[Federal Register: July 11, 2008 (Volume 73, Number 134)]
[Proposed Rules]
[Page 40124-40142]
[DOCID:fr11jy08-18]

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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.

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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 Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>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,<PHONE_NUMBER>, 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\
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    \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.
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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.
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    \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).
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    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

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.
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    \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.
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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.
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    \8\ 17 CFR 240.15c3-1.
    \9\ 15 U.S.C. 78a.
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    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\
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    \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.
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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\
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    \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).
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    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\
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    \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.
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    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\
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    \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.
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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

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.
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    \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.
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    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.
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    \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).
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    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\
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    \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.
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    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

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.
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    \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).
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    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.
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    \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.
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    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.
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    \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'').
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    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\
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    \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).
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    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

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.
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    \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\
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    \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)

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

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

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

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\
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    \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\
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    \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.
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    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

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\
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    \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).
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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

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

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

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\
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    \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.
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    \107\ Rule 10f-3(c)(10).
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    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\
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    \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.
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    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.
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    \111\ 15 U.S.C. 80a-2(c) and 15 U.S.C. 80b-2(c).
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    Efficiency. As discussed above, the proposed amendments could
result in additional costs for investment companies and registered
investment advisers, which could affect the

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:
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    \112\ 5 U.S.C. 603(a).
    \113\ 5 U.S.C. 605(b).
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    (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

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.
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    \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.
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    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.
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    \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.
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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