability of the issuer of such securities; (2) have a fixed maturity date that is at least one year following the date of issuance; and (3) are not exempted securities, as defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)). * * * * * 17. Form PILOT (referenced in Sec. 249.821) is amended by: a. In the instructions to the form, Section B, revising the second term and removing the third term; and b. In Section 9 of the form, revising Line J, to read ``Corporate debt securities,'' removing Line K, and redesignating Lines L, M, N and O as Lines K, L, M and N. Note: The text of Form PILOT does not and this amendment will not appear in the Code of Federal Regulations. The revision reads as follows: Form PILOT, Initial Operation Report, Amendment to Initial Operation Report and Quarterly Report for Pilot Trading Systems Operated by Self- Regulatory Organizations Form PILOT Instructions B. * * * Corporate Debt Securities--shall mean any securities that (1) evidence a liability of the issuer of such securities; (2) have a fixed maturity date that is at least one year following the date of issuance; and (3) are not exempted securities, as defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)). By the Commission. Dated: July 1, 2008. Florence E. Harmon, Acting Secretary. [FR Doc. E8-15280 Filed 7-10-08; 8:45 am] BILLING CODE 8010-01-P
[Federal Register: July 11, 2008 (Volume 73, Number 134)][Proposed Rules] [Page 40106-40124] From the Federal Register Online via GPO Access [wais.access.gpo.gov] [DOCID:fr11jy08-17] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 229, 230, 239, and 240 [Release No. 33-8940; 34-58071; File No. S7-18-08] RIN 3235-AK18 Security Ratings AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. ----------------------------------------------------------------------- SUMMARY: This is one of three releases that the Commission is publishing simultaneously relating to the use of security ratings by nationally recognized statistical rating organizations in its rules and forms. In this release, the Commission proposes to replace rule and form requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934 that rely on security ratings (for example, Forms S-3 and F-3 eligibility criteria) with alternative requirements. In addition, the Commission requests comment on its rules relating to the disclosure of security ratings. DATES: Comments should be received on or before September 5, 2008. ADDRESSES: Comments may be submitted by any of the following methods: Electronic CommentsUse the Commission's Internet comment form (http:// www.sec.gov/rules/proposed.shtml); or Send an e-mail to rule-comments@sec.gov. Please include File Number S7-18-08 on the subject line; or Use the Federal eRulemaking Portal (http:// www.regulations.gov). Follow the instructions for submitting comments. Paper Comments Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090. All submissions should refer to File Number S7-18-08. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: Steven Hearne, Eduardo Aleman, or Katherine Hsu, Special Counsels in the Office of Rulemaking, Division of Corporation Finance, at (202) 551-3430, 100 F Street NE., Washington, DC 20549. SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to Regulation S-K,\1\ and rules and forms under the Securities Act of 1933 (Securities Act),\2\ and the Securities Exchange Act of 1934 (Exchange Act).\3\ In Regulation S-K, the Commission is proposing to amend Items 10,\4\ 1100,\5\ 1112,\6\ and 1114.\7\ Under the Securities Act, the Commission is proposing to amend Rules 134,\8\ 138,\9\ 139,\10\ 168,\11\ 415,\12\ 436,\13\ Form S-3,\14\ Form S-4,\15\ Form F-1,\16\ Form F-3,\17\ Form F-4,\18\ and Form F-9.\19\ The Commission is also proposing to amend Schedule 14A \20\ under the Exchange Act. --------------------------------------------------------------------------- \1\ 17 CFR 229.10 through 1123. \2\ 15 U.S.C. 77a et seq. \3\ 15 U.S.C. 78a et seq. \4\ 17 CFR 229.10. \5\ 17 CFR 229.1100. \6\ 17 CFR 229.1112. \7\ 17 CFR 229.1114. \8\ 17 CFR 230.134. \9\ 17 CFR 230.138. \10\ 17 CFR 230.139. \11\ 17 CFR 230.168. \12\ 17 CFR 230.415. \13\ 17 CFR 230.436. \14\ 17 CFR 239.13. \15\ 17 CFR 239.25. \16\ 17 CFR 239.31. \17\ 17 CFR 239.33. \18\ 17 CFR 239.34. \19\ 17 CFR 239.39. \20\ 17 CFR 240.14a-101. --------------------------------------------------------------------------- I. Background On June 16, 2008, in furtherance of the Credit Rating Agency Reform Act of 2006,\21\ the Commission published for notice and public comment two rulemaking initiatives.\22\ The first proposes additional requirements for nationally recognized statistical rating organizations (NRSROs) that were directed at reducing conflicts of interest in the credit rating process, fostering competition and comparability among credit rating agencies, and increasing transparency of the credit rating [[Page 40107]] process.\23\ The second is designed to improve investor understanding of the risk characteristics of structured finance products. These proposals address concerns about the integrity of the credit rating procedures and methodologies of NRSROs in light of the role they played in determining the security ratings for securities that were the subject of the recent turmoil in the credit markets. --------------------------------------------------------------------------- \21\ Pub. L. No. 109-291, 120 Stat. 1327 (2006). \22\ Proposed Rules for Nationally Recognized Statistical Rating Organizations, Release No. 34-57967 (Jun. 16, 2008). \23\ See Press Release No. 2008-110 (Jun. 11, 2008). As described in more detail below, an NRSRO is an organization that issues ratings that assess the creditworthiness of an obligor itself or with regard to specific securities or money market instruments, has been in existence as a credit rating agency for at least three years, and meets certain other criteria. The term is defined in section 3(a)(62) of the Exchange Act (15 U.S.C. 78c(a)(62)). A credit rating agency must apply with the Commission to register as an NRSRO, and currently there are nine registered NRSROs. --------------------------------------------------------------------------- Today's proposals comprise the third of these three rulemaking initiatives relating to security ratings by an NRSRO that the Commission is proposing. This release, together with two companion releases, sets forth the results of the Commission's review of the requirements in its rules and forms that rely on security ratings by an NRSRO. The proposals also address recent recommendations issued by the President's Working Group on Financial Markets, the Financial Stability Forum on Enhancing Market and Institutional Resilience, and the Technical Committee of the International Organization of Securities Commissions.\24\ Consistent with these recommendations, the Commission is considering whether the inclusion of requirements related to security ratings in its rules and forms has, in effect, placed an ``official seal of approval'' on ratings that could adversely affect the quality of due diligence and investment analysis. The Commission believes that today's proposals could reduce undue reliance on ratings and result in improvements in the analysis that underlies investment decisions. --------------------------------------------------------------------------- \24\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments (March 2008), available at www.ustreas.gov; The Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 2008), available at www.fsforum.org; Technical Committee of the International Organization of Securities Commissions, Consultation Report: The Role of Credit Rating Agencies in Structured Finance Markets (March 2008), page 9, available at www.iosco.org. --------------------------------------------------------------------------- In 1981, the Commission issued a statement of policy regarding its view of disclosure of security ratings in registration statements under the Securities Act.\25\ This statement marked a clear delineation between the Commission's historic practice of precluding the disclosure of security ratings in these filings and the Commission's then- developing acknowledgement of the growing importance of ratings in the securities markets and in the regulation of those markets. Soon thereafter, the Commission adopted rules that not only set forth its new policy of permitting the voluntary disclosure of security ratings in registration statements but that also encouraged such disclosure by the issuer.\26\ The rules permitted the voluntary disclosure of security ratings in a communication deemed not to be a prospectus and provided that a security rating by an NRSRO is generally not part of a registration statement or report prepared or certified by a person within the meaning of Sections 7 \27\ and 11 \28\ of the Securities Act. --------------------------------------------------------------------------- \25\ See Disclosure of Ratings in Registration Statements, Release No. 33-6336 (Aug. 6, 1981) [46 FR 42024]. The Commission first began using ratings by an NRSRO in 1975 for purposes of determining capital charges on different grades of debt securities under Rule 15c3-1 under the Exchange Act (Net Capital Rule). See 17 CFR 240.15c-31(c)(2)(vi)(E) and Adoption of Amendments to Rule 15c3- 1 and Adoption of Alternative Net Capital Requirement for Certain Brokers and Dealers, Release No. 34-11497 (Jun. 26, 1975) [40 FR 29795]. \26\ See Adoption of Integrated Disclosure System, Release No. 33-6383 (Mar. 3, 1982) [47 FR 11380] (``Integrated Disclosure Release''). \27\ 15 U.S.C. 77g. \28\ 15 U.S.C. 77k. --------------------------------------------------------------------------- Concurrent with the adoption of these rules regarding security ratings, the Commission adopted Securities Act Form S-3, the short-form Securities Act registration statement for eligible domestic issuers.\29\ The Commission adopted a provision in Form S-3 that a primary offering of non-convertible debt securities may be eligible for registration on the form if rated investment grade.\30\ This provision provided debt securities issuers whose public float did not reach the required threshold, or that did not have a public float, with an alternate means of becoming eligible to register offerings on Form S- 3.\31\ In adopting this requirement, the Commission specifically noted that commenters believed that the component relating to investment grade ratings was appropriate because nonconvertible debt securities are generally purchased on the basis of interest rates and security ratings.\32\ Consistent with Form S-3, the Commission adopted a provision in Form F-3 providing for the eligibility of a primary offering of investment grade non-convertible debt securities by eligible foreign private issuers.\33\ --------------------------------------------------------------------------- \29\ 17 CFR 239.13 and the Integrated Disclosure Release. \30\ See General Instruction I.B.2 of Form S-3. A non- convertible security is an ``investment grade security'' for purposes of form eligibility if at the time of sale, at least one NRSRO has rated the security in one of its generic rating categories which signifies investment grade, typically one of the four highest rating categories. See id. \31\ Pursuant to the recently adopted revisions to Form S-3 and Form F-3, issuers also may conduct primary securities offerings on these forms without regard to the size of their public float or the rating of debt securities being offered, so long as they satisfy the other eligibility conditions of the respective forms, have a class of common equity securities listed and registered on a national securities exchange, and the issuers do not sell more than the equivalent of one-third of their public float in primary offerings over any period of 12 calendar months. See Revisions to Eligibility Requirements for Primary Offerings on Forms S-3 and F-3, Release No. 33-8878 (Dec. 19, 2007) [72 FR 73534]. \32\ See Section III.A.1 of the Integrated Disclosure Release. Later, in 1992, the Commission expanded the eligibility requirement to delete references to debt or preferred securities and provide Form S-3 eligibility for other investment grade securities (such as foreign currency or other cash settled derivative securities). See Simplification of Registration Procedures for Primary Securities Offerings, Release No. 33-6964 (Oct. 22, 1992) [57 FR 48970]. \33\ General Instruction I.B.2 of Form F-3. See Adoption of Foreign Issuer Integrated Disclosure System, Release No. 33-6437 (Nov. 19, 1982) [47 FR 54764]. In 1994, the Commission expanded the eligibility requirement to delete references to debt or preferred securities and provide Form F-3 eligibility for other investment grade securities (such as foreign currency or other cash settled derivative securities). See Simplification of Registration of Reporting Requirements for Foreign Companies, Release No. 33-7053A (May 12, 1994) [59 FR 25810]. --------------------------------------------------------------------------- Since the adoption of those rules relating to security ratings and Form S-3 and Form F-3, other Commission forms and rules have included requirements that likewise rely on the ratings issued to a security.\34\ Among them are Form F-9,\35\ Forms S-4 and F-4,\36\ and Exchange Act Schedule 14A.\37\ Shelf registration requirements for asset-backed securities also depend on a security ratings component.\38\ In 1983, the Commission adopted Securities Act Rule 415 which permits certain mortgage related securities, among others, to be offered on a delayed basis.\39\ A mortgage related security is defined in section 3(a)(41) of the Exchange Act,\40\ as, among other things, ``a security that is rated in one of the two highest rating categories by at least one nationally recognized statistical [[Page 40108]] rating organization.'' \41\ In 1992, the Commission expanded the Form S-3 eligibility provisions to provide for the registration of investment grade asset-backed securities offerings, regardless of the issuer's reporting history or public float.\42\ In addition, if they are related to investment grade rated securities, certain registration statements and other requirements afford foreign private issuers with an option to comply with less extensive U.S. GAAP reconciliation requirements.\43\ --------------------------------------------------------------------------- \34\ This release addresses rules and forms filed by issuers under the Securities Act and Exchange Act. In separate releases, the Commission is proposing to address other rules and forms that rely on an investment grade ratings component. \35\ See General Instruction I. of Form F-9. \36\ See General Instruction B.1 of Form S-4 and General Instruction B.1(a) of Form F-4. \37\ See Note E and Item 13 of Schedule 14A. \38\ General Instruction I.B.5 of Form S-3. \39\ 17 CFR 230.415(a)(1)(vii). See Shelf Registration, Release No. 33-6499 (Nov. 17, 1983) [48 FR 5289]. \40\ 15 U.S.C. 78c(a)(41). \41\ See discussion of mortgage related securities in Section II.A.2. below. \42\ See Simplification of Registration Procedures for Primary Securities Offerings, Release No. 33-6964 (Oct. 22, 1992) [57 FR 32461]. \43\ See Exchange Act Forms 20-F (17 CFR 249.220f) and 40-F (17 CFR 249.240f), Securities Act Forms F-1 (17 CFR 239.31), F-3 (17 CFR 239.33), and F-4 (17 CFR 239.34), and Form F-9 (17 CFR 239.39) and Rule 502(b)(2)(i)(C) of Regulation D (17 CFR 230.502(b)(2)(i)(C)). --------------------------------------------------------------------------- At various times since the adoption of these form requirements and rules, however, the Commission has reviewed and reconsidered its permissive views toward the disclosure of ratings in filings and the reliance on ratings in the Commission's form requirements. For example, in 1994, the Commission published a proposing release that would have mandated disclosure in Securities Act prospectuses of a rating given by an NRSRO whenever a rating with respect to the securities being offered is ``obtained by or on behalf of an issuer.'' \44\ The proposals would have required disclosure of specified information with respect to security ratings, whether or not disclosed voluntarily or mandated by the proposed new rules. In addition, the 1994 Ratings Release sought comment on various areas relating to the disclosure of security ratings. --------------------------------------------------------------------------- \44\ See Disclosure of Security Ratings, Release No. 33-7086 (Aug. 31, 1994) [59 FR 46304] (the ``1994 Ratings Release''). A concept release on this subject was published in Disclosure of Security Ratings, Release No. 33-5882 (Nov. 3, 1977) [42 FR 58414]. --------------------------------------------------------------------------- The 1994 Ratings Release also proposed to require the disclosure on a Form 8-K current report of any material change in the security rating assigned to the registrant's securities by an NRSRO.\45\ Later, in 2002, the Commission again proposed to require an issuer to file a Form 8-K current report when it received a notice or other communication from any rating agency regarding, for example, a change or withdrawal of a particular rating.\46\ The Commission did not adopt this proposal, noting that it would continue to consider the appropriate regulatory approach for rating agencies.\47\ --------------------------------------------------------------------------- \45\ See the 1994 Ratings Release. \46\ See Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, Release No. 33-8106 (Jun. 17, 2002) [67 FR 42914]. \47\ See Additional Form 8-K Filing Requirements and Acceleration of Filing Date, Release No. 33-8400 (Mar. 16, 2004) [69 FR 15594], amended by Release No. 33-8400A (Aug. 4, 2004) [69 FR 48370]. --------------------------------------------------------------------------- In 2003, the Commission issued a concept release requesting comment on whether it should cease using the NRSRO designation and, as an alternative to the ratings criteria, provide for Form S-3 eligibility where investor sophistication or large size denomination criteria are met.\48\ The Commission also requested comment on alternatives to Form S-3 ratings reliance with regard to offerings of asset-backed securities. In the 2004 adopting release for Regulation AB,\49\ while retaining the eligibility provision for investment grade rated asset- backed securities, the Commission noted that it was engaged in a broad review of the role of credit rating agencies in the securities markets, including whether security ratings should continue to be used for regulatory purposes under the securities laws.\50\ The release made note of the 2003 concept release and the comments received on possible alternatives to using the investment grade requirement for determining Form S-3 eligibility for asset-backed securities. --------------------------------------------------------------------------- \48\ See Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws, Release No. 33-8236 (Jun. 4, 2003) [68 FR 35258]. Comments on the concept release are available at: http:// www.sec.gov/rules/concept/s71203.shtml. As discussed above, recent events have highlighted the need to revisit our reliance on NRSRO ratings in the context of these developments. See also the extensive discussion of market developments in Release No. 34-57967. \49\ 17 CFR 229.1100 through 1123. \50\ See Section III.A.3.c of Asset-Backed Securities, Release No. 33-8518 (Dec. 22, 2004) [70 FR 1506, 1524]. --------------------------------------------------------------------------- In 2005, the Commission adopted rules and form amendments to modify the framework for the registration, communications, and offerings processes, relaxing restrictions and requirements on the largest issuers.\51\ These large issuers, defined as well-known seasoned issuers, include issuers that have issued for cash more than an aggregate of $1 billion in non-convertible securities, other than common equity, through registered primary offerings over the prior three years.\52\ In adopting this definition, the Commission did not rely on investment grade ratings, noting in the adopting release that the securities included in the calculation for determining whether the $1 billion threshold has been met need not be investment grade securities.\53\ --------------------------------------------------------------------------- \51\ See Securities Offering Reform, Release No. 33-8591 (July 19, 2005) [70 FR 44722]. \52\ See definition of well-known seasoned issuer in Rule 405. 17 CFR 230.405. \53\ See Section II.A.1.b of Release No. 33-8591. --------------------------------------------------------------------------- II. Proposed Amendments A. Shelf Registration for Issuers of Asset-Backed Securities 1. Form S-3 Eligibility for Offerings of Asset-Backed Securities Under the existing requirements, an offering of asset-backed securities, or ABS, as defined in Item 1101 of Regulation AB,\54\ may be eligible for registration on Form S-3 and may therefore be offered on a delayed or continuous basis \55\ if they are rated investment grade by an NRSRO and meet certain other conditions.\56\ The Commission now proposes to amend this requirement in Form S-3 for ABS to replace the component that relies on investment grade ratings with an alternate provision. --------------------------------------------------------------------------- \54\ 17 CFR 229.1101. \55\ General Instruction I.B.5 of Form S-3. The Commission expanded the use of Form S-3 to all types of asset-backed securities in 1992. See Simplification of Registration Procedures for Primary Securities Offerings, Release No. 33-6964 (Oct. 22, 1992) [57 FR 48970]. \56\ As discussed below, two additional conditions also apply in order for ABS offered for cash to be Form S-3 eligible: (1) delinquent assets do not constitute 20% or more, as measured by dollar volume, of the asset pool as of the measurement date; and (2) with respect to securities that are backed by leases other than motor vehicle leases, the portion of the securitized pool balance attributable to the residual value of the physical property underlying the leases, as determined in accordance with the transaction agreements for the securities, does not constitute 20% or more, as measured by dollar volume, of the securitized pool balance as of the measurement date. General Instruction I.B.5(a) of Form S-3. --------------------------------------------------------------------------- In the 2004 proposing release for Regulation AB, the Commission requested comment on whether the investment grade reliance component of the Form S-3 eligibility requirements for ABS offerings was appropriate and whether alternative criteria such as investor sophistication, minimum denomination, or experience criteria were more appropriate.\57\ The Commission received four comment letters in response that provided suggestions on possible alternatives to the investment grade requirement for Form S-3 eligibility purposes for ABS offerings.\58\ One commenter [[Page 40109]] recommended that the Commission replace the investment grade ratings requirement with a sponsor \59\ experience requirement (e.g., Exchange Act reporting).\60\ Another commenter suggested that the Commission either (1) eliminate the use of the ratings as a bright line test for the Form S-3 eligibility criteria, thereby eliminating the incentive to shop for ratings simply to satisfy a regulatory requirement; or (2) reflective of developing market practice, require an investment grade rating which is the lower of two ratings.\61\ --------------------------------------------------------------------------- \57\ See Section III.A.3.c of Asset-Backed Securities, Release No. 33-8419 (May 3, 2004) [69 FR 16650]. In the 2003 concept release where the Commission requested comment on alternatives to the ratings reliance requirement in Form S-3 for corporate debt, the Commission requested comment on alternatives to ratings reliance with respect to ABS offerings. No comment letters submitted in response to the concept release provided specific suggestions on alternatives for ABS offerings. See Release No. 33-8236. \58\ See letters commenting on Release No. 33-8419 from the American Bar Association (ABA), Kutak Rock, LLP (Kutak), State Street Global Advisors (State Street), and Moody's Investor Service (Moody's). The public comments received are available for inspection in our Public Reference Room at 100 F Street, NE., Washington, DC 20549 in File No. S7-21-04, or may be viewed at http://www.sec.gov/ rules/proposed/s72104.shtml. \59\ While ``sponsor'' is a commonly used term for the entity that initiates the asset-backed securities transaction, the terms ``seller'' or ``originator'' also are often used in the market. In some instances the sponsor is not the originator of the financial assets but has purchased them in the secondary market. See footnote 46 of Release No. 33-8518. \60\ See letter from State Street. \61\ See letter from Moody's. --------------------------------------------------------------------------- Two commenters recommended that the Commission adopt a minimum denomination requirement (e.g., $100,000 or $250,000) that would determine form eligibility, limiting investment in the offering to investors who had such capital.\62\ One of these commenters recommended that the Commission make short-form registration available to otherwise eligible non-investment grade rated or unrated classes of asset-backed securities provided that sales are made in minimum denominations and initial sales of classes of securities are made only to qualified institutional buyers (as defined in Securities Act Rule 144A(a)(1)) \63\ and institutional accredited investors (as defined in Rule 501 \64\ of Regulation D).\65\ The commenter reasoned that such restrictions should ensure that securities are sold and subsequently resold only to investors who are capable of undertaking their own analysis of the merits and risks of their investment.\66\ --------------------------------------------------------------------------- \62\ See letters from ABA and Kutak. \63\ 17 CFR 230.144A(a)(1). \64\ 17 CFR 230.501. \65\ See letter from ABA. \66\ Id. --------------------------------------------------------------------------- In light of our effort to reduce regulatory reliance on security ratings, the Commission has revisited the comments in 2004 and now proposes to replace the investment grade component in the Form S-3 eligibility requirement for ABS offerings with a minimum denomination requirement for initial and subsequent sales and a requirement that initial sales of classes of securities be made only to qualified institutional buyers. The eligibility requirement, as proposed to be revised, would retain the other provisions relating to delinquency concentration and residual value percentages for offerings of securities backed by leases other than motor vehicle leases.\67\ Thus, as proposed, asset-backed securities offered for cash may be Form S-3 eligible provided: --------------------------------------------------------------------------- \67\ See proposed General Instruction I.B.5(a)(iii) and (iv) of Form S-3. --------------------------------------------------------------------------- Initial and subsequent resales are made in minimum denominations of $250,000; Initial sales are made only to qualified institutional buyers (as defined in Rule 144A(a)(1)); Delinquent assets do not constitute 20% or more, as measured by dollar volume, of the asset pool as of the measurement date; and With respect to securities that are backed by leases other than motor vehicle leases, the portion of the securitized pool balance attributable to the residual value of the physical property underlying the leases, as determined in accordance with the transaction agreements for the securities, does not constitute 20% or more, as measured by dollar volume, of the securitized pool balance as of the measurement date.\68\ --------------------------------------------------------------------------- \68\ See proposed General Instruction I.B.5(a) of Form S-3. --------------------------------------------------------------------------- This proposed amendment would limit use of a short-form shelf registration statement for asset-backed securities to offerings to large sophisticated and experienced investors without, we believe, causing undue detriment to the liquidity of the asset-backed securities market.\69\ In keeping with that purpose and given the unique nature and structure of asset-backed securities, we are proposing at this time only to include qualified institutional buyers rather than also including institutional accredited investors as suggested by the commenter in 2004. --------------------------------------------------------------------------- \69\ We are aware of two types of asset-backed offerings that may not meet these new criteria, unit repackaging and securitization of insurance funding agreements but believe that they can be effectively registered using Form S-1 instead of Form S-3. --------------------------------------------------------------------------- 2. Mortgage Related Securities and Securities Act Rule 415 In addition to being shelf eligible by meeting the requirements of Form S-3, a particular subset of ABS may also be shelf eligible by meeting the requirements in Securities Act Rule 415,\70\ which enumerates the securities which are permitted to be offered on a continuous or delayed basis. Among those securities are ``mortgage related securities, including such securities as mortgage-backed debt and mortgage participation or pass through certificates.'' \71\ By specifically referring to mortgage related securities, Rule 415 has permitted such securities to be offered on a delayed basis, even if the offering cannot be registered on the Form S-3 short form registration statement because it does not meet the eligibility requirements of Form S-3. --------------------------------------------------------------------------- \70\ 17 CFR 230.415. \71\ 17 CFR 230.415(a)(vii). --------------------------------------------------------------------------- Currently, the term ``mortgage related securities'' is defined by Section 3(a)(41) of the Exchange Act \72\ as, among other things, ``a security that is rated in one of the two highest rating categories by at least one nationally recognized statistical rating organization.'' Given that the term mortgage related securities also depends on a ratings component, it would be a logical extension of our amendments here to amend the Rule 415 reference to a mortgage related security to add that the sale of such security must be in compliance with the additional requirements that initial sales are made to qualified institutional buyers and initial and subsequent sales are made in certain minimum denominations. Given that reliance on security ratings could just as easily impact an investor's investment decision in mortgage-backed securities as it could for other asset-backed securities,\73\ we believe it is appropriate that mortgage-backed securities be treated the same as all asset-backed securities.\74\ --------------------------------------------------------------------------- \72\ 15 U.S.C. 78c(a)(41). Section 3(a)(41) was added by the Secondary Mortgage Market Enhancement Act of 1984 (SMMEA) (Pub. L. 98-440-98 Stat. 1690). In 1984, contemporaneous with the enactment of SMMEA, the Commission amended Rule 415, which is known as the shelf rule, to allow SMMEA-eligible mortgage related securities to use the shelf offering process. See Shelf Registration, Release No. 33-6499 (Nov. 17, 1983) [48 FR 5289]. \73\ The President's Working Group has noted that one of the principal underlying causes of the current global market turmoil relating to the mortgage-backed securities industry was the credit rating agencies' assessments of subprime residential mortgage-backed securities and other complex structured credit products that held residential mortgage-backed and other asset-backed securities. See Section I of the Policy Statement on Financial Market Developments. See n. 24 above. \74\ Indeed, mortgage-backed securities are merely a type of, or subset of, asset-backed securities. We believe that there have not been any recent offerings that have relied on Rule 415(a)(vii) for shelf eligibility rather than through meeting the requirements of Form S-3. --------------------------------------------------------------------------- Therefore, under the proposed revision to Rule 415, mortgage-backed securities, having the same characteristics as mortgage related securities under the Section 3(a)(41) definition, regardless of the security [[Page 40110]] rating, could be offered on a delayed basis provided that: Initial sales and any resales of the securities are made in minimum denominations of $250,000; \75\ and --------------------------------------------------------------------------- \75\ Denominations of any amounts above $250,000 would meet this requirement. --------------------------------------------------------------------------- initial sales of the securities are made only to qualified institutional buyers (as defined in Rule 144A(a)(1)). Request for Comment Is the proposed amendment to the Form S-3 eligibility requirement for asset-backed securities appropriate? Is there a better alternative to the investment grade ratings component? If so, what is that alternative and why is it better? Is the proposed amendment requiring that initial and subsequent sales be made in a minimum denomination appropriate? Should the denomination level be higher or lower (e.g., $400,000 or $100,000)? We understand that non-convertible securities may typically be held in book entry form with a depository. Are there any system issues or processes at the depository that may affect the ability to limit transferability based on a minimum denomination? If yes, what are those issues or processes and how should the rule provisions be revised to prohibit subsequent transfers below the minimum denominations? Should there be any restriction on permitting purchasers from allocating securities in denominations lower than $250,000 if the purchasers are acquiring the nonconvertible securities for more than one account? For example, if an investment advisor acquires the securities for more than one qualified institutional buyer, should it be allowed to allocate securities to the accounts of the qualified institutional buyers in denominations lower than $250,000? Should Form S-3 limit initial sales of eligible asset- backed securities to qualified institutional buyers? Should the requirement include sales to an additional group of investors (e.g., institutional accredited investors)? If so, why? Should subsequent sales be limited as well? Would it be appropriate to eliminate the minimum denomination requirements after some period of time, such as after six months or one year from the date of issuance? Are there particular kinds of ABS offerings that are sold to investors other than qualified institutional buyers? What would be the impact on liquidity in the ABS secondary market if Form S-3 registration required that initial sales be limited to qualified institutional buyers, institutional accredited investors, or other groups of sophisticated investors? What would be the impact on liquidity in the secondary market if resales of securities that were originally offered and sold off of the Form S-3 were so limited? What would be the impact on the cost of capital for ABS sponsors if Form S-3 registration required that initial sales or resales were limited to qualified institutional buyers or other groups of sophisticated investors? Would a better standard than qualified institutional buyer be any purchaser that owns and invests on a discretionary basis not less than $25,000,000? Would a threshold like this that does not limit the purchasers to institutions be appropriate, particularly in light of recent market events? Should there be other thresholds for particular investors, such as owning and investing on a discretionary basis not less than $50,000,000 for government or political subdivisions, agencies or instrumentalities of a government? Should we use Qualified Investor as defined in Exchange Act Section 3(a)(54) \76\ rather than qualified institutional buyer? --------------------------------------------------------------------------- \76\ 15 U.S.C. 78c(a)(54). --------------------------------------------------------------------------- We note that there are two types of ABS offerings that may not meet this new criteria, unit repackagings, and securitizations of insurance funding agreements. Can the offer and sale of these securities be effectively registered on Form S-1? We note that these securities are typically listed on a national securities exchange. Should we instead add an alternative eligibility requirement that would provide eligibility to use Form S-3 for securities listed on a national securities exchange? Should we instead assess Form S-3 and shelf eligibility in a manner similar to what we are proposing for corporate debt that is discussed in the next section? If so, what would be the appropriate amount of required issuance? Should the issuance amount be measured only for the same sponsor, same asset class, and same structure? Should it matter if the assets are purchased by the sponsor rather than originated by the sponsor or an affiliate? Is the proposed revision to Securities Act Rule 415 appropriate? Is there any reason why mortgage related securities should be treated differently from other asset-backed securities for purposes of delayed offerings? Are there SMMEA eligible loans that could not be securitized in circumstances meeting the proposed threshold for S-3 eligibility? Should Rule 415 be amended as proposed? In the alternative, should the reference to mortgage related securities in Rule 415 be deleted (i.e., so that mortgage-backed securities could only be offered on a delayed basis if eligible for registration on Form S-3)? Are there securities that are currently offered pursuant to Rule 415(a)(1)(vii) that do not meet the current requirements of Form S-3 and would not meet the requirements of the proposal? B. Primary Offerings of Non-convertible Securities 1. Form S-3 and Form F-3 Forms S-3 and F-3 are the ``short forms'' used by eligible issuers to register securities offerings under the Securities Act. These forms allow eligible issuers to rely on reports they have filed under the Exchange Act to satisfy many of the disclosure requirements under the Securities Act. Form S-3 eligibility for primary offerings also enables form eligible issuers to conduct primary offerings ``off the shelf'' under Securities Act Rule 415. Rule 415 provides considerable flexibility in accessing the public securities markets in response to changes in the market and other factors. Issuers that are eligible to register these primary ``shelf'' offerings under Rule 415 are permitted to register securities offerings prior to planning any specific offering and, once the registration statement is effective, offer securities in one or more tranches without waiting for further Commission action. To be eligible to use Form S-3 or F-3, an issuer must meet the form's eligibility requirements as to registrants, which generally pertain to reporting history under the Exchange Act,\77\ and at least one of the form's transaction requirements.\78\ One such transaction requirement permits registrants to register primary offerings of non-convertible securities if they are rated investment grade by at least one NRSRO.\79\ Instruction I.B.2 provides that a security is ``investment grade'' if, at the time of sale, at least one NRSRO has rated the security in one of its generic rating categories, typically the four highest, which signifies investment grade. --------------------------------------------------------------------------- \77\ See General Instruction I.A to Forms S-3 and F-3. \78\ See General Instruction I.B to Forms S-3 and F-3. \79\ See General Instruction I.B.2 to Forms S-3 and F-3. --------------------------------------------------------------------------- The Form S-3 investment grade requirement was originally proposed by [[Page 40111]] the Commission in a 1982 release.\80\ Prior to adopting Form S-3, the Commission had previously provided a short form registration statement on Form S-9, which permitted the registration of issuances of certain high quality debt securities.\81\ The criteria for use of Form S-9 related primarily to the quality of the issuer.\82\ While these eligibility criteria delineated the type of issuer of high quality debt for which Form S-9 was intended, the Commission believed that certain of its requirements may have overly restricted the availability of the form.\83\ The Commission believed that security ratings were a more appropriate standard on which to base Form S-3 eligibility than specified quality of the issuer criteria, citing letters from commenters indicating that short form prospectuses are appropriate for investment grade debt because such securities are generally purchased on the basis of interest rates and security ratings.\84\ --------------------------------------------------------------------------- \80\ See Reproposal of Comprehensive Revision to System for Registration of Securities Offerings, Release No. 33-6331 (Aug. 6, 1981) [46 FR 41902] (``the S-3 Proposing Release''). \81\ Form S-9 was rescinded on December 20, 1976, because it was being used by only a very small number of registrants. The Commission believed the lack of usage was due in part to interest rate increases which made it difficult for many registrants to meet the minimum fixed charges coverage standards required by the form. Adoption of Amendments to Registration Forms and Guide and Rescission of Registration Form, Release No. 33-5791 (Dec. 20, 1976) [41 FR 56301]. \82\ The criteria included net income during each of the registrant's last five fiscal years, no defaults in the payment of principal, interest, or sinking funds on debt or of rental payments for leases, and various fixed charge coverages. The use of fixed charges coverage ratios, typically 1.5, was common in state statutes defining suitable debt investments for banks and other fiduciaries. \83\ See the S-3 Proposing Release. \84\ See the Integrated Disclosure Release. --------------------------------------------------------------------------- Today we are proposing to revise the transaction eligibility criteria for registering primary offerings of non-convertible securities on Forms S-3 and F-3. As proposed, the instructions to these forms would no longer refer to security ratings by an NRSRO as a transaction requirement to permit issuers to register primary offerings of non-convertible securities for cash. Instead, these forms would be available to register primary offerings of non-convertible securities if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non-convertible securities, other than common equity, through registered primary offerings over the prior three years.\85\ --------------------------------------------------------------------------- \85\ See proposed General Instruction I.B.2 of Forms S-3 and F- 3. We are also proposing to delete Instruction 3 to the signature block of Forms S-3 and F-3. --------------------------------------------------------------------------- We are proposing to revise the form criteria using the same method and threshold by which the Commission defined an issuer of non- convertible securities, other than common equity, that does not meet the public equity float test as a ``well-known seasoned issuer.'' \86\ Similar to our approach with well-known seasoned issuers, we believe that having issued $1 billion of registered non-convertible securities over the prior three years would lead to a wide following in the marketplace. These issuers generally have their Exchange Act filings broadly followed and scrutinized by investors and the markets.\87\ The Commission intends for the number of issuers eligible under the proposed criteria to register primary offerings of non-convertible securities on Forms S-3 and F-3 to not be significantly reduced, or to differ significantly from, the number of those eligible under the current form requirements.\88\ Using the $1 billion threshold, we preliminarily believe that for issuances that have occurred thus far this year, the proposed change would result in approximately six issuers filing on Form S-1 instead of on a short-form registration statement. This approach is designed to provide assurance that eligible issuers are followed by the markets such that it is appropriate to allow forward incorporation by reference and delayed offering. We realize that it is now possible that some offerings of non-investment grade securities, such as high-yield bonds (also known as ``junk bonds'') may be registered for sale on Form S-3. --------------------------------------------------------------------------- \86\ See Securities Offering Reform, Release No. 33-8591 (Jul. 19, 2005) [70 FR 44722]. Rule 405 under the Securities Act defines a ``well-known seasoned issuer'' as an issuer that meets the registrant requirements of Form S-3 or F-3, and either has a worldwide market value of its outstanding voting and non-voting common equity held by non-affiliates of $700 million or more, or has issued in the last three years, in registered offerings, at least $1 billion aggregate principal amount of non-convertible securities in primary offerings for cash. 17 CFR 230.405. \87\ See Securities Offering Reform, Release No. 33-8501 (Nov. 3, 2004) [69 FR 67392]. \88\ We preliminarily anticipate that under the proposed threshold some additional high yield debt issuers would be eligible to use the Forms. --------------------------------------------------------------------------- These issuers also would have to satisfy the other conditions of the form eligibility requirement. In determining compliance with this threshold: Issuers may aggregate the amount of non-convertible securities, other than common equity, issued in registered primary offerings during the prior three years; issuers may include only such non-convertible securities that were issued in registered primary offerings for cash--they may not include registered exchange offers; \89\ and --------------------------------------------------------------------------- \89\ Issuers may not include the principal amount of securities that were offered in registered exchange offers by the issuer when determining compliance with the $1 billion non-convertible securities threshold. A substantial portion of these offerings involve registered exchange offers of substantially identical securities for securities that were sold in private offerings. In those cases, the original sale to investors in the private offering, relying upon, for example, the exemptions of Securities Act Section 4(2) and Rule 144A, is not registered and is not carried out under the Securities Act's disclosure or liability standards. Moreover, in the subsequent registered exchange offers purchasers may not be able, in certain cases, to avail themselves effectively of the remedies otherwise available to purchasers in registered offerings for cash. --------------------------------------------------------------------------- parent company issuers only may include in their calculation the principal amount of their full and unconditional guarantees, within the meaning of Rule 3-10 of Regulation S-X,\90\ of non-convertible securities, other than common equity, of their majority-owned subsidiaries issued in registered primary offerings for cash during the three-year period. --------------------------------------------------------------------------- \90\ 17 CFR 210.3-10. --------------------------------------------------------------------------- The aggregate principal amount of non-convertible securities that may be counted toward the $1 billion issuance threshold may have been issued in any registered primary offering for cash, on any form (other than Form S-4 or Form F-4). Non-convertible securities need not be investment grade securities to be included in the calculation. In calculating the $1 billion amount, issuers generally may include the principal amount of any debt and the greater of liquidation preference or par value of any non-convertible preferred stock that were issued in primary registered offerings for cash.\91\ --------------------------------------------------------------------------- \91\ In determining the dollar amount of securities that have been registered during the preceding three years, issuers should use the same calculation that they use to determine the dollar amount of securities they are registering for purposes of determining fees under Rule 457. 17 CFR 230.457. --------------------------------------------------------------------------- Request for Comment The recent turmoil in the credit markets, particularly in the structured finance market, strongly suggests that there has been undue reliance on security ratings and that the ratings for many issuers did not reflect the risks of the investment. We are proposing thresholds on the amount of issuance in order to move away from reliance on security ratings in the Commission's rules. Does the proposed eligibility based on the amount of prior registered non- convertible securities issued serve as an adequate replacement for the investment grade eligibility condition? Would the cumulative offering amount [[Page 40112]] for the most recent three-year period reflect market following? Since most of the problems in the market have occurred with respect to asset- backed securities, should we retain the current eligibility requirement for investment grade non-convertible securities? Would the specific issuers eligible under the investment grade condition be different from the issuers eligible under the proposal? Would certain investors, such as pension funds, be impacted if investment grade securities could not be offered on Form S-3? If the Commission adopts a Form S-3 eligibility requirement designed to reflect the market following of a debt issuer, should the condition be sensitive to the number of debt holders? Is it reasonable to expect that analysts would be more likely to follow issuers with a larger number of debt holders insofar as such holders are potential customers of the analysts' products? If so, how should we determine the number of holders? Should there be an eligibility requirement based on a minimum number of holders of record of non-convertible securities offered for cash? If so, should this number be 300 or 500, by analogy to our registration and deregistration rules relating to equity securities? Would linking the eligibility requirement to the number of holders of record help to assure market following? Is the cumulative offering amount for the most recent three-year period the appropriate threshold at which to differentiate issuers? Should the threshold be higher (e.g., $1.25 billion) or lower (e.g., $800 million), and, if so, at what level should it be set? Are there any transactions that currently meet the requirements of current General Instruction I.B.2. that would not be eligible to use the form under the proposed revision? Are there any transactions that do not meet the current Form S-3 or Form F-3 eligibility requirements for investment grade securities but now would be eligible under the proposed revision that should not be eligible? If practicable, provide information on the frequency such offerings are made. Would the proposed threshold increase or decrease the number of issuers eligible to use Forms S-3 and F-3 under the current investment grade criteria? Is there a reason that this Form S-3 eligibility requirement should not mirror the debt only well-known seasoned issuer definition? Should the measurement time period for $1 billion of issuance be longer than three years (e.g., four or five years)? If so, why? Would it be more appropriate for the threshold to include non- convertible securities, other than common equity, outstanding rather than issued over the prior three years? Is there a better alternative by which Form S-3 eligibility for non-convertible securities could be required? By what metrics could one measure the market following for debt issuers? Is there an alternative definition of ``investment grade debt securities'' that does not rely on NRSRO ratings and adequately meets the objective of relating short-form registration to the existence of widespread following in the marketplace? Should there be a different standard for foreign private issuers eligible to use Form F-3? If so, explain why and what would be a more appropriate criteria. Does the $1 billion threshold of offering in the prior three years present any issues that are unique to foreign private issuers, especially those that may undertake U.S. registered public offerings as only a portion of their overall plan of financing, and how might these problems be addressed? Would it be appropriate to provide a longer time period for measurement, or to include public offerings of securities for cash outside the United States? 2. U.S. GAAP Reconciliation Requirements The Commission's rules relating to U.S. GAAP reconciliation requirements for foreign filers also rely on ratings. Forms F-1, F-3, and F-4 under the Securities Act permit foreign private issuers registering offerings of investment grade securities to provide financial information in accordance with Item 17 of Exchange Act Form 20-F. Item 17 requires foreign private issuers to reconcile their financial statements and schedules to U.S. GAAP if they are prepared in accordance with a basis of accounting other than U.S. GAAP or International Financial Reporting Standards as issued by the International Accounting Standards Board. This reconciliation need only include a narrative discussion of reconciling differences, a reconciliation of net income for each year and any interim periods presented, a reconciliation of major balance sheet captions for each year and any interim periods, and a reconciliation of cash flows for each year and any interim periods. Item 18 of Form 20-F, by contrast, requires that a foreign private issuer provide all of the information required by U.S. GAAP and Regulation S-X, in addition to the reconciling information for the line items specified in Item 17.\92\ Foreign private issuers of investment grade rated securities are permitted to provide the less-extensive U.S. GAAP reconciliation disclosure pursuant to Item 17 in registration statements and annual reports. --------------------------------------------------------------------------- \92\ See also Foreign Issuer Reporting Enhancements, Release No. 33-8900 (Feb. 29, 2008) [73 FR 13404] at Section III.A. --------------------------------------------------------------------------- The definition of ``investment grade'' is the same as in the Form S-3 eligibility requirements. A security is ``investment grade'' if, at the time of sale, at least one NRSRO has rated it in one of its generic rating categories that signifies investment grade. Also, a foreign private issuer conducting a private placement of investment grade securities under Regulation D can provide Item 17 information to the extent the issuer is able to do so in a registration statement.\93\ --------------------------------------------------------------------------- \93\ Rule 502 requires a foreign private issuer to provide the same kind of information the issuer would be required to include in a registration statement on a form the issuer would be eligible to use if any sales are made to investors who are not accredited investors. See 17 CFR 230.502(b)(2)(i)(C). --------------------------------------------------------------------------- The Commission recently proposed to require foreign private issuers offering investment grade securities, among others, to file financial statements that comply with the more complete Item 18 level of reconciliation, thus eliminating the option of providing Item 17 financial disclosure.\94\ The Commission reasoned that ``a reconciliation that includes footnote disclosures required by U.S. GAAP and Regulation S-X \95\ can provide important additional information.'' \96\ The Commission specifically requested comment, however, on whether foreign private issuers should continue to be permitted to provide Item 17 financial disclosure for offerings of, and periodic reporting relating to, investment grade securities.\97\ We now also propose to remove from these requirements the components relying on investment grade ratings and instead permit foreign private issuers to comply with the less extensive U.S. GAAP reconciliation requirements under Item 17 in a registration statement or private offering document if the issuer would meet the proposed Form F-3 eligibility requirements (i.e., if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non- convertible securities, other than common equity, through registered [[Page 40113]] primary offerings over the prior three years). --------------------------------------------------------------------------- \94\ See Release No. 33-8900. \95\ 17 CFR 210.1-01 et seq. \96\ Release No. 33-8900 at Section III.A. \97\ See Request for Comment No. 23 of Release No. 33-8900. --------------------------------------------------------------------------- Request for Comment If the Commission does not adopt the proposal in Release No. 33-8900 that would eliminate the ability of a foreign private issuer to comply with the less extensive U.S. GAAP reconciliation requirements under Item 17 for filings with respect to investment grade securities, should the Commission revise the requirements as proposed to permit a foreign private issuer to comply with the less extensive U.S. GAAP reconciliation requirements under Item 17 if the issuer has met the proposed Form F-3 eligibility criteria for debt issuers? Are there different criteria that should be used? 3. Form F-9 Form F-9 allows certain Canadian issuers to register investment grade debt or investment grade preferred securities that are offered for cash or in connection with an exchange offer, and which are either non-convertible or not convertible for a period of at least one year from the date of issuance.\98\ Under the Form's requirements, a security is rated ``investment grade'' if it has been rated investment grade by at least one NRSRO, or at least one Approved Rating Organization (as defined in National Policy Statement No. 45 of the Canadian Securities Administrator).\99\ This eligibility requirement was adopted as part of a 1993 revision to the multijurisdictional disclosure system originally adopted by the Commission in 1991 in coordination with the Canadian Securities Administrators.\100\ Consistent with the Commission's proposal to reduce reliance on security ratings in its rules and regulations the Commission is proposing to eliminate the eligibility requirement of Form F-9 that allows Canadian issuers to register certain debt and preferred securities if they are rated investment grade by at least one NRSRO. As with our proposals regarding Forms S-3 and F-3, this requirement would be replaced by a requirement that the issuer has issued in the three years immediately preceding the filing of the Form F-9 registration statement at least $1 billion of aggregate principal amount of debt or preferred securities for cash in primary offerings registered under the Securities Act. --------------------------------------------------------------------------- \98\ Securities convertible after a period of at least one year may only be convertible into a security of another class of the issuer. \99\ See General Instruction I.A to Form F-9. \100\ See Amendments to the Multijurisdictional Disclosure System for Canadian Issuers, Release No. 33-7025 (Nov. 3, 1993) [58 FR 62028]. See also Multijurisdictional Disclosure and Modifications to the Current Registration and Reporting System for Canadian Issuers, Securities Act Release No. 33-6902 (Jun. 21, 1991) [56 FR 30036]. --------------------------------------------------------------------------- The proposed revision would not change a Canadian issuer's ability to use Form F-9 to register debt or preferred securities meeting the requirements of current General Instruction I.A if the securities are rated ``investment grade'' by at least one Approved Rating Organization (as defined in National Policy Statement No. 45 of the Canadian Securities Administrators). While the proposal would still permit Canadian issuers to register certain securities rated investment grade by an Approved Rating Organization, the Commission believes this approach is appropriate and consistent with the Commission's intent in adopting the multijurisdictional disclosure system to look to form eligibility requirements under Canadian rules.\101\ To the extent that the Canadian securities regulators revise similar requirements to remove references to investment grade ratings, we may revise Form F-9 to mirror those revisions. --------------------------------------------------------------------------- \101\ See Release No. 33-6902, section II. --------------------------------------------------------------------------- Request for Comment The Commission requests comment on whether the proposed threshold for issuances of debt or preferred securities in the three years immediately preceding the filing of the registration statement is appropriate. Should the Form F-9 eligibility requirements continue to permit the use of ratings by Approved Rating Organizations? Is a different threshold or measurement period more appropriate for Form F- 9? 4. NRSRO Ratings Reliance in Other Forms and Rules a. Forms S-4 and F-4 and Schedule 14A Issuing investment grade securities confers benefits that extend to other forms and rules as well. Forms S-4 and F-4 allow registrants that meet the registrant eligibility requirements of Form S-3 or F-3 and are offering investment grade securities to incorporate by reference certain information.\102\ Similarly, Schedule 14A permits a registrant to incorporate by reference if the Form S-3 registrant requirements are met and the registrant is offering investment grade securities.\103\ Because the Commission proposes to change the eligibility requirements in Forms S-3 and F-3 to remove references to ratings by an NRSRO, the Commission believes the same standard should apply to the disclosure options in Forms S-4 and F-4 based on Form S-3 or F-3 eligibility. That is, a registrant will be eligible to use Forms S-4 and F-4 to register non-convertible debt or preferred securities if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non-convertible securities, other than common equity, through registered primary offerings over the prior three years. Similarly, we propose to amend Schedule 14A to refer simply to the requirements of General Instruction I.B.2. of Form S-3, rather than to ``investment grade securities.'' --------------------------------------------------------------------------- \102\ See General Instruction B.1 of Forms S-4 and Form F-4. \103\ See Note E and Item 13 of Schedule 14A. --------------------------------------------------------------------------- b. Securities Act Rules 138, 139 and 168 The reliance on security ratings is also evident in other Securities Act rules. Rules 138, 139, and 168 under the Securities Act provide that certain communications are deemed not to be an offer for sale or offer to sell a security within the meaning of Sections 2(a)(10) \104\ and 5(c) \105\ of the Securities Act when the communications relate to an offering of non-convertible investment grade securities. These communications include the following: --------------------------------------------------------------------------- \104\ 15 U.S.C. 77b(a)10. \105\ 15 U.S.C. 77e(c). --------------------------------------------------------------------------- Under Securities Act Rule 138, a broker's or dealer's publication about securities of a foreign private issuer that meets F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities; Under Securities Act Rule 139, a broker's or dealer's publication or distribution of a research report about an issuer or its securities where the issuer meets Form S-3 or F-3 registrant requirements and is or will be offering investment grade securities pursuant to General Instruction I.B.2 of Form S-3 or F-3, or where the issuer meets Form F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities; and Under Securities Act Rule 168, the regular release and dissemination by or on behalf of an issuer of communications containing factual business information or forward-looking information where the issuer meets Form F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities. The Commission proposes to revise Rules 138, 139, and 168 to be consistent with the proposed revisions to the eligibility requirements in Forms S-3 and F-3 since in order to rely on these rules the issuer must either satisfy the public float threshold of Form S-3 or F- [[Page 40114]] 3, or issue non-convertible investment grade securities as defined in the instructions to Form S-3 or F-3 as proposed to be revised. Request for Comment Should the Commission revise Rules 138, 139, and 168 as proposed? c. Item 1100 of Regulation AB Under the existing Item 1100(c) of Regulation AB,\106\ if a significant obligor \107\ meets the registrant requirements for Form S- 3 or Form F-3 and the pool assets relating to the obligor are non- convertible investment grade rated securities, then an ABS issuer's filings may include a reference to the financial information of the obligor rather than presenting the full financial information of the obligor. The Commission now proposes to amend this provision of Item 1100(c) to remove the ratings reference and permit incorporation by reference of third party financial statements if the third party meets the registrant requirements of Form S-3 and the pool assets relating to such third party are non-convertible securities, other than common equity, that were issued in a primary offering for cash that was registered under the Securities Act. The Commission believes that, for the most part, non-convertible securities that were issued in a registered offering constitute higher quality securities than securities issued under an exemption under, for example, Securities Act Rule 144A, and then subsequently exchanged for registered securities because such securities are subject to the Securities Act. --------------------------------------------------------------------------- \106\ 17 CFR 229.1100(c). \107\ The term ``significant obligor'' is defined in Item 1101(k) of Regulation AB [17 CFR 229.1101(k)]. --------------------------------------------------------------------------- Request for Comment Should the Commission revise Item 1100 of Regulation AB as proposed? If not, explain why? d. Items 1112 and 1114 of Regulation AB Items 1112 and 1114 of Regulation AB require the disclosure of certain financial information regarding significant obligors of an asset pool and significant credit enhancement providers relating to a class of asset-backed securities. An instruction to Item 1112(b)\108\ provides that no financial information on a significant obligor, however, is required if the obligations of the significant obligor as they relate to the pool assets are backed by the full faith and credit of a foreign government and the pool assets are investment grade securities. Item 1114 of Regulation AB contains a similar instruction that relieves an issuer from providing financial information when the obligations of the credit enhancement provider are backed by a foreign government and the enhancement provider has an investment grade rating. Under both Items 1112 and 1114, to the extent that pool assets are not investment grade securities, information required by paragraph (5) of Schedule B of the Securities Act may be provided in lieu of the required financial information.\109\ --------------------------------------------------------------------------- \108\ Instruction 2 to 17 CFR 229.1112(b). \109\ Paragraph 5 of Schedule B requires disclosure of three years of the issuer's receipts and expenditures classified by purpose in such detail and form as the Commission prescribes. --------------------------------------------------------------------------- We are now proposing to revise these instructions so that these exceptions based on investment grade ratings to the requirements of Items 1112 and 1114 of Regulation AB would no longer apply and information required by paragraph (5) of Schedule B would be required in all situations when the obligations of a significant obligor are backed by the full faith and credit of a foreign government. We are not aware of any benchmark comparable to an investment grade rating here and the requirement would not impose substantial costs or burdens to an ABS issuer, as such information should be readily available. Request for Comment Should the Commission revise the instructions that rely on investment grade ratings in Items 1112 and 1114, as proposed? In the alternative, should the Commission instead permit issuers to omit all information relating to the obligors and credit enhancement providers when the obligations are backed by the full faith and credit of the foreign government? Are there any risks in doing so? Should the Commission allow incorporation by reference of the information required by paragraph (5) of Schedule B of the Securities Act in lieu of providing the information to the extent such information is contained in a filing with the Commission? Are there any other provisions in Regulation AB or other rules applicable to asset-backed securities that should be revised? C. The Commission's Policy on Security Ratings As noted above, in 1981 the Commission issued its policy on disclosure of security ratings, articulated in Item 10(c) of Regulation S-K,\110\ that permits, but does not require, issuers to disclose in Commission filings security ratings assigned by credit rating agencies to classes of debt securities, convertible debt securities, and preferred stock.\111\ In 1994, the Commission proposed to change from permissible to mandated disclosure of security ratings.\112\ While the Commission did not adopt mandatory disclosure at that time, it signaled concerns relating to adequate disclosure to the markets regarding new financial products and security ratings. In the proposal we noted the dramatic proliferation in the types of securities offered in the marketplace with the development of the market for mortgage- and asset- backed securities and other highly structured or derivative financial obligations. In response to the growth of this market, we adopted new and amended rules and forms to address comprehensively the registration, disclosure, and reporting requirements for asset-backed securities.\113\ The adoption of Regulation AB in 2004 codified disclosure requirements and assisted in providing more disclosure with greater comparability for investors in the asset-backed securities markets. While the adoption of Regulation AB has enhanced the disclosure about asset-backed securities, it did not significantly address securities ratings disclosure. --------------------------------------------------------------------------- \110\ 17 CFR 229.10(c). \111\ See the Integrated Disclosure Release. See also Release No. 33-6336. The release indicated that a debt rating was simply ``an evaluation of the likelihood that an issuer will be able to make timely interest payments and will be able to repay principal.'' \112\ See the 1994 Ratings Release. \113\ Release No. 33-8518. --------------------------------------------------------------------------- Because mandating disclosure of, and about, securities ratings might unduly emphasize or over rely on ratings, the Commission is at this time retaining the current Item 10(c) policy on security ratings, with minor changes to accommodate our proposed changes to Rule 436(g),\114\ which asks registrants to consider, but does not require, certain additional disclosure if a registration statement includes disclosure of a rating. While the Commission has not determined to propose mandatory disclosure, we are again requesting comment as to whether we should require disclosure by issuers regarding ratings in their Securities Act registration statements and their Exchange Act periodic reports. The goal of such disclosure requirements would be to enhance security rating disclosure so that investors are better able to understand the terms of a security rating and the limitations on the rating. --------------------------------------------------------------------------- \114\ 17 CFR 230.436(g). --------------------------------------------------------------------------- We are proposing to amend Rule 436(g) so that applicability would no longer be limited to just NRSROs. [[Page 40115]] Securities Act Rule 436(g)\115\ provides that a security rating assigned to a class of debt securities, a class of convertible debt securities, or a class of preferred stock is not a part of a registration statement prepared or certified by a person or a report or valuation prepared or certified by a person within the meaning of sections 7 and 11 of the Securities Act. We propose to amend the reference to ``nationally recognized statistical rating organization'' in Rule 436(g) to expand the relief to any ``credit rating agency'' as defined in 15 U.S.C. 78c(a)(61). By proposing to permit issuers to disclose security ratings provided by any credit rating agency without requiring consents, the Commission believes this relief may foster competition between credit rating agencies.\116\ --------------------------------------------------------------------------- \115\ 17 CFR 230.436(g). \116\ See also Section II.B.1 of the 1994 Ratings Release where the Commission requested comment on eliminating the consent requirement for credit rating agencies that are not NRSROs. --------------------------------------------------------------------------- Request for Comment Prior to 1981 the Commission precluded disclosure regarding security ratings in registration statements under the Securities Act. Should we revise our disclosure policy to prohibit disclosure of security ratings in an issuer's Securities Act registration statements or Exchange Act periodic reports? Should we simply delete Item 10(c) and provide no established disclosure policy regarding credit ratings? In 1994, the Commission noted ``the extensive use of, and reliance on, ratings, and the wide disparity in the meaning and significance of the rating'' as important factors in its decision to propose mandated disclosure.\117\ In light of the recent turmoil in the credit markets, some of the factors for the proposed disclosure may be no less of concern today than they were in 1994. Should the Commission require disclosure like the disclosure we currently recommend in Item 10(c) of Regulation S-K in order to enhance issuers' security rating disclosure so that investors are better able to understand the terms of a security rating and the limitations on that rating? Would requiring disclosure of a security rating place the Commission's ``official seal of approval'' on security ratings such that it could adversely affect the quality of due diligence and investment analysis? --------------------------------------------------------------------------- \117\ See Section II.A of the 1994 Proposing Release. --------------------------------------------------------------------------- Item 10(c) of Regulation S-K currently refers to ``security ratings'' while the 2006 Credit Rating Agency Reform Act added the definition of ``credit rating'' to the Exchange Act, which means an assessment of the creditworthiness of an obligor as an entity or with respect to specific securities or money market instruments. Should we revise the reference to ``security rating'' in Item 10(c) to refer to ``credit rating'' instead? Would such a revision increase or decrease the scope of ratings covered by 10(c)? Would such a change limit the types of ratings that could be disclosed in a registration statement? In particular, are there any types of ratings that are issued that would not be covered by the term ``credit rating,'' particularly for ABS or structured products that should be covered by Item 10(c)? Are there any other changes we should make to Item 10(c) to align it with the Credit Rating Agency Reform Act or otherwise modernize it? For instance, should we specifically delineate structured products and asset-backed securities in the list of securities covered by the item since it currently only lists debt securities, convertible debt securities and preferred stock? While Item 10(c) currently only recommends disclosure, commenters on the 1994 Ratings Release expressed that most issuers provide this disclosure in their Securities Act filings. Do issuers generally provide this disclosure today? Is disclosure about an issuer's securities rating appropriate disclosure for their Securities Act filings? Is it appropriate disclosure for their periodic Exchange Act filings? Is there any reason that this disclosure should only be recommended rather than required? In addition to the information Item 10(c) currently recommends disclosure regarding security ratings would it be valuable for investors to have additional disclosure of all material scope limitations of the rating and any related designation (or other published evaluation) of non-credit payment risks assigned by the rating agency with respect to the security assist investors in better understanding the credit rating and assessing the risks of an investment in the securities? What additional disclosure would be helpful to investors in making these assessments? If we were to mandate security rating disclosure, should disclosure be required for any published designation that reflects the results of any evaluation, other than a credit risk evaluation, done by a credit rating agency? Should disclosure be required for any evaluation by a credit rating agency that is communicated to the issuer, regardless of whether it is published? If the Commission were to require security rating disclosure, when should an issuer be required to provide that disclosure? In 1994, we proposed to require disclosure: if a registrant has obtained a security rating from an NRSRO with respect to a class of securities being registered under the Securities Act; if the rating is used in the offer or sale of the securities by any participant in an offering; or if the registrant voluntarily discloses a security rating. Should disclosure about the security rating be required under those circumstances? If not, under what circumstances, if any, should disclosure be required? Should we require disclosure of unsolicited ratings? It has been suggested that such ratings may not reflect the level of information on the security that is reflected in a solicited rating, at least in part because of a lack of access to the issuer by the unsolicited credit rating agency.\118\ Is there a difference between solicited and unsolicited ratings such that they should be treated disparately? Should it matter if the issuer uses the unsolicited rating in the offer and sale of the securities being rated? If we were to require disclosure of unsolicited ratings, should there be limitations on how many ratings or which credit rating agencies ratings should be required to be disclosed? At what point would this create too great a burden on the issuer? --------------------------------------------------------------------------- \118\ However, in the corollary release amending rules for NRSROs, the Commission proposed various changes to Exchange Act Rule 17g-5 [17 CFR 240.17g-5] that would provide the opportunity for other credit rating agencies to use the information to develop ``unsolicited ratings'' for certain rated asset-backed securities. See proposed amendments to Rule 17g-5 in Release No. 34-57967 (Jun. 16, 2008). --------------------------------------------------------------------------- In Release 34-57967, we expressed our concerns about ratings shopping by issuers and the potential for credit rating agencies to use less conservative rating methodologies in order to gain business, presumably lessening the value of the ratings. If an issuer would be required to provide ratings disclosure where the issuer has obtained either a preliminary security rating or a final security rating from a rating agency, would such disclosure enhance investors' understanding of, and therefore the value of, the ratings? Would it help to address our concerns with ratings shopping? If you do not believe such disclosure would be helpful, how would you suggest that we address these concerns? Should we include a disclosure requirement for indications of a rating prior to a preliminary rating? Would disclosure of indication from a credit rating agency of a likely or possible rating be appropriate? [[Page 40116]] If we were to interpret that a security rating is ``obtained'' if: it is solicited by or on behalf of an issuer from a credit rating agency; or the issuer pays a credit rating agency for services related to a rating issued by that credit rating agency, would the standard capture sufficient disclosure about an issuer's security ratings and the credit rating agencies that have issued them? Could that lead to non-substantive or procedural modifications to the practice of assigning ratings so that issuers could avoid the disclosure requirement? Would that lead to disclosure of security ratings that would not be useful to investors? What standard would provide the most useful information for investors? Could this threshold lead to ratings being obtained in connection with an offering but not being disclosed? In the 1994 Ratings Release, we proposed to require issuers to disclose any material differences between the terms of the security as assumed in rating the security and (1) the terms of the security as specified in the governing instruments, and (2) the terms of the security as marketed to investors. The terms of the securities are required to be disclosed in the prospectus, a prospectus supplement, or a post-effective amendment, as applicable. Would this disclosure assist investors? Would requiring this disclosure in periodic filings assist investors in the secondary market in making their investment decisions? Having previously proposed requiring material changes in security ratings be reported on Form 8-K under the Exchange Act,\119\ we recognize that such security rating changes can be important information to an investor in making investment and voting decisions. We note, however, that issuer-paid rating agencies make their rating designations public. The current failures of security ratings, particularly in the asset-backed securities markets, have led us to re- evaluate the required level of disclosure regarding security ratings. Would requiring detailed current and/or periodic reporting of an issuer's security ratings provide investors and the markets sufficient, timely information about an issuer's security ratings to assist them in making their investment decisions? Would a Form 8-K provide investors with material and timely information about an issuer's security ratings and changes in those ratings? Would periodic reports on Form 10-K, Form 20-F, Form 10-Q and Form 10-D provide investors with material and timely information about an issuer's security ratings and changes in those ratings? Is the information that would be provided regarding a material change in a rating in a Form 8-K already provided by the credit rating agency? Would a Form 8-K be unduly burdensome? Should a Form 8-K requirement be limited to solicited ratings? If a credit rating agency does not publicly disclose the security rating of an issuer's securities, should we require disclosure of the rating in a Form 8-K or in the issuer's periodic reports? How would the existence of subscriber paid credit rating agencies affect your response? --------------------------------------------------------------------------- \119\ See the 1994 Ratings Release and Release No. 33-8106. --------------------------------------------------------------------------- We are only proposing to amend Item 10(c) to remove references to consents in conjunction with our proposed amendments to Rule 436(g) to no longer requiring consents from any credit rating agencies for inclusion of their ratings in an issuer's registration statement. Should there be a written consent requirement? Would a written consent requirement create any issues if the Commission were to require disclosure regarding those ratings? Would issuers find it problematic or costly to obtain consents? Should we require the consent of a credit rating agency for the use of its security rating by an issuer? What would be the additional costs of such a requirement? Would a consent requirement result in fewer ratings being obtained? Should we continue to limit the consent requirement to non-NRSROs as our rules currently do? Does our proposed regulatory oversight and additional disclosure regarding the ratings process and results of ratings justify allowing the use of NRSROs ratings without requiring consents? Would such a provision provide a ``seal of approval'' for NRSROs? Would there be any competitive effect on non- NRSRO credit rating agencies? Are there any issues with periodic disclosure regarding security ratings that are particular to ABS issuers? For instance, how would the responsibility to monitor changes or development in security ratings impact ABS offerings? D. Other Rules Referencing Security Ratings Other rules under the Securities Act also reference security ratings assigned by NRSROs. Rule 134(a)(17)\120\ permits the disclosure of security ratings in certain communications deemed not to be a prospectus or free writing prospectus. We are not proposing to eliminate this reference to security ratings in our rules. However, we are proposing to revise the rule to allow for disclosure of ratings assigned by any credit rating agency, not just NRSROs. In addition, disclosure must also note that the credit rating agency is not an NRSRO, if that is the case. --------------------------------------------------------------------------- \120\ 17 CFR 230.134(a)(17). --------------------------------------------------------------------------- Under Rule 100(b)(2) of Regulation FD, disclosures to an entity whose primary business is the issuance of security ratings are excluded from coverage provided the information is disclosed solely for the purpose of developing a credit rating and the entity's ratings are publicly available. We believe this exception for disclosures to credit rating agencies is appropriate given the purpose of Regulation FD and are therefore not proposing to revise that provision. Request for Comment Should we continue to allow disclosure of security ratings in ``tombstones'' to be deemed not to be a prospectus or free writing prospectus? Is it appropriate to allow such disclosure of a security rating by any credit rating agency and not limit the allowance to NRSROs? If the credit rating agency is not an NRSRO, is it appropriate to require additional disclosure to that effect? Should we revise Rule 100(b)(2) of Regulation FD to eliminate the requirement that the entity's ratings be publicly available or to require public disclosure of information submitted to credit rating agencies by issuers? If so, please explain the basis for recommending the change and discuss how to implement such changes. How would requiring disclosure under Regulation FD affect security ratings? III. General Request for Comments We request and encourage any interested person to submit comments regarding: The proposed amendments that are the subject of this release; Additional or different changes; or Other matters that may have an effect on the proposals contained in this release. We request comment from the point of view of companies, investors, and other market participants. With regard to any comments, we note that such comments are of great assistance to our rulemaking initiative if accompanied by supporting data and analysis of the issues addressed in those comments. In addition, we request comment on the following: Should the Commission include a phase-in for issuers beyond the effective date to accommodate pending offerings? [[Page 40117]] If so, should a phase-in apply only to particular rules, such as Form S-3 eligibility? As proposed, compliance with the new standards would begin on the effective date of the new rules. Will a significant number of issuers have their offerings limited by the proposed rules? If a phase-in is appropriate, should it be for a certain period of time or only for the term of a pending registration statement? What impact on competition should the Commission expect were it to adopt the proposed non-convertible debt eligibility requirements? Would any issuers that currently take advantage, or are eligible to take advantage of the investment grade condition and are planning to do so, be adversely affected? Is the ability to offer debt off the shelf a significant competitive advantage that the Commission should be concerned about limiting to only large debt issuers? IV. Paperwork Reduction Act A. Background Certain provisions of the proposed rule amendments contain a ``collection of information'' within the meaning of the Paperwork Reduction Act of 1995 (PRA).\121\ The Commission is submitting these proposed amendments and proposed rules to the Office of Management and Budget (OMB) for review in accordance with the PRA. An agency may not conduct or sponsor, and a person is not required to comply with, a collection of information unless it displays a currently valid control number. The titles for the collections of information are: \122\ --------------------------------------------------------------------------- \121\ 44 U.S.C. 3501 et seq. ; 5 CFR 1320.11. \122\ The paperwork burden from Regulation S-K and S-B is imposed through the forms that are subject to the requirements in those regulations and is reflected in the analysis of those forms. To avoid a Paperwork Reduction Act inventory reflecting duplicative burdens and for administrative convenience, we assign a one-hour burden to Regulation S-K. --------------------------------------------------------------------------- ``Regulation S-K'' (OMB Control No. 3235-0071); ``Regulation C'' (OMB Control No. 3235-0074); ``Form S-1'' (OMB Control No. 3235-0065) ; ``Form S-3'' (OMB Control No. 3235-0073); ``Form S-4'' (OMB Control No. 3235-0324); ``Form F-1'' (OMB Control No. 3235-0258); ``Form F-3'' (OMB Control No. 3235-0256); and ``Form F-4'' (OMB Control No. 3235-0325). We adopted all of the existing regulations and forms pursuant to the Securities Act or the Exchange Act. These regulations and forms set forth the disclosure requirements for periodic reports and registration statements that are prepared by issuers to provide investors with information to make investment decisions in registered offerings and in secondary market transactions. Our proposed amendments to existing forms and regulations are intended to replace rule and form requirements of the Securities Act and the Exchange Act that rely on security ratings with alternative requirements. The hours and costs associated with preparing disclosure, filing forms, and retaining records constitute reporting and cost burdens imposed by the collection of information. There is no mandatory retention period for the information disclosed, and the information disclosed would be made publicly available on the EDGAR filing system. B. Summary of Collection of Information Requirements The threshold we are proposing for issuers of non-convertible securities who are otherwise ineligible to use Form S-3 or Form F-3 to conduct primary offerings because they do not meet the aggregate market value requirement is designed to capture those issuers with an active market following. The Commission expects that under the proposed threshold, approximately the same number of issuers who are currently eligible will be eligible to register on Form S-3 or Form F-3 for primary offerings of non-convertible securities for cash. In addition, because these proposed amendments relate to those forms' eligibility requirements, rather than the disclosure requirements, the Commission does not expect that the proposed revisions will impose any new material recordkeeping or information collection requirements. Issuers may be required to ascertain the aggregate principal amount of non- convertible securities issued in registered primary offerings for cash, but the Commission believes that this information should be readily available and easily calculable. Our proposed amendments to Form S-3 and Rule 415 for ABS offerings is intended to limit the investors purchasing asset-backed securities in a delayed offering and off a short-form registration statement to sophisticated and experienced investors without creating an undue detriment to the liquidity of the asset-backed securities market. The Commission expects preliminarily that the proposed amendments for ABS offerings would not substantially change the number of ABS issuers registering their offerings on Form S-3.\123\ --------------------------------------------------------------------------- \123\ As noted above, we have identified two areas of exception: unit repackagings and securitizations of insurance funding agreements. We do not believe that changes in these areas would substantially change the number of issuers that would be eligible under the proposed Form S-3 eligibility requirement for ABS offerings. --------------------------------------------------------------------------- C. Paperwork Reduction Act Burden Estimates For purposes of the Paperwork Reduction Act, we estimate that there will be no annual incremental increase in the paperwork burden for issuers to comply with our proposed collection of information requirements. D. Solicitation of Comments We request comments in order to evaluate: (1) Whether the proposed collection of information is necessary for the proper performance of the functions of the agency, including whether the information would have practical utility; (2) the accuracy of our estimate of the burden of the proposed collection of information; (3) whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (4) whether there are ways to minimize the burden of the collection of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology.\124\ --------------------------------------------------------------------------- \124\ We request comment pursuant to 44 U.S.C. 3506(c)(2)(B). --------------------------------------------------------------------------- Any member of the public may direct to us any comments concerning the accuracy of these burden estimates and any suggestions for reducing these burdens. Persons submitting comments on the collection of information requirements should direct the comments to the Office of Management and Budget, Attention: Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Washington, DC 20503, and should send a copy to Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090, with reference to File No. S7-18-08. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7-18-08, and be submitted to the Securities and Exchange Commission, Records Management, Office of Filings and Information Services, 100 F Street, NE., Washington, DC 20549. OMB is required to make a decision concerning the collection of information between 30 and 60 days after publication of this [[Page 40118]] release. Consequently, a comment to OMB is best assured of having its full effect if OMB receives it within 30 days of publication. V. Cost-Benefit Analysis A. Proposed Amendments The Commission is sensitive to the costs and benefits imposed by its rules. We have identified certain costs and benefits of the proposed amendments and request comment on all aspects of this cost- benefit analysis, including identification and assessment of any costs and benefits not discussed in this analysis. We seek comment and data on the value of the benefits identified. We also welcome comments on the accuracy of the cost estimates in each section of this analysis, and request that commenters provide data that may be relevant to these cost estimates. In addition, we seek estimates and views regarding these costs and benefits for particular covered institutions, including small institutions, as well as any other costs or benefits that may result from the adoption of these proposed amendments. As discussed above, the proposed rule amendments are designed to address the risk that the reference to and use of NRSRO ratings in our rules is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs, and may encourage investors to place undue reliance on the NRSRO ratings. Today's proposals seek to replace rule and form requirements of the Securities Act and the Exchange Act that rely on security ratings by NRSROs with alternative requirements that do not rely on ratings. The Commission is proposing to revise the transaction eligibility requirements of Forms S-3, F-3, and F-9. Currently, these forms allow issuers who do not meet the forms' other transaction eligibility requirements to register primary offerings of non-convertible securities for cash if such securities are rated investment grade by an NRSRO.\125\ The proposed rules would replace the current eligibility requirement with a requirement that for primary offerings of non- convertible securities for cash, an issuer must have issued in the three years (as of a date within 60 days prior to the filing of the registration statement) at least $1 billion aggregate principal amount of non-convertible securities, other than common equity, in registered primary offerings for cash. In addition, the Commission proposes to replace the Form S-3 eligibility requirement for ABS offerings to require that initial sales of eligible offerings be made only to qualified institutional buyers and that initial and subsequent resales of the securities in the eligible offerings be made only in denominations of at least $250,000. In conjunction with this proposal, the Commission proposes to amend Rule 415 to provide for delayed offerings of mortgage related securities, regardless of the security ratings, only if they meet the same criteria as proposed for ABS offerings on Form S-3. --------------------------------------------------------------------------- \125\ The proposed revisions to Form F-9 would eliminate a Canadian issuer's ability to rely on security ratings by NRSROs, but would continue to rely on ratings issued by Approved Rating Organizations, as defined in National Policy Statement No. 45 of the Canadian Securities Administrator. --------------------------------------------------------------------------- Currently, issuers are required to obtain consent from a rating agency that is not an NRSRO for disclosure of a security rating issued by that rating agency in a registration statement or report. The Commission is also proposing to amend Securities Act Rule 436(g) and related rules to expand the relief from the consent requirements for security ratings currently provided to NRSROs to other credit rating agencies that are not NRSROs. In addition, the proposed revision to Rule 134 of the Securities Act would permit an issuer to disclose the security rating of any credit rating agency, but would require an issuer to provide, if it elects to include a security rating in a communication under Rule 134, a statement as to whether the entity issuing the rating is an NRSRO. B. Benefits The Commission anticipates that one of the primary benefits of the proposed amendments, if adopted, would be the benefit to investors of reducing their possible undue reliance on NRSRO ratings that could be caused by references to NRSROs in our rules. An over-reliance on ratings can inhibit independent analysis and could possibly lead to investment decisions that are based on incomplete information. The purpose of the proposed rule amendments is to encourage investors to examine more than a single source of information in making an investment decision. Eliminating reliance on ratings in the Commission's rules could also result in greater investor due diligence and investment analysis. In addition, the Commission believes that eliminating the reliance on ratings in its rules would remove any appearance that the Commission has placed its imprimatur on certain ratings. The Commission believes that the proposed amendments to the Form S- 3 eligibility requirements for ABS offerings and eligibility to rely on Rule 415(a)(vii) for mortgage-backed securities are designed to make shelf eligibility and short-form registration available to sophisticated and experienced investors. The proposed requirement to permit initial sales only to qualified institutional buyers is intended to limit the market to investors who understand the risks involved with an ABS offering. The proposed requirement that initial sales and subsequent resales of the securities are in minimum denominations of $250,000 is designed to limit offerings to investors with such capital, increasing the probability that these investors have the resources to analyze and comprehend the risks involved with an investment decision in the ABS offering. As with the other amendments to our rules and form requirements relying on investment grade ratings, the Commission believes that these proposals would reduce or eliminate undue reliance on ratings. The proposed revision to Rule 134 of the Securities Act would require an issuer to provide, if it elects to include a security rating in a communication under Rule 134, a statement as to whether the entity issuing the rating is an NRSRO. The Commission believes that disclosure of this information would be beneficial to investors in evaluating the value of the rating. Under our proposed amendment to Rule 436(g), an issuer would not be required to obtain consent from the rating agency even with respect to a rating disclosed in a registration statement or report that is issued by a credit rating agency that is not an NRSRO. We believe that our proposed change would foster competition between credit rating agencies.\126\ --------------------------------------------------------------------------- \126\ This would be consistent with our proposed amendments to the rules governing NRSROs in Release No. 34-57967. As discussed in that release, such competition could promote ease of comparability between ratings. --------------------------------------------------------------------------- C. Costs We are proposing to revise the transaction eligibility criteria for registering primary offerings of non-convertible securities on short- form registration statements. Forms S-3 and F-3 would be available to register primary offerings of non-convertible securities if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non- convertible securities, other than common equity, through registered primary offerings over the prior three years. The proposed eligibility thresholds may be more difficult to ascertain for some issuers than an NRSRO rating and impose some [[Page 40119]] burden on issuers to ascertain the information. In addition, while we do not anticipate that fewer issuers will be eligible, to the extent that the proposal results in fewer issuers eligible to use Forms S-3 and F-3 to register primary offerings of non-convertible securities, this could result in increased costs of preparing and filing registration statements.\127\ Issuers who do not meet the proposed threshold and are not otherwise eligible to use Forms S-3 and F-3, would have to register offerings on Forms S-1 or F-1. This could result in additional time spent in the offering process, and issuers may incur costs associated with preparing and filing post-effective amendments to the registration statement. --------------------------------------------------------------------------- \127\ The ability to conduct primary offerings on short form registration statements confers significant advantages on eligible companies in terms of cost savings and capital formation. The time required to prepare Form S-3 or F-3 is significantly lower than that required for Forms S-1 and F-1 primarily because registration statements on Forms S-3 and F-3 can be automatically updated. Forms S-3 and F-3 permit registrants to forward incorporate required information by reference to disclosure in their Exchange Act filings. --------------------------------------------------------------------------- The Commission does not expect the proposed changes to Forms F-1, F-3 and F-4 to impact substantially the number of registrants able to provide information required by Item 17 of Form 20-F in lieu of Item 18 information. However, because the Commission is proposing changes to the provisions of the forms that provide the eligibility requirements for registrants to provide Item 17 information instead of Item 18, registrants who do not meet the proposed criteria could incur more costs as a result of being required to provide Item 18 information instead. For the most part, the Commission believes that there would be minimal costs involved with the adoption of the proposed ABS offering Form S-3 eligibility requirements and eligibility to rely on Rule 415(a)(vii) for mortgage-backed securities.\128\ Some costs may be incurred on the part of issuers to ensure that sales of the securities in an offering on Form S-3 are made only to qualified institutional buyers and in the prescribed denominations; however, the Commission believes these costs are not significant. To the extent that some issuers would no longer be able to use Form S-3 to register their offerings, those issuers may face some additional costs, such as those arising from no longer being able to utilize certain rules permitting the use of offering materials. --------------------------------------------------------------------------- \128\ ABS issuers generally provide the same disclosure in Form S-1 and Form S-3 registration statements. As such, there may not be the same cost concerns for ABS issuers that no longer qualify for registration on Form S-3 as for other issuers. --------------------------------------------------------------------------- The proposed revision to Rule 134 could impose a disclosure burden of ascertaining whether the entity is an NRSRO, but the Commission believes this burden is slight given the limited number of NRSROs, the availability of this information from public filings, and the issuer's relationship with the credit rating agency. D. Request for Comments We seek comments and empirical data on all aspects of this Cost- Benefit Analysis. Specifically, we ask the following: Are there any costs involved with tracking whether the initial purchaser is a qualified institutional buyer? Are most ABS offerings on Form S-3 sold to such purchasers? What kind of asset- backed securities are sold to retail investors? Are there any costs entailed with tracking the denominations of the sale for the purposes of meeting the proposed ABS offering Form S-3 eligibility requirements? Would there be any significant transition costs imposed on issuers as a result of the proposals, if adopted? Please be detailed and provide quantitative data or support, as practicable. VI. Consideration of Burden on Competition and Promotion of Efficiency, Competition, and Capital Formation Section 23(a) of the Exchange Act \129\ requires the Commission, when making rules and regulations under the Exchange Act, to consider the impact a new rule would have on competition. Section 23(a)(2) prohibits the Commission from adopting any rule which would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. Section 2(b) of the Securities Act \130\ and Section 3(f) of the Exchange Act \131\ require the Commission, when engaging in rulemaking, to consider whether an action is necessary or appropriate in the public interest, and in addition, to consider the protection of investors and whether the action would promote efficiency, competition, and capital formation. --------------------------------------------------------------------------- \129\ 15 U.S.C. 78w(a). \130\ 15 U.S.C. 77b(b). \131\ 15 U.S.C. 78c(f). --------------------------------------------------------------------------- The proposed amendments would eliminate reliance on ratings by an NRSRO in various rules and forms under the Securities Act and the Exchange Act. If adopted, the Commission believes that these amendments would reduce the potential for over-reliance on ratings, and thereby promote investor protection. The Commission anticipates that these proposed amendments would improve investors' ability to make informed investment decisions, which will therefore lead to increased efficiency and competitiveness of the U.S. capital markets. The Commission expects that this increased market efficiency and investor confidence also may encourage more efficient capital formation. Specifically, the proposed amendments would: Seek to limit the investors purchasing asset-backed securities off a short-form registration statement to sophisticated and experienced investors without creating an undue detriment to the liquidity of the asset-backed securities market; and Seek to limit the issuers eligible to register primary offerings of non-convertible securities on Forms S-3 and F-3 and incorporate by reference to issuers that are actively followed by the markets; and Enhance the ability of credit rating agencies to offer security ratings to issuers. The Commission solicits comment on whether the proposed amendments would change the Forms S-3 and F-3 eligibility requirements for registering primary offerings of non-convertible securities, if adopted, would promote or burden efficiency, competition, and capital formation. The Commission also requests comment on whether the proposed amendments would have harmful effects on investors or on issuers who could use Form S-3 and Form F-3 for primary offerings of non- convertible securities, and what options would best minimize those effects. The Commission requests comment on whether the proposed changes to the eligibility requirement on Form S-3 for offerings of asset-backed securities would promote or burden efficiency, competition, and capital formation. The Commission requests comment on whether the proposed eligibility criterion is less efficient than using the current NRSRO criterion? Additionally, the Commission solicits comment on whether the proposed expansion of the ability of credit rating agencies to proffer their security ratings without being required to provide a consent for an issuer to disclose those ratings would promote or burden efficiency, competition, and capital formation. Finally, the Commission requests comment on the anticipated effect of disclosure requirements on competition in the market for credit rating agencies. [[Page 40120]] The Commission requests commenters to provide empirical data and other factual support for their views, if possible. VII. Regulatory Flexibility Act Certification The Commission hereby certifies, pursuant to 5 U.S.C. 605(b), that the amendments contained in this release, if adopted, would not have a significant economic impact on a substantial number of small entities. The proposed amendments would: Amend the Securities Act Form S-3 eligibility requirements for offerings of asset-backed securities by replacing the investment grade component with a minimum denomination requirement for initial and subsequent sales and require that initial sales of classes of securities only be made to qualified institutional buyers; Amend Rule 415 of the Securities Act that references mortgaged related securities by adding the requirement that an initial and subsequent sale of such a security must meet certain minimum denominations, and initial sales must be made to qualified institutional buyers; Amend the Securities Act Form S-3 and Form F-3 eligibility requirements for primary offerings of non-convertible securities if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non- convertible securities, other than common stock, through registered primary offerings, within the prior three years; Amend Form F-9 which requires securities to be rated investment grade to instead require that the issuer have issued in the prior three years at least $1 billion of aggregate principle amount of debt or preferred securities for cash in registered primary offerings; Amend Forms S-4 and F-4 and Schedule 14A to conform with the proposed Form S-3/F-3 eligibility requirements; Amend Securities Act Rules 138, 139, and Rules 168 to be consistent with the proposed Form S-3/F-3 eligibility requirements; Amend Item 10(c) to conform to our proposed Rule 436(g) changes; Amend Rule 134(a)(17) to allow for disclosure of ratings assigned by any Credit Rating Agency--not just NRSROs; and Amend Rule 436(g) to replace the current reference to ``nationally recognized statistical rating organization'' with a reference to ``credit rating agency.'' We are not aware of any issuers that currently rely on the rules that we propose to change or any issuers that would be eligible to register under the affected rules that is a small entity. In this regard, we note that credit rating agencies rarely, if ever, rate the securities of small entities. We further note most security ratings that will be disclosed are expected to be ratings obtained and used by the issuer. Issuers are required to pay for these security ratings and the cost of these ratings relative to the size of a debt or preferred securities offering by a small entity would generally be prohibitive. Finally, based on an analysis of the language and legislative history of the Regulatory Flexibility Act, we note that Congress did not intend that the Act apply to foreign issuers. Accordingly, some of the entities directly affected by the proposed rule and form amendments will fall outside the scope of the Act. For these reasons, the proposed amendments would not have a significant economic impact on a substantial number of small entities. VIII. Small Business Regulatory Enforcement Fairness Act For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996,\132\ a rule is ``major'' if it has resulted, or is likely to result in: --------------------------------------------------------------------------- \132\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996). --------------------------------------------------------------------------- An annual effect on the U.S. economy of $100 million or more; A major increase in costs or prices for consumers or individual industries; or Significant adverse effects on competition, investment, or innovation. We request comment on whether our proposal would be a ``major rule'' for purposes of the Small Business Regulatory Enforcement Fairness Act. We solicit comment and empirical data on: The potential effect on the U.S. economy on an annual basis; Any potential increase in costs or prices for consumers or individual industries; and Any potential effect on competition, investment, or innovation. IX. Statutory Authority and Text of Proposed Rule and Form Amendments We are proposing the amendments contained in this document under the authority set forth in Sections 6, 7, 10, 19(a) of the Securities Act and Sections 12, 13, 14, 15(d) and 23(a) of the Exchange Act. List of Subjects in 17 CFR Parts 229, 230, 239, and 240 Reporting and recordkeeping requirements, Securities. For the reasons set out in the preamble, Title 17, Chapter II of the Code of Federal Regulations is proposed to be amended as follows: PART 229--STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND CONSERVATION ACT OF 1975--REGULATION S-K 1. The authority citation for part 229 continues to read in part as follows: Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn, 77sss, 78c, 78i, 78j, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-9, 80a-20, 80a-29, 80a-30, 80a-31(c), 80a-37, 80a- 38(a), 80a-39, 80b-11, and 7201 et seq.; 18 U.S.C. 1350, unless otherwise noted. * * * * * 2. Amend Sec. 229.10, paragraph (c)(1)(i) by: a. Removing the second sentence; b. Revising ``NRSRO'' in the third sentence to read, ``credit rating agency (as defined in 15 U.S.C. 78c(a)(61))''; and c. Revising the phrase ``Instruction to paragraph (a)(2)'' in the fourth sentence to read, ``paragraph A.2.(B)''. 3. Amend Sec. 229.1100 by revising paragraph (c)(2)(ii)(B) to read as follows: Sec. 229.1100 (Item 1100) General. * * * * * (c) * * * (2) * * * (ii) * * * (B) The third party meets the requirements of General Instruction I.A. of Form S-3 or General Instructions 1.A.1, 2, 3, 4, and 6 of Form F-3 and the pool assets relating to such third party are non- convertible securities, other than common equity, that were issued in a primary offering for cash that was registered under the Securities Act. * * * * * 4. Amend Sec. 229.1112 by: a. In paragraph (b) remove Instruction 2 to Item 1112(b); b. Redesignating Instructions 3 and 4 to Items 1112(b) as Instructions 2 and 3 to Item 1112(b). 5. Amend Sec. 229.1114 by: a. In paragraph (b) revise the heading for ``Instructions to Item 1114:'' to read ``Instructions to Item 1114(b):''. b. Removing Instruction 3 to Item 1114. c. Redesignating Instructions 4 and 5 to Item 1114 as Instructions 3 and 4 to Item 1114. [[Page 40121]] PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933 6. The authority citation for part 230 continues to read in part as follows: Authority: 15 U.S.C. 77b, 77c, 77d, 77f, 77g, 77h, 77j, 77r, 77s, 77z-3, 77sss, 78c, 78d, 78j, 78l, 78m, 78n, 78o, 78t, 78w, 78ll(d), 78mm, 80a-8, 80a-24, 80a-28, 80a-29, 80a-30, and 80a-37, unless otherwise noted. * * * * * 7. Amend Sec. 230.134 by: a. Revising paragraph (a)(17)(i); b. Redesignating paragraph (a)(17)(ii) as paragraph (a)(17)(iii); and c. Adding new paragraph (a)(17)(ii). The revision and addition read as follows: Sec. 230.134 Communications not deemed a prospectus. * * * * * (a) * * * (17) * * * (i) Any security rating assigned, or reasonably expected to be assigned, by a credit rating agency, as that term is defined in 15 U.S.C. 78c(a)(61), and the name or names of the credit rating agencies that assigned or is or are reasonably expected to assign the rating(s); (ii) If the credit rating agency or agencies that assigned or is or are reasonably expected to assign the rating(s) is not a nationally recognized security rating organization, as that term is defined in 15 U.S.C. 78c(a)(62), include a statement to that effect; and * * * * * 8. Amend Sec. 230.138 by revising paragraph (a)(2)(ii)(B)(2) to read as follows: Sec. 230.138 Publications or distributions of research reports by brokers or dealers about securities other than those they are distributing. (a) * * * (2) * * * (ii) * * * (B) * * * (2) Is issuing non-convertible securities and the registrant meets the provisions of General Instruction I.B.2 of Form F-3; and * * * * * 9. Amend Sec. 230.139 by revising paragraphs (a)(1)(i)(A)(1)(ii) and (a)(1)(i)(B)(2)(ii) to read as follows: Sec. 230.139 Publications or distributions of research reports by brokers or dealers distributing securities. (a) * * * (1) * * * (i) * * * (A)(1) * * * (ii) At the date of reliance on this section, is, or if a registration statement has not been filed, will be, offering non- convertible securities and meets the requirements for the General Instruction I.B.2 of Form S-3 or Form F-3; or * * * * * (B) * * * (2) * * * (ii) Is issuing non-convertible securities and meets the provisions of General Instruction I.B.2. of Form F-3; and * * * * * 10. Amend Sec. 230.168 by revising paragraph (a)(2)(ii)(B) to read as follows: Sec. 230.168 Exemption from sections 2(a)(10) and 5(c) of the Act for certain communications of regularly released factual business information and forward-looking information. * * * * * (a) * * * (2) * * * (ii) * * * (B) Is issuing non-convertible securities and meets the provisions of General Instruction I.B.2 of Form F-3; and * * * * * 11. Amend Sec. 230.415 by revising paragraph (a)(1)(vii) to read as follows: Sec. 230.415 Delayed or continuous offering and sale of securities. (a) * * * (1) * * * (vii) Mortgage backed securities, including such securities as mortgage backed debt and mortgage participation or pass through certificates, provided that: (A) Initial sale and any resales of the securities are made in minimum denominations of $250,000; and (B) Initial sales of the securities are made only to qualified institutional buyers (as defined in Sec. 230.144A(a)(1)); and (C) Either of the following is true: (1) Represents ownership of one or more promissory notes or certificates of interest or participation in such notes (including any rights designed to assure servicing of, or the receipt or timeliness of receipt by the holders of such notes, certificates, or participations of amounts payable under, such notes, certificates, or participations), which notes: (i) Are directly secured by a first lien on a single parcel of real estate, including stock allocated to a dwelling unit in a residential cooperative housing corporation, upon which is located a dwelling or mixed residential and commercial structure, on a residential manufactured home as defined in section 603(6) of the National Manufactured Housing Construction and Safety Standards Act of 1974, whether such manufactured home is considered real or personal property under the laws of the State in which it is to be located, or on one or more parcels of real estate upon which is located one or more commercial structures; and (ii) Were originated by a savings and loan association, savings bank, commercial bank, credit union, insurance company, or similar institution which is supervised and examined by a Federal or State authority, or by a mortgage approved by the Secretary of Housing and Urban Development pursuant to sections 203 and 211 of the National Housing Act, or, where such notes involve a lien on the manufactured home, by any such institution or by any financial institution approved for insurance by the Secretary of Housing and Urban Development pursuant to section 2 of the National Housing Act; or (2) Is secured by one or more promissory notes or certificates of interest or participations in such notes (with or without recourse to the issuer thereof) and, by its terms, provides for payments of principal in relation to payments, or reasonable projections of payments, on notes meeting the requirements of paragraphs (a)(1)(vii)(C)(1) (i) and (ii) of this section or certificates of interest or participations in promissory notes meeting such requirements. Note to paragraph (a)(1)(vii): For purposes of paragraph (a)(1)(vii) of the section, the term ``promissory note,'' when used in connection with a manufactured home, shall also include a loan, advance, or credit sale as evidence by a retail installment sales contract or other instrument. * * * * * 12. Amend Sec. 230.436 by revising paragraph (g) and removing the authority citations following the section to read as follows: Sec. 230.436 Consents required in special cases. * * * * * (g) Notwithstanding the provisions of paragraphs (a) and (b) of this section, the security rating assigned to a class of debt securities, a class of convertible debt securities, or a class of preferred stock by a credit rating agency as defined in 15 U.S.C. 78c(a)(61), or with respect to registration statements on Form F-9 (Sec. 239.39 of this chapter) by any other rating organization specified in the Instruction to paragraph A of General Instruction I of Form F-9, shall not be considered a part of the registration statement prepared or certified by a person within the meaning of sections 7 and 11 of the Act. [[Page 40122]] PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933 13. The authority citation for part 239 continues to read in part as follows: Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 77sss, 78c, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll, 78mm, 80a- 2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24, 80a-26, 80a-29, 80a-30, and 80a-37, unless otherwise noted. * * * * * 14. Amend Form S-3 (referenced in Sec. 239.13) by: a. Revising General Instructions I.B.2 and I.B.5; and b. Removing Instruction 3 to the signature block. The revisions read as follows: Note: The text of Form S-3 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM S-3 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * GENERAL INSTRUCTIONS I. Eligibility Requirements for Use of Form S-3 * * * * * B. Transaction Requirements* * * 2. Primary Offerings of Non-convertible Securities. Non-convertible securities to be offered for cash by or on behalf of a registrant, provided the registrant, as of a date within 60 days prior to the filing of the registration statement on this Form, has issued in the last three years at least $1 billion aggregate principal amount of non- convertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Act. * * * * * 5. Offerings of Asset-backed Securities. (a) Asset-backed securities (as defined in 17 CFR 229.1101) to be offered for cash, provided: (i) Initial sales and any resales of the securities are made in minimum denominations of $250,000; (ii) Initial sales of the securities are made only to qualified institutional buyers (as defined in 17 CFR 230.144A(a)(1)); (iii) Delinquent assets do not constitute 20% or more, as measured by dollar volume, of the asset pool as of the measurement date; and (iv) With respect to securities that are backed by leases other than motor vehicle leases, the portion of the securitized pool balance attributable to the residual value of the physical property underlying the leases, as determined in accordance with the transaction agreements for the securities, does not constitute 20% or more, as measured by dollar volume, of the securitized pool balance as of the measurement date. Instruction. For purposes of making the determinations required by paragraphs (a)(iii) and (a)(iv) of this General Instruction I.B.5, refer to the Instructions to Item 1101(c) of Regulation AB (17 CFR 229.1101(c)). * * * * * 15. Amend Form S-4 (referenced in Sec. 239.25) by revising General Instruction B.1.a.(ii)(B) to read as follows: Note: The text of Form S-4 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM S-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * GENERAL INSTRUCTIONS * * * * * B. Information With Respect to the Registrant 1. * * * a. * * * (ii) * * * (B) Non-convertible debt or preferred securities are to be offered pursuant to this registration statement and the requirements of General Instruction I.B.2. of Form S-3 have been met; or * * * * * 16. Amend Form F-1 (referenced in Sec. 239.31) by revising Item 4.c, including the Instructions to read as follows: Note: The text of Form F-1 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM F-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * Item 4. Information with Respect to the Registrant and the Offering. * * * * * c. Information required by Item 17 of Form 20-F may be furnished in lieu of the information specified by Item 18 thereof if: 1. The only securities being registered are non-convertible securities offered for cash and the registrant, as of a date within 60 days prior to the filing of the registration statement on this Form, has issued in the last three years at least $1 billion aggregate principal amount of non-convertible securities, other than common equity, in primary offerings for cash registered under the Act; or 2. The only securities to be registered are to be offered: i. Upon the exercise of outstanding rights granted by the issuer of the securities to be offered, if such rights are granted on a pro rata basis to all existing security holders of the class of securities to which the rights attach and there is no standby underwriting in the United States or similar arrangement; or ii. Pursuant to a dividend or interest reinvestment plan; or iii. Upon the conversion of outstanding convertible securities or upon the exercise of outstanding transferable warrants issued by the issuer of the securities to be offered, or by an affiliate of such issuer. Instruction: Attention is directed to section 10(a)(3) of the Securities Act. * * * * * 17. Amend Form F-3 (referenced in Sec. 239.33) by: a. Revising General Instruction I.B.2; and b. Deleting Instruction 3 to the signature block. The revision to General Instruction I.B.2 reads as follows: Note: The text of Form F-3 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM F-3 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * GENERAL INSTRUCTIONS I. Eligibility Requirements for Use of Form F-3 * * * * * B. Transaction Requirements * * * 2. Primary Offerings of Non-convertible Securities. Non-convertible securities to be offered for cash provided the issuer, as of a date within 60 days prior to the filing of the registration statement on this Form, has issued in the last three years at least $1 billion aggregate principal amount of non-convertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Act. In the case of securities registered pursuant to this paragraph, the financial statements included in this registration statement may comply with Item 17 or 18 of Form 20-F. * * * * * 18. Amend Form F-4 (referenced in Sec. 239.34) by: a. revising General Instruction B.1(a)(ii)(B); and [[Page 40123]] b. revising the following in Part I.B: Instruction 1 to Item 11 following paragraph (a)(3); the first sentence in paragraph (b)(2) to Item 12; Instruction 1 to Item 13 following paragraph (b); and paragraph (h) to Item 14. The revisions read as follows: Note: The text of Form F-4 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM F-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * GENERAL INSTRUCTIONS * * * * * B. Information with Respect to the Registrant 1. * * * a. * * * (ii) * * * (B) Non-convertible debt or preferred securities are to be offered pursuant to this registration statement and the requirements of General Instruction I.B.2. of Form F-3 have been met; or * * * * * PART I--INFORMATION REQUIRED IN THE PROSPECTUS * * * * * B. INFORMATION ABOUT THE REGISTRANT * * * * * Item 11. Incorporation of Certain Information by Reference. * * * * * (a) * * * (3) * * * Instructions 1. All annual reports or registration statements incorporated by reference pursuant to Item 11 of this Form shall contain financial statements that comply with Item 18 of Form 20-F except that financial statements of the registrants may comply with Item 17 of Form 20-F if the only securities being registered are non-convertible securities offered for cash and the requirements of General Instruction I.B.2 of Form F-3 have been satisfied. * * * * * Item 12. Information With Respect to F-3 Registrants. * * * * * (b) * * * (2) Include financial statements and information as required by Item 18 of Form 20-F, except that financial statements of the registrant may comply with Item 17 of Form 20-F if the requirements of General Instruction I.B.2 of Form F-3 have been satisfied. * * * * * * * * Item 13. Incorporation of Certain Information by Reference. * * * * * (b) * * * Instructions 1. All annual reports incorporated by reference pursuant to Item 13 of this Form shall contain financial statements that comply with Item 18 of Form 20-F, except that financial statements of the registrants may comply with Item 17 of Form 20-F if the only securities being registered are non-convertible securities offered for cash and the requirements of General Instruction I.B.2 of Form F-3 have been satisfied. * * * * * Item 14. Information With Respect to Foreign Registrants Other Than F-3 Registrants. * * * * * (h) Financial statements required by Item 18 of Form 20-F, except that financial statements of the registrants may comply with Item 17 of Form 20-F if the only securities being registered are non-convertible securities offered for cash and the requirements of General Instruction I.B.2 of Form F-3 have been satisfied, as well as financial information required by Rule 3-05 and Article 11 of Regulation S-X with respect to transactions other than that pursuant to which the securities being registered are to be issued (Schedules required by Regulation S-X shall be filed as ``Financial Statement Schedules'' pursuant to Item 21 of this Form); and * * * * * 19. Amend Form F-9 (referenced in Sec. 239.39) by: a. Revising General Instruction I.A; b. Removing Instruction D to the signature block. The revision reads as follows: Note: The text of Form F-9 does not, and this amendment will not, appear in the Code of Federal Regulations. FORM F-9 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 * * * * * GENERAL INSTRUCTIONS I. Eligibility Requirements for Use of Form F-9 A. Form F-9 may be used for the registration under the Securities Act of 1933 (the ``Securities Act'') for an offering of debt or preferred securities if: (1) The debt or preferred securities to be offered are: (A) Offered for cash or in connection with an exchange offer; and (B) Either non-convertible or not convertible for a period of at least one year from the date of issuance and, except as noted in E. below, are thereafter only convertible into a security of another class of the issuer; and (2) Either of the following is true: (A) The registrant, as of a date within 60 days prior to the filing of the registration statement on this Form, has issued in the last three years at least $1 billion of aggregate principal amount of debt or preferred securities for cash in primary offerings registered under the Act; or (B) The securities are investment grade debt or investment grade preferred securities. Securities shall be ``investment grade'' for purposes of this requirement if, at the time of sale, at least one Approved Rating Organization (as defined in National Policy Statement No. 45 of the Canadian Securities Administrator, as the same may be amended from time to time) has rated the security in one of its generic rating categories that signifies investment grade; typically the four highest rating categories (within which there may be subcategories or gradations indicating relative standing) signify investment grade. PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 20. The authority citation for part 240 continues to read in part as follows: Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise noted. * * * * * 21. Amend Sec. 240.14a-101 by revising Note E(2)(ii) to read as follows: Sec. 240.14a-101 Schedule 14A. Information required in proxy statement. * * * * * Notes * * * * * E. * * * (2) * * * (ii) Action is to be taken as described in Items 11, 12, and 14 of this schedule which concerns non-convertible debt or preferred securities issued by a registrant meeting the requirements of General Instruction I.B.2 of Form S-3; or * * * * * By the Commission. [[Page 40124]] Dated: July 1, 2008. Florence E. Harmon, Acting Secretary. [FR Doc. E8-15281 Filed 7-10-08; 8:45 am] BILLING CODE 8010-01-P
[Federal Register: July 11, 2008 (Volume 73, Number 134)][Proposed Rules] [Page 40124-40142] From the Federal Register Online via GPO Access [wais.access.gpo.gov] [DOCID:fr11jy08-18] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 270 and 275 [Release Nos. IC-28327; IA-2751 File No. S7-19-08] RIN 3235-AK19 References to Ratings of Nationally Recognized Statistical Rating Organizations AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. ----------------------------------------------------------------------- SUMMARY: This is one of three releases that the Securities and Exchange Commission (``Commission'') is publishing simultaneously relating to the use in its rules and forms of credit ratings issued by nationally recognized statistical rating organizations (``NRSROs''). In this release, the Commission proposes to amend five rules under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 that rely on NRSRO ratings. The proposed amendments are designed to address concerns that the reference to NRSRO ratings in Commission rules may have contributed to an undue reliance on NRSRO ratings by market participants. DATES: Comments should be received on or before September 5, 2008. ADDRESSES: Comments may be submitted by any of the following methods: Electronic CommentsUse the Commission's Internet comment form (http:// www.sec.gov/rules/proposed.shtml); or Send an e-mail to rule-comments@sec.gov. Please include File Number S7-19-08 on the subject line; or Use the Federal eRulemaking Portal (http:// www.regulations.gov). Follow the instructions for submitting comments. Paper Comments Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number S7-19-08. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available. FOR FURTHER INFORMATION CONTACT: Penelope Saltzman, Acting Assistant Director, or Vincent Meehan, Senior Counsel, (202) 551-6792, Office of Regulatory Policy, or Smeeta Ramarathnam, Senior Counsel, (202) 551- 6792, Office of Special Projects, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-5041. SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment amendments to rules 2a-7 [17 CFR 270.2a-7], 3a-7 [17 CFR 270.3a-7], 5b-3 [17 CFR 270.5b-3], and 10f-3 [17 CFR 270.10f-3] under the Investment Company Act of 1940 (``Investment Company Act''),\1\ and amendments to rule 206(3)-3T [17 CFR 275.206(3)-3T] under the Investment Advisers Act of 1940 (``Investment Advisers Act'' or ``Advisers Act'').\2\ --------------------------------------------------------------------------- \1\ 15 U.S.C. 80a. Unless otherwise noted, all references to rules under the Investment Company Act will be to Title 17, Part 270 of the Code of Federal Regulations [17 CFR 270], and all references to statutory sections are to the Investment Company Act. \2\ 15 U.S.C. 80b. Unless otherwise noted, all references to rules under the Investment Advisers Act will be to Title 17, Part 275 of the Code of Federal Regulations [17 CFR 275], and all references to statutory sections are to the Investment Advisers Act. --------------------------------------------------------------------------- Table of Contents I. Introduction II. Background III. Discussion A. Rule 2a-7 1. Minimal Credit Risk Determination 2. Portfolio Liquidity 3. Monitoring Minimal Credit Risks 4. Commission Notice of Rule 17a-9 Transactions B. Rule 3a-7 C. Rule 5b-3 D. Rule 10f-3 E. Rule 206(3)-3T IV. Request for Comment V. Paperwork Reduction Act VI. Cost-Benefit Analysis VII. Consideration of Promotion of Efficiency, Competition and Capital Formation VIII. Regulatory Flexibility Act Certification IX. Initial Regulatory Flexibility Analysis X. Statutory Authority Text of Proposed Rule Amendments I. Introduction On June 16, 2008, in furtherance of the Credit Rating Agency Reform Act of 2006,\3\ the Commission published for notice and comment two rulemaking initiatives.\4\ The first proposes additional requirements for NRSROs \5\ that were directed at reducing conflicts of interest in the credit rating process, fostering competition and comparability among credit rating agencies, and increasing transparency of the credit rating process.\6\ The second is designed to improve investor understanding of the risk characteristics of structured finance products. Those proposals address concerns about the integrity of the credit rating procedures and methodologies of NRSROs in light of the role they played in determining the credit ratings for securities that were the subject of the recent turmoil in the credit markets. --------------------------------------------------------------------------- \3\ Public Law No. 109-291, 120 Stat. 1327 (2006). \4\ Proposed Rules for Nationally Recognized Statistical Rating Organizations, Securities Exchange Act Release No. 57967 (June 16, 2008) [73 FR 36212 (June 25, 2008)] (``NRSRO June 16, 2008 Proposing Release''). \5\ As described in more detail below, an NRSRO is an organization that issues ratings that assess the creditworthiness of an obligor itself or with regard to specific securities or money market instruments, has been in existence as a credit rating agency for at least three years, and meets certain other criteria. The term is defined in section 3(a)(62) of the Securities Exchange Act of 1934 (``Exchange Act''). A credit rating agency must apply with the Commission to register as an NRSRO, and currently there are ten registered NRSROs. \6\ See Press Release No. 2008-110 (June 11, 2008). --------------------------------------------------------------------------- Today's proposals comprise the third of these three rulemaking initiatives relating to credit ratings by an NRSRO that the Commission is proposing. This release, together with two companion releases, sets forth the results of the Commission's review of the requirements in its rules and forms that rely on credit ratings by an NRSRO. The proposals also address recent recommendations issued by the President's Working Group on Financial Markets (``PWG''), the Financial Stability Forum (``FSF'') and the Technical Committee of the International Organization of Securities Commissions (``IOSCO'').\7\ Consistent [[Page 40125]] with these recommendations, the Commission is considering whether the inclusion of requirements related to ratings in its rules and forms has, in effect, placed an ``official seal of approval'' on ratings that could adversely affect the quality of due diligence and investment analysis. The Commission believes that today's proposals could reduce undue reliance on credit ratings and result in improvements in the analysis that underlies investment decisions. --------------------------------------------------------------------------- \7\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments (March 2008), available at www.ustreas.gov (``PWG Statement''); The Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 2008), available at www.fsforum.org (``FSF Report''); Technical Committee of the International Organization of Securities Commissions, Consultation Report: The Role of Credit Rating Agencies in Structured Finance Markets (March 2008), p. 9, available at www.iosco.org. --------------------------------------------------------------------------- II. Background The Commission first used the term ``NRSRO'' in our rules in 1975 in the net capital rule for broker-dealers, Rule 15c3-1 (``Net Capital Rule'') \8\ under the Securities Exchange Act of 1934 (the ``Exchange Act'') \9\ as an objective benchmark to prescribe capital charges for different types of debt securities. Since then, we have used the designation in a number of regulations under the federal securities laws. Although we originated the use of the term NRSRO for a narrow purpose in our own regulations, ratings by NRSROs today are used widely as benchmarks in federal and state legislation, rules issued by other financial regulators, in the United States and abroad, and private financial contracts. --------------------------------------------------------------------------- \8\ 17 CFR 240.15c3-1. \9\ 15 U.S.C. 78a. --------------------------------------------------------------------------- Referring to NRSRO ratings in regulations was intended to provide a clear reference point to both regulators and market participants. Increasingly, we have seen clear disadvantages of using the term in many of our regulations. Foremost, there is a risk that investors interpret the use of the term in laws and regulations as an endorsement of the quality of the credit ratings issued by NRSROs, which may have encouraged investors to place undue reliance on the credit ratings issued by these entities. In addition, as demonstrated by recent events,\10\ there has been increasing concern about ratings and the ratings process. Further, by referencing ratings in the Commission's rules, market participants operating pursuant to these rules may be vulnerable to failures in the ratings process. In light of this, the Commission proposes to amend regulations under the Investment Company Act and the Investment Advisers Act that use the term NRSRO or refer to NRSRO ratings.\11\ --------------------------------------------------------------------------- \10\ See NRSRO June 16, 2008 Proposing Release, supra note 4, at Section I.C. \11\ These regulations include rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment Company Act and rule 206(3)-3T under the Investment Advisers Act. --------------------------------------------------------------------------- III. Discussion The credit ratings issued by NRSROs are used in four of the Commission's rules under the Investment Company Act--rules 2a-7, 3a-7, 5b-3, and 10f-3--and one rule under the Investment Advisers Act--rule 206(3)-3T. These rules use the credit ratings issued by the NRSROs in different contexts, and for different purposes, to distinguish among various grades of debt and other rated securities. We propose to amend each rule to omit references to NRSRO ratings and, except with respect to one of the rules, substitute alternative provisions that are designed to appropriately achieve the same purpose as the ratings. Below we discuss these proposals in greater detail in the context of each rule we propose to amend. A. Rule 2a-7 Rule 2a-7 under the Investment Company Act governs the operation of money market funds. Unlike other investment companies (``funds''), money market funds seek to maintain a stable share price, typically at $1.00 per share. To do so, most money market funds use the amortized cost method of valuation (``amortized cost method'') or the penny- rounding method of pricing (``penny-rounding method'') permitted by rule 2a-7.\12\ The Investment Company Act and applicable rules generally require funds to calculate current net asset value per share by valuing their portfolio instruments at market value or, if market quotations are not readily available, at fair value as determined in good faith by the board of directors.\13\ These valuation requirements are designed to prevent unfair share pricing from diluting or otherwise adversely affecting the interests of investors.\14\ --------------------------------------------------------------------------- \12\ Under the amortized cost method, portfolio instruments are valued by reference to their acquisition cost as adjusted for amortization of premium or accretion of discount. See rule 2a- 7(a)(2). Share price is determined under the penny-rounding method by valuing securities at market value, fair value or amortized cost and rounding the per share net asset value to the nearest cent on a share value of a dollar, as opposed to the nearest one tenth of one cent. See rule 2a-7 (a)(18). \13\ See section 2(a)(41) of the Investment Company Act (defining value) and rules 2a-4 (defining current net asset value) and 2a-7(c) thereunder (money market fund share price calculations). \14\ If shares are sold or redeemed based on a net asset value which turns out to have been either understated or overstated to the amount at which portfolio instruments could have been sold, then the interests of either existing shareholders or new investors will have been diluted. See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Sen. Comm. on Banking and Currency, 76th Cong., 3d Sess. 136-138, 288 (1940). --------------------------------------------------------------------------- Rule 2a-7 exempts money market funds from these provisions but contains maturity, quality, and diversification conditions designed to minimize the deviation between a money market fund's stabilized share price and the market value of its portfolio.\15\ Among these conditions, rule 2a-7 limits a money market fund's portfolio investments to securities that have received credit ratings from the ``Requisite NRSROs'' in one of the two highest short-term rating categories or comparable unrated securities (i.e., ``Eligible Securities'').\16\ Rule 2a-7 further restricts money market funds to securities that the fund's board of directors (which typically rely on the fund's adviser \17\) determines present minimal credit risks, and specifically requires that determination ``be based on factors pertaining to credit quality in addition to any ratings assigned to such securities by an NRSRO.'' \18\ --------------------------------------------------------------------------- \15\ Rule 2a-7 contains conditions that apply to each investment a money market fund proposes to make, as well as conditions that apply to a money market fund's entire portfolio. \16\ The term ``Eligible Security'' is defined in rule 2a- 7(a)(10). ``Requisite NRSROs'' is defined in rule 2a-7(a)(21). \17\ See rule 2a-7(e). \18\ Rule 2a-7(c)(3)(i). Thus, under the current rule, where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor considered in determining whether a security presents minimal credit risks. See Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)], at text preceding n.18. --------------------------------------------------------------------------- We propose to eliminate references to ratings by amending rule 2a-7 in four principal ways.\19\ In combination, these proposed amendments are designed to offer similar protections to the current rule's reliance on NRSRO ratings.\20\ --------------------------------------------------------------------------- \19\ The proposed amendments would also make conforming amendments to rule 2a-7's record keeping and reporting requirements. See proposed rule 2a-7(c)(11). \20\ In 2003, the Commission published a concept release in which we sought comment on the use of NRSRO ratings in our rules. See Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws, Investment Company Act Release No. 26066 (June 4, 2003) [68 FR 35258 (June 12, 2003)]. Comments on the concept release are available at: http://www.sec.gov/rules/concept/s71203.shtml. As discussed above, recent events have highlighted the need to revisit our reliance on NRSRO ratings in the context of these developments. See also the extensive discussion of market developments in the NRSRO June 16, 2008 Proposing Release, supra note 4. --------------------------------------------------------------------------- 1. Minimal Credit Risk Determination Under the proposed amendments, we would rely on money market fund boards of directors to determine that each portfolio instrument presents minimal credit risks,\21\ and whether the [[Page 40126]] security is a ``First Tier Security'' or a ``Second Tier Security'' for purposes of the rule.\22\ We believe that money market fund boards of directors would still be able to use quality determinations prepared by outside sources, including NRSRO ratings that they conclude are credible, in making credit risk determinations. We expect that the boards of directors (or their delegates) would understand the basis for the rating and make an independent judgment of credit risks. --------------------------------------------------------------------------- \21\ See proposed rule 2a-7(a)(10). \22\ Rule 2a-7(c)(4) addresses portfolio diversification requirements for money market funds, including diversification requirements relating to First and Second Tier Securities. --------------------------------------------------------------------------- Under the proposed amendments, a security would be an Eligible Security if the board of directors determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations.\23\ A security would be a First Tier Security if the fund's board had determined that the issuer has the ``highest capacity to meet its short-term financial obligations.'' \24\ A security would be a Second Tier Security if it is an Eligible Security but is not a First Tier Security.\25\ We have designed these proposed definitions to retain a degree of risk limitations similar to what is in the current rule. --------------------------------------------------------------------------- \23\ Proposed rule 2a-7(a)(10). \24\ Proposed rule 2a-7(a)(12). \25\ See rule 2a-7(a)(22). The specific language of this provision would not change, but the definitions of ``Eligible Security'' and ``First Tier Security'' would change under the proposal. Consistent with the current rule, under proposed rule 2a- 7, a money market fund that is not a tax exempt fund generally must limit its investments in Second Tier Securities to no more than five percent of fund assets, with investment in the Second Tier Securities of any one issuer being limited to the greater of one percent of fund assets or one million dollars. Proposed rule 2a- 7(c)(3)(ii)(A) and (c)(4)(i)(C)(1). Tax exempt money market funds are subject to different limitations on investments in Second Tier Conduit Securities. Rule 2a-7(c)(3)(ii)(B) and (c)(4)(i)(C)(2). --------------------------------------------------------------------------- We request comment on the proposed amendments. What are the advantages and disadvantages of eliminating the requirement to use NRSRO ratings from rule 2a-7? Would eliminating the rating requirements from rule 2a-7 affect the amount or nature of risks money market funds would be willing or able to take? What are the advantages and disadvantages of relying on minimum credit risk determinations? What are the advantages and disadvantages of having fund directors and investment advisers exclusively make credit quality determinations? Are we correct that the current rule's reliance on credit ratings discourages fund directors and investment advisers from performing independent credit risk assessments? What other alternatives could we adopt to encourage more independent credit risk analysis and meet the regulatory objectives of rule 2a-7's requirement of NRSRO ratings? Are the distinctions our proposed amendments would draw between First Tier and Second Tier Securities workable? Is there a better way to describe the characteristics of a First Tier Security without reference to ratings? Are we correct in our expectation that the proposed standards would not impose additional burdens on boards or investment advisers, or require new recordkeeping requirements? 2. Portfolio Liquidity Under the proposed amendments, a money market fund must hold securities that are sufficiently liquid to meet reasonably foreseeable redemptions in light of the fund's obligations under section 22(e) of the Investment Company Act and any commitments the fund has made to its shareholders.\26\ In addition, the proposed amendments would expressly limit a money market fund's investment in illiquid securities to not more than 10 percent of its total assets.\27\ The proposed amendments would define a Liquid Security as a security that can be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the money market fund.\28\ These proposed provisions should be familiar to managers of money market funds. Past releases proposing, adopting and amending rule 2a-7 repeatedly emphasized the special duty of the board of directors of a money market fund to monitor purchases of illiquid instruments.\29\ Money market funds often have a greater and perhaps less predictable volume of redemptions than other open-end investment companies. Further, the portfolio management of a money market fund may be impaired if a fund were forced to meet redemption requests by selling marketable securities that it would otherwise wish to retain in order to avoid attempting to dispose of illiquid portfolio instruments.\30\ In light of these potential problems, the proposal would prohibit money market funds from acquiring illiquid securities representing more than 10 percent of their total assets.\31\ In the event that changes in the money market fund's portfolio or other external events cause the fund's investments in illiquid instruments to exceed 10 percent of the fund's assets, the money market fund would have to take steps to bring the aggregate amount of illiquid securities back within the proposed limitations as soon as reasonably practicable. However, consistent with the current rule, this requirement generally would not force the money market fund to liquidate any portfolio security where the fund would suffer a loss on the sale of that instrument.\32\ --------------------------------------------------------------------------- \26\ See proposed rule 2a-7(c)(5). Section 22(e) of the Investment Company Act prohibits registered investment companies from suspending the right of redemption or postponing the date of payment upon redemption of any redeemable security for more than seven days except for certain periods specified in the provision. While the Investment Company Act requires only that an investment company make payment of the proceeds of redemption within seven days, most money market funds promise investors that they will receive proceeds much sooner, often on the same day that the request for redemption is received by the fund. \27\ The proposed standard codifies the current standard regarding portfolio liquidity. See Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 21837 (Mar. 21, 1996) [61 FR 13956 (Mar. 28, 1996)] (``Rule 2a-7 1996 Amending Release''), at text accompanying n.108 (``The limit on money fund holdings of illiquid securities is ten percent of fund assets.''); Acquisition and Valuation of Certain Portfolio Instruments by Registered Investment Companies, Investment Company Act Release No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] (``1986 Valuation Release''). Although credit ratings do not directly incorporate liquidity risks, they have been used as a proxy for liquidity because a security may lose liquidity if its credit rating falls. \28\ See proposed rule 2a-7(a)(17). See also 1986 Valuation Release, supra note 27 at text following n.21. \29\ See, e.g., Valuation of Debt Instruments and Computation of Current Price per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 12206 (Feb. 1, 1982) [47 FR 5428 (Feb. 5, 1982)] (proposing rule 2a-7); Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)] (``Rule 2a-7 Adopting Release''); 1986 Valuation Release, supra note 27. \30\ Rule 2a-7 Adopting Release, supra note 29, at text preceding, accompanying and following nn.37-39. \31\ Proposed rule 2a-7(c)(5). Money market funds must limit their investments in illiquid assets to not more than 10 percent of their net assets. See rule 2a-7 1996 Amending Release, supra note 27, at n.108 and accompanying text. An investment company's portfolio security is illiquid if it cannot be disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the investment company. See id. at n.107 and accompanying text. \32\ See Rule 2a-7 Adopting Release, supra note 29, at n.38. --------------------------------------------------------------------------- We request comment on the proposed amendments. Should we include in rule 2a-7 an express requirement that money market funds limit their exposure to illiquid securities? Do the proposed requirements provide money market funds sufficient flexibility to retain securities that may be illiquid if the disposal of those securities would not be in the best interests of the fund? Are there alternative or additional provisions that we should consider to address the way in which money market [[Page 40127]] funds should evaluate liquidity risk and determine whether to dispose of securities that present an increasing liquidity risk? 3. Monitoring Minimal Credit Risks The proposed amendments would also amend rule 2a-7's downgrade and default provisions. We propose that in the event the money market fund's investment adviser becomes aware of any information about a portfolio security or an issuer of a portfolio security that suggests that the security may not continue to present minimal credit risks, the money market fund's board of directors would have to reassess promptly whether the portfolio security continues to present minimal credit risks.\33\ This proposed requirement would replace the provisions in the current rule that generally require a money market fund board to promptly reassess whether a security that has been downgraded by an NRSRO continues to present minimal credit risks, and take such action as the board determines is in the best interests of the fund and its shareholders.\34\ We do not believe that the proposed amendments would require investment advisers to subscribe to every rating service publication in order to comply with this proposal. However, we would expect an investment adviser to exercise reasonable diligence in keeping abreast of new information about a portfolio security that is reported in the national financial press or in publications to which the investment adviser subscribes. --------------------------------------------------------------------------- \33\ Proposed rule 2a-7(c)(7) (``In the event the money market fund's investment adviser (or any person to whom the fund's board of directors has delegated portfolio management responsibilities) becomes aware of any information about a portfolio security or an issuer of a portfolio security that may suggest that the security may not continue to present minimal credit risks, the board of directors shall reassess promptly whether such security continues to present minimal credit risks and shall cause the fund to take such action as the board of directors determines is in the best interests of the money market fund and its shareholders.''). \34\ Rule 2a-7(c)(6)(i)(A). This current assessment is not required, however, if the downgraded security is disposed of or matures within five business days of the specified event and in the case of events specified in rule 2a-7(c)(6)(i)(A)(2), the board is subsequently notified of the adviser's actions. Rule 2a- 7(c)(6)(i)(B). --------------------------------------------------------------------------- We request comment on the proposed amendments. Would the requirement that the board of directors reassess the credit risk of a security when investment advisers become aware of information that may suggest the security no longer presents minimal credit risks provide adequate investor protections? Would investment advisers be able to stay abreast of new information about their portfolio securities? 4. Commission Notice of Rule 17a-9 Transactions Finally, the proposed amendments would require that money market funds provide the Commission with prompt notice when an affiliate of the money market fund (or its promoter or principal underwriter) purchases from the fund a security that is no longer an Eligible Security, pursuant to rule 17a-9 under the Investment Company Act.\35\ We believe that the current notice provisions, which are triggered when a security held by a fund defaults, provide us with incomplete information about money market funds holding distressed securities, particularly those that have engaged in an affiliated transaction with an affiliated person. The additional notice, which we believe would impose little burden on money market funds or their managers, would enhance our oversight of money market funds especially during times of economic stress. --------------------------------------------------------------------------- \35\ Proposed rule 2a-7(c)(7)(iii)(B) (requiring notice to the Commission of any ``purchase of a security from the fund by an affiliated person or promoter of or principal underwriter for the fund or an affiliated person of such a person in reliance on rule 17a-9''). See rule 17a-9 (exempting from section 17(a) of the Act the purchase of a security ``that is no longer an Eligible Security (as defined in [rule 2a-7(a)(10)]) under certain conditions).'' Notification under this proposed provision would also be amended to require electronic mail, instead of the other means currently listed in rule 2a-7(c)(6)(iii). We believe this change is appropriate in light of recent changes in telecommunications technology, and because most of the notices of default that we have received in the past year have been transmitted electronically. --------------------------------------------------------------------------- We request comment on the proposed amendments. B. Rule 3a-7 Rule 3a-7 under the Investment Company Act excludes structured finance vehicles from the Act's definition of ``investment company'' subject to certain conditions.\36\ In a typical financing, a sponsor transfers a pool of assets (such as residential mortgages) to a limited purpose entity, which in turn issues fixed income securities that are rated investment grade or higher by at least one NRSRO. Payment on the securities depends primarily on the cash flows generated by the pooled assets. As a result, these are often referred to as ``asset-backed'' securities. --------------------------------------------------------------------------- \36\ Structured financings meet the definition of investment company under section 3(a) of the Act because they issue securities and invest in, own, hold, or trade securities. Almost none of the structured financings, however, are able to operate under the Act's requirements. See Exclusion from the Definition of Investment Company for Structured Financings, Investment Company Act Release No. 19105 (Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] (``Rule 3a-7 Adopting Release''). --------------------------------------------------------------------------- Rule 3a-7 contains a number of conditions that differentiate investment companies from structured financings. The conditions include the requirement that structured financings offered to the general public are rated by at least one NRSRO in one of the four highest ratings categories.\37\ The rule contains an exception under which asset-backed securities sold to accredited investors \38\ and qualified institutional buyers \39\ may be unrated, or may be rated less than investment grade, if the issuer and its underwriters use reasonable care to ensure that all excepted sales are to such persons.\40\ We concluded that these persons are in a position to evaluate the structured financing vehicle and to take steps to protect themselves from the types of abusive practices against which the Investment Company Act was designed to protect.\41\ --------------------------------------------------------------------------- \37\ Rule 3a-7(a)(2). \38\ The exception permits the sale of asset backed fixed-income securities to ``accredited investors'' as defined in paragraphs (1), (2), (3) and (7) of rule 501(a) under the Securities Act [17 CFR 230.501(a)], and includes any entity in which all of the equity owners come within such paragraphs. Rule 3a-7(a)(2)(i). \39\ The exception permits the sale of any asset backed securities to ``qualified institutional buyers'' as defined in rule 144A under the Securities Act [17 CFR 230.144A] and certain other persons involved in the organization or operation of the issuer or an affiliate, as defined in rule 405 under the Securities Act [17 CFR 230.405]. Rule 3a-7(a)(2)(ii). \40\ Rule 3a-7(a)(2). \41\ See Exclusion from the Definition of Investment Company for Certain Structured Financings, Investment Company Act Release No. 18736 (May 29, 1992) [57 FR 23980 (June 5, 1992)] (proposing rule 3a-7). --------------------------------------------------------------------------- We understand that today most asset-backed securities are issued by special purpose vehicles that do not rely on rule 3a-7 to exclude them from the application of the Investment Company Act. Instead, they rely on section 3(c)(7), which was added to the Act in 1996, after the Commission adopted rule 3a-7, and provides an exception from the Act for companies whose securities are limited to any issuer, the outstanding securities of which are owned exclusively by persons who are qualified purchasers, and that is not making and does not at that time propose to make a public offering of such securities. Moreover, asset-backed securities issued by financing vehicles that rely on rule 3a-7, even when highly rated, generally are not marketed to retail investors.\42\ Accordingly, we propose to eliminate the rule's reliance on ratings by amending the rule to [[Page 40128]] eliminate the exclusion for structured financings offered to the general public. --------------------------------------------------------------------------- \42\ See Credit & Finance Risk Analysis Asset Backed Securities and Structural Finance, at http://www.credfinrisk.com/ assetsecure.html. --------------------------------------------------------------------------- In addition, we are proposing to amend the part of the rule that addresses substitution of eligible assets to remove the reference to ratings downgrades. The rule permits the issuer to acquire additional eligible assets or dispose of assets only if, among other conditions, the acquisition or disposition of the assets does not result in a downgrading in the rating of the issuer's outstanding fixed-income securities.\43\ We propose to require instead that the issuer have procedures to ensure that the acquisition or disposition does not adversely affect the full and timely payment of the outstanding fixed income securities.\44\ --------------------------------------------------------------------------- \43\ Rule 3a-7(a)(3)(ii). \44\ Proposed rule 3a-7(a)(3)(ii). --------------------------------------------------------------------------- Finally, we propose to amend the portion of the rule that deals with the safekeeping of assets.\45\ Among other requirements, the rule provides that cash flows from the asset pool periodically be deposited in a segregated account, consistent with the rating of the outstanding fixed income securities.\46\ This provision was intended to ensure that the segregated account in which the cash flows are deposited and the length of time that the servicer holds the cash flows before depositing them in the segregated account would pose a minimal risk of loss to the fixed income security holders. We propose to change this provision to require that the cash flows be deposited in a segregated account consistent with the full and timely payment of the outstanding fixed income securities.\47\ The proposed amendment is designed to minimize the risk of loss of cash flows pending payment to the fixed income securities holders. --------------------------------------------------------------------------- \45\ Rule 3a-7(a)(4). \46\ Rule 3a-7(a)(4)(iii). \47\ Proposed rule 3a-7(a)(4)(iii). The proposed amendment would require the issuer to take ``actions necessary for the cash flows derived from eligible assets for the benefit of the holders of fixed-income securities to be deposited periodically in a segregated account that is maintained or controlled by the trustee consistent with the full and timely payment of the outstanding fixed income securities.'' --------------------------------------------------------------------------- We request comment on our proposed amendments to rule 3a-7. What are the advantages and disadvantages of eliminating the NRSRO rating requirement from the rule? Is our understanding that structured financings are generally not marketed to retail investors correct? If not, should we retain an exclusion for structured finance offerings to the general public? If so, what standards should we impose that could distinguish structured finance vehicles from investment companies for those investors? For example, should we permit offerings to the general public if a sponsor or trustee conducts an independent statistical analysis of the anticipated cash flows? Are we correct in our assumption that dropping the rating requirement from the rule will not blur the current distinction between structured finance vehicles and investment companies? If not, should the rule incorporate alternatives to the rule's rating requirement that would clarify the distinction? For example, should the rule contain specific requirements regarding abuses that the Act is designed to address, such as self-dealing and overreaching by the issuer? Does our proposal regarding the deposit of cash flows into a segregated account provide sufficient protection against the possibility of loss while the servicer is handling cash flows pending payment to the fixed income security holders? Would an alternative standard provide better protection? C. Rule 5b-3 Rule 5b-3 under the Investment Company Act permits a fund, subject to certain conditions, to treat a repurchase agreement as an acquisition of the securities collateralizing the repurchase agreement in determining whether the fund is in compliance with two provisions of the Act that may affect a fund's ability to invest in repurchase agreements.\48\ Section 12(d)(3) of the Investment Company Act generally prohibits a fund from acquiring an interest in a broker, dealer, or underwriter. Because a repurchase agreement may be considered to be the acquisition of an interest in the counterparty, section 12(d)(3) may limit a fund's ability to enter into repurchase agreements with many of the firms that act as repurchase agreement counterparties. Section 5(b)(1) of the Act limits the amount that a fund that holds itself out as being a diversified investment company may invest in the securities of any one issuer (other than the U.S. Government). This provision may limit the number and principal amounts of repurchase agreements a diversified fund may enter into with any one counterparty. --------------------------------------------------------------------------- \48\ In a typical investment company repurchase agreement, a fund enters into a contract with a broker, dealer, or bank (the ``counterparty'' to the transaction) for the purchase of securities. The counterparty agrees to repurchase the securities at a specified future date, or on demand, for a price that is sufficient to return to the fund its original purchase price, plus an additional amount representing the return on the fund's investment. Repurchase agreements provide funds with a convenient means to invest excess cash on a secured basis, generally for short periods of time. Economically, a repurchase agreement functions as a loan from the fund to the counterparty, in which the securities purchased by the fund serve as collateral for the loan and are placed in the possession or under the control of the fund's custodian during the term of the agreement. See Treatment of Repurchase Agreements and Refunded Securities as an Acquisition of the Underlying Securities, Investment Company Act Release No. 25058 (July 5, 2001) [66 FR 36156 (July 11, 2001)] (``Rule 5b-3 Adopting Release''). --------------------------------------------------------------------------- Rule 5b-3 allows funds to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of sections 5(b)(1) and 12(d)(3) of the Act if the obligation of the seller to repurchase the securities from the fund is ``collateralized fully.'' \49\ A repurchase agreement is collateralized fully if, among other things, the collateral for the repurchase agreement consists entirely of (i) cash items, (ii) government securities, (iii) securities that at the time the repurchase agreement is entered into are rated in the highest rating category by the ``Requisite NRSROs'' or (iv) unrated securities that are of a comparable quality to securities that are rated in the highest rating category by the Requisite NRSROs, as determined by the fund's board of directors or its delegate.\50\ --------------------------------------------------------------------------- \49\ Rule 5b-3(a). The term ``Collateralized Fully'' is defined in rule 5b-3(c)(1). An investment company investing in a repurchase agreement primarily looks to the value and liquidity of the securities collateralizing the repurchase agreement rather than the credit quality of the counterparty for satisfaction of the repurchase agreement. \50\ Rule 5b-3(c)(1)(iv). The term ``Requisite NRSROs'' means any two NRSROs that have issued a rating with respect to a security or class of debt obligations of an issuer or, if only one NRSRO has issued a rating with respect to such security or class of debt obligations of an issuer at the time the investment company acquires the security, that NRSRO. Rule 5b-3(c)(6). The term ``unrated securities'' means securities that have not received a rating from the Requisite NRSROs. Rule 5b-3(c)(8). --------------------------------------------------------------------------- In proposing rule 5b-3, the Commission explained that the highest rating category requirement in the definition of collateralized fully was designed to ensure that the market value of the collateral would remain fairly stable and that the fund could more readily liquidate the collateral quickly in the event of a default.\51\ --------------------------------------------------------------------------- \51\ See Treatment of Repurchase Agreements and Refunded Securities as an Acquisition of the Underlying Securities, Investment Company Act Release No. 24050 (Sept. 23, 1999) [64 FR 52476 (Sept. 29, 1999)] (``Rule 5b-3 Proposing Release''), at n.43 and accompanying text. --------------------------------------------------------------------------- We propose to eliminate the requirement that collateral other than cash or government securities be rated by an NRSRO. As an alternative, we propose to require that if the collateral is not cash or government securities, the fund's board of directors (or its delegate) [[Page 40129]] determines that the collateral securities present minimum credit risks and are highly liquid. Specifically, the proposal would require collateral other than cash or government securities to consist of securities that the fund's board of directors (or its delegate) determines at the time the repurchase agreement is entered into (i) are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time, (ii) are subject to no greater than minimal credit risk, and (iii) are issued by a person that has the highest capacity to meet its financial obligations.\52\ Although the rule would no longer require the collateral to be rated by an NRSRO, we anticipate that evaluating credit risk and liquidity of the collateral could incorporate ratings, reports, analyses, and other assessments issued by NRSROs and other persons.\53\ --------------------------------------------------------------------------- \52\ Proposed rule 5b-3(c)(1)(iv)(C). Under the proposal, the board would make credit quality determinations for all non- government collateral securities, rather than just unrated securities. As in the current rule, the proposed rule would permit the board to delegate this credit quality and liquidity determination. \53\ A fund that acquires repurchase agreements would have to adopt and implement a written policy reasonably designed to comply with this requirement under rule 38a-1 under the Investment Company Act. See rule 38a-1(a) (requiring registered funds to adopt and implement written policies and procedures reasonably designed to prevent the fund's violation of federal securities laws). --------------------------------------------------------------------------- NRSRO ratings are also used in a provision of rule 5b-3 that permits a fund to deem the acquisition of a ``refunded security'' as the acquisition of the escrowed government securities for purposes of section 5(b)(1)'s diversification requirements.\54\ Under this provision, a debt security must satisfy certain conditions to be considered a refunded security under the rule. One of these conditions is that an independent certified public accountant must have certified to the escrow agent that the escrowed securities will satisfy all scheduled payments of principal, interest, and applicable premiums on the refunded securities.\55\ This condition is not required, however, if the refunded security has received a debt rating in the highest rating category from an NRSRO.\56\ --------------------------------------------------------------------------- \54\ Rule 5b-3(b). Under the rule, a refunded security means a debt security the principal and interest payments of which are to be paid by U.S. government securities that have been irrevocably placed in an escrow account and are pledged only to the payment of the debt security. Rule 5b-3(c)(4). \55\ Rule 5b-3(c)(4)(iii). \56\ Id. --------------------------------------------------------------------------- We are proposing to eliminate the exception to the certification requirement for securities that have received the highest rating from an NRSRO. Rule 5b-3 requires the certification by an independent certified public accountant (together with the other conditions) to ensure that the bankruptcy of the issuer of the pre-refunded securities would not affect payments on the securities from the escrow account.\57\ The Commission included this exception because in rating refunded securities, NRSROs typically require that an independent third party make the same determination.\58\ --------------------------------------------------------------------------- \57\ See Rule 5b-3 Adopting Release, supra note 48, at text accompanying n.25 (explaining that the conditions required in the definition of refunded security correspond to those in the definition of the term in rule 2a-7); Rule 2a-7 1986 Amending Release, supra note 31, at section II.D.2. \58\ See Technical Revisions to the Rules and Forms Regulating Money Market Funds, Investment Company Act Release No. 22921 (Dec. 2, 1997) [62 FR 64968 (Dec. 9, 1997)], at section I.B.2.c. --------------------------------------------------------------------------- We request comment on the proposed amendments. How would the proposed elimination of the rating requirement from the definition of ``collateralized fully'' affect funds? Would the proposed board determinations sufficiently address our concerns that collateral securities be of high quality in order to limit a fund's exposure to counterparties' credit risks? If not, are there additional or alternative standards that would better address our concerns? How would the proposal to eliminate the exception for rated securities from the condition that refunded securities obtain a certification from an independent auditor affect funds? We expect that with respect to rated refunded securities, funds may be able to satisfy the certification requirement by determining that an NRSRO required an independent certified public accountant to make the same determination.\59\ Would funds incur any costs in determining that a refunded security has received an accountant certification rather than relying on an NRSRO rating? Is there an alternative standard that would provide an equivalent evaluation? For example, should we permit the board to rely on another independent third party to provide the certification? --------------------------------------------------------------------------- \59\ See, e.g., Standard & Poor's, Public Finance Criteria: Defeasance: Legal Defeasance Criteria, Cash Flow Verification (Sept. 8, 2006). --------------------------------------------------------------------------- D. Rule 10f-3 Section 10(f) of the Investment Company Act prohibits a registered investment company from purchasing any security for which an affiliated underwriter is acting as a principal underwriter \60\ during the existence of an underwriting or selling syndicate for that security.\61\ The prohibition was intended to address Congress's concern that underwriters were ``dumping'' otherwise unmarketable securities on affiliated funds, either by forcing the fund to purchase unmarketable securities from the underwriting affiliate itself, or by forcing or encouraging the fund to purchase the securities from another member of the syndicate.\62\ Congress also expressed concern regarding the amount of underwriting fees earned by the sponsors and affiliated persons who placed the securities with the fund.\63\ --------------------------------------------------------------------------- \60\ The term ``principal underwriter'' means (in relevant part) an underwriter who, in connection with a primary distribution for securities: (i) Is in privity of contract with the issuer or an affiliated person of the issuer; (ii) acting alone or in concert with one or more other persons, initiates or directs the formation of an underwriting syndicate; or (iii) is allowed a rate of gross commission, spread, or other profit greater than the rate allowed another underwriter participating in the distribution. 15 U.S.C. 80a-2a(a)(29). \61\ Section 10(f) prohibits a fund from purchasing a security during the existence of an underwriting or selling syndicate if a principal underwriter of the security is an officer, director, member of an advisory board, investment adviser, or employee of the fund or is a person of which any such officer, director, member of an advisory board, investment adviser, or employee is an affiliated person. An affiliated person of a fund includes, among others: (i) Any person directly or indirectly owning, controlling, or holding with power to vote, five percent or more of the outstanding voting securities of the fund; (ii) any person five percent or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote by the fund; and (iii) any person directly or indirectly controlling, controlled by, or under common control with such other person. 15 U.S.C. 80a- 2(a)(3)(A), (B) and (C). \62\ See Report of the SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 279, 76th Cong., 2d Sess., pt. 3, at 2581, 2589 (1939). The sales were also used to alleviate certain of an affiliated underwriter's financial difficulties. For example, an underwriter could benefit by rapidly turning over its securities inventory to produce working capital and to reduce the related expenses of carrying the inventory. \63\ See Hearings on S.3580 Before a Subcommittee of the Commission on Banking and Currency, 76th Cong., 3d Sess. 209, 212-23 (1940). --------------------------------------------------------------------------- The Commission adopted rule 10f-3 in 1958 to permit a fund that is affiliated with members of an underwriting syndicate to purchase securities from the syndicate if certain conditions are met.\64 \We amended rule 10f-3 in 1979 to add municipal securities to the class of securities that funds could purchase under the rule.\65\ The rule defines [[Page 40130]] municipal securities that may be purchased during an underwriting in reliance on the rule (``eligible municipal securities'') to include securities that have an investment grade rating from at least one NRSRO or, if the issuer or the entity supplying the revenues or other payments from which the issue is to be paid has been in continuous operation for less than three years (i.e., a less seasoned security), one of the three highest ratings from an NRSRO.\66\ The Commission explained that the rationale behind the rating requirement was to prevent the purchase of less seasoned securities and reduce the risk of unloading unmarketable securities on the fund.\67\ --------------------------------------------------------------------------- \64\ Adoption of Rule N-10-F-3 Permitting Acquisition of Securities of Underwriting Syndicate Pursuant to Section 10(f) of the Investment Company Act of 1940, Release No. 2797 (Dec. 2, 1958) [23 FR 9548 (Dec. 10, 1958)]. The rule codified the conditions of orders that the Commission had granted prior to 1958 exempting certain funds from section 10(f) to permit them to purchase specific securities. \65\ Exemption of Acquisition of Securities During the Existence of Underwriting Syndicate, Investment Company Act Release No. 10736 (June 14, 1979) [44 FR 36152 (June 20, 1979)] (``Rule 10f-3 1979 Adopting Release''). Rule 10f-3(c)(1)(iii). \66\ Rule 10f-3(a)(3). \67\ Exemption of Acquisition of Securities During the Existence of Underwriting Syndicate, Investment Company Act Release No. 10592 (Feb. 13, 1979) [44 FR 10580 (Feb. 21, 1979)] (``1979 10f-3 Amendments Proposing Release''). --------------------------------------------------------------------------- We propose to eliminate the references to ratings in rule 10f-3, and amend the rule's definition of ``eligible municipal security'' to mean securities that are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time. In addition, the securities would have to be either: (i) Subject to no greater than moderate credit risk; or (ii) if they are less seasoned securities, subject to a minimal or low amount of credit risk.\68\ --------------------------------------------------------------------------- \68\ Proposed rule 10f-3(a)(3). The proposed rule would define ``eligible municipal securities'' to mean ``'municipal securities'' as defined in section 3(a)(29) of the Securities Exchange Act of 1934, that have sufficient liquidity such that they can be sold at or near their carrying value within a reasonably short period of time and either (i) are subject to no greater than moderate credit risk or (ii) if the issuer of the municipal securities, or the entity supplying the revenues or other payments from which the issue is to be paid, has been in continuous operation for less than three years, including the operation of any predecessors, the securities are subject to a minimal or low amount of credit risk.'' --------------------------------------------------------------------------- Unlike our proposals to amend other rules, we are not proposing to add a requirement that the board of directors make the determination regarding credit risk and liquidity. Rule 10f-3 already requires a fund's directors, including a majority of disinterested directors, to approve procedures regarding purchases made in reliance on the rule and to determine each quarter that all purchases were made in compliance with the procedures.\69\ Accordingly, the board, including a majority of disinterested directors, already is required to review purchases of municipal securities made in reliance on the rule, and would continue to do so under our proposal. In addition, pursuant to its oversight role, the board would be required to approve procedures for ensuring that municipal securities meet the proposed conditions for credit quality and liquidity. Although the rule would no longer require municipal securities to be rated by an NRSRO, fund boards of directors would still be able to incorporate quality determinations prepared by outside sources, including ratings, reports, analyses, and other assessments issued by NRSROs and other persons, in their approval of procedures and in their review of transactions under the rule. --------------------------------------------------------------------------- \69\ Rule 10f-3(c)(10). The Commission added the requirement that disinterested directors adopt procedures made in reliance on the rule and periodically review the fund's compliance with these procedures in 1979. See Rule 10f-3 1979 Adopting Release, supra note 65. At the time, we stressed that in determining specific procedures to be included in the guidelines for transactions in reliance on the rule, the board should be aware generally of the nature of any affiliation that the investment company (or any of its officers, directors, employees or adviser) may have with underwriters and any role the affiliate person would play in mounting the underwriting of a particular issue. See 1979 10f-3 Amendments Proposing Release, supra note 67, at text preceding n.23. Our proposal would not affect this existing requirement with respect to the purchase of municipal securities. --------------------------------------------------------------------------- We request comment on the proposed amendment to rule 10f-3. What would be the effect of eliminating the rating requirement in the definition of ``eligible municipal securities''? Is the proposed standard that municipal securities purchased in reliance on rule 10f-3 present no more than moderate credit risks and are highly liquid sufficient to limit the possibility underwriters may sell unmarketable securities to the fund? Is there an alternative that would better address our regulatory concerns? E. Rule 206(3)-3T Rule 206(3)-3T under the Investment Advisers Act of 1940 establishes a temporary alternative means for investment advisers who are registered with the Commission as broker-dealers to meet the requirements of section 206(3) of the Advisers Act when they act in a principal capacity in transactions with certain of their advisory clients.\70\ That section makes it unlawful for any investment adviser, directly or indirectly ``acting as principal for his own account, knowingly to sell any security to or purchase any security from a client * * *, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.'' \71\ Rule 206(3)-3T contains several conditions that are designed to prevent overreaching by advisers by requiring an adviser to disclose to its client the conflicts of interest involved in principal transactions, inform the client of the circumstances in which the adviser may effect a trade on a principal basis, and provide the client with meaningful opportunities to refuse to consent to a particular transaction or revoke the prospective general consent to these transactions.\72\ --------------------------------------------------------------------------- \70\ Rule 206(3)-3T [17 CFR 275.206(3)-3T]. See also Temporary Rule Regarding Principal Trades with Certain Advisory Clients, Investment Advisers Act Release No. 2653 (Sept. 24, 2007) [72 FR 55022 (Sept. 28, 2007)] (``Principal Trade Rule Release''). \71\ 15 U.S.C. 80b-6(3). \72\ See Principal Trade Rule Release, supra note 70, at text accompanying n.28. --------------------------------------------------------------------------- An adviser generally may not rely on the rule for principal trades of securities if the investment adviser or a person who controls, is controlled by, or is under common control with the adviser (``control person'') is the issuer or is an underwriter of the security.\73\ As we stated when we adopted the rule, the incentives associated with underwriting securities may bias the advice being provided or lead the adviser to exert undue influence on its client's decision to invest in the offering or the terms of that investment.\74\ The rule contains an exception to this ``underwritten securities'' exclusion for trades in which the adviser or a control person is an underwriter of non- convertible investment-grade debt securities.\75\ We provided this exception because non-convertible investment grade debt securities may be less risky and therefore less likely to be ``dumped'' on clients.\76\ The rule defines an ``investment grade debt security'' as a non-convertible debt security that, at the time of sale, is rated in one of the four highest rating categories of at least two NRSROs.\77\ --------------------------------------------------------------------------- \73\ Rule 206(3)-3T(a)(2). \74\ Principal Trade Rule Release, supra note 70, at n.35 and accompanying and following text. \75\ Id. at text accompanying n.36. There is no exception if the adviser or a control person is the issuer of the securities. \76\ Id. at text following n.36. We also noted in the Principal Trade Rule Release that it may be easier for clients to identify whether the price they are being quoted for a non-convertible investment grade debt security is fair given the relative comparability, and the significant size, of the non-convertible investment grade debt markets. Id. \77\ Rule 206(3)-3T(c). --------------------------------------------------------------------------- We propose to amend rule 206(3)-3(T), to eliminate an adviser's ability to rely exclusively on NRSRO ratings to determine whether a security is investment grade for purposes of the rule. Instead, the adviser would have to make its own assessment taking into account specified criteria, including that the security: (i) Has no greater than [[Page 40131]] moderate credit risk; and (ii) is sufficiently liquid that it can be sold at or near its carrying value within a reasonably short period of time.\78\ --------------------------------------------------------------------------- \78\ Proposed rule 206(3)-3T(c). Although the proposed amendment would no longer require a security underwritten by an adviser or its control person to be rated by NRSROs to be eligible under the rule, investment advisers could refer to ratings, reports, analyses, and other assessments issued by NRSROs and other persons, for the purpose of evaluating credit risk and liquidity. --------------------------------------------------------------------------- Finally, as we stated when we adopted rule 206(3)-3T, an adviser subject to rule 206(4)-7 of the Advisers Act must adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act (and the rules thereunder) by the adviser or any of its supervised persons.\79\ An adviser seeking to rely on rule 206(3)-3T, therefore, would have to adopt and implement policies and procedures that address the adviser's methodology for determining whether a security is investment grade quality. --------------------------------------------------------------------------- \79\ Principal Trade Rule Release, supra note 70, at nn.56-58 and accompanying text. In that connection, an adviser seeking to rely on rule 206(3)-3T, as proposed to be amended, would need to adopt and implement policies and procedures reasonably designed to ensure that the adviser's methodology for determining investment grade quality is consistent with the adviser's legal obligations. --------------------------------------------------------------------------- We request comment on our proposed revised definition of ``investment grade debt security.'' Is it appropriate for us to allow advisers seeking to rely upon the rule to determine whether a security is investment grade based on the criteria in the rule? Is there another definition of ``investment grade'' elsewhere in the federal securities laws that we should incorporate by reference into the rule? Are there alternative methods to ensure that advisers seeking to rely on the exception to the underwriting exclusion do so only with respect to investment grade debt? Are there alternative or additional factors we should require an adviser to consider in making its determination? In addition, we expect that advisers, in order to establish their eligibility to rely on the rule, would document their determination that a security is investment grade quality, as well as the process for making such a determination. Are we correct? Should we make such documentation an explicit requirement of the rule, or amend rule 204-2 under the Advisers Act \80\ (the books and records rule) to require such documentation? --------------------------------------------------------------------------- \80\ 17 CFR 275.204-2. --------------------------------------------------------------------------- IV. Request for Comment We request comment on the rule amendments proposed in this release. We also request suggestions for additional changes to existing rules, and comments on other matters that might have an effect on the proposals contained in this release. Commenters are requested to provide empirical data to support their views. V. Paperwork Reduction Act Certain provisions of the proposed amendments to rules 2a-7, 3a-7, 5b-3, and 10f-3 under the Investment Company Act, and rule 206(3)-(3)T under the Investment Advisers Act, contain ``collection of information'' requirements within the meaning of the Paperwork Reduction Act of 1995 (``PRA'').\81\ The Commission is submitting this proposal to the Office of Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The titles for the collections of information are: ``Rule 2a-7 under the Investment Company Act of 1940, Money market funds'' (OMB Control No. 3235-0268); ``Rule 10f-3 under the Investment Company Act of 1940, Exemption for the Acquisition of Securities During the Existence of an Underwriting and Selling Syndicate'' (OMB Control No. 3235-0226); and ``Temporary rule for principal trades with certain advisory clients, rule 206(3)- 3T'' (OMB Control No. 3235-0630). There are currently no approved collections for rules 3a-7 and 5b-3, and the proposed amendments would not create any new collections. We adopted the rules pursuant to the Investment Company Act and the Investment Advisers Act. --------------------------------------------------------------------------- \81\ 44 U.S.C. 3501-3520. --------------------------------------------------------------------------- Our proposed amendments are designed to address the risk that the reference to and required use of NRSRO ratings in our rules: Is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs; and Encourages investors to place undue reliance on NRSRO ratings. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number. A. Rule 2a-7 Rule 2a-7 under the Investment Company Act exempts money market funds from the Act's valuation requirements, permitting money market funds to maintain stable share pricing, subject to certain risk- limiting conditions. We propose to amend rule 2a-7 in four principal ways to: (i) Rely on money market fund boards of directors (who usually rely on the funds' advisers) to determine that each portfolio instrument presents minimal credit risks, and whether the security is a ``First Tier Security'' or a ``Second Tier Security;'' (ii) add a portfolio liquidity requirement to the rule that would require that money market funds hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions, and expressly limit their investment in illiquid securities to not more than 10% of their total assets; (iii) in the event the money market fund's investment adviser becomes aware of any new information about a portfolio security (or an issuer of a portfolio security) that may suggest that the security may not continue to present minimal credit risks, the proposal would amend rule 2a-7's downgrade and default provisions to require a money market fund's board of directors to reassess promptly whether the portfolio security continues to present minimal credit risks; and (iv) require a money market fund to notify the Commission of the purchase of a money market fund's portfolio security by an affiliated person in reliance on rule 17a-9 under the Investment Company Act.\82\ The proposed amendments also would make conforming amendments to rule 2a- 7's record keeping and reporting requirements.\83\ --------------------------------------------------------------------------- \82\ See rule 17a-9. \83\ See proposed rule 2a-7(c)(11). --------------------------------------------------------------------------- The proposed amendments to rule 2a-7 would impose a new reporting obligation on money market funds. The proposed reporting requirement to notify the Commission of the purchase of a money market fund's portfolio securities by an affiliated person in reliance on rule 17a-9 under the Investment Company Act is designed to assist Commission staff in overseeing money market funds' affiliated transactions that are otherwise prohibited. If adopted, the new collection of information would be mandatory for money market funds. Information submitted to the Commission related to a rule 17a-9 transaction would be accorded confidential treatment to the extent permitted by law.\84\ --------------------------------------------------------------------------- \84\ See, e.g., 17 CFR 200.83. --------------------------------------------------------------------------- Commission staff estimates that there are 808 money market funds, all of whom are subject to rule 2a-7.\85\ Of these money market funds, Commission staff estimates that an average of 10 funds per year would be required to provide notice to the Commission of a rule 17a-9 transaction, with the total [[Page 40132]] annual responses per fund, on average, requiring .5 hours of an attorney's time at a cost of $147.50.\86\ Given these estimates, we estimate that the total annual burden of the proposed amendments to rule 2a-7 for all money market funds would be approximately 5 hours and $1,475.\87\ --------------------------------------------------------------------------- \85\ These include registered money market funds and series of registered money market funds. See Investment Company Institute, Trends in Mutual Fund Investing April 2008, May 29, 2008. Available at http://www.ici.org/stats/latest/trends_04_08.html. \86\ Based on information provided by money market fund representatives, Commission staff estimates the cost would equal 0.5 hours of an attorney's time at $295 per hour (0.5 hours x $295 per hour = $147.50). The estimated hourly wages used in this PRA analysis were derived from reports prepared by the Securities Industry and Financial Markets Association. See Securities Industry and Financial Markets Association, Report on Management and Professional Earnings in the Securities Industry--2007 (2007), modified to account for an 1800-hour work year and multiplied by 5.35 to account for bonuses, firm size, employee benefits and overhead; and Securities Industry and Financial Markets Association, Office Salaries in the Securities Industry--2007 (2007), modified to account for an 1800-hour work year and multiplied by 2.93 to account for bonuses, firm size, employee benefits and overhead. \87\ These estimates are based on the following calculations: (10 money market funds x .5 hours) = 5 hours; (10 money market funds x 147.50) = $1,475. --------------------------------------------------------------------------- We seek comment on these estimates. If commenters believe these estimates are not reasonable, we request they provide data that would allow us to make more accurate estimates. B. Rule 3a-7 Rule 3a-7 under the Investment Company Act excludes structured finance vehicles from the Act's definition of ``investment company'' subject to certain conditions. The conditions include the requirement that structured financings offered to the general public are rated by at least one NRSRO in one of the four highest rating categories. The proposed amendments would: (i) Eliminate rule 3a-7's reliance on ratings by eliminating the exclusion for structured financings offered to the general public; (ii) remove the reference to ratings downgrades in the section of the rule that addresses substitution of eligible assets; and (iii) amend the portion of the rule that deals with safekeeping of assets. Commission staff estimates that the proposal may result in a new collection of information but any collection of information would not have an associated burden. Although in the condition in rule 3a-7 dealing with the substitution of assets, the proposed amendments would require the issuer to have procedures to ensure that the acquisition or disposition of assets does not adversely affect the full and timely payment of the outstanding fixed income securities, Commission staff believes that almost all issuers currently have these procedures in place. We request comment on whether issuers currently have these procedures in place. C. Rule 5b-3 Rule 5b-3 under the Investment Company Act allows funds to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of sections 5(b)(1) and 12(d)(3) of the Investment Company Act under certain conditions. We propose to amend rule 5b-3 by requiring a fund's board of directors, or its delegate, to determine that the securities collateralizing a repurchase agreement present minimum credit risks and are highly liquid.\88\ To that end, the fund's board of directors, pursuant to rule 38a-1 under the Investment Company Act, would have to develop procedures to ensure that at the time the repurchase agreement is entered into the securities meet the requirements for collateral outlined in the amendments to the proposed rule. These procedures are necessary to make sure that the market value of the collateral remains fairly stable and that the fund would be able to liquidate the collateral quickly in the event of a default.\89\ This collection of information would be mandatory for funds that rely on rule 5b-3. Records of information made in connection with this requirement would be required to be maintained for inspection by Commission staff, but the collection would not otherwise be submitted to the Commission. --------------------------------------------------------------------------- \88\ Proposed rule 5b-3(c)(1)(iv)(C). \89\ See Rule 5b-3 Proposing Release, supra note 51, at text accompanying n.43. --------------------------------------------------------------------------- The existing rule provides that unrated securities are collateral if the fund's board, or its delegate, makes the determination that the unrated securities are comparable to securities that are rated in the highest rating category by the Requisite NRSROs.\90\ Thus, fund boards may have existing procedures regarding credit quality determinations for unrated securities. In addition, as a matter of good business practice, we believe that some funds currently evaluate the credit risk and liquidity of rated securities. Thus, we believe that most funds already have procedures to evaluate collateral securities. As of March 31, 2008, 4,714 investment companies were registered with the Commission. Commission staff estimates that 90% of all registered investment companies, or 4,243 funds, currently have procedures for evaluating collateral securities. Commission staff therefore estimates that 471 funds would need to develop procedures and evaluate collateral securities, and the staff estimates this would involve a one-time burden of 942 hours and an ongoing burden of 5,652 hours, at a cost of approximately $1,294,308.\91\ --------------------------------------------------------------------------- \90\ Rule 5b-3(c)(1)(iv)(D). \91\ Commission staff estimates that each fund board would incur a one-time burden of 2 hours to develop procedures for evaluating credit and liquidity risks (471 boards x 2 hours = 942 hours). Commission staff believes that any incidental costs incurred by boards of directors would be incorporated into funds' overall board costs and would not add any particular costs. In addition, staff estimates that a board delegate would spend an average of 1 hour to evaluate the credit risks for the collateral for each of an average of 12 repurchase agreements each year (471 funds x 12 hours = 5,652 hours). Assuming the evaluation would be performed by a senior business analyst (at $229 per hour), the total cost estimate would be $1,294,308. --------------------------------------------------------------------------- We seek comment on these estimates. If commenters believe these estimates are not reasonable, we request they provide data that would allow us to make more accurate estimates. D. Rule 10f-3 Rule 10f-3, permits funds that are affiliated with members of an underwriting syndicate to purchase securities from the syndicate if certain conditions are met. We are proposing to amend the rule's definition of ``eligible municipal securities'' to include credit quality and liquidity requirements. Under the current rule, fund boards are required to approve procedures regarding purchases made in reliance on the rule and to determine each quarter that all purchases were made in compliance with the procedures.\92\ Accordingly, the board currently reviews purchases of municipal securities made in reliance on the rule, and would continue to do so under our proposal. Pursuant to the amendments to the proposed rule, fund boards would need to approve additional procedures for ensuring that municipal securities meet the standards for credit quality and liquidity. These procedures are necessary to eliminate any possibility that an affiliated underwriter may ``unload'' otherwise unmarketable securities on a fund. This collection of information would be mandatory for funds that rely on rule 10f-3. Records of information made in connection with this requirement would be required to be maintained for inspection by Commission staff, but the collection would not otherwise be submitted to the Commission. --------------------------------------------------------------------------- \92\ Rule 10f-3(c)(10). --------------------------------------------------------------------------- In our most recent PRA submission, we estimated that approximately 350 funds engage in rule 10f-3 transactions each year. We further estimated that each fund would, on average, take two [[Page 40133]] hours to review and revise, as needed, written procedures for rule 10f- 3 transactions. We believe that any revisions funds would have to make to comply with the proposed amendments would be incorporated in the two hours of review. Accordingly, we do not believe that the proposed amendments to rule 10f-3 would change the burdens currently approved for rule 10f-3. We seek comment on these estimates. If commenters believe these estimates are not reasonable, we request they provide data that would allow us to make more accurate estimates. E. Rule 206(3)-3T Rule 206(3)-3T under the Advisers Act establishes a temporary alternative means for investment advisers who are registered with the Commission as broker-dealers to meet the requirements of section 206(3) of the Advisers Act when they act in a principal capacity in transactions with certain of their advisory clients. So long as each condition of the rule is met, an eligible adviser may provide the transaction-by-transaction disclosure required under section 206(3) of the Advisers Act either orally or in writing. One condition of the rule is that an adviser generally may not rely on rule 206(3)-3T for principal trades of securities if the investment adviser or a person who controls, is controlled by, or is under common control with the adviser (``control person'') is the issuer or is an underwriter of the security. The rule contains an exception to this ``underwritten securities'' exclusion for trades in which the adviser or a control person is an underwriter of non-convertible investment-grade debt securities. The proposed amendment to rule 206(3)-3T would modify the definition of ``investment grade debt security'' to mean a non- convertible debt security that, at the time of sale, the investment adviser has determined to be subject to no greater than moderate credit risk and sufficiently liquid that it can be sold at or near its carrying value within a reasonably short period of time. Under the proposed amendment to rule 206(3)-3T, there is a single new collection burden. Pursuant to its obligations under rule 206(4)-7 under the Advisers Act, an adviser seeking to rely on rule 206(3)-3T must adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act that address the adviser's methodology for determining whether a security is investment grade quality pursuant to the definition. This collection of information is designed to minimize the incentives associated with underwriting securities that may bias the advice being provided or may lead the adviser to exert undue influence on its client's decision to invest in the offering or the terms of that investment. Although the rule does not call for any of the information collected to be provided to us, to the extent advisers include any of the information in a filing, such as Form ADV, the information would not be kept confidential. We anticipate that the burden associated with this collection would mostly be borne upfront as advisers develop their policies and procedures for how to identify non-convertible investment grade debt securities in connection with the credit risk and liquidity elements specified under the rule. This would require drafting the policies and procedures, potentially subjecting them to review of outside counsel, implementing them, and explaining their contours in the adviser's Form ADV. We estimate that the average burden for drafting the required policies and procedures for each eligible adviser that chooses to rely on the rule in connection with underwritten securities in particular, would be approximately 10 hours on average. Further, we expect the drafting burden would be uniform with respect to each eligible adviser regardless of how many individual non-discretionary advisory accounts that adviser administers or seeks to engage with in principal trading. As of June 1, 2008, there were 639 advisers that were eligible to rely on the temporary rule (i.e., also registered as broker-dealers), 409 of which indicate that they have non-discretionary advisory accounts.\93\ We estimate that 90% of those 409 advisers, or a total of 368 of those advisers, rely on the rule.\94\ Of those, we estimate that only 50% would seek to engage in principal trades with clients of securities they or a control person underwrote. Thus, we estimate that the total number of advisers who would rely on the non-convertible investment grade debt exception to the ``underwritten securities'' exclusion under the rule would be approximately 185. --------------------------------------------------------------------------- \93\ IARD data as of June 1, 2008, for Items 6.A(1) and 5.F(2)(e) of Part 1A of Form ADV. \94\ We anticipate that most investment advisers that are dually registered as broker-dealers will make use of the rule to engage in, at a minimum, riskless principal transactions to limit the need for these advisers to process trades for their advisory clients with other broker-dealers. We estimate that 10% of these advisers will determine that the costs involved to comply with the rule are too significant in relation to the benefits that the adviser, and their clients, will enjoy. --------------------------------------------------------------------------- Accordingly, we estimate that the total burden for creating initial policies and procedures under the proposal for the estimated 185 advisers that would rely on the rule would be 1,850 hours.\95\ We also estimate an average one-time cost for the preparation of the policies and procedures for approximately three hours of outside legal counsel time of $1,200 per eligible adviser on average,\96\ for a total of $222,000.\97\ --------------------------------------------------------------------------- \95\ This estimate is based on the following calculation: 10 hours per adviser x 185 eligible advisers that will rely on the rule = 1,850 total hours. \96\ Outside legal fees are in addition to the projected 10 hours per adviser burden discussed in note 95 and accompanying text. \97\ This estimate is based on the following calculation: ($400 per hour x 3 hours x 185 advisers = $222,000). --------------------------------------------------------------------------- F. Request for Comments We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (i) Evaluate whether the proposed collections of information are necessary for the proper performance of the functions of the Commission, including whether the information would have practical utility; (ii) evaluate the accuracy of the Commission's estimate of the burden of the proposed collections of information; (iii) determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (iv) determine whether there are ways to minimize the burden of the collections of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. Persons wishing to submit comments on the collection of information requirements of the proposed amendments should direct them to the Office of Management and Budget, Attention Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Room 10102, New Executive Office Building, Washington, DC 20503, and should send a copy to Florence E. Harmon, Acting Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090, with reference to File No. S7-19-08. OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this Release; therefore a comment to OMB is best assured of having its full effect if OMB receives it within 30 days after publication of this Release. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in [[Page 40134]] writing, refer to File No. S7-19-08, and be submitted to the Securities and Exchange Commission, Public Records Management Office Room, 100 F Street, NE., Washington, DC 20549-1110. VI. Cost-Benefit Analysis The Commission is sensitive to the costs and benefits imposed by its rules. We have identified certain costs and benefits of the proposed amendments and request comment on all aspects of this cost- benefit analysis, including identification and assessment of any costs and benefits not discussed in this analysis. We seek comment and data on the value of the benefits identified. We also welcome comments on the accuracy of the cost estimates in each section of this analysis, and request that commenters provide data that may be relevant to these cost estimates. In addition, we seek estimates and views regarding these costs and benefits for particular covered institutions, including small institutions, as well as any other costs or benefits that may result from the adoption of these proposed amendments. As discussed above, the proposed rule amendments are designed to address the risk that the reference to and use of NRSRO ratings in our rules is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs, and may encourage investors to place undue reliance on the NRSRO ratings. The proposed amendments to rules 2a-7, 3a-7, 5b-3, and 10f-3 under the Investment Company Act and rule 206(3)-(3)T under the Investment Advisers Act would eliminate the reference to and requirement for the use of NRSRO ratings in these rules. A. Benefits The Commission anticipates that one of the primary benefits of the proposed amendments, if adopted, would be the benefit to investors of reducing their possible undue reliance on NRSRO ratings that could be caused by references to NRSROs in our rules. An over-reliance on ratings can inhibit independent analysis and could possibly lead to investment decisions that are based on incomplete information. The purpose of the proposed rule amendments is to encourage investors to examine more than a single source of information in making an investment decision. Eliminating reliance on ratings in the Commission's rules could also result in greater investor due diligence and investment analysis. In addition, the Commission believes that eliminating the reliance on ratings in its rules would remove any appearance that the Commission has placed its imprimatur on certain ratings. More specifically, the principal benefit of the proposed amendments to rule 2a-7 would be to emphasize the importance of money market funds making independent assessments of credit risks. The benefit of the proposed amendments to rule 3a-7 would be to emphasize that ratings are not necessary for accredited investors and qualified institutional buyers to protect themselves in evaluating structured finance vehicles issued under the rule. Similarly, the benefit of the proposed amendments to rules 5b-3 and 10f-3 would be to emphasize the importance to funds that acquire repurchase agreements or securities in an affiliated underwriting of making an independent evaluation of the credit risks associated with the collateral or the underwritten security, respectively. In addition, by moving away from a required reliance on credit ratings in our rules, funds may benefit by acquiring a wider range of securities that present attractive investment opportunities and the requisite level of credit risks, although they do not meet the current rules' ratings requirements. The principal benefit of the proposed amendment to rule 206(3)-3T would be to allow advisers to consider factors other than only a rating by NRSROs of the credit quality of a debt security for purposes of eligibility of the rule. Advisers would determine, based upon established criteria of whether the security presents no more than moderate credit risk and has sufficient liquidity, whether a security is investment grade for purposes of the rule. Investment advisers could, in addition to considering NRSRO ratings, weigh various factors and consider a security's credit quality based on those qualitative and quantitative elements it deems most relevant. An additional benefit of the proposed amendment would be that non-discretionary advisory clients of advisers also registered with us as broker-dealers may have easier access to a wider range of securities. This, in turn, would increase liquidity in the markets for these securities and promote capital formation in these areas. These benefits are difficult to measure quantitatively, but qualitatively we believe the potential benefits are significant. We request comment on available metrics to quantify these benefits and any other benefits the commenter may identify. Commenters are also requested to identify sources of empirical data that could be used for the metrics they propose. B. Costs We anticipate that funds and investment advisers could incur certain costs if the proposed amendments are adopted. Funds and investment advisers may incur additional costs if they perform a more detailed and comprehensive analysis before making an investment decision. Such costs are difficult to measure, but we believe that they would be justified by the benefits related to a more informed investment decision as discussed in the previous section. In addition, the purpose of the proposal is to emphasize that it is not the Commission's intent to encourage investors to place undue reliance on NRSRO ratings in making investment decisions. In many cases, investors may still choose to rely solely on NRSRO ratings without incurring additional costs. Additionally, in proposing to remove the ratings requirements from our rules, we would broaden the set of potential investments available to funds and investment advisers. For example, under the proposed amendments to rule 2a-7, money market funds would be able to invest in securities that have received credit ratings outside of the two highest short-term rating categories. It is possible that some investors, funds, or investment advisers may incur additional costs if funds and investment advisers use this expanded discretion to purchase (or sell in the case of principal transactions under rule 206(3)-3T) risky or illiquid securities. We believe that these potential costs would be mitigated, however, by market forces, including, in the case of money market funds, investors' desire to maintain the principal value of their investments. We request comment on these costs. Would eliminating the rating requirements from our rules affect the amount or nature of risks that investment companies and investment advisers would be willing or able to take? We request comment on available metrics to quantify these costs and any other costs the commenter may identify. Commenters are also requested to identify sources of empirical data that could be used for the metrics they propose. Rule 2a-7. We anticipate that the proposed amendments to rule 2a-7 would impose minimal new costs on a portion of money market funds. In general, we expect that money market fund boards of directors (or their delegates) would incur no additional costs in making credit and liquidity risk determinations regarding portfolio securities because the proposed rules would codify the determinations [[Page 40135]] regarding credit risk and liquidity that we believe boards (or their delegates) make under the current rule. Some money market funds, however, would incur costs to notify the Commission regarding rule 17a- 9 transactions. For purposes of the PRA analysis, Commission staff estimates that on average 10 money market funds each year are likely to provide notices regarding rule 17a-9 transactions, at a cost of approximately $1,475.\98\ We request comment on these cost estimates. Do commenters foresee additional or alternative costs if the proposed amendments to rule 2a-7 are adopted? Have we accurately estimated the number of money market funds that would have to report rule 17a-9 transactions annually? Have we accurately estimated money market funds' potential costs in reporting rule 17a-9 transactions? --------------------------------------------------------------------------- \98\ See supra note 87 and accompanying text. --------------------------------------------------------------------------- Rule 3a-7. Our proposed amendments to rule 3a-7 under the Investment Company Act may impose minor costs. Specifically, retail investors who are able, because of the rule, to buy structured finance products would no longer be able to participate in the market. We understand that these products generally are not marketed to retail investors, however, and the number of retail investors affected, if there are any, may be quite low. The proposed amendments also may result in more limited access to capital for issuers of structured financings to the extent there is a retail market that is eliminated under the proposed amendments. All investors who hold structured finance products bought under the existing rule may bear some costs of reduced liquidity to the extent a retail market no longer exists because the pool of potential buyers in the secondary market may be reduced. These costs are difficult to assess given that any existing market may be very small. Commission staff estimates the following potential costs associated with the proposed amendments to rule 3a-7: Costs to retail investors--Retail investors may incur certain opportunity costs under the proposal because they would not be able to purchase the securities of structured finance vehicles that rely on rule 3a-7. These potential costs may be mitigated, however, because we understand, based on staff experience that this market, if it exists, represents a very small amount of all structured finance products (perhaps less than 1% of the $306.7 billion in asset-backed securities issued in 2007).\99\ --------------------------------------------------------------------------- \99\ See Worldwide ABS Issuance, Asset-Backed Alert: The Weekly Update on Worldwide Securitization (June 13, 2008), p. 11. --------------------------------------------------------------------------- Procedures for the acquisition or disposition of assets-- Although we are proposing to remove rule 3a-7's rating requirement, we anticipate that structured financing vehicles would be rated by the NRSROs. We expect that market participants generally will continue to require that issuers obtain ratings. Accordingly, as a matter of good business practice, Commission staff estimates that almost all issuers will continue to have procedures in place to ensure that the acquisition or disposition of assets does not adversely affect the full and timely payments to outstanding security holders. Thus, Commission staff believes that the proposed amendments would not impose any new cost burdens on issuers. Deposits in segregated accounts--We believe that almost all issuers have already taken the actions necessary for cash flows to be deposited in segregated accounts consistent with the full and timely payment of outstanding fixed income securities in meeting the current rule's ratings requirement. Commission staff does not anticipate any new costs associated with this provision of the proposal. We request comment on these cost estimates. Are structured financings offered to the retail market under rule 3a-7? If so, how large is the retail market for these products? What costs would retail investors incur if the proposed amendments are adopted? How would retail investors sell or dispose of their current structured finance vehicle holdings if the proposed amendments were adopted? How should any opportunity costs investors may face if the proposed amendments are adopted be quantified? Would there be any new costs associated with developing procedures for the acquisition or disposition of assets and deposits in segregated accounts? Rule 5b-3. Our proposed amendments to rule 5b-3 under the Investment Company Act may impose costs on funds that rely on the rule. Specifically, a fund's board of directors, or its delegate, pursuant to rule 38a-1 under the Investment Company Act, would be required to develop written policies and procedures to ensure that at the time the repurchase agreement is entered into the collateral meets the requirements outlined in the amendments to the proposed rule.\100\ The proposal would require collateral other than cash or government securities to consist of securities that the fund's board of directors (or its delegate) determines at the time the repurchase agreement is entered into: (i) Are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time; (ii) are subject to no greater than minimal credit risk; and (iii) the issuer of which has the highest capacity to meet its financial obligations. The existing rule provides that collateral may consist of unrated securities if the fund's board, or its delegate, makes the determination that the unrated securities are comparable to securities that are rated in the highest rating category by the Requisite NRSROs. Consistent with the requirements of rule 38a-1 under the Investment Company Act, we expect that fund boards would have existing procedures regarding credit quality determinations for unrated securities. In addition, as a matter of good business practice, we believe that most funds currently evaluate the credit risk and liquidity of rated securities. Thus, we believe that most funds already have procedures to evaluate collateral securities. For purposes of the PRA analysis, Commission staff estimates that 90% of all investment companies, or 4,243 funds, currently have procedures for evaluating collateral securities.\101\ Commission staff therefore estimates that 471 funds would need to develop procedures and evaluate collateral securities, at an annual cost of approximately $1,294,308.\102\ --------------------------------------------------------------------------- \100\ Rule 38a-1(a). \101\ See supra text preceding note 90. \102\ See supra note 91. --------------------------------------------------------------------------- Our proposed amendments to rule 5b-3 may result in another cost to affected funds. Currently, NRSRO ratings are used in a provision of rule 5b-3 that permits a fund to deem the acquisition of a ``refunded security'' as the acquisition of the escrowed government securities for purposes of section 5(b)(1)'s diversification requirements.\103\ Under this provision, a debt security must satisfy certain conditions to be considered a refunded security under the rule. One of these conditions is that an independent certified public accountant must have certified to the escrow agent that the escrowed securities would satisfy all scheduled payments of principal, interest, and applicable premiums on [[Page 40136]] the refunded securities.\104\ This condition is not required, however, if the refunded security has received a debt rating in the highest rating from an NRSRO.\105\ --------------------------------------------------------------------------- \103\ Under the rule, a refunded security is defined as a debt security the principal and interest payments of which are to be paid by U.S. government securities that have been irrevocably placed in an escrow account and are pledged only to the payment of the debt security. Rule 5b-3(c)(4). \104\ Rule 5b-3(c)(4)(iii). \105\ Id. --------------------------------------------------------------------------- We propose to eliminate the exception to the certification requirement for securities that have received the highest rating from an NRSRO. As previously discussed, the Commission included this exception because in rating refunded securities, NRSROs typically require that an independent third party make the same determination.\106\ As previously noted, Commission staff believes that market pressures currently require almost all issuers to have refunded securities certified by an independent accountant. To the extent that refunded securities are rated, and the rating agency requires certification by an independent certified public accountant, funds would not incur additional costs in determining whether a security had been certified in accordance with the rule. Accordingly, we do not expect there would be a change in current costs to issuers as a result of this proposal. --------------------------------------------------------------------------- \106\ See rule 5b-3 Proposing Release, supra note 51. --------------------------------------------------------------------------- We request comment on these cost estimates. Do commenters foresee additional or alternative costs if the proposed amendments to rule 5b-3 are adopted? Have we accurately estimated current and future costs for collateral procedures? Are we correct in estimating that funds are unlikely to incur any additional costs in determining that a refunded security has received an accountant certification? Rule 10f-3. We do not believe that our proposed amendments to rule 10f-3 would impose costs on funds that rely on rule 10f-3 to purchase municipal securities. Under the current rule, fund boards are required to adopt procedures regarding purchases made in reliance on the rule and to determine each quarter that all purchases were made in compliance with the procedures.\107\ Commission staff estimates that these costs would not change. As noted above in our analysis of the PRA, we currently estimate that boards spend, on average, two hours each year to review and revise their procedures for acquiring securities in compliance with the conditions in rule 10f-3. We believe that any changes funds would make to their procedures in order to comply with the proposed amendments to the rule would be included in this annual review and revision. --------------------------------------------------------------------------- \107\ Rule 10f-3(c)(10). --------------------------------------------------------------------------- We request comment on these cost estimates. Have we accurately estimated the costs associated with the proposal's required additional procedures for purchases of municipal securities? Do commenters foresee additional or alternative costs if the proposed amendments to rule 10f- 3 are adopted? Rule 206(3)-3T. In lieu of relying exclusively on credit ratings to determine eligibility for principal trading of underwritten securities under the rule, advisers would need to make a determination of a security's credit risk and liquidity. This determination would impose some costs on advisers. Advisers seeking to rely on the exception would need to develop and implement procedures regarding their eligibility determinations in accordance with their responsibilities under Advisers Act rule 206(4)-7. And, in making their determinations, many advisers would expend resources beyond merely obtaining credit ratings from NRSROs, as is required under the current rule. Commission staff estimates that the costs of preparing the procedures for making the determinations of credit quality and liquidity under the rule would be borne upfront. Once generated, reviewed, and implemented by eligible advisers, advisers would be able to follow them for purposes of making further determinations of eligibility for underwritten securities under the requirements of the rule. For purposes of the PRA analysis, our staff has estimated the number of hours and costs the average adviser would spend in the initial preparation of its policies and procedures.\108\ Based on those estimates, our staff estimates that advisers would incur costs of approximately $1,820 on average per adviser, including legal consultation.\109\ Assuming there are 185 eligible advisers (i.e., advisers that also are registered broker-dealers) that would prepare relevant policies and procedures, our staff estimates that the total costs would be $336,700.\110\ --------------------------------------------------------------------------- \108\ See supra note 97 and accompanying text. We estimate the following burdens and/or costs: (i) for drafting the policies and procedures, approximately 10 hours on average per eligible adviser, of which we estimate there are 185, for a total of 1,850 hours; and (ii) for utilizing outside legal professionals in the preparation of the policies and procedures, approximately $1,200 on average per eligible adviser, for a total of $222,000. \109\ We estimate that the internal preparation function will most likely be performed by a compliance clerk at $62 per hour. $62 per hour x 10 hours = $620 on average per adviser of internal costs for preparation of the policies and procedures. $620 on average per adviser of internal costs + $1,200 on average per adviser of costs for outside legal counsel = $1,820 on average per adviser. \110\ This estimate is based on the following calculation: $1,820 on average per adviser x 185 advisers = $336,700 in total costs for preparation of the policies and procedures. --------------------------------------------------------------------------- We request comment on these cost estimates. Are the cost estimates accurate regarding the proposed procedures for making credit quality determinations? Do commenters foresee additional or alternative costs if the proposed amendments to rule 206(3)-3T are adopted? C. Request for Comment We request comment on all aspects of this cost-benefit analysis, including comment as to whether the estimates we have used in our analysis are reasonable. We welcome comment on any aspect of our analysis, including the estimates and the assumptions we have described. In particular, we request comment as to any costs or benefits we may not have considered here that could result from the adoption of the proposed amendments. We also request comment on the numerical estimates discussed above, and request comment on specific costs and benefits from covered institutions that have experienced any of the situations analyzed above. VII. Consideration of Promotion of Efficiency, Competition and Capital Formation Investment Company Act section 2(c) and Investment Advisers Act section 202(c) require us, when engaging in rulemaking where we are required to consider or determine whether an action is necessary or appropriate in the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.\111\ If adopted, the Commission believes that these amendments would reduce the potential for over- reliance on ratings, and thereby promote investor protection. The Commission anticipates that these proposed amendments would improve investors' ability to make informed investment decisions, which would therefore lead to increased efficiency and competitiveness of the U.S. capital markets. The Commission expects that this increased market efficiency and investor confidence also may encourage more efficient capital formation. --------------------------------------------------------------------------- \111\ 15 U.S.C. 80a-2(c) and 15 U.S.C. 80b-2(c). --------------------------------------------------------------------------- Efficiency. As discussed above, the proposed amendments could result in additional costs for investment companies and registered investment advisers, which could affect the [[Page 40137]] efficiency of these institutions. The proposed amendments to rule 2a-7 may slightly decrease the efficiency of certain money market funds, to the extent that any funds may be relying exclusively on credit ratings to make current minimal credit risk determinations. We believe that independently generated assessments of credit risks are important, however, and a slight decrease in efficiency may be warranted. Our proposed amendments to rule 3a-7 may reduce market efficiency by limiting the ability of retail investors who invest in structured financing vehicles. However, the proposal to eliminate sales of structured finance vehicles to the retail market would clearly delineate investors who are eligible to buy these products, which may increase market efficiency. Ratings provide a standard for retail investors, funds, and advisers alike. By eliminating reliance on ratings, the proposed amendments may have a negative impact on efficiency by eliminating an objective standard in credit quality determinations. The proposed amendments also could decrease efficiency to the extent that funds acquired securities that do not meet the particular ratings requirement and that result in the concerns that the rating requirements were designed to address. On the other hand, the proposed amendments may result in some increased market efficiency by affording funds access to securities that do not meet the rating requirements in the current rules, but that would satisfy the credit risk and liquidity standards in the proposed amendments. We do not anticipate that the proposed amendments to rules 2a-7, 5b-3, and 10f-3 would have other impacts on the efficiency of funds that rely on those rules. The proposed amendments to rule 206(3)-3T may increase efficiency by affording clients access to certain investment grade debt securities underwritten by the adviser or its affiliate that they might not have had access to under the standard requiring NRSRO ratings. Competition. If investors believe the proposed amendments to rule 2a-7 would make the rule less rigorous in part because of the loss of an independent third party check on money market fund investments, they may turn to other cash investment vehicles they perceive as offering greater protections. In addition, investors in money market funds may unduly rely on ratings of the money market funds themselves as a proxy for the quality and safety of these funds' portfolio securities. This may potentially increase costs to money market funds that would not otherwise seek ratings. The proposed amendments to rule 3a-7, may impact certain issuers of structured finance vehicles that, for example, may specialize in the retail market if they had some competitive advantage, such as a distribution channel. Eliminating the exclusion for structured finance vehicles offered to retail investors may make these issuers less competitive in this market. The proposed amendments to rule 206(3)-3T may promote competition because, by providing a more subjective standard for the underwritten securities exception, they may increase the alternative sources of the security for the client without diminishing the adviser's best execution obligations, thereby potentially improving price. We do not believe the proposed amendments to rules 5b-3 or 10f-3 would significantly affect competition because these amendments would apply to all money market funds and other funds. Capital formation. We do not believe the proposed amendments to the rules would have a significant effect on capital formation. To the extent potential money market fund investors may react positively to money market funds' independent credit risk assessments and management of risks, we believe any effect the proposed amendments to rule 2a-7 may have on capital formation would be positive. Our proposed amendments to rule 3a-7 would limit capital formation for issuers that offer structured finance products to retail investors in reliance on rule 3a-7. The proposed amendments would have no effect on the ability of issuers who rely on rule 3a-7 to offer structured financings to accredited investors and qualified institutional buyers to raise capital. We do not expect that the proposed amendments to rules 5b-3 or 10f-3 would have an adverse effect on capital formation. If the proposed amendments to rule 206(3)-3T have any effect on capital formation, it is likely to be positive, although indirect. Providing a means for advisers, consistent with their fiduciary obligations, to offer their clients underwritten investment grade securities sold as principal, might serve to broaden the potential universe of purchasers of securities, opening the door to greater investor participation in the securities markets with a potential positive effect on capital formation. We request comment on all aspects of this analysis, and specifically request comment on any effect the proposed amendments might have on the promotion of efficiency, competition, and capital formation that we have not considered. Commenters are requested to provide empirical data and other factual support for their views to the extent possible. VIII. Regulatory Flexibility Act Certification Section 3(a) of the Regulatory Flexibility Act of 1980 \112\ (``RFA'') requires the Commission to undertake an initial regulatory flexibility analysis (``IRFA'') of the proposed rule amendments on small entities unless the Commission certifies that the rule, if adopted, would not have a significant economic impact on a substantial number of small entities.\113\ Pursuant to Section 605(b) of the RFA, the Commission hereby certifies that the proposed amendments to rules 2a-7 and 3a-7 under the Investment Company Act, would not, if adopted, have a significant economic impact on a substantial number of small entities. The proposal would: --------------------------------------------------------------------------- \112\ 5 U.S.C. 603(a). \113\ 5 U.S.C. 605(b). --------------------------------------------------------------------------- (a) Amend rule 2a-7 under the Investment Company Act to: (i) Rely on money market fund boards of directors (who usually rely on the funds' advisers) to determine that each portfolio instrument presents minimal credit risks, and whether the security is a ``First Tier Security'' or a ``Second Tier Security''; (ii) add a portfolio liquidity requirement to the rule that would require that money market funds hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions, and expressly limit their investment in illiquid securities to not more than 10% of the their total assets; (iii) in the event the money market fund's portfolio manager becomes aware of any new information about a portfolio security (or an issuer of a portfolio security) that may suggest that the security may not continue to present minimal credit risks, the proposal would amend rule 2a-7's downgrade and default provisions to require a money market fund's board of directors to reassess promptly whether the portfolio security continues to present minimal credit risks; and (iv) require a money market fund to notify the Commission of the purchase of a money market fund's portfolio securities by an affiliated person in reliance on rule 17a-9 under the Investment Company Act. The proposed amendments also would make conforming amendments to rule 2a-7's record keeping and reporting requirements; and (b) Amend rule 3a-7 under the Investment Company Act to: (i) Eliminate the rule's reliance on ratings by eliminating the exclusion for [[Page 40138]] structured financings offered to the general public; (ii) remove the reference to ratings downgrades in the section of the rule that addresses substitution of eligible assets; and (iii) amend the portion of the rule that deals with safekeeping of assets. Based on information in filings submitted to the Commission, we believe that there are no money market funds that are small entities.\114\ In addition, we are not aware of any issuers that currently rely on rule 3a-7 that are small entities. For these reasons, the Commission believes the proposed amendments to rules 2a-7 and 3a-7 under the Investment Company Act would not, if adopted, have a significant economic impact on a substantial number of small entities. --------------------------------------------------------------------------- \114\ Under the Investment Company Act, an investment company is considered a small entity if it, together with other investment companies in the same group of related investment companies, have net assets of $50 million or less as of the end of its most recent fiscal year. See 17 CFR 270.0-10. --------------------------------------------------------------------------- We encourage written comments regarding this certification. The Commission solicits comment as to whether the proposed amendments to rules 2a-7 and 3a-7 could have an effect on small entities that has not been considered. We request that commenters describe the nature of any impact on small entities and provide empirical data to support the extent of such impact. IX. Initial Regulatory Flexibility Analysis This IRFA has been prepared in accordance with 5 U.S.C. 603. It relates to proposed amendments to rules 5b-3 and 10f-3 under the Investment Company Act and rule 206(3)-(3)T under the Investment Advisers Act. The proposed amendments would remove references to and the required use of NRSRO ratings from these rules. A. Reasons for the Proposed Action As discussed above, the proposed rule amendments are designed to address the risk that the reference to and use of NRSRO ratings in our rules is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs, and may encourage investors to place undue reliance on the NRSRO ratings. B. Objectives of the Proposed Action Our proposed amendments are designed to address the risk that reference to and use of NRSRO ratings in our rules: Is interpreted by investors as an endorsement of the quality of the credit ratings issued by NRSROs; and encourages investors to place undue reliance on the NRSRO ratings. C. Legal Basis The Commission is proposing amendments to rule 5b-3 under the authority set forth in sections 6(c) and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c) and 80a-37(a)]. The Commission is proposing amendments to rule 10f-3 under the authority set forth in sections 10(f), 31(a) and 38(a) of the Investment Company Act [15 U.S.C. 80a-10(f), 80a-30(a) and 80a-37(a)]. The Commission is proposing amendments to rule 206(3)-(3)T under the authority set forth in sections 206A and 211(a) of the Investment Advisers Act [15 U.S.C. 80b- 6A, 80b-11(a)]. D. Small Entities Subject to the Proposed Rule Amendments The proposed amendments to rules 5b-3 and 10f-3 under the Investment Company Act and rule 206(3)-(3)T under the Investment Advisers Act would affect funds and registered investment advisers, including entities that are considered to be a small business or small organization (collectively, ``small entity'') for purposes of the RFA. Under the Investment Company Act, a fund is considered a small entity if it, together with other funds in the same group of related funds, has net assets of $50 million or less as of the end of its most recent fiscal year.\115\ Under the Investment Advisers Act, a small entity is an investment adviser that: (i) Manages less than $25 million in assets; (ii) has total assets of less than $5 million on the last day of its most recent fiscal year; and (iii) does not control, is not controlled by, and is not under common control with another investment adviser that manages $25 million or more in assets, or any person (other than a natural person) that has had total assets of $5 million or more on the last day of the most recent fiscal year.\116\ Based on Commission filings, we estimate that 122 investment companies may be considered small entities. We also estimate that as of June 1, 2008, 572 investment advisers were small entities.\117\ The Commission assumes for purposes of this IRFA that 19 of these small entities (those that are both investment advisers and broker-dealers) could rely on rule 206(3)-3T,\118\ and that 50% of these, or 10 advisers, will seek to engage in principal trades with clients of securities they or a control person underwrote. --------------------------------------------------------------------------- \115\ 17 CFR 270.0-10. \116\ 17 CFR 275.0-7. \117\ IARD data as of June 1, 2008, for Item 12 of Part 1A of Form ADV. \118\ IARD data as of June 1, 2008, for Items 6.A(1) and 12 of Part 1A of Form ADV. --------------------------------------------------------------------------- E. Reporting, Recordkeeping, and Other Compliance Requirements The proposed amendments to rule 5b-3 would require collateral for repurchase agreements other than cash or government securities to have minimal credit risk and be highly liquid. Specifically, the proposal would require collateral other than cash or government securities to consist of securities that the fund's board of directors (or its delegate) determines at the time the repurchase agreement is entered into: (i) Are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time; (ii) are subject to no greater than minimal credit risk, and (iii) the issuer of which has the highest capacity to meet its financial obligations.\119\ The proposed amendments to rule 10f-3 would amend the rule's definition of ``eligible municipal security'' to mean securities that are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time. In addition, the securities would have to be either: (i) subject to no greater than moderate credit risk; or (ii) if they are less seasoned securities, subject to a minimal or low amount of credit risk.\120\ The proposed amendments to rule 206(3)-3T would impose a new compliance requirement in connection with advisers' obligations relating to written policies and procedures under rule 206(4)-7 under the Advisers Act. --------------------------------------------------------------------------- \119\ Proposed rule 5b-3(c)(1)(iv)(C). \120\ Proposed rule 10f-3(a)(3). --------------------------------------------------------------------------- Small entities registered with the Commission as investment companies or investment advisers seeking to rely on each of the rules as it is proposed to be amended would be subject to the same requirements as larger entities. With respect to rule 206(3)-3T, in each case, however, an investment adviser, whether large or small, would only be able to rely on the rule as it is proposed to be amended if it also is registered with us as a broker-dealer. As noted above, we estimate that 19 small entities are advisers that are also registered as broker-dealers and therefore only those small entities are eligible to rely on the rule. In developing the requirements of the proposed amendments to each of rules 5b-3 and 10f-3 under the Investment Company Act, and rule 206(3)-3T under the Investment Advisers Act, we considered the extent to which the proposed amendments would have a significant impact on a substantial number of small entities. [[Page 40139]] We encourage written comments regarding this analysis. We solicit comments as to whether the proposed amendments could have any effect that we have not considered. We also request that commenters describe the nature of any impact on small entities and provide empirical data to support the extent of the impact. F. Duplicative, Overlapping, or Conflicting Federal Rules Rule 31a-1 under the Act requires the retention of ledger accounts for each portfolio security and each person through which a portfolio transaction is effected. Although some of the procedures under the proposed amendments to rules 5b-3 and 10f-3 may overlap with information in the ledgers, the rule 5b-3 and 10f-3 procedures would contain additional information specifically related to the concerns underlying these rules. The Commission believes that there are no rules that duplicate or conflict with the proposed amendments to rule 206(3)-3T. G. Significant Alternatives The RFA directs us to consider significant alternatives that would accomplish our stated objective, while minimizing any significant adverse impact on small entities. Alternatives in this category would include: (i) Establishing different compliance or reporting standards or timetables that take into account the resources available to small entities; (ii) clarifying, consolidating, or simplifying compliance requirements under the rule for small entities; (iii) using performance rather than design standards; and (iv) exempting small entities from coverage of the rule, or any part of the rule. With respect to rules 5b-3 and 10f-3, the Commission preliminarily believes that special compliance requirements or timetables for small entities, or an exemption from coverage for small entities, may create a risk that those entities could acquire repurchase agreements with collateral that may not retain its market value or liquidity in the event of a counterparty default. We do not expect that the requirement that refunded securities be certified by a certified public accountant would result in any costs or burdens for either small or large entities. With respect to rule 10f-3, we preliminarily believe that special compliance requirements or timetables for small entities, or an exemption from coverage for small entities, may put those entities at greater risk for purchasing unmarketable municipal securities in an affiliated underwriting. We preliminarily believe, therefore, that it is important for the credit quality and liquidity considerations required by the proposed amendments to rules 5b-3 and 10f-3 to apply to all funds relying on the rules, not just those that are not considered small entities. Further consolidation or simplification of the proposals for funds that are small entities would be inconsistent with the Commission's goals of fostering investor protection. With respect to rule 206(3)-3T, the Commission preliminarily believes that special compliance or reporting requirements or timetables for small entities, or an exemption from coverage for small entities may create the risk that the investors who are advised by and effect securities transactions in underwritten securities through such small entities may not receive adequate protection combined with access to securities. We believe, therefore, that it is important for the investment quality consideration required by the proposed amendments to apply to all advisers, not just those that are not considered small entities. Further consolidation or simplification of the proposals for investment advisers that are small entities would be inconsistent with the Commission's goals of fostering investor protection. We have endeavored through the proposed amendments to rules 5b-3, 10f-3 and 206(3)-3T to minimize the regulatory burden on all entities eligible to rely on the respective rules, including small entities, while meeting our regulatory objectives. It was our goal to ensure that eligible small entities may benefit from the Commission's approach to the proposed amendments to the same degree as other funds or eligible advisers, as appropriate. We request comment on whether it is feasible or necessary for small entities to have special requirements or timetables for, or exemptions from, compliance with the proposed amendments to each of the rules. In particular, could any of the proposed amendments be altered in order to ease the regulatory burden on small entities, without sacrificing the effectiveness of the proposed amendments? H. Request for Comments We encourage the submission of comments with respect to any aspect of this IRFA. In particular, we request comments regarding: (i) The number of small entities that may be affected by the proposed amendments; (ii) the existence or nature of the potential impact of the proposed amendments on small entities discussed in the analysis; and (iii) how to quantify the impact of the proposed amendments. Commenters are asked to describe the nature of any impact and provide empirical data supporting the extent of the impact. Such comments will be considered in the preparation of the Final Regulatory Flexibility Analysis, if the proposed amendments are adopted, and will be placed in the same public file as comments on the proposed amendments. Comments should be submitted to the Commission at the addresses previously indicated. X. Statutory Authority The Commission is proposing amendments to rules 2a-7, 3a-7, and 5b- 3 under the authority set forth in sections 6(c) and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c), 80a-37(a)]. The Commission is proposing amendments to rule 10f-3 under the authority set forth in sections 10(f), 31(a) and 38(a) of the Investment Company Act [15 U.S.C. 80a-10(f), 80a-30(a), 80a-37(a)]. The Commission is proposing amendments to rule 206(3)-(3)T under the authority set forth in sections 206A and 211(a) of the Investment Advisers Act [15 U.S.C. 80b- 6A, 80b-11(a)]. List of Subjects 17 CFR Part 270 Investment companies, Reporting and recordkeeping requirements, Securities. 17 CFR Part 275 Reporting and recordkeeping requirements, Securities. Text of Proposed Rule Amendments For reasons set out in the preamble, Title 17, Chapter II of the Code of Federal Regulations is proposed to be amended as follows: PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940 1. The authority citation for part 270 continues to read in part as follows: Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a- 39, unless otherwise noted. * * * * * 2. Section 270.2a-7 is amended by: a. Revising paragraphs (a)(10), (a)(12), and (a)(17); b. Removing paragraph (a)(19); c. Redesignating paragraph (a)(20) as paragraph (a)(19); d. Removing paragraph (a)(21); e. Redesignating paragraphs (a)(22) through (a)(27) as paragraphs (a)(20) through (a)(25); f. Removing paragraph (a)(28); g. Redesignating paragraph (a)(29) as paragraph (a)(26); [[Page 40140]] h. In paragraphs (b)(1) and (b)(2), revising the phrase ``(c)(2), (c)(3), and (c)(4)'' to read ``(c)(2), (c)(3), (c)(4), and (c)(5)''; i. Revising paragraphs (c)(3)(i), (c)(3)(iii), and (c)(3)(iv)(C); j. Adding paragraph (c)(3)(iv)(D); k. In paragraph (c)(4)(v), revising the phrase ``requirements of paragraphs (c)(4) and (c)(5)'' to read ``requirements of paragraphs (c)(4) and (c)(6)''; l. Redesignating paragraphs (c)(5) through (c)(10) as paragraphs (c)(6) through (c)(11); m. Adding new paragraph (c)(5); n. In newly redesignated paragraph (c)(6), revising the phrase ``(pursuant to paragraphs (c)(9)(ii) and (c)(10)(vi) of this section)'' to read ``(pursuant to paragraphs (c)(10)(ii) and (c)(11)(vi) of this section)''; o. In newly redesignated paragraph (c)(7): i. revising the paragraph heading; ii. revising paragraph (i); iii. in the introductory text of paragraph (ii), revising the phrase ``paragraphs (c)(6)(ii)(A) through (D)'' to read ``paragraphs (c)(7)(ii)(A) through (C)''; iv. adding ``or'' at the end of paragraph (ii)(B); v. removing paragraph (ii)(C) and redesignating paragraph (ii)(D) as paragraph (ii)(C); vi. revising paragraph (iii); vii. revising the heading to paragraph (iv); and viii. in paragraph (iv), revising the phrase ``For purposes of paragraphs (c)(6)(ii) and (iii)'' to read ``For purposes of paragraphs (c)(7)(ii) and (iii)''; p. Revising newly designated paragraph (c)(10)(ii); q. In newly redesignated paragraph (c)(11): i. in paragraph (i), revising the phrase ``paragraphs (c)(6) through (c)(9)'' to read ``paragraphs (c)(7) through (c)(10)''; ii. revising paragraph (iii); iii. in paragraph (iv), revising the phrase ``paragraph (c)(9)(iii) of this section'' to read ``paragraph (c)(10)(iii) of this section''; iv. in the introductory text of paragraph (v), in the first sentence, revising ``paragraph (c)(9)(iv) of this section'' to read ``paragraph (c)(10)(iv) of this section''; v. in paragraph (vi), revising the phrase ``paragraph (c)(9)(ii)'' to read ``paragraph (c)(10)(ii)''; vi. in paragraph (vii), in the first sentence, revising the phrase ``this paragraph (c)(10)'' to read ``this paragraph (c)(11)''; and vii. in paragraph (vii), in the second sentence, revising the phrase ``paragraphs (c)(6)(ii) (with respect to defaulted securities and events of insolvency) or (c)(7)(ii)'' to read ``paragraphs (c)(7)(ii) (with respect to defaulted securities and events of insolvency) or (c)(8)(ii)''; and r. Revising the introductory text of paragraph (e) and in paragraph (e)(2) revising the phrase ``paragraph (c)(6)(iii) of this section'' to read ``paragraph (c)(7)(iii) of this section''. These additions and revisions read as follows: Sec. 270.2a-7 Money market funds. (a) * * * (10) Eligible Security means a security with a remaining maturity of 397 calendar days or less that the fund's board of directors determines presents minimal credit risks (which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations). * * * * * (12) First Tier Security means a security the issuer of which the fund's board of directors has determined has the highest capacity to meet its short-term financial obligations. * * * * * (17) Liquid Security means a security that can be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the money market fund. * * * * * (c) * * * (3) * * * (i) General. The money market fund shall limit its portfolio investments to those United States Dollar-Denominated securities that are at the time of Acquisition Eligible Securities. * * * * * (iii) Securities Subject to Guarantees. A security that is subject to a Guarantee may be determined to be an Eligible Security or a First Tier Security based solely on whether the Guarantee is an Eligible Security or First Tier Security, as the case may be; Provided, however, that the issuer of the Guarantee, or another institution, has undertaken to promptly notify the holder of the security in the event the Guarantee is substituted with another Guarantee (if such substitution is permissible under the terms of the Guarantee). (iv) * * * (C) The issuer of the Demand Feature, or another institution, has undertaken to promptly notify the holder of the security in the event the Demand Feature is substituted with another Demand Feature (if such substitution is permissible under the terms of the Demand Feature); and (D) The fund's board of directors determines that the Underlying Security or any Guarantee of such security presents minimal credit risks (which determination must be based on factors pertaining to credit quality). * * * * * (5) Portfolio Liquidity. The money market fund shall hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions in light of the fund's obligations under section 22(e) of the Act (15 U.S.C. 80a-22(e)) and any commitments it has made to shareholders; Provided, however, immediately after the Acquisition of any security, a money market fund shall not have invested more than ten percent of its Total Assets in securities that are not Liquid Securities. * * * * * (7) Monitoring, Defaults and Other Events. (i) Monitoring. In the event the money market fund's investment adviser (or any person to whom the fund's board of directors has delegated portfolio management responsibilities) becomes aware of any information about a portfolio security or an issuer of a portfolio security that may suggest that the security may not continue to present minimal credit risks, the board of directors shall reassess promptly whether such security continues to present minimal credit risks and shall cause the fund to take such action as the board of directors determines is in the best interests of the money market fund and its shareholders. * * * * * (iii) Notice to the Commission. The money market fund shall promptly notify the Commission by electronic mail directed to the Director of the Division of Investment Management of any: (A) Default with respect to one or more portfolio securities (other than an immaterial default unrelated to the financial condition of the issuer) or an Event of Insolvency with respect to the issuer of the security or any Demand Feature or Guarantee to which it is subject, where immediately before default the securities (or the securities subject to the Demand Feature or Guarantee) accounted for \1/2\ of 1 percent or more of a money market fund's Total Assets, of such fact and the actions the money market fund intends to take in response to such situation; or (B) Purchase of a security from the fund by an affiliated person or promoter of or principal underwriter for the fund [[Page 40141]] or an affiliated person of such a person in reliance on Sec. 270.17a- 9. * * * * * (iv) Defaults for Purposes of Paragraphs (c)(7) (ii) and (iii).* * * * * * * * (10) * * * (ii) Securities Subject to Demand Features or Guarantees. In the case of a security subject to one or more Demand Features or Guarantees that the fund's board of directors has determined that the fund is not relying on to determine the quality (pursuant to paragraph (c)(3) of this section), maturity (pursuant to paragraph (d) of this section) or liquidity (pursuant to paragraph (c)(5) of this section) of the security subject to the Demand Feature or Guarantee, written procedures shall require periodic evaluation of such determination. * * * * * (11) * * * (iii) Credit Risk Analysis. For a period of not less than three years from the date that the credit risks of a portfolio security were most recently reviewed, a written record of the determination that a portfolio security presents minimal credit risks used to determine the status of the security as an Eligible Security shall be maintained and preserved in an easily accessible place. * * * * * (e) Delegation. The money market fund's board of directors may delegate to the fund's investment adviser or officers the responsibility to make any determination required to be made by the board of directors under this section (other than the determinations required by paragraphs (c)(1) (board findings); (c)(7)(ii) (defaults and other events); (c)(8)(i) (general required procedures: Amortized Cost Method); (c)(8)(ii)(A) (shadow pricing), (B) (prompt consideration of deviation), and (C) (material dilution or unfair results); and (c)(9) (required procedures: Penny Rounding Method) of this section) provided: * * * * * 3. Section 270.3a-7 is amended by: a. Revising paragraph (a)(2) introductory text; b. In paragraph (a)(2)(i) revising the phrase ``Any fixed-income securities may be sold'' to read ``Any fixed-income securities sold''; c. In paragraph (a)(2)(ii), revising the phrase ``Any securities may be sold'' to read ``Any securities sold''; d. In the undesignated paragraph after paragraph (a)(2)(ii), revise the phrase ``persons specified in paragraphs (a)(2) (i) and (ii) of this section'' to read ``persons specified in this section''; e. Revising paragraph (a)(3)(ii); and f. Revising paragraph (a)(4)(iii). The revisions read as follows: Sec. 270.3a-7 Issuers of asset-backed securities. (a) * * * (2) Securities sold by the issuer or any underwriter thereof are: * * * * * (3) * * * (ii) The issuer has procedures to ensure that the acquisition or disposition does not adversely affect the full and timely payment of the outstanding fixed-income securities; and * * * * * (4) * * * (iii) Takes actions necessary for the cash flows derived from eligible assets for the benefit of the holders of fixed-income securities to be deposited periodically in a segregated account consistent with the full and timely payment of the outstanding fixed- income securities. * * * * * 4. Section 270.5b-3 is amended by: a. Adding ``or'' at the end of paragraph (c)(1)(iv)(B); b. Revising paragraph (c)(1)(iv)(C); c. Removing paragraph (c)(1)(iv)(D); d. Revising paragraph (c)(4)(iii); e. Removing paragraphs (c)(5), (c)(6), and (c)(8); and f. Redesignating paragraph (c)(7) as paragraph (c)(5). The revisions read as follows: Sec. 270.5b-3 Acquisition of repurchase agreement or refunded security treated as acquisition of underlying securities. * * * * * (c) * * * (1) * * * (iv) * * * (C) Securities that the investment company's board of directors, or its delegate, determines at the time the repurchase agreement is entered into: (1 ) Are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time; (2) Are subject to no greater than minimal credit risk; and (3) The issuer of which has the highest capacity to meet its financial obligations; and * * * * * (4) * * * (iii) At the time the deposited securities are placed in the escrow account, or at the time a substitution of the deposited securities is made, an independent certified public accountant has certified to the escrow agent that the deposited securities will satisfy all scheduled payments of principal, interest and applicable premiums on the Refunded Securities. * * * * * 5. Section 270.10f-3 is amended by: a. Revising paragraph (a)(3); b. Removing paragraph (a)(5); and c. Redesignating paragraphs (a)(6), (a)(7), and (a)(8) as paragraphs (a)(5), (a)(6), and (a)(7). The revision reads as follows: Sec. 270.10f-3 Exemption for the acquisition of securities during the existence of an underwriting or selling syndicate. (a) * * * (3) Eligible Municipal Securities means ``municipal securities,'' as defined in section 3(a)(29) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(29)), that are sufficiently liquid that they can be sold at or near their carrying value within a reasonably short period of time and either: (i) Are subject to no greater than moderate credit risk; or (ii) If the issuer of the municipal securities, or the entity supplying the revenues or other payments from which the issue is to be paid, has been in continuous operation for less than three years, including the operation of any predecessors, the securities are subject to a minimal or low amount of credit risk. * * * * * PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 6. The authority citation for part 275 continues to read in part as follows: Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(17), 80b-3, 80b- 4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted. * * * * * 7. Section 275.206(3)-3T is amended by revising paragraph (c) to read as follows: Sec. 275.206(3)-3T Temporary rule for principal trades with certain advisory clients. * * * * * (c) For purposes of paragraph (a)(2) of this section, an investment grade debt security means a non-convertible debt security that, at the time of sale, the investment adviser has determined to be subject to no greater than moderate credit risk and sufficiently liquid that it can be sold at or near its carrying value within a reasonably short period of time. * * * * * [[Page 40142]] By the Commission. Dated: July 1, 2008. Florence E. Harmon, Acting Secretary. [FR Doc. E8-15282 Filed 7-10-08; 8:45 am] BILLING CODE 8010-01-P