[Federal Register Volume 79, Number 5 (Wednesday, January 8, 2014)]
[Rules and Regulations]
[Pages 1316-1330]
[FR Doc No: 2013-31425]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 270, and 274

[Release Nos. 33-9506; IC-30847; File No. S7-7-11]
RIN 3235-AL02

Removal of Certain References to Credit Ratings Under the
Investment Company Act

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting amendments to a rule and three forms under the Investment
Company Act of 1940 (``Investment Company Act'') and the Securities Act
of 1933 (``Securities Act'') in order to implement a provision of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-Frank
Act''). Specifically, rule 5b-3 under the Investment Company Act
contains a reference to credit ratings in determining when an
investment company (``fund'') may treat a repurchase agreement as an
acquisition of securities collateralizing the repurchase agreement for
certain purposes under the Investment Company Act. The amendments we
are adopting today replace this reference to credit ratings with an
alternative standard designed to retain a similar degree of credit
quality to that in current rule 5b-3. The Commission is also adopting
amendments to Forms N-1A, N-2, and N-3 under the Investment Company Act
and Securities Act to eliminate the required use of NRSRO credit
ratings when a fund chooses to depict its portfolio holdings by credit
quality.

DATES: Effective Date: February 7, 2014; Compliance Date: July 7, 2014.

FOR FURTHER INFORMATION CONTACT: Adam Bolter, Senior Counsel, Thoreau
Bartmann, Branch Chief, or C. Hunter Jones, Assistant Director (202)
551-6792, Office of Investment Company Rulemaking, Division of
Investment Management, Securities and Exchange Commission, 100 F Street
NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to
rule 5b-3 [17 CFR 270.5b-3] under the Investment Company Act.\1\ The

Commission is also adopting amendments to Forms N-1A [17 CFR 239.15A
and 17 CFR 274.11A], N-2 [17 CFR 239.14 and 17 CFR 274.11a-1], and N-3
[17 CFR 239.17a and 17 CFR 274.11b] under the Investment Company Act
and the Securities Act.\2\
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    \1\ 15 U.S.C. 80a. Unless otherwise noted, all references to
statutory sections are to the Investment Company Act, and all
references to rules under the Investment Company Act are to Title
17, Part 270 of the Code of Federal Regulations [17 CFR part 270].
    \2\ 15 U.S.C. 77a.
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Table of Contents

I. Background
II. Prior Actions of the Commission and Other Regulators
III. Discussion
    A. Rule 5b-3
    B. Forms N-1A, N-2, and N-3
IV. Paperwork Reduction Act
V. Economic Analysis
VI. Final Regulatory Flexibility Analysis
Statutory Authority
Text of Rule and Rule and Form Amendments

I. Background

    The first use of a reference to ratings or rating agencies in
Commission rules was in 1975, when the Commission adopted the term
``nationally recognized statistical rating organization'' (``NRSRO'')
as part of amendments to the net capital rule for broker-dealers, rule
15c3-1 under the Securities Exchange Act of 1934 (``Exchange Act'')
(the ``Net Capital Rule'').\3\ The Commission eventually included
references to credit ratings issued by NRSROs in other rules under the
securities laws, including the Investment Company Act.\4\ In addition,
credit ratings by NRSROs have been used as benchmarks in federal and
state legislation, rules administered by other federal agencies, and
foreign regulatory schemes.\5\ Even prior to the enactment of the Dodd-
Frank Act,\6\ concerns about the wide-spread use of NRSRO credit
ratings in statutes and regulations prompted the Commission to explore
whether to eliminate references to credit ratings in Commission rules
because of the potential overreliance by investors and, investment
advisers and other financial professionals on these ratings, and
whether there are practical alternatives to NRSRO credit ratings that
could be used as benchmarks in regulations.\7\
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    \3\ See Adoption of Uniform Net Capital Rule and an Alternative
Net Capital Requirement for Certain Brokers and Dealers, Exchange
Act Release No. 11497 (June 26, 1975) [40 FR 29795 (July 16, 1975)];
17 CFR 240.15c3-1. The Net Capital Rule prescribes minimum net
capital requirements for broker-dealers and it uses NRSRO credit
ratings to determine the amount of the charge to capital a broker-
dealer must apply to certain types of debt instruments. See 17 CFR
240.15c3-1. The regulatory purpose was to provide a method for
determining net capital charges on different grades of debt
securities under the Net Capital Rule. See 17 CFR 240.15c3-1.
    \4\ See, e.g., 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)]
(incorporating the concept of NRSROs into the definition of
``eligible security'' in rule 2a-7 (governing money market funds)).
    \5\ See, e.g., Report to Congress on Credit Ratings, Board of
Governors of the Federal Reserve System (July 2011); References to
Credit Ratings in FDIC Regulations, Federal Deposit Insurance
Corporation (July 2011); and Basel Committee on Banking Supervision,
Stocktaking on the use of credit ratings, Joint Forum (June 2009).
    \6\ See Public Law 111-203, 124 Stat. 1376 (2010).
    \7\ See infra section II.A (discussing other Commission actions
to remove references to credit ratings from its rules). See also
infra section II.B (discussing actions of other regulators to remove
references to credit ratings from their rules).
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    Section 939A of the Dodd-Frank Act requires each Federal agency,
including the Commission, to ``review any regulation issued by such
agency that requires the use of an assessment of the credit-worthiness
of a security or money market instrument and any references to or
requirements in such regulations regarding credit ratings.'' \8\ That
section further provides that each such agency shall ``modify any such
regulations identified by the review . . . to remove any reference to
or requirement of reliance on credit ratings and to substitute in such
regulations such standard of credit-worthiness as each respective
agency shall determine as appropriate for such regulations.'' \9\
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    \8\ Public Law 111-203, sec. 939A(a)(1)-(2). Section 939A of the
Dodd-Frank Act applies to all federal agencies.
    \9\ Public Law 111-203, sec. 939A(b).
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    As a step toward implementing these mandates, in March 2011 the
Commission proposed to replace references to ratings issued by NRSROs
in two Commission rules and four Commission forms under the Investment
Company Act, including rule 5b-3 and Forms N-1A, N-2, and N-3.\10\ We
received 26 comment letters on the proposed rule and form
amendments.\11\ Several commenters addressed specific provisions of the
proposal to amend rule 5b-3 and Forms N-1A, N-2, and N-3, which we
discuss in more detail below.
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    \10\ See References to Credit Ratings in Certain Investment
Company Act Rules and Forms, Investment Company Act Release No.
29592 (Mar. 3, 2011) [76 FR 12896 (Mar. 9, 2011)] (``2011 Proposing
Release''). Specifically, we proposed to: (i) Remove references to
credit ratings in rules 2a-7 and 5b-3 under the Investment Company
Act and replace them with alternative standards of creditworthiness;
(ii) adopt new rule 6a-5 under the Investment Company Act that would
establish a creditworthiness standard to replace the credit rating
reference in section 6(a)(5) removed by the Dodd-Frank Act; (iii)
eliminate required disclosures of credit ratings in Form N-MFP; and
(iv) remove the requirement that credit ratings be used when
portraying credit quality in shareholder reports from Forms N-1A, N-
2, and N-3. The Commission adopted new rule 6a-5 on November 19,
2012 and noted in its 2013 proposing release for money market reform
that the Commission would address references to credit ratings in
rule 2a-7 and Form N-MFP in a separate rulemaking. See Purchase of
Certain Debt Securities by Business and Industrial Development
Companies Relying on an Investment Company Act Exemption, Investment
Company Act Release No. 30268 (Nov. 19, 2012) [77 FR 70117 (Nov. 23,
2012)]; Money Market Fund Reform; Amendments to Form PF, Investment
Company Act Release No. 30551 (June 5, 2013) [78 FR 36834 (June 19,
2013)]. Rule 3a-7 under the Investment Company Act also contains a
reference to ratings. In August 2011, in a concept release
soliciting comment on the treatment of asset-backed issuers under
the Investment Company Act, we sought comment on the role, if any,
that credit ratings should continue to play in the context of rule
3a-7. See Treatment of Asset-Backed Issuers under the Investment
Company Act, Investment Company Act Release No. 29779 (Aug. 31,
2011) [76 FR 55308 (Sept. 7, 2011)] at section III.A.1.
    \11\ Most of these commenters criticized removing credit ratings
from rule 2a-7, but acknowledged that the Commission's proposal was
in response to the mandate in the Dodd-Frank Act. The Commission
plans to address these comments in a future rulemaking. See supra
note 10. The comment letters on the 2011 Proposing Release (File No.
S7-07-11) are available at http://www.sec.gov/comments/s7-07-11/s70711.shtml. In addition, to facilitate public input on the Dodd-
Frank Act, we provided a series of email links, organized by topic
on our Web site at http://www.sec.gov/spotlight/regreformcomments.shtml. The public comments we received on section
939A of the Dodd-Frank Act are available on our Web site at http://www.sec.gov/comments/df-title-ix/credit-rating-agencies/credit-rating-agencies.shtml.
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    We are adopting, largely as proposed, amendments to rule 5b-3 and
Forms N-1A, N-2, and N-3 to implement section 939A of the Dodd-Frank
Act and effectuate Congressional intent to reduce reliance on NRSRO
credit ratings.\12\ As discussed below, the amendments replace a
reference to required NRSRO credit ratings in rule 5b-3 for certain
securities held by funds as collateral for repurchase agreements with
an alternative standard that is designed to retain a similar degree of
credit quality. We are also amending Forms N-1A, N-2, and N-3 to
eliminate the required use of NRSRO credit ratings by funds that choose
to use credit quality categorizations in the required table, chart, or
graph of portfolio holdings. Under the amendments, funds that choose to
use credit quality to depict portfolio holdings must include a
description of how the credit quality of the holding was determined. If
a fund chooses to use credit ratings issued by a credit rating agency
to depict the credit quality of portfolio holdings, the fund must

include a description of how the credit ratings were identified and
selected.
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    \12\ See Section 939A of the Dodd-Frank Act. Section 939A was
intended, at least in part, to address potential over-reliance on
NRSRO credit ratings resulting from perceived government-endorsement
of NRSROs. See Report of the House of Representatives Financial
Services Committee to Accompany H.R. 4173, H. Rep. No. 111-517 at
871 (2010).
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    In a separate release, the Commission is adopting final amendments
to remove references to credit ratings from rules on broker-dealer
financial responsibility and confirmations of transactions. These
amendments follow the Commission's April 2011 proposed rules in which
we proposed to amend rules and one form under the Exchange Act
applicable to broker-dealer financial responsibility, distributions of
securities, and confirmations of transactions in order to remove
references to credit ratings pursuant to section 939A of the Dodd-Frank
Act.\13\
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    \13\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, Exchange Act Release No. 64352
(Apr. 27, 2011) [76 FR 26550 (May 6, 2011)] (requesting public
comment on proposed amendments to rule 15c3-1 (17 CFR 240.15c3-1),
rule 15c3-3 (17 CFR 240.15c3-3), rule 17a-4 (17 CFR 240.17a-4),
rules 101 and 102 of Regulation M (17 CFR 242.101 and 242.102), and
rule 10b-10 (17 CFR 240.10b-10), and one form--the General
Instructions to Form X-17A-5, Part IIB (17 CFR 249.617)--to remove
references to credit ratings and, in certain cases, substitute
alternative standards of creditworthiness). For purposes of
implementing section 939(e) of the Dodd-Frank Act, which eliminated
provisions in sections 3(a)(41) and 3(a)(53)(A) of the Exchange Act
that referenced NRSRO credit ratings, the Commission also requested
comment in the proposing release on potential standards of
creditworthiness to replace the credit rating references.
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II. Prior Actions of the Commission and Other Regulators

    As part of our implementation of section 939A, we have reviewed our
prior actions and those of other regulators. As discussed below, both
the Commission and other regulators have proposed and issued several
final rules towards implementation of the mandate under section 939A of
the Dodd-Frank Act. In some cases, the references to credit ratings
were replaced with an alternative standard of credit quality designed
to retain the same degree of credit quality and liquidity as reflected
by the use of credit ratings.

A. Prior Commission Actions

    The Commission has long been concerned with the use of credit
ratings and has taken a variety of actions even before the enactment of
the Dodd-Frank Act regarding the use of NRSRO credit ratings in its
rules. For example, in 1994, the Commission published a concept release
soliciting comment on, among other things, whether the Commission
should eliminate references to NRSRO credit ratings from certain
rules.\14\ The Commission continued to consider the use of credit
ratings in its rules, when in 2003, we sought comment on alternative
benchmarks that could be used to meet the Commission's regulatory
objectives.\15\ Finally, in 2008, the Commission proposed amendments to
remove references to NRSRO credit ratings from certain of its rules
under the Securities Act, Exchange Act, and Investment Company Act.\16\
As previously noted, after the enactment of the Dodd-Frank Act, in
2011, the Commission proposed to remove credit ratings references from
certain rules and forms under the Investment Company Act.\17\ Also in
2011, the Commission separately proposed and adopted amendments
removing references to credit ratings in rules and forms under the
Securities Act and the Exchange Act related to offerings of securities
or issuer disclosure.\18\ Generally, in these prior actions, the
Commission has proposed or adopted amendments to its rules that seek to
retain a similar degree of credit quality to that in the rule being
amended by replacing credit ratings references with a two-part standard
that includes an assessment of the credit quality and the liquidity of
the security, the details of which vary according to the requirements
of the particular rule or form.
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    \14\ See Nationally Recognized Statistical Rating Organizations,
Exchange Act Release No. 34616 (Aug. 31, 1994) [59 FR 46314 (Sep. 7,
1994)]; see also Capital Requirements for Brokers or Dealers Under
the Securities Exchange Act of 1934, Exchange Act Release No. 39457
(Dec. 17, 1997) [62 FR 68018 (Dec. 30, 1997)].
    \15\ See Rating Agencies and the Use of Credit Ratings under the
Federal Securities Laws, Exchange Act Release No. 47972 (June 4,
2003) [68 FR 35258 (June 12, 2003)]; see also Report on the Role and
Function of Credit Rating Agencies in the Operation of the
Securities Markets: As Required by Section 702(b) of the Sarbanes-
Oxley Act of 2002, Commission (Jan. 2003).
    \16\ See, e.g., References to Ratings of Nationally Recognized
Statistical Rating Organizations, Exchange Act Release No. 58070
(July 1, 2008) [73 FR 40088 (July 11, 2008)]. In October 2009, the
Commission adopted several of the 2008 proposed amendments and re-
opened for comment the remaining amendments. See References to
Ratings of Nationally Recognized Statistical Rating Organizations,
Exchange Act Release No. 60789 (Oct. 5, 2009) [74 FR 52358 (Oct. 9,
2009)] (adopting release).
    \17\ See 2011 Proposing Release supra note 10. One aspect of
that rule proposal has already been adopted. New rule 6a-5, adopted
by the Commission, replaced a credit rating requirement (removed by
Congress as part of the Dodd-Frank Act) applicable to debt
securities that certain business and industrial development
companies (``BIDCOs'') relying on the Investment Company Act
exemption in section 6(a)(5) may invest in. Under new rule 6a-5, a
BIDCO that relies on the exemption in section 6(a)(5) may invest in
certain debt securities, provided that the BIDCO board determines,
at the time of purchase, that the debt security is (1) of no greater
than moderate credit risk and (2) is sufficiently liquid. The
standard for liquidity is whether the security can be sold at or
near its carrying value within a reasonably short period of time.
See Purchase of Certain Debt Securities by Business and Industrial
Development Companies Relying on an Investment Company Act
Exemption, Investment Company Act Release No. 30268 (Nov. 19, 2012)
[77 FR 70117 (Nov. 23, 2012)].
    \18\ See Security Ratings, Securities Act Release No. 9186 (Feb.
9, 2011) [76 FR 8946 (Feb. 16, 2011)]; see also Security Ratings,
Securities Act Release No. 9245 (July 27, 2011) [76 FR 46603 (Aug.
3, 2011)] (adopting amendments to rule 134 (17 CFR 230.134), rule
138 (17 CFR 230.138), rule 139 (17 CFR 230.139), rule 168 (17 CFR
230.168), Form S-3 (17 CFR 239.13), Form S-4 (17 CFR 239.25), Form
F-3 (17 CFR 239.33), and Form F-4 (17 CFR 230. 34) under the
Securities Act; rescinding Form F-9 (17 CFR 239.39); adopting
amendments to the Securities Act and Exchange Act forms and rules
that referred to Form F-9 to eliminate those references; and
amending Schedule 14A (17 CFR 240.14a-101) under the Exchange Act).
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B. Actions of Other Regulators

    A number of other federal agencies have also taken action to
implement section 939A of the Dodd-Frank Act, including regulations
proposed or adopted by the Commodity Futures Trading Commission
(``CFTC''),\19\ the Office of the Comptroller of the Currency
(``OCC''),\20\ the National Credit Union Administration (``NCUA''),\21\
the Federal Housing Finance Agency (``FHFA''),\22\ the Department of
Labor (``DOL''),\23\ and jointly by the OCC and Federal Reserve Board
(``FRB'').\24\ The actions taken by these other regulators were
considered in adopting today's amendments.
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    \19\ CFTC, Removing Any Reference to or Reliance on Credit
Ratings in Commission Regulations; Proposing Alternatives to the Use
of Credit Ratings, 76 FR 44262 (July 25, 2011).
    \20\ OCC, Alternatives to the Use of External Credit Ratings in
the Regulations of the OCC, 77 FR 35253 (June 13, 2012).
    \21\ NCUA, Alternatives to the Use of Credit Ratings, 77 FR
74103 (Dec. 13, 2012).
    \22\ FHFA, Removal of References to Credit Ratings in Certain
Regulations Governing the Federal Home Loan Banks, 78 FR 30784 (May
23, 2013).
    \23\ DOL, Proposed Amendments to Class Prohibited Transaction
Exemptions to Remove Credit Ratings Pursuant to the Dodd-Frank Wall
Street Reform and Consumer Protection Act, 78 FR 37572 (June 21,
2013).
    \24\ OCC & FRB, Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018 (Oct. 11, 2013).
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III. Discussion

A. Rule 5b-3

    Rule 5b-3 allows funds to treat the acquisition of a repurchase
agreement as an acquisition of securities collateralizing the
repurchase agreement for certain diversification and broker-dealer
counterparty limit purposes under the Investment Company Act \25\ if

the obligation of the seller to repurchase the securities from the fund
is ``collateralized fully.'' \26\ In a typical investment company
repurchase agreement, a fund enters into a contract with a broker,
dealer, or bank (the ``counterparty'' to the transaction) to purchase
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 a return to the fund on its investment.
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.\27\
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    \25\ Section 5(b)(1) of the Investment Company 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 that a
diversified fund may enter into with any one counterparty. 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. Rule
12d3-1 provides an exemption from the prohibitions of section
12(d)(3) under certain conditions, which exemption a fund may be
able to rely on in the event the repurchase agreement fails to meet
the look-through requirements of rule 5b-3. See Rule 5b-3 Adopting
Release, infra note 27, at section II.C. The ability of funds to
rely on rule 5b-3 of the Investment Company Act may affect the
degree to which a fund invests in repurchase agreements.
    \26\ Rule 5b-3(a). The term ``collateralized fully'' is defined
in rule 5b-3(c)(1). In general, under rule 5b-3, a fund investing in
a repurchase agreement looks to the value and liquidity of the
securities collateralizing the repurchase agreement rather than the
creditworthiness of the counterparty for satisfaction of the
repurchase agreement. See Rule 5b-3 Adopting Release, infra note 27,
at section II.A.3. But see rule 2a-7(c)(4)(ii)(A) (requiring money
market fund boards to evaluate the counterparty's creditworthiness).
    \27\ 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''). Repurchase
agreements provide funds with a convenient means to invest excess
cash on a secured basis, generally for short periods of time.
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    Under current requirements, 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,\28\ (iii) securities that at the time the
repurchase agreement is entered into are rated in the highest rating
category by the ``requisite NRSROs'' \29\ 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.\30\ When the Commission
proposed rule 5b-3, we explained that the highest rating category
requirement in the definition of fully collateralized was designed to
help ensure that the market value of the collateral would remain stable
and that the fund could liquidate the collateral quickly in the event
of a default by the counterparty. The high quality requirement was also
designed to limit a fund's exposure to the ability of the counterparty
to maintain sufficient collateral, and reflected the understanding that
securities of lower quality may be subject to greater price
fluctuation.\31\
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    \28\ Government Security means ``any security issued or
guaranteed as to principal or interest by the United States, or by a
person controlled or supervised by and acting as an instrumentality
of the Government of the United States pursuant to authority granted
by the Congress of the United States; or any certificate of deposit
for any of the foregoing.'' Section 2(a)(16) of the Investment
Company Act. Government securities include, for example, U.S.
Treasury notes and bonds, and securities issued by the Federal Home
Loan Mortgage Company (``Freddie Mac''), Federal National Mortgage
Association (``Fannie Mae''), and Government National Mortgage
Association (``Ginnie Mae'').
    \29\ 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). This definition is deleted under the
amended rule.
    \30\ Rule 5b-3(c)(1)(iv). The term ``unrated securities'' means
securities that have not received a rating from the requisite
NRSROs. Rule 5b-3(c)(8). This definition is deleted under the
amended rule.
    \31\ 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.
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    Today we are amending rule 5b-3 to eliminate the requirement that
collateral other than cash or government securities be rated in the
highest category by the requisite NRSROs or be of comparable quality.
In place of this requirement, the amended rule requires that collateral
other than cash or government securities consist of securities that the
fund's board of directors (or its delegate) determines at the time the
repurchase agreement is entered into are: (i) Issued by an issuer that
has an exceptionally strong capacity to meet its financial obligations
on the securities collateralizing the repurchase agreement; and (ii)
sufficiently liquid that they can be sold at approximately their
carrying value in the ordinary course of business within seven calendar
days.\32\
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    \32\ Amended rule 5b-3(c)(1)(iv)(C).
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    The new credit quality standard we are adopting is designed to
retain a degree of credit quality that is similar to the existing
standard under rule 5b-3 and consistent with the two-part approach we
have taken in establishing credit quality standards to replace credit
rating references in other rules under the federal securities laws.\33\
We note that our amendment to rule 5b-3 does not affect a money market
fund that seeks special treatment of its repurchase agreement holdings
under the diversification provisions of rule 2a-7 because in order to
obtain such treatment, a money market fund is limited to investing in
repurchase agreements collateralized by cash items or government
securities (which remain unaffected by our amendments today).\34\ We
are adopting the liquidity component of the new standard as proposed,
but we have revised the credit quality component from what was proposed
to address certain commenters' concerns.
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    \33\ See supra section II.A.
    \34\ See rule 2a-7(a)(5).
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    We proposed that collateral issuers be required to have the
``highest capacity'' to meet their financial obligations on the
collateral securities.\35\ Three of the five commenters who addressed
the proposed amendments to rule 5b-3 argued that this standard is not
consistent with the standard established by the ratings reference in
the current rule because the proposed standard does not contemplate any
variation in creditworthiness among issuers that meet the highest
rating standard.\36\ Commenters suggested that short-term collateral
securities rated ``A-1+'' or ``A-1'' by Standard & Poor's both would
satisfy the rating condition under the current rule, but that only
those rated ``A-1+'' would likely have satisfied the credit standard
under our proposal.\37\ Accordingly, as these commenters recommended,
the amended rule requires an issuer to have an ``exceptionally strong''
capacity to meet its financial obligations on the collateral
securities.\38\ We are adopting this

standard, as revised from our proposal, because we believe that, like
the current rule, it permits some variation in creditworthiness among
issuers while being designed to retain a degree of risk limitation
similar to the current rule.\39\ In the case of asset-backed securities
that serve as collateral, an evaluation of the capacity of the issuer
to meet its financial commitment on the security should include an
assessment of the quality of the underlying assets and the structure of
the asset-backed security.\40\
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    \35\ See proposed rule 5b-3(c)(1)(iv)(C)(1).
    \36\ Federated Investors, Inc. Comment Letter (Apr. 25, 2011)
(``Federated Comment Letter''); Investment Company Institute Comment
Letter (Apr. 25, 2011) (``ICI Comment Letter''); T. Rowe Price
Associates, Inc. Comment Letter (Apr. 25, 2011) (``T. Rowe Price
Comment Letter''). But see 2011 Proposing Release (discussing the
proposed ``highest capacity'' standard and noting that ``[a]n issuer
of collateral securities that the board (or its delegate) determined
has an exceptionally strong capacity to repay its short or long-term
debt obligations . . . would satisfy the proposed [highest capacity]
standard'').
    \37\ See Standard & Poor's Ratings Definitions, infra note 39 at
5 (which may designate an ``A-1'' rating with a plus sign to
designate the obligor's capacity to meet its financial obligations
is extremely strong).
    \38\ See ICI Comment Letter; Federated Comment Letter
(supporting the ICI Comment Letter); and T. Rowe Price Comment
Letter (generally agreeing with the ICI Comment Letter).
    \39\ See Fitch Ratings, International Issuer and Credit Rating
Scales, http://www.fitchratings.com/web_content/ratings/fitch_ratings_definitions_and_scales.pdf (stating that a rating of AAA
is used in cases of ``exceptionally strong capacity for payment of
financial commitments''); Moody's Investor Service Rating Symbols
and Definitions, https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004 (stating that
ratings of Aaa are of the ``highest quality, subject to the lowest
level of credit risk''); and Standard & Poor's Ratings Definitions,
http://img.en25.com/Web/StandardandPoors/Ratings_Definitions.pdf
(stating that for a rating of AAA, ``[t]he obligor's capacity to
meet its financial commitment on the obligation is extremely
strong'').
    \40\ See Revisions to Rules Regulating Money Market Funds,
Investment Company Act Release No. 19959 (Dec. 17, 1993) [58 FR
68585 (Dec. 28, 1993)] at text accompanying nn.108-109 (``[t]he
credit quality of a typical asset backed security depends both upon
the structure of the security and the quality of the underlying
assets.''); Money Market Fund Reform, Investment Company Act Release
No. 29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)] at text
accompanying n.131 (noting that the minimal credit risk analysis
that a money market fund board (or its delegate) must conduct before
investing in an asset-backed security should include, among other
things, (i) an analysis of the underlying assets to ensure they are
properly valued and provide sufficient asset coverage for the cash
flow required to fund the asset-backed security under various market
conditions and (ii) an analysis of the terms of any liquidity or
other support provided by the sponsor of the asset-backed security).
See also Alternatives to the Use of External Credit Ratings in the
Regulations of the Office of the Comptroller of the Currency (June
4, 2012) [77 FR 35253 (June 13, 2012)] at text following n.2 (in
adopting an issuer-based credit quality standard to replace credit
ratings, the OCC indicates that, in the case of a structured finance
transaction, principal and interest repayment is not necessarily
solely reliant on the direct debt repaying capacity of the issuer or
obligor).
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    As discussed above, we are adopting the liquidity component of the
new standard as proposed. The liquidity standard in the amended rule is
similar to the standard used in rule 2a-7 governing money market funds,
and is also used in other rules under the Investment Company Act.\41\
No commenters addressed the proposed liquidity standard.
---------------------------------------------------------------------------

    \41\ See rule 2a-7(a)(19) (defining illiquid security to mean a
security that cannot be sold or disposed of in the ordinary course
of business within seven calendar days at approximately the value
ascribed to it by the fund). See also rule 10f-3(a)(3) (requiring,
among other things, that ``eligible municipal securities'' be
sufficiently liquid that they can be sold at or near their carrying
value within a reasonably short period of time).
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    We expect that securities that actively trade in a secondary market
at the time of the acquisition of the repurchase agreement will satisfy
the liquidity component of the standard. We also understand that most
securities used to collateralize repurchase agreements generally
actively trade in a secondary market.\42\ Securities that do not
actively trade in a secondary market would likely require a more in-
depth evaluation by the board or its delegate to determine whether they
meet the liquidity standard.
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    \42\ Repurchase agreements are often collateralized by
securities that include, but are not limited to, agency
collateralized mortgage-backed obligations (``CMOs''), agency
debentures and strips, agency mortgage-backed securities, private
label CMOs, corporate debt, equity securities, money market
instruments and U.S. Treasury securities. See, e.g., Tri-Party Repo
Statistical Data (as of August 2013), http://www.newyorkfed.org/banking/tpr_infr_reform_data.html. The securities that often
collateralize repurchase agreements trade frequently. For example,
data from the Securities Industry and Financial Markets Association
for January through August 2013 shows average daily trading volume,
in billions of dollars, as follows: Agency debentures and strips
($7.1); agency mortgage-backed securities ($242.9); corporate debt
($145.4); U.S. Treasury securities ($551.4) (available at http://www.sifma.org/research/statistics.aspx).
---------------------------------------------------------------------------

    The final amendments do not, as one commenter suggested, include
specific factors or tests that the board or its delegate must apply in
performing its credit analysis.\43\ This commenter acknowledged that a
reliable and objective shorthand measure of credit risk that could be
incorporated into Commission regulations is currently unavailable.\44\
The Commission considered including specific factors for funds to
consider in performing credit analysis under rule 5b-3. On balance, we
believe that, in the context of rule 5b-3, the new credit quality
standards provide sufficiently clear criteria under which a fund board
or its delegate can make determinations regarding credit quality and
liquidity for this particular purpose. Fund boards should also be
familiar with applying similar credit quality standards used in other
Commission rules.\45\ Fund boards may also consult external resources
and Commission staff guidance (if applicable) for additional guidance
on making credit quality determinations in certain circumstances.\46\
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    \43\ See Better Markets Comment Letter (Apr. 25, 2011) (``Better
Markets Comment Letter''). This commenter suggested certain factors
that they believed funds should be required to consider when
evaluating the creditworthiness of an issuer or a debt security.
    \44\ Id. We note that another commenter that recommended that we
establish an objective standard for credit quality determinations
did not provide any examples of such criteria. See New York City Bar
Committee on Investment Management Regulation Comment Letter (Apr.
29, 2011) (``NY City Bar Comment Letter'').
    \45\ See adopting release, supra note 16 (the Commission adopted
amendments to rule 10f-3, revising the definition of ``eligible
municipal security'' by replacing references to credit ratings with
a similar two-part credit quality standard). See also text
accompanying note 49.
    \46\ See, e.g., Tri-Party Repo Infrastructure, Reform Task
Force, http://www.newyorkfed.org/tripartyrepo/. See cf. Securities
and Exchange Commission, Division of Investment Management, IM
Guidance Update, Counterparty Risk Management Practices With Respect
to Tri-Party Repurchase Agreements (July 2013) (providing guidance
to funds on the legal and operational steps that funds should
consider if a counterparty fails and defaults on its obligations
under a tri-party repurchase agreement), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-03.pdf.
---------------------------------------------------------------------------

    The new credit quality standard is intended to achieve the same
objectives that the credit rating requirement was designed to achieve,
i.e., to limit collateral securities to those that are likely to retain
a sufficiently stable market value and that, under ordinary
circumstances, the fund would be able to liquidate quickly, at or near
their carrying value in the event of a counterparty default.\47\
Amended rule 5b-3 would not, however, prohibit a fund board from
establishing its own additional criteria for what the fund may accept
as collateral for repurchase agreements under the amended rule.
---------------------------------------------------------------------------

    \47\ See supra note 31.
---------------------------------------------------------------------------

    Under the final rule, as was proposed, the fund's board will be
required to make credit quality determinations for all collateral
securities that are not cash items or government securities, rather
than just for unrated securities. In addition, as in the current rule,
the amended rule continues to permit the board to delegate these credit
quality and liquidity determinations.\48\ We do not agree with the
concerns of one commenter that this determination will impose undue
burdens on the board because the determination is similar to what rule
5b-3 currently requires a fund board (or its delegate) to make with
respect to unrated collateral securities.\49\ In addition, the amended
rule will continue to permit the board of directors to delegate credit
quality and liquidity determinations that the board believes

are within the delegate's expertise if the board retains sufficient
oversight.\50\
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    \48\ This is similar to rule 2a-7, which permits the board to
delegate decisions regarding credit quality. See rule 2a-7(e).
    \49\ See NY City Bar Comment Letter (asserting that fund boards
would be assigned responsibility for making determinations that are
not within their expertise and arguing that the ability to delegate
the determination does not relieve them of ultimate responsibility).
See also infra section V.b.2. See rule 5b-3(c)(1)(iv)(D) (requiring
that unrated securities other than government securities be ``of
comparable quality'' to securities rated in the highest category by
requisite NRSROs).
    \50\ See Amended rule 5b-3(c)(1)(iv)(C); see also 2011 Proposing
Release, supra note 10, at n.51 (``As in the current rule, the
proposed rule would permit the board to delegate this credit quality
and liquidity determination.''). We expect that a fund's written
policies and procedures would include guidelines for the fund's
delegate (typically, the investment adviser) in making required
determinations under rule 5b-3 and oversight of the fund adviser's
compliance in making such determinations. See rule 38a-1. These
policies and procedures typically would identify the process to be
followed by the board (or its delegate) in making these credit and
liquidity evaluations, including, as appropriate, the types of data
to be used or factors to be considered and the person(s) or
position(s) responsible. They also typically would provide for
regular reporting to the board, as appropriate, about these
evaluations, to allow the board to provide effective oversight of
the process.
---------------------------------------------------------------------------

    Under the amended rule, when determining credit quality and
liquidity, the board (or its delegate) may incorporate into its
analysis ratings, reports, opinions and other assessments issued by
third parties, including NRSROs. A board should evaluate the basis for
using any third-party assessment, including an NRSRO rating, in
determining whether collateral meets the new standard and would not
rely on the use of an NRSRO rating as a standard by itself without
evaluating the quality of each NRSRO's assessment. In this way, the
board could determine which third-party providers are credible and
reliable and provide assessments that would be most appropriate to
incorporate in making determinations under the amended rule. Delegation
of these functions, as well as the use of third-party providers, may
help to limit the potential increase in burdens on the board. One
commenter suggested that we not allow a fund board to consider credit
ratings in determining if a repurchase agreement is fully
collateralized, stating that this would conflict with section 939A of
the Dodd-Frank Act.\51\ We believe, however, that credit ratings can
serve as a useful data point for evaluating credit quality, and as
noted above, a fund's board (or its delegate) may not rely solely on
the credit ratings of an NRSRO without performing additional due
diligence.
---------------------------------------------------------------------------

    \51\ See Better Markets Comment Letter.
---------------------------------------------------------------------------

    A fund that enters into repurchase agreements and relies on rule
5b-3 must maintain written policies and procedures that are reasonably
designed to comply with the conditions of the rule, including the
credit quality and liquidity requirements we are adopting today, and
funds may therefore have to amend their policies and procedures.\52\ We
also understand that credit quality standards for securities
collateralizing repurchase agreements are typically negotiated in the
agreements between funds and counterparties.\53\ We understand that
those standards currently include a rating (for rated collateral
securities) and any additional criteria that a fund manager considers
necessary to ensure that the credit quality of collateral securities
meets the fund's requirements, or, for unrated securities, a comparable
credit quality standard. The amended rule does not prohibit fund boards
(or their delegates) from considering the credit quality standards in
current repurchase agreements and policies and procedures adopted to
comply with the current rule as part of their analysis, provided that
fund boards (or their delegates) determine that the ratings specified
in the repurchase agreements and policies and procedures meet the
standards we are adopting today, and that the agencies providing the
ratings used in the policies and procedures are credible and reliable
for that use. A fund could also revise its repurchase agreements and
policies and procedures to change or eliminate the consideration of
specific credit ratings or to incorporate other third-party evaluations
of credit quality.\54\
---------------------------------------------------------------------------

    \52\ Registered funds are required to adopt and implement
written policies and procedures reasonably designed to prevent the
fund's violation of federal securities laws. See rule 38a-1(a); see
also infra sections IV.A and V.B.
    \53\ Many repurchase market participants will only accept AAA-
rated paper such as government bonds as collateral. See Moorad
Choudhry, The Repo Handbook (2d ed. 2010) at 298. Counterparties to
repurchase agreements generally assess counterparty credit risk
exposure based on the ``haircut''--For example, $100 of securities
collateralizing a loan of $97 produces a 3% haircut. The haircut may
be greater depending on the counterparties' assessment of the
collateral provider's creditworthiness. See Repo and Securities
Lending, Staff Report No. 529, Federal Reserve Bank of New York
(Dec. 2011, Rev. Feb. 2013). Assessments of credit quality are not
standardized but are participant specific and negotiated at the time
of the transaction. Id.
    \54\ See 2011 Proposing Release, supra note 10, at n.58. An
estimate of the potential costs is discussed infra at section IV.A.
---------------------------------------------------------------------------

    As discussed above, amended rule 5b-3 replaces the requirement that
collateral for repurchase agreements consist of securities rated in the
highest category by the requisite NRSROs (other than cash and
government securities) with a requirement that the collateral other
than cash and government securities consist of securities issued by an
issuer that has an exceptionally strong capacity to meet its financial
obligations and that are sufficiently liquid. Consistent with the
protection of investors and as necessary and appropriate in the public
interest, we are also amending rule 5b-3 to define an issuer to include
an issuer of an unconditional guarantee of the security.\55\ We
proposed this amendment to preserve a fund's ability to use the same
types of collateral securities as it currently uses to satisfy the
conditions of rule 5b-3. We received no comments on this aspect of the
proposal and are adopting it as proposed. Thus, under amended rule 5b-
3, a collateral security with an unconditional guarantee, the issuer of
which meets the new credit quality test, satisfies that element of the
standard.
---------------------------------------------------------------------------

    \55\ Amended rule 5b-3(c)(4) (defining ``issuer'' to mean ``the
issuer of a collateral security or the issuer of an unconditional
obligation of a person other than the issuer of the collateral
security to undertake to pay, upon presentment by the holder of the
obligation (if required), the principal amount of the underlying
collateral security plus accrued interest when due or upon
default.'').
---------------------------------------------------------------------------

B. Forms N-1A, N-2, and N-3

    We are also adopting amendments to Forms N-1A, N-2, and N-3 to
remove the required use of credit ratings assigned by an NRSRO. Forms
N-1A, N-2, and N-3, among other things, contain the requirements for
shareholder reports of mutual funds, closed-end funds, and certain
insurance company separate accounts that offer variable annuities.\56\
---------------------------------------------------------------------------

    \56\ Open-end management investment companies, commonly known as
mutual funds, use Form N-1A. Closed-end management investment
companies use Form N-2. Separate accounts organized as management
investment companies that offer variable annuity contracts use Form
N-3.
---------------------------------------------------------------------------

    Currently, Forms N-1A, N-2, and N-3 require shareholder reports to
include a table, chart, or graph depicting portfolio holdings by
reasonably identifiable categories (e.g., type of security, industry
sector, geographic region, credit quality, or maturity).\57\ The forms
require the categories to be selected in a manner reasonably designed
to depict clearly the types of investments made by the fund, given its
investment objectives. If credit quality is used to present portfolio
holdings, the forms currently require that credit quality be depicted
using the credit ratings assigned by a single NRSRO. We are amending
Forms N-1A, N-2, and N-3, as proposed, to no longer require the use of
NRSRO credit ratings by funds that choose to use credit quality
categorizations in the required table, chart, or graph of portfolio
holdings. Accordingly, funds that choose to show credit quality
categorizations in the required table, chart, or graph may use
alternative categorizations that are not based on NRSRO credit ratings.
---------------------------------------------------------------------------

    \57\ Item 27(d)(2) of Form N-1A; Instruction 6(a) to Item 24 of
Form N-2; Instruction 6(i) to Item 28(a) of Form N-3.
---------------------------------------------------------------------------

    In a change from the 2011 Proposing Release, however, under the
amended forms, funds that choose to continue to

use credit ratings will no longer be restricted to using the credit
ratings assigned by a single NRSRO. Accordingly, funds that choose to
depict credit quality using credit ratings assigned by a credit rating
agency may use different credit rating agencies for split-rated
securities (i.e., securities that have received different ratings from
multiple credit rating agencies) and they may use ratings provided by
credit rating agencies that are not NRSROs.\58\ Funds will also be
required to describe how the credit quality of the holdings was
determined, and if credit ratings are used, a description of how they
were identified and selected.\59\
---------------------------------------------------------------------------

    \58\ We are replacing the term ``ratings'' with ``credit
ratings'' and ``nationally recognized statistical rating
organization `NRSRO' '' with ``credit rating agency'' as defined
under the Exchange Act. See sections 3(a)(60) [15 U.S.C. 78c(a)(60)]
and 3(a)(61) [15 U.S.C. 78c(a)(61)] of the Exchange Act, which
define ``credit rating'' and ``credit rating agency'', respectively.
    \59\ See Amended Item 27(d)(2) of Form N-1A; Amended Instruction
6(a) to Item 24 of Form N-2; Amended Instruction 6(i) to Item 28(a)
of Form N-3.
---------------------------------------------------------------------------

    Four of the five substantive comments we received on the proposed
amendments to Forms N-1A, N-2, and N-3, supported eliminating the
required use of NRSRO credit ratings to depict credit quality.\60\ Two
of these commenters noted that shareholders would benefit from
information about the credit quality of a fund's portfolio securities,
whether determined by an NRSRO or internally.\61\
---------------------------------------------------------------------------

    \60\ ICI Comment Letter; Vanguard Comment Letter; T. Rowe Price
Comment Letter; Federated Comment Letter (supporting the ICI's
comments). The fifth commenter argued that the Commission is not
required to remove references to credit ratings from the forms
pursuant to section 939A of the Dodd-Frank Act. See BlackRock
Comment Letter. Regardless of whether the Commission is required to
remove from the forms references to credit ratings, the Commission
believes that the removal of such references is consistent with the
purpose of section 939A of the Dodd-Frank Act.
    \61\ ICI Comment Letter; Federated Comment Letter (supporting
the ICI's comments).
---------------------------------------------------------------------------

    Although most commenters supported eliminating the required use of
credit ratings to depict credit quality, four commenters opposed the
proposed requirement that a fund that chooses to use NRSRO credit
ratings must use the credit ratings of a single NRSRO. Instead, these
commenters recommended that when a security is split-rated, the fund be
permitted to choose which NRSRO rating to use, provided the choice is
made consistently pursuant to a disclosed policy.\62\ These commenters
argued that this approach would benefit funds and investors by allowing
funds to disclose credit quality information in shareholder reports in
a manner consistent with marketing materials and internal investment
policies.\63\
---------------------------------------------------------------------------

    \62\ ICI Comment Letter; Vanguard Comment Letter; T. Rowe Price
Comment Letter; Federated Comment Letter (supporting the ICI's
comments). Two commenters noted that the Financial Industry
Regulatory Authority (``FINRA'') permits funds to use different
approaches to portray the credit quality of split-rated bonds in
marketing materials (noting further that funds receive credit rating
information through data feeds and that it would be more cost
efficient for funds to rely on a single data feed to comply with one
consistent SEC/FINRA requirement). See ICI Comment Letter; Vanguard
Comment Letter.
    \63\ See ICI Comment Letter; Federated Comment Letter
(supporting the ICI's comments); Vanguard Comment Letter.
---------------------------------------------------------------------------

    We agree with commenters and have revised the final form amendments
to provide this additional degree of flexibility. Accordingly, the
amended forms permit funds to consider alternative approaches to
presenting credit quality that accurately and effectively describe the
credit quality of the fund's portfolio. For example, under the amended
forms, a fund could have a policy of disclosing the median credit
quality rating for split-rated securities instead of only using the
ratings of a single credit rating agency (when more than two rating
agencies rate the security).\64\ In the 2011 Proposing Release, we
proposed to maintain the general requirement that ratings be selected
from a single NRSRO because we were concerned about the possibility
that a fund may select the most favorable credit ratings among credit
ratings assigned by multiple NRSROs. On balance, we are persuaded by
commenters that the benefits of this additional flexibility outweigh
the potential ``cherry picking'' concern. We believe that the risks
associated with cherry picking ratings are mitigated by the disclosure
requirements discussed below.\65\ For example, if a fund discloses
that, with respect to split-rated securities, it is the fund's policy
to select the highest credit rating provided by a credit rating agency,
investors will be on notice that the fund has made a decision not to
include potentially lower and more conservative measures of credit
quality. In addition, we believe that in some circumstances selecting
credit ratings from more than one credit rating agency may reflect a
more comprehensive approach to credit quality analysis that results in
information about credit quality that may be more accurate or complete.
For example, a fund that reviews credit ratings from three rating
agencies, discards the outliers (i.e., the highest and lowest ratings),
and selects the middle rating,\66\ has evaluated credit quality from a
broader set of market participants that may lead to a more complete
evaluation of credit quality.
---------------------------------------------------------------------------

    \64\ See infra note 70 and accompanying and following text
(discussing the difference between using median and average credit
ratings).
    \65\ See Amended Item 27(d)(2) of Form N-1A; Amended Instruction
6(a) to Item 24 of Form N-2; Amended Instruction 6(i) to Item 28(a)
of Form N-3.
    \66\ See, e.g., Fact Sheet, BlackRock Bond Index Fund
(portraying credit quality using the median credit rating from among
S&P, Moody's, and Fitch, when all three agencies rate a security),
available at https://www2.blackrock.com/webcore/litService/search/getDocument.seam?venue=PUB_IND&source=CONTENT&serviceName=publicServiceView&ContentID=1111147239&venue=FP_ML; Fact Sheet, Vanguard High-Yield Tax-Exempt Fund
Investor Shares (same), available at https://personal.vanguard.com/us/funds/snapshot?FundId=0044&FundIntExt=INT.
---------------------------------------------------------------------------

    Under the amended forms, funds that choose to depict portfolio
holdings according to credit quality must include a description of how
the credit quality of the holdings was determined.\67\ This description
should include a discussion of the credit quality evaluation process,
the rationale for its selection, and an overview of the factors
considered, such as the terms of the security (e.g., interest rate, and
time to maturity), the obligor's capacity to repay the debt, and the
quality of any collateral. If the fund uses credit ratings issued by a
credit rating agency to depict credit quality, the fund should explain
how the credit ratings were identified and selected, and include this
description near, or as part of, the graphical representation.\68\ This
description should include, if applicable, a discussion of: (i) The
criteria considered or process used in selecting the credit ratings
(e.g., the fund might use the median credit rating from among three
rating agencies \69\); (ii) how the fund evaluated those criteria
(i.e., the due diligence performed); (iii) how the fund reports credit
ratings for any security that is not rated by the credit rating agency
selected if the fund has a policy of using the ratings of a

single rating agency (e.g., has the fund selected a designated
alternate rating agency); (iv) how the fund reports credit ratings for
any security that is not rated by any credit rating agency (i.e., the
process for self-rating); or (v) other fund policies on selecting
credit ratings for purposes of disclosure. We expect that this
discussion, modified and expanded upon by funds as appropriate, will
provide investors with insight into how the fund identified and
selected the credit ratings used in depicting the fund's portfolio by
credit quality.
---------------------------------------------------------------------------

    \67\ See supra note 65; see also ICI Comment Letter
(recommending that funds be permitted to choose which NRSRO rating
to use for split-rated securities, provided that the choice is made
pursuant to a disclosed policy).
    \68\ If a fund does not use credit ratings, its description of
how the credit quality of the holdings was determined would also
need to be near, or as part of, the graphical representation. See
Amended Item 27(d)(2) of Form N-1A; Amended Instruction 6(a) to Item
24 of Form N-2; Amended Instruction 6(i) to Item 28(a) of Form N-3.
    \69\ For example, Morningstar prefers that bonds be classified
using the Barclays Capital Family of Indices ratings rules (i.e.,
use the middle rating of Moody's, S&P and Fitch after dropping the
highest and lowest available ratings; if only two rating agencies
rate a security then the lowest rating should be used; and if only
one agency rates a security then that rating should be used). See
Morningstar Fixed-Income Style Box Methodology (Apr. 30, 2012) at
http://corporate.morningstar.com/us/documents/MethodologyDocuments/MethodologyPapers/FixedIncomeStyleBoxMeth.pdf.
---------------------------------------------------------------------------

    We recognize that under the final form amendments, a fund has a
variety of options when depicting its portfolio holdings using credit
quality. For example, a fund might choose not to use credit ratings and
could rely instead on internal credit assessments. If a fund does not
use credit ratings, we note that it might be misleading for a fund to
describe its portfolio holdings quality with similar descriptions as
the ratings nomenclature used by rating agencies (e.g., AAA, Aa), or to
characterize the securities as ``rated.'' If a fund chooses to depict
its portfolio using credit ratings issued by a credit rating agency, a
fund could choose to use the median credit rating from among multiple
credit rating agencies (discarding the highest and lowest ratings) when
a security is split-rated.\70\ We note, however, that it might be
misleading for a fund to disclose an average credit quality rating that
is based on ratings from multiple credit rating agencies because credit
rating agencies may use different criteria to evaluate the credit
quality of an issuer. A fund might also choose other methods for
evaluating credit quality of portfolio securities, such as a policy of
selecting the highest or lowest credit rating for split-rated
securities among the ratings issued by certain specified rating
agencies.\71\ As discussed above, a fund must include in its disclosure
a description of how the credit quality of the holdings was determined,
no matter the method used.
---------------------------------------------------------------------------

    \70\ Id.; see also supra note 66.
    \71\ See, e.g., Fact Sheet, Fidelity Institutional Money Market
Prime Money Market Portfolio--Institutional CL (categorizing
portfolio credit quality for investment grade taxable and municipal
bond funds and multi-asset class funds with a fixed income component
using the highest credit rating among Moody's, S&P, or Fitch),
available at https://fundresearch.fidelity.com/mutual-funds/composition/31607A208.
---------------------------------------------------------------------------

    The amended forms are intended to provide funds with the
flexibility to present credit ratings in a manner that more clearly
explains the credit quality of the fund's portfolio and the method by
which the fund determined that quality.

IV. Paperwork Reduction Act

    Certain provisions of the amendments we are adopting contain
``collections of information'' within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\72\ The titles for the existing
collections of information we are amending are: (i) ``Rule 30e-1 under
the Investment Company Act of 1940, Reports to Stockholders of
Management Companies''; \73\ and (ii) ``Rule 38a-1 under the Investment
Company Act of 1940, Compliance procedures and practices of registered
investment companies.'' We adopted those rules pursuant to the
Investment Company Act. There is currently no approved collection of
information for rule 5b-3, and the amendments do not create any new
collections under that rule. The amendments to rule 5b-3 do, however,
affect the collection of information burden for rule 38a-1.
---------------------------------------------------------------------------

    \72\ 44 U.S.C. 3501-3520.
    \73\ The amendments to Forms N-1A, N-2, and N-3 relate solely to
the contents of fund shareholder reports. The PRA burden associated
with fund shareholder reports is included in the burden associated
with the collection of information for rule 30e-1 under the
Investment Company Act rather than Forms N-1A, N-2 and N-3.
---------------------------------------------------------------------------

    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. We published notice soliciting comments
on the collection of information requirements in the 2011 Proposing
Release and submitted the proposed collections of information to the
Office of Management and Budget (``OMB'') for review in accordance with
44 U.S.C. 3507(d) and 5 CFR 1320.11 under the control numbers 3235-0025
(rule 30e-1) and 3235-0586 (rule 38a-1). We received no comments on the
PRA estimates contained in the 2011 Proposing Release.

A. Rule 38a-1

    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. Rule 5b-3, as amended, requires that the securities
collateralizing a repurchase agreement consist of securities that the
fund's board of directors, or its delegate, determines are issued (or
have unconditional guarantees that are issued) by an issuer that has an
exceptionally strong capacity to meet its financial obligations and are
highly liquid.\74\ To that end, the fund's board of directors, pursuant
to rule 38a-1 under the Investment Company Act, must have procedures
that are reasonably designed to ensure that the fund is able to comply
with the conditions of amended rule 5b-3, including the credit quality
and liquidity requirements outlined in the amended rule.\75\ As
discussed above, these procedures should be designed to limit
collateral securities to those that are likely to retain a stable
market value and that, in ordinary circumstances, the fund would be
able to liquidate quickly in the event of a default. This rule 38a-1
collection of information will be mandatory for funds that rely on rule
5b-3. Records of information made in connection with this requirement
will be required to be maintained for inspection by Commission staff,
but the collection will not otherwise be submitted to the Commission.
To the extent that the Commission receives confidential information
pursuant to this collection of information, such information would be
kept confidential, subject to the provisions of applicable law.\76\
---------------------------------------------------------------------------

    \74\ Amended rule 5b-3(c)(1)(iv)(C). See supra section III.A.
    \75\ Under rule 38a-1, funds must have written policies and
procedures reasonably designed to prevent violation of the federal
securities laws. Rule 38a-1(a)(1). Funds thus would have policies
and procedures for complying with rule 5b-3, which would include
policies and procedures relating to credit quality determinations of
unrated collateral securities, if appropriate.
    \76\ See, e.g., 5 U.S.C. 552. Exemption 4 of the Freedom of
Information Act provides an exemption for ``trade secrets and
commercial or financial information obtained from a person and
privileged or confidential.'' 5 U.S.C. 552(b)(4). Exemption 8 of the
Freedom of Information Act provides an exemption for matters that
are ``contained in or related to examination, operating, or
condition reports prepared by, on behalf of, or for the use of an
agency responsible for the regulation or supervision of financial
institutions.'' 5 U.S.C. 552(b)(8).
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    We do not anticipate that the amendments to rule 5b-3 will
significantly change collection of information burdens under rule 38a-1
because we believe funds would likely rely significantly on their
current policies and procedures to determine the credit quality of
collateral securities and comply with amended rule 5b-3. As we
indicated above, we understand that credit quality standards for
securities collateralizing repurchase agreements typically are
contained in the repurchase agreements between funds and
counterparties.\77\ We understand that those standards currently
include a rating (for rated collateral securities) and any additional
criteria a fund manager considers

necessary to ensure that the credit quality of the collateral
securities meets the fund's requirements, or, for unrated securities, a
comparable credit quality standard. Counterparties provide collateral
securities to conform to these standards and funds confirm that the
securities are conforming. As we have noted above, funds can continue
to consider evaluations of outside sources, including credit ratings
that the board determines are credible and reliable in making their
credit quality determinations under the amended rule. We expect that
funds will likely continue to rely on their current policies and
procedures (i.e., using credit quality standards that include ratings
currently set forth in their repurchase agreements with
counterparties). Thus, we do not expect that the amendments to rule 5b-
3 will significantly change the current collection of information
burden estimates for rule 38a-1.\78\ Nevertheless, funds may review
their repurchase agreements and policies and procedures that address
rule 5b-3 compliance and make technical changes to those documents in
response to the amendments. Staff estimated in the proposal and
continues to believe that it will take, on average, 1.5 hours of a
senior business analyst's time to perform this review and make any
technical changes for an individual fund portfolio, for an estimated
one-time additional burden of 15,176 hours for all fund portfolios
(other than money market fund portfolios).\79\ Amortized over three
years, the staff estimates that the estimated annual aggregate burden
will be 5,059 burden hours.\80\
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    \77\ See supra note 53 and accompanying text.
    \78\ The current approved annual burden for rule 38a-1 under the
PRA is 248,455 hours. As discussed below, as amended, the collection
of information requirement will be 263,631 hours (248,455 + 15,176).
    \79\ For purposes of this PRA analysis, we assume that all funds
enter into repurchase agreements and rely on rule 5b-3. We have not
included money market funds in our estimates, however, because they
are subject to different requirements for the collateralization of
repurchase agreements under rule 2a-7. See text accompanying note
34. The staff's estimate is based on staff examination of industry
data as of August 31, 2013 and includes 10,117 fund portfolios. We
therefore estimate that there will be 10,117 respondents to this
collection of information. The amount is calculated as follows:
10,117 fund portfolios x 1.5 hours = 15,176 one-time additional
burden hours for all fund portfolios. We estimate that the one-time
additional annual burden is 1.5 hours per respondent.
    The monetized burden hours are calculated as follows: 15,176
hours x $245 per hour = $3,718,120 one-time additional costs. The
staff estimates that the internal cost for time spent by a senior
business analyst is $245 per hour. This estimate, as well as other
internal time cost estimates made in this analysis, is derived from
SIFMA's Management and Professional Earnings in the Securities
Industry 2012, modified by Commission staff to account for an 1800-
hour work week and multiplied by 5.35 to account for bonuses, firm
size, employee benefits and overhead.
    \80\ The amount is calculated as follows: 15,176 burden hours/3
= 5,059 burden hours. Amortized over three years, staff estimates
that the annual aggregate burden cost will be: $3,718,820/3 =
$1,239,373.
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    We anticipate that the fund's board will review the fund manager's
recommendation, but that the cost of this review will be incorporated
in the fund's overall annual board costs and would not result in any
particular additional cost. We received no comments on these estimates
and therefore have not modified them.\81\
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    \81\ The PRA costs have been modified slightly since the 2011
Proposing Release to reflect a more current estimate of the number
of fund portfolios affected, as well as updated hourly wages based
on the 2012 SIFMA table.
---------------------------------------------------------------------------

B. Rule 30e-1

    The amendments to Forms N-1A, N-2, and N-3 eliminate the required
use of NRSRO credit ratings by funds that choose to use credit quality
categorizations in the table, chart, or graph of portfolio holdings
provided in shareholder reports. The collection of information is
mandatory for those funds that choose to use credit quality
categorizations in these forms. If a fund chooses to depict portfolio
holdings according to credit quality, the fund must include a
description of how the credit quality of the holdings was determined.
If credit ratings assigned by a credit rating agency are used, the fund
must disclose how it identified and selected the credit ratings.
Responses to the disclosure requirements will not be kept confidential.
    Although funds would remain obligated to provide a table, chart, or
graph of portfolio holdings by reasonably identifiable categories, the
amendments require that certain funds must make new disclosures. Under
our proposed amendment, we estimated that there would be no additional
collection of information burden as a result of proposing to remove the
required use of credit ratings from the forms.\82\ Under our amended
rule, however, funds that choose to use credit quality categorizations
must disclose how the fund made the credit quality determinations, and
if the fund uses credit ratings issued by a credit rating agency, the
fund must disclose how it identified and selected the credit
ratings.\83\
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    \82\ See 2011 Proposing Release, section IV.C.
    \83\ The current approved annual burden for rule 30e-1 under the
PRA is 903,000 hours. As discussed below, as amended, the collection
of information requirement will be 935,049 hours (903,000 + 32,049).
---------------------------------------------------------------------------

    Accordingly, based on staff experience, the staff estimates that it
will take, on average, 3 hours of an attorney's time to perform this
review and make any technical changes to an individual fund's
disclosures, for an estimated burden of 32,049 hours for all funds.\84\
Amortized over three years, the staff estimates that the estimated
annual aggregate burden will be 10,683 burden hours and that there will
be approximately 10,683 respondents.\85\
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    \84\ The staff's estimate of the number of funds is based on
staff examination of industry data as of August 31, 2013 and
includes 10,683 funds that collectively file reports on Forms N-1A,
N-2, and N-3 each year. We note that this estimate is conservative
because it is likely that some fund complexes will achieve economies
of scale when revising their disclosures, do not use credit quality
when describing portfolio holdings, or whose current disclosures
already satisfy the requirements of the amended rule and thus would
not need to make any changes. The amount is calculated as follows:
10,683 funds x 3 hours = 32,049 one-time additional burden hours for
all funds. We estimate that the one-time additional annual burden is
3 hours per respondent.
     The monetized burden hours are calculated as follows: 32,049
hours x $379 per hour = $12,146,571 one-time additional costs. The
staff estimates that the internal cost for time spent by an in-house
attorney is $379 per hour. This estimate, as well as other internal
time cost estimates made in this analysis, is derived from SIFMA's
Management and Professional Earnings in the Securities Industry
2012, modified by Commission staff to account for an 1800-hour work
week and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead.
    \85\ The amount is calculated as follows: 32,049 burden hours/3
= 10,683 burden hours. Amortized over three years, staff estimates
that the annual aggregate burden cost will be: $12,146,571/3 =
$4,048,857.
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V. Economic Analysis

A. Overview

    As discussed above, we are adopting rule and form amendments to
implement section 939A of the Dodd-Frank Act. The amendments to rule
5b-3 replace a NRSRO credit rating standard with alternative credit
quality and liquidity criteria that are designed to achieve the same
purposes as the NRSRO credit rating standard without imposing
unnecessarily burdensome costs. The amendments to Forms N-1A, N-2, and
N-3 remove the required use of credit ratings when portraying credit
quality in shareholder reports, but require that those funds include a
description of how the credit quality of the holdings were determined,
and if credit ratings assigned by a credit rating agency are used, how
the credit ratings were identified and selected. The regulatory changes
adopted today will directly affect investment companies registered
under the Investment Company Act and could affect the demand for rating
agencies' services by eliminating the required use of NRSRO credit
ratings in rule 5b-3 and Forms N-1A, N-2, and N-3. The amendments to

rule 5b-3 may also affect other parties such as repurchase agreement
counterparties (e.g., broker-dealers and banks), investors, and issuers
of collateral securities. Finally, we recognize that the elimination of
the required use of NRSRO credit ratings in rule 5b-3 and Forms N-1A,
N-2, and N-3 may reduce the incentive for credit rating agencies to
register as NRSROs and thereby be subject to the Commission's oversight
and statutory and regulatory requirements applicable to NRSROs. We
received no comments on the cost-benefit analysis contained the 2011
Proposing Release.
    At the outset, the Commission notes that, where possible, we have
attempted to quantify the costs and benefits expected to result from
adopting the amendments to rule 5b-3 and Forms N-1A, N-2, and N-3.
However, wherever the discussion of costs or benefits is not quantified
in this section it is because the Commission is unable to quantify the
economic effects because it lacks the information necessary to provide
a reasonable estimate. For example, as discussed below, the Commission
does not have available to it comprehensive information on the exposure
of funds to different repurchase agreement market segments, the nature
and type of collateral used in repurchase agreements, or the extent to
which funds rely on rule 5b-3. Because of this lack of data, including
the extent to which funds may rely on rule 5b-3, we are unable to
quantify the costs to comply with the amended rule and note that the
costs could vary from our estimates. We discuss below the economic
baseline, costs and benefits of our final rule and form amendments,
alternatives considered, as well as the impact on efficiency,
competition, and capital formation.

B. Rule 5b-3

    Rule 5b-3, as amended, permits a fund 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 if the collateral other than cash or
government securities consists of securities that the fund's board of
directors, or its delegate, determines at the time the repurchase
agreement is entered into are: (i) Issued by an issuer that has an
exceptionally strong capacity to meet its financial obligations; and
(ii) sufficiently liquid that they can be sold at approximately their
carrying value in the ordinary course of business within seven calendar
days.
1. Economic Baseline
    The economic baseline against which we measure the economic effects
of these amendments is the regulatory framework as it exists
immediately before the adoption of today's amendments. Currently, rule
5b-3 allows funds to treat the acquisition of a repurchase agreement as
an acquisition of securities collateralizing the repurchase agreement
for certain diversification and broker-dealer counterparty limit
purposes under the Investment Company Act if the obligation of the
seller to repurchase the securities from the fund is ``collateralized
fully.'' In general, under rule 5b-3, a fund investing in a repurchase
agreement looks to the value and liquidity of the securities
collateralizing the repurchase agreement rather than the
creditworthiness of the counterparty for satisfaction of the repurchase
agreement. Under current requirements, 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.
    As of the end of 2012, the total repurchase agreement market
approximated $3 trillion.\86\ The repurchase agreement market has two
primary segments, bilateral and tri-party.\87\ The bilateral segment
comprises cash-driven transactions against specific collateral while
the tri-party segment comprises cash-driven transactions against
general collateral. We believe that investment companies' primary
exposure to repurchase agreements is through the tri-party market, but
the Commission does not have available to it comprehensive information
on the exposure in either market segment. The collateral used in the
approximately $2 trillion tri-party market is dominated by government
securities: Approximately 35% consists of Treasury securities and
approximately 50% consists of agency mortgage-backed securities, agency
debentures, and agency collateralized mortgage obligations.\88\
---------------------------------------------------------------------------

    \86\ See Financial Stability Oversight Council, 2013 Annual
Report at 65-66, available at http://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202013%20Annual%20Report.pdf.
    \87\ See id. (noting a third repo market segment--the general
collateral finance market--which primarily settles inter-dealer
transactions on the tri-party repo platform).
    \88\ Id.
---------------------------------------------------------------------------

    While we believe that many funds invest in tri-party repurchase
agreements, comprehensive information about the extent to which funds
invest in these agreements is not available to us. Nor are we able to
estimate how often funds rely on rule 5b-3 when entering into
repurchase agreements, or the extent to which fund repurchase
agreements are collateralized with securities other than cash or
government securities. However, we are able to estimate the extent of
money market fund participation in the tri-party repurchase market
using Form N-MFP data, which shows that money market funds held
approximately $591 billion in tri-party repurchase agreements as of the
end of 2012. While we understand almost all funds rely on rule 5b-3 on
occasion (for example when approaching diversification limits or
avoiding restrictions on investments in certain entities), we do not
have the information necessary to determine how frequently those funds
rely on rule 5b-3 in their daily transactions in repurchase agreements.
Accordingly, we are largely unable to quantify the benefits and costs
discussed below.
2. Economic Analysis
    Amended rule 5b-3 is intended to establish a similar credit quality
standard to the NRSRO credit rating standard we are replacing in order
to achieve the same objectives that the NRSRO credit rating reference
requirement was designed to achieve in the existing rule, i.e., limit
collateral securities to those that are likely to retain a stable
market value and that, under ordinary circumstances, the fund would be
able to liquidate quickly at or near its carrying value in the event of
a counterparty default. Although amended rule 5b-3 seeks to maintain a
similar degree of credit quality as the standard it replaces, the Dodd-
Frank Act mandate is designed to reduce reliance on NRSRO credit
ratings.\89\
---------------------------------------------------------------------------

    \89\ See supra note 12.
---------------------------------------------------------------------------

    Some fund boards or their delegates, after independent analysis,
might make a determination of credit quality that comports with the
analysis of the NRSRO credit ratings and, accordingly, make no
substantive changes to the funds' investments in repurchase agreements.
Other fund boards might turn to non-NRSRO sources (``third-party
providers'') to satisfy the new requirements, which may result in a
different pool of assets from which the funds may select for
collateralizing

repurchase agreements. We believe that this flexibility of allowing for
a broader range of credit quality models will increase competition for
such models, whether from internal assessments made by the fund or from
external assessments made by third-party providers such as credit
rating agencies. As a result, credit assessments, and the repurchase
agreement market in general, may become more efficient and may promote
capital formation through a more accurate assessment of credit risk
that may increase investment in repurchase agreements.
    We recognize, as discussed above, that funds typically establish
standards for the credit quality of collateral securities (that include
credit ratings and additional credit quality criteria required by the
fund) in repurchase agreements with counterparties.\90\ Funds could
change their policies and procedures to reflect changes made to the
rule by the amendments, but the rule would not prohibit funds from
considering the standards in current repurchase agreements and policies
and procedures provided that the fund's board or its delegate made the
determination that those standards satisfy the standards in amended
rule 5b-3. As a result, amended rule 5b-3 may not significantly change
the types of collateral securities held by funds relying on rule 5b-3.
---------------------------------------------------------------------------

    \90\ See supra text preceding note 53.
---------------------------------------------------------------------------

    Amended rule 5b-3 requires the fund's board or its delegate to make
a determination about the collateral of each repurchase agreement. This
will increase the regulatory burden on the fund's board,\91\ but we
believe that the burden is significantly reduced by the fund board's
ability to incorporate ratings, reports, analyses, and other
assessments issued by third parties, including NRSRO ratings that the
fund's board concludes are credible and reliable for purposes of making
the evaluation. Moreover, fund boards that find these increased
regulatory burdens to be excessive can mitigate them by restricting the
fund to repurchase agreement collateral that consists of cash and
government securities.
---------------------------------------------------------------------------

    \91\ See NY City Bar Comment Letter, supra note 44.
---------------------------------------------------------------------------

    If the fund's board decides to rely primarily on NRSRO ratings as
part of the process of evaluating credit quality, the fund may incur
some additional costs from today's amendments.\92\ However, some fund
boards may decide not to rely primarily on NRSRO ratings, perhaps
because of a more cost efficient way of making the required
determinations or because they believe NRSRO ratings are not helpful or
sufficient in evaluating credit quality. Reducing the emphasis on NRSRO
ratings could also adversely affect the quality of NRSRO ratings.
Currently, the importance attached to NRSRO ratings may impart
franchise value to the NRSRO's ratings business. By eliminating
references to NRSRO ratings in Federal regulations, section 939A of the
Dodd-Frank Act could reduce these franchise values and mitigate NRSROs'
incentives to produce credible and reliable ratings. Moreover, the
Commission recognizes that the elimination of the required use of
credit ratings in Commission rules and forms may reduce the incentive
for credit rating agencies to register as NRSROs with the Commission
and thereby be subject to the Commission's oversight and the statutory
and regulatory requirements applicable to NRSROs. To the extent that
the quality and accuracy of NRSRO ratings is adversely affected,
negative impacts on the capital allocation process and economic
efficiency would result.
---------------------------------------------------------------------------

    \92\ See supra text following note 53.
---------------------------------------------------------------------------

    The new methodologies that the fund's board employs may result in a
pool of assets from which the fund may select for collateralizing
repurchase agreements that is different from a pool based on NRSRO
ratings. This may affect the fund relative to the baseline of NRSRO
ratings by including or excluding as collateral assets that are
different from the collateral permitted under the current rule. In
turn, this could increase the credit risk in the pool of collateral
assets or decrease the return earned by investing in repurchase
agreements. Both of these effects may lead to a less efficient market
for repurchase agreement collateral. Issuers' ability to raise capital
may also be adversely affected to the extent that issuers of collateral
securities lose the regulatory preference that currently exists because
of the required use of NRSRO ratings within rule 5b-3. We do not,
however, believe that the amended rule is likely to lead to the
acceptance of riskier collateral in practice because the standard we
are adopting is very similar to the standard articulated by the NRSROs
for securities that have received the highest ratings. In addition, we
anticipate that fund boards and advisers will retain the credit quality
standards in their current repurchase agreements and their existing
policies and procedures that address compliance with current rule 5b-3
and include ratings that they believe are credible and reliable.
    Although we believe that boards of funds relying on rule 5b-3 have
established policies and procedures for complying with the rule,\93\
funds may incur costs to revise existing policies and procedures for
investing in repurchase agreements to comply with amended rule 5b-3. We
recognize that increased compliance costs are a necessary result of our
amendments to rule 5b-3 and may disproportionately impact smaller funds
to the extent these funds do not today have policies and procedures for
assessing creditworthiness. As noted above, we are not able to quantify
many of the costs (and benefits) discussed above. However, we estimate
that each fund will incur, at a minimum, the collection of information
costs discussed in the Paperwork Reduction Act section for a total
average one-time cost of approximately $368 per fund.\94\ Funds may
also incur additional costs in complying with the amendments which we
are unable to quantify, for the reasons discussed above.
---------------------------------------------------------------------------

    \93\ See rule 38a-1(a).
    \94\ See supra note 79 and accompanying text. Staff estimates
that all funds will incur a one-time aggregate cost of approximately
$3.7 million to make any necessary changes related to collections of
information under the Paperwork Reduction Act. Id.
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3. Alternatives
    In adopting today's amendments to rule 5b-3, the Commission
considered, as noted by one commenter, including specific factors or
tests that a fund board must apply in performing its credit analysis
under the rule.\95\ As noted above, the number and scope of factors
that may be appropriate to making a credit quality determination with
respect to a security may vary significantly depending on the
particular security and through time. Accordingly, we are not adopting
specific factors or tests that a fund board must apply in performing
credit analysis, but may provide guidance in the future.\96\
---------------------------------------------------------------------------

    \95\ See supra note 43.
    \96\ See supra notes 43-46 and accompanying text.
---------------------------------------------------------------------------

    We also considered different standards to replace credit ratings
that would help ensure that funds can liquidate collateral quickly in
the event of a default. These alternatives included, for example,
omitting an explicit liquidity requirement because securities in the
``highest rating category'' generally are more liquid than lower
quality securities. Other liquidity alternatives we considered included
limiting collateral securities only to cash and government securities
because liquidity may decline between the time of acquisition and the
time of default, or prohibiting a fund from relying on rule

5b-3 if, at any point after the time a fund enters into a repurchase
agreement, the collateral could no longer be liquidated within seven
calendar days. After considering the alternatives, we believe that
amended rule 5b-3 strikes a better balance than the alternatives by
imposing a liquidity requirement that is similar to the liquidity
standard inherent to the credit quality rating required under the
current rule, while not unduly restricting funds' flexibility to
utilize a larger pool of assets for collateralizing repurchase
agreements.

C. Forms N-1A, N-2, and N-3

    Forms N-1A, N-2, and N-3, as amended, eliminate the required use of
NRSRO credit ratings by funds that choose to use credit quality
categorizations in the required table, chart, or graph of portfolio
holdings. If a fund chooses to depict portfolio holdings according to
credit quality, the fund must include a description of how the credit
quality of the holdings was determined. If a fund uses credit ratings
assigned by a credit rating agency to depict credit quality, the fund
must disclose how it identified and selected the credit ratings.
1. Economic Baseline
    As noted above, the economic baseline against which we measure the
economic effects is the regulatory framework as it exists immediately
before the adoption of today's amendments. Currently, Forms N-1A, N-2,
and N-3 require shareholder reports to include a table, chart, or graph
depicting portfolio holdings by reasonably identifiable categories
(e.g., type of security, industry sector, geographic region, credit
quality, or maturity). The forms require the categories to be selected
in a manner reasonably designed to depict clearly the types of
investments made by the fund, given its investment objectives. If
credit quality is used to present portfolio holdings, the forms
currently require that credit quality be depicted using the credit
ratings assigned by a single NRSRO.
    We believe, based on staff experience, that the majority of funds
choose to depict their portfolios using credit quality, and
accordingly, report credit ratings from a single NRSRO. As discussed
above, we conservatively estimate that 10,683 funds collectively file
reports on Forms N-1A, N-2, and N-3 each year and will be affected by
the amendments.\97\
---------------------------------------------------------------------------

    \97\ See supra note 84.
---------------------------------------------------------------------------

2. Economic Analysis
    The Dodd-Frank Act mandate is designed to reduce potential reliance
on NRSRO credit ratings. Under the amendments, funds have greater
flexibility to assess and depict credit quality, which may lead to
better-informed investors who can, in turn, make better capital
allocation decisions. Accordingly, better-informed investors may make
more effective investment decisions based on their risk tolerance and
may promote increased competition among funds. We note, however, that
funds might choose to report credit quality in a more positive light
than is possible under the prior requirement to use the credit ratings
from a single NRSRO. However, as discussed above, the disclosure
requirements we are adopting today should mitigate many of the
potential adverse consequences. As a result, today's amendments may
have a varied effect on investors' ability to make effective capital
allocation choices.
    Because we do not anticipate that these amendments will result in
large changes in the portfolios held by funds or their investors, we do
not believe the amendments would have more than a marginal effect on
efficiency or capital formation. A potential benefit may arise by
allowing funds to use different credit rating agencies for split-rated
securities because that may promote competition between credit rating
agencies to provide ratings that are more accurate if funds use the
most accurate ratings for each part of their portfolios even if those
ratings come from different credit rating agencies. This may foster
innovation in the industry, and it may foster the growth of niche
credit rating agencies. Although some funds may eliminate the specific
use of credit ratings in their depiction of portfolio credit quality,
we anticipate that many of those funds are likely to consider some
outside analyses in evaluating the credit quality of portfolio
securities.\98\ A fund's consideration of external analyses by third-
party sources determined to be credible and reliable may contribute to
the accuracy of funds' determinations and thus help funds arrive at
consistent and more accurate depictions of credit quality.
---------------------------------------------------------------------------

    \98\ Funds may elect to use a combination of factors, including
NRSRO credit ratings, in depicting credit quality; or funds may use
or establish entirely new methods of depicting credit quality. See
ICI Comment Letter; Federated Comment Letter (supporting the ICI
Comment Letter).
---------------------------------------------------------------------------

    Under the amended forms, funds may continue to depict portfolio
holdings as they do today: Funds can continue to depict portfolio
holdings without making reference to credit quality, and funds can
continue to depict portfolio holdings using credit ratings from one
NRSRO. Today's amendments impose no new costs on funds that depict
portfolio holdings based on criteria other than credit quality, but
they do impose small additional costs on funds that choose to portray
portfolio holdings using credit ratings from one NRSRO because they
must make new disclosures about how the ratings were identified and
selected. We believe that the majority of costs related to today's
amendments to Forms N-1A, N-2, and N-3 are the costs described above
related to the collections of information under the Paperwork Reduction
Act. Accordingly, we estimate that funds on average will incur costs of
approximately $1,137 per fund in complying with the amendments.\99\ In
addition, funds may voluntarily incur additional costs if they choose
to develop and apply new methodologies to depict credit quality. Funds
that choose to do so will incur a cost not only to determine the credit
quality of portfolio holdings but also a cost to include in the
registration statement a description of how the credit quality of
portfolio holdings was determined, and if credit ratings are used, how
the ratings were identified and selected.
---------------------------------------------------------------------------

    \99\ See supra note 84 and accompanying text. Staff estimates
that all funds will incur a one-time aggregate cost of approximately
$12.1 million to make any necessary changes to the registration
statement related to collections of information under the Paperwork
Reduction Act. Id.
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3. Alternatives
    In adopting the amendments to the forms, the Commission considered
replacing the required use of credit ratings with an option to depict a
fund's portfolio by credit quality using the credit ratings of only a
single credit rating agency. This approach, proposed in 2011, was
intended to eliminate the possibility that a fund could choose to use
NRSRO credit ratings and then select the most favorable ratings among
the credit ratings assigned by multiple NRSROs. As discussed above, a
number of commenters suggested that funds be permitted to use the
credit ratings assigned by more than one NRSRO for split-rated
securities, provided the choice is made consistently, pursuant to a
disclosed policy. On balance, we believe that the benefits of this
additional flexibility outweigh the potential costs associated with the
possibility that funds cherry pick the highest credit rating available.
We note that the risks associated with cherry picking ratings are
mitigated by the fact that the forms, as amended, require that

funds disclose how they identified and selected the credit ratings,
which would include, for example, a fund policy that selects the
highest credit rating available.

VI. Final Regulatory Flexibility Analysis

    The Commission has prepared the following Final Regulatory
Flexibility Analysis (``FRFA'') in accordance with section 4(a) of the
Regulatory Flexibility Act regarding the rule and form amendments we
are adopting today to give effect to provisions of the Dodd-Frank
Act.\100\ The FRFA relates to amendments to rule 5b-3 under the
Investment Company Act and Forms N-1A, N-2, and N-3 under the
Investment Company Act and Securities Act. We prepared an Initial
Regulatory Flexibility Analysis (``IRFA'') in conjunction with the 2011
Proposing Release in March 2011.\101\
---------------------------------------------------------------------------

    \100\ 5 U.S.C. 604(a).
    \101\ See 2011 Proposing Release, supra note 10, at section
VIII.
---------------------------------------------------------------------------

A. Need for and Objectives of the Rule and Form Amendments

    As described more fully in sections I and III of this Release, to
implement section 939A of the Dodd-Frank Act, the Commission is
adopting amendments to (i) rule 5b-3 to eliminate references to the
credit rating and replace it with an alternative standard of
creditworthiness that is intended to achieve the same objectives that
the credit rating requirement was designed to achieve and (ii) Forms N-
1A, N-2, and N-3 to eliminate the required use of NRSRO credit ratings
by funds that choose to use credit quality categorizations in the
required table, chart, or graph of portfolio holdings in their
shareholder reports, and to permit funds that choose to depict credit
quality using credit ratings assigned by a credit rating agency to use
different credit rating agencies for split-rated securities.

B. Significant Issues Raised by Public Comment

    In the 2011 Proposing Release, we requested comment on the IRFA. In
particular, we sought comment on how many small entities would be
subject to the proposed rule and form amendments and whether the effect
of the proposed rule and form amendments on small entities subject to
them would be economically significant. None of the comment letters we
received addressed the IRFA. None of the comment letters made comments
about the effect of the rule and form amendments on small investment
companies.

C. Small Entities Subject to the Rule and Form Amendments

    The amendments to rule 5b-3 and Forms N-1A, N-2, and N-3 under the
Investment Company Act would affect funds, including entities that are
considered to be a small business or small organization (collectively,
``small entity'') for purposes of the Regulatory Flexibility Act.
    Investment Companies. Under Commission rules, for purposes of the
Investment Company Act and the Regulatory Flexibility Act, an
investment company is a small entity if it, together with other
investment companies in the same group of related investment companies,
has net assets of $50 million or less as of the end of its most recent
fiscal year.\102\ Based on a current review of filings submitted to the
Commission, we estimate that 171 investment companies may be considered
small entities and that all of these investment companies may
potentially rely on rule 5b-3.\103\ As discussed above, we recognize
that increased compliance costs are a necessary result of the
amendments to rule 5b-3 and may disproportionately impact smaller funds
to the extent these funds do not have policies and procedures for
assessing creditworthiness. Based on a current review of filings
submitted to the Commission, we estimate that approximately 131
investment companies that meet the definition of small entity would be
subject to the amendments to Forms N-1A, N-2, and N-3.
---------------------------------------------------------------------------

    \102\ 17 CFR 270.0-10(a).
    \103\ The 183 investment companies that meet the definition of
small entity include 12 business development companies, which are
subject to sections 5 and 12 of the Investment Company Act. 15
U.S.C. 80a-58; 15 U.S.C. 80a-59.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements

    Rule 5b-3. The amendments to rule 5b-3 allow a fund 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 if the collateral
other than cash or government securities consists of securities that
the fund's board of directors (or its delegate) determines at the time
the repurchase agreement is entered into are: (i) Issued by an issuer
that has an exceptionally strong capacity to meet its financial
obligations; and (ii) sufficiently liquid that they can be sold at
approximately their carrying value in the ordinary course of business
within seven calendar days. A fund that acquires repurchase agreements
and intends the acquisition to be treated as an acquisition of the
collateral securities must determine whether it must change its
policies for evaluating collateral securities under the amended rule
and must adopt and implement written policies and procedures reasonably
designed to comply with the conditions of amended rule 5b-3, including
these credit quality and liquidity requirements that we are
adopting.\104\ The costs associated with the amendments to rule 5b-3
are those discussed in section IV.A and V.B above.
---------------------------------------------------------------------------

    \104\ 17 CFR 270.38a-1(a).
---------------------------------------------------------------------------

    Forms N-1A, N-2, and N-3. The amendments to Forms N-1A, N-2, and N-
3 apply to open-end management investment companies, closed-end
management investment companies, and separate accounts organized as
management investment companies that offer variable annuity contracts,
including those that are small entities. The amendments to Forms N-1A,
N-2, and N-3 eliminate the required use of NRSRO credit ratings by
funds that choose to use credit quality categorizations in the required
table, chart, or graph of portfolio holdings in their shareholder
reports. If a fund chooses to depict portfolio holdings according to
credit quality, it must include a description of how the credit quality
of the holdings was determined, and if credit ratings assigned by a
credit rating agency are used to depict credit quality, the fund must
disclose how it identified and selected the credit ratings. The amended
forms also permit funds that choose to depict credit quality using
credit ratings assigned by a credit rating agency to use different
credit rating agencies for split-rated securities. The costs associated
with the amendments to the forms are those discussed in section IV.B
and V.C above.

E. Agency Action To Minimize Effect on Small Entities

    The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish our stated objectives, while
minimizing any significant adverse effect on small entities. In
connection with the rule and form amendments, the Commission considered
the following alternatives: (i) Establishing different compliance
standards or timetables that take into account the resources available
to small

entities; (ii) clarifying, consolidating, or simplifying compliance and
reporting requirements under the rule for small entities; (iii) use of
performance rather than design standards; and (iv) exempting small
entities from all or part of the requirements.
    We believe that special compliance or reporting requirements for
small entities, or an exemption from coverage for small entities, is
not appropriate or consistent with investor protection or the Dodd-
Frank Act. We believe that, with respect to rule 5b-3, different credit
quality standards, special compliance requirements or timetables for
small entities, or an exemption from coverage for small entities, may
create a risk that those entities could acquire repurchase agreements
with collateral that is less likely to retain its market value or
liquidity in the event of a counterparty default. Further consolidation
or simplification of the rule and form amendments for funds that are
small entities is inconsistent with the Commission's goals of fostering
investor protection.
    The form amendments apply to all investment companies that use
Forms N-1A, N-2, and N-3 to register under the Investment Company Act
and to offer their securities under the Securities Act. If the
Commission had excluded small entities from the form amendments, small
entities would have been required to use NRSRO credit ratings if they
chose to depict credit quality, while other entities would not have
been subject to that requirement. We believe that special compliance or
reporting requirements, or an exemption, for small entities would not
be appropriate because the amended requirement--eliminating the
required use of credit ratings where a fund chooses to depict the
fund's portfolio based on credit quality--is intended to eliminate
potential reliance on NRSRO credit ratings resulting from the
perception that the Commission endorses the ratings because of their
required use in Commission forms.
    We have endeavored through the form amendments to minimize
regulatory burdens on investment companies, including small entities,
while meeting our regulatory objectives. We have endeavored to clarify,
consolidate, and simplify the requirements applicable to investment
companies, including those that are small entities. Finally, the
amendments will use performance rather than design standards for
determining the credit quality of specific securities. For these
reasons, we have not adopted alternatives to rule 5b-3 and Forms N-1A,
N-2, and N-3.

Statutory Authority

    The Commission is adopting 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), 80a-37(a)] and section 939A of the
Dodd-Frank Act. The Commission is adopting amendments to Form N-1A,
Form N-2, and Form N-3 under the authority set forth in sections 5, 6,
7, 10 and 19(a) of the Securities Act [15 U.S.C. 77e, 77f, 77g, 77j,
and 77s(a)]; sections 8, 24(a), 30 and 38 of the Investment Company Act
[15 U.S.C. 80a-8, 80a-24(a), 80a-29, and 80a-37]; and section 939A of
the Dodd-Frank Act.

List of Subjects

17 CFR Part 239

    Reporting and recordkeeping requirements, Securities.

17 CFR Parts 270 and 274

    Investment companies, Reporting and recordkeeping requirements,
Securities.

Text of Rule and Rule and Form Amendments

    For reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended as follows:

PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933

0
1. The authority citation for Part 239 is revised to read in part as
follow:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77sss, 78c, 78l, 78m, 78n, 78o(d), 78o-7, 78o-7 note, 78u-5, 78w(a),
78ll, 78mm, 80a-2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24,
80a-26, 80a-29, 80a-30, 80a-37, and Pub. L. 111-203, sec. 939A, 124
Stat. 1376 (2010), unless otherwise noted.
* * * * *

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
2. The authority citation for Part 270 is revised to read in part as
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39,
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless
otherwise noted.
* * * * *

0
3. Section 270.5b-3 is amended by:
0
a. Adding ``or'' at the end of paragraph (c)(1)(iv)(B);
0
b. Revising paragraph (c)(1)(iv)(C);
0
c. Removing paragraph (c)(1)(iv)(D);
0
d. Removing paragraphs (c)(5), (c)(6), and (c)(8);
0
e. Redesignating paragraph (c)(4) as (c)(5);
0
f. Adding new paragraph (c)(4); and
0
g. Redesignating paragraph (c)(7) as paragraph (c)(6).
    The revisions and addition read as follows:

Sec.  270.5b-3  Acquisition of repurchase agreement or refunded
security treated as acquisition of underlying securities.

* * * * *
    (c) * * *
    (1) * * *
    (iv) * * *
    (C) Securities that the investment company's board of directors, or
its delegate, determines at the time the repurchase agreement is
entered into:
    (1) Each issuer of which has an exceptionally strong capacity to
meet its financial obligations; and

    Note to paragraph (c)(1)(iv)(C)(1):
    For a discussion of the phrase ``exceptionally strong capacity
to meet its financial obligations'' see Investment Company Act
Release No. 30847, (December 27, 2013).

    (2) Are sufficiently liquid that they can be sold at approximately
their carrying value in the ordinary course of business within seven
calendar days; and
* * * * *
    (4) Issuer, as used in paragraph (c)(1)(iv)(C)(1) of this section,
means the issuer of a collateral security or the issuer of an
unconditional obligation of a person other than the issuer of the
collateral security to undertake to pay, upon presentment by the holder
of the obligation (if required), the principal amount of the underlying
collateral security plus accrued interest when due or upon default.
* * * * *

PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933

PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940

0
4. The authority citation for Part 274 is revised to read in part as
follows:

    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and Pub. L. 111-203,
sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
0
5. Form N-1A (referenced in Sec. Sec.  239.15A and 274.11A) is amended
by revising Item 27(d)(2) to read as follows:

    Note: The text of Form N-1A does not, and these amendments will
not, appear in the Code of Federal Regulations.

FORM N-1A

* * * * *

Item 27. Financial Statements

* * * * *
    (d) Annual and Semi-Annual Reports. * * *
    (2) Graphical Representation of Holdings. One or more tables,
charts, or graphs depicting the portfolio holdings of the Fund by
reasonably identifiable categories (e.g., type of security, industry
sector, geographic region, credit quality, or maturity) showing the
percentage of net asset value or total investments attributable to
each. The categories and the basis of presentation (e.g., net asset
value or total investments) should be selected, and the presentation
should be formatted, in a manner reasonably designed to depict clearly
the types of investments made by the Fund, given its investment
objectives. If the Fund depicts portfolio holdings according to credit
quality, it should include a description of how the credit quality of
the holdings were determined, and if credit ratings, as defined in
section 3(a)(60) of the Securities Exchange Act [15 U.S.C.
78(c)(a)(60)], assigned by a credit rating agency, as defined in
section 3(a)(61) of the Securities Exchange Act [15 U.S.C.
78(c)(a)(61)], are used, explain how they were identified and selected.
This description should be included near, or as part of, the graphical
representation.
* * * * *

0
6. Form N-2 (referenced in Sec. Sec.  239.14 and 274.11a-1) is amended
by revising Instruction 6.a. to Item 24 to read as follows:

    Note: The text of Form N-2 does not, and these amendments will
not, appear in the Code of Federal Regulations.

FORM N-2

* * * * *

Item 24. Financial Statements

* * * * *
    Instructions:
* * * * *
    6. * * *
    a. one or more tables, charts, or graphs depicting the portfolio
holdings of the Fund by reasonably identifiable categories (e.g., type
of security, industry sector, geographic region, credit quality, or
maturity) showing the percentage of net asset value or total
investments attributable to each. The categories and the basis of
presentation (e.g., net asset value or total investments) should be
selected, and the presentation should be formatted, in a manner
reasonably designed to depict clearly the types of investments made by
the Fund, given its investment objectives. If the Fund depicts
portfolio holdings according to credit quality, it should include a
description of how the credit quality of the holdings were determined,
and if credit ratings, as defined in section 3(a)(60) of the Securities
Exchange Act [15 U.S.C. 78(c)(a)(60)], assigned by a credit rating
agency, as defined in section 3(a)(61) of the Securities Exchange Act
[15 U.S.C. 78(c)(a)(61)], are used, explain how they were identified
and selected. This description should be included near, or as part of,
the graphical representation.
* * * * *

0
7. Form N-3 (referenced in Sec. Sec.  239.17a and 274.11b) is amended
by revising Instruction 6.(i) to Item 28(a) to read as follows:

    Note:  The text of Form N-3 does not, and these amendments will
not, appear in the Code of Federal Regulations.

FORM N-3

* * * * *

Item 28. Financial Statements

    (a) * * *
    Instructions:
* * * * *
    6. * * *
    (i) One or more tables, charts, or graphs depicting the portfolio
holdings of the Fund by reasonably identifiable categories (e.g., type
of security, industry sector, geographic region, credit quality, or
maturity) showing the percentage of net asset value or total
investments attributable to each. The categories and the basis of
presentation (e.g., net asset value or total investments) should be
selected, and the presentation should be formatted, in a manner
reasonably designed to depict clearly the types of investments made by
the Fund, given its investment objectives. If the Fund depicts
portfolio holdings according to credit quality, it should include a
description of how the credit quality of the holdings were determined,
and if credit ratings, as defined in section 3(a)(60) of the Securities
Exchange Act [15 U.S.C. 78(c)(a)(60)], assigned by a credit rating
agency, as defined in section 3(a)(61) of the Securities Exchange Act
[15 U.S.C. 78(c)(a)(61)], are used, explain how they were identified
and selected. This description should be included near, or as part of,
the graphical representation.
* * * * *

    By the Commission.

    Dated: December 27, 2013.
Lynn M. Powalski,
Deputy Secretary.
[FR Doc. 2013-31425 Filed 1-7-14; 8:45 am]
BILLING CODE P