# 76 FR 12896: References to Credit Ratings in Certain Investment Company Act Rules and Forms

> Federal · Regulations · In force

URL: https://www.frixlaw.com/law-library/statutes/FR_PRORULE_2011-5184

## Section

- **Citation:** 76 FR 12896
- **Heading:** References to Credit Ratings in Certain Investment Company Act Rules and Forms
- **Jurisdiction:** Federal
- **Kind:** Regulations
- **Status:** In force
- **Text as of:** August 14, 2026
- **Source:** Compiled text
- **Location:** Federal Register / Vol. 76 / 76 FR 12896

## Text

SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 239, 270, and 274 [Release Nos. 33-9193; IC-29592; File No. S7-07-11] RIN 3235-AL02 References to Credit Ratings in Certain Investment Company Act Rules and Forms AGENCY:
Securities and Exchange Commission.

ACTION:
Proposed rule.

SUMMARY:
This is one of several releases that the Securities and Exchange Commission (“Commission”) will be considering relating to the use of credit ratings in our rules and forms. In this release, we are proposing a new rule as well as rule and form amendments under the Securities Act of 1933 and the Investment Company Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The Commission is proposing amendments to two rules and four forms under the Investment Company Act and the Securities Act that contain references to credit ratings. The proposed amendments would give effect to provisions of the Dodd-Frank Act that call for the amendment of Commission regulations that contain credit rating references. In addition, the Commission is proposing a new rule under the Investment Company Act to establish a standard of credit-worthiness in place of a statutory reference to credit ratings in that Act that the Dodd-Frank Act removes.

DATES:
Comments should be received on or before April 25, 2011.

ADDRESSES:
Comments may be submitted by any of the following methods:
Electronic Comments
• Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); or
• Send an e-mail to rule-comments@sec.gov. Please include File Number S7-07-11 on the subject line; or
• Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments.
Paper Comments
• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-07-11
include File Number S7-07-11 on the subject line; or
• Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments.
Paper Comments
• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-07-11. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available. FOR FURTHER INFORMATION CONTACT:
With respect to the proposed rule, rule amendments or Form N-MFP, Anu Dubey, Attorney, or Penelope Saltzman, Assistant Director (202) 551-6792, Office of Regulatory Policy, or with respect to Forms N-1A, N-2 and N-3, Jane H. Kim, Attorney, or Mark T. Uyeda, Assistant Director, (202) 551-6784, Office of Disclosure Regulation, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:
The Commission is proposing for public comment amendments to rules 2a-7 [17 CFR 270.2a-7] and 5b-3 [17 CFR 270.5b-3] and new rule 6a-5 [17 CFR 270.6a-5] under the Investment Company Act of 1940 (“Investment Company Act”)
e of Disclosure Regulation, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:
The Commission is proposing for public comment amendments to rules 2a-7 [17 CFR 270.2a-7] and 5b-3 [17 CFR 270.5b-3] and new rule 6a-5 [17 CFR 270.6a-5] under the Investment Company Act of 1940 (“Investment Company Act”). 1 The Commission is also proposing for comment 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 of 1933 (“Securities Act”) 2 and FormN-MFP [17 CFR 274.201] under the Investment Company Act.
1 15 U.S.C. 80a-1. 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 270].
2 15 U.S.C. 77a.
Table of Contents
I. Background II. Discussion A. Rule 2a-7 1. Eligible Securities 2. Securities With a Conditional Demand Feature 3. Monitoring Minimal Credit Risks 4. Stress Testing B. Form N-MFP C. Rule 5b-3 D. Proposed Rule 6a-5 E. Forms N-1A, N-2 and N-3 III. Request for Comment IV. Paperwork Reduction Act V. Cost-Benefit Analysis VI. Consideration of Promotion of Efficiency, Competition and Capital Formation VII. Regulatory Flexibility Act Certification VIII. Initial Regulatory Flexibility Analysis Statutory Authority Text of Proposed Rule and Form Amendments I. Background
The Dodd-Frank Act was enacted on July 21, 2010
Forms N-1A, N-2 and N-3 III. Request for Comment IV. Paperwork Reduction Act V. Cost-Benefit Analysis VI. Consideration of Promotion of Efficiency, Competition and Capital Formation VII. Regulatory Flexibility Act Certification VIII. Initial Regulatory Flexibility Analysis Statutory Authority Text of Proposed Rule and Form Amendments I. Background
The Dodd-Frank Act was enacted on July 21, 2010. 3 Section 939A of the Act requires the Commission to review its regulations for any references to or requirements regarding credit ratings that require the use of an assessment of the credit-worthiness of a security or money market instrument, remove these references or requirements and substitute in those regulations other standards of credit-worthiness in place of the credit ratings that we determine to be appropriate. 4 Section 939 of the Dodd-Frank Act removes a reference to credit ratings from section 6(a)(5) of the Investment Company Act and replaces it with a reference to “such standards of credit-worthiness as the Commission shall adopt.” 5
3 Public Law 111-203, 124 Stat. 1376 (2010).
4 Section 939A(a)-(b) of the Dodd-Frank Act.
5 Section 939(c) of the Dodd-Frank Act (amending section 6(a)(5)(A)(iv)(I) of the Investment Company Act). The Dodd-Frank Act also requires the Commission to adopt a number of rules concerning the integrity and transparency of the credit rating process and the accountability of credit rating agencies. See sections 931 to 939H of the Dodd-Frank Act.
In 2008, we undertook a review similar to that required under section 939A for references to credit ratings in our rules. As a result of that review, we proposed to eliminate references to ratings issued by nationally recognized statistical rating organizations (“NRSROs”) in four rules under the Investment Company Act
ity of credit rating agencies. See sections 931 to 939H of the Dodd-Frank Act.
In 2008, we undertook a review similar to that required under section 939A for references to credit ratings in our rules. As a result of that review, we proposed to eliminate references to ratings issued by nationally recognized statistical rating organizations (“NRSROs”) in four rules under the Investment Company Act. 6 Specifically, 7 In 2010, when we adopted amendments to rule 2a-7 (which governs the operation of money market funds), we retained the use of credit ratings in rule 2a-7 as an initial threshold requirement for whether a money market fund may invest in the security, but eliminated a requirement that all asset-backed securities in which a money market fund invests have received a rating. 8
6 See References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28327 (July 1, 2008) [73 FR 40124 (July 11, 2008)] (“2008 Ratings Removal Proposing Release”). The Commission also proposed to eliminate references to credit ratings in rules under the Securities Act and the Securities Exchange Act of 1934 (15 U.S.C. 78a) (“Exchange Act”). See Security Ratings, Securities Act Release No. 8940 (July 1, 2008) [73 See Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws, Investment Company Act Release No. 26066 (June 4, 2003) [68 FR 35258 (June 12, 2003)].
7 See References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28939 (Oct. 5, 2009) [74 FR 52358 (Oct. 9, 2009)] (“2009 Ratings Removal Adopting Release”) (adopting amendments to rule 5b-3, with respect to the treatment of refunded securities, and rule 10f-3); References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28940 (Oct. 5, 2009) [74 FR 52374 (Oct
ganizations, Investment Company Act Release No. 28939 (Oct. 5, 2009) [74 FR 52358 (Oct. 9, 2009)] (“2009 Ratings Removal Adopting Release”) (adopting amendments to rule 5b-3, with respect to the treatment of refunded securities, and rule 10f-3); References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28940 (Oct. 5, 2009) [74 FR 52374 (Oct. 9, 2009)] at Section IV (reopening the comment period for the proposed amendments to rules 3a-7 and 5b-3, with respect only to repurchase agreements). We also sought comment on removing references to credit ratings in rule 2a-7 in our 2009 proposal for certain reforms for money market funds. See Money Market Fund Reform Proposing Release, infra note 8. We received over 70 comments in response to the 2008 proposed amendments. Most commenters opposed the proposals. These comment letters are available on the Commission's Internet Web site ( http://www.sec.gov/comments/s7-19-08/s71908.shtml; http://www.sec.gov/comments/s7-17-08/s71708.shtml ). In light of today's proposal to amend rule 5b-3, we are withdrawing the 2008 proposed amendments to rule 5b-3 from further consideration.
8 See Money Market Fund Reform, Investment Company Act Release No. 29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)] (“Money Market Fund Reform Adopting Release”). See also Money Market Fund Reform, Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] (“Money Market Fund Reform Proposing Release”). Most commenters that responded to our request for additional comment on the 2008 proposed amendments to rule 2a-7 in the Money Market Fund Reform Proposing Release opposed that approach.
As directed by section 939A of the Dodd-Frank Act, we have reviewed our regulations for any references to or requirements regarding credit ratings in regulations that require the use of an assessment of the credit-worthiness of a security or money market instrument
tional comment on the 2008 proposed amendments to rule 2a-7 in the Money Market Fund Reform Proposing Release opposed that approach.
As directed by section 939A of the Dodd-Frank Act, we have reviewed our regulations for any references to or requirements regarding credit ratings in regulations that require the use of an assessment of the credit-worthiness of a security or money market instrument. In light of our review, and as further directed by the Dodd-Frank Act, we are proposing in this release to amend two rules and four forms under the Investment Company Act and the Securities Act. 9 In addition, in order to implement section 939(c) of the Dodd-Frank Act, we are proposing a new rule to establish a standard of credit-worthiness for purposes of section 6(a)(5) of the Investment Company Act.
9 We have already proposed to remove references to credit ratings in certain rules and forms under the Securities Act and the Exchange Act. See Security Ratings, Securities Act Release No. 9186 (Feb. 9, 2011) [76 FR 8946 (Feb. 16, 2011)].
II. Discussion
Three rules—rules 2a-7, 3a-7 and 5b-3 and four forms—Forms N-1A, N-2, N-3 and N-MFP under the Investment Company Act currently contain references to credit ratings issued by NRSROs. 10 We propose to remove the references to credit ratings in rules 2a-7 and 5b-3 and replace them with alternative standards of credit-worthiness that are designed to appropriately achieve the same purposes as the ratings requirements. In addition to the amendments to rules 2a-7 and 5b-3, we are proposing a new rule—rule 6a-5 under the Investment Company Act—to establish a credit-worthiness standard to replace the credit rating reference in section 6(a)(5) of that Act that the Dodd-Frank Act eliminates. 11 Finally, we propose to eliminate required disclosures of credit ratings in Form N-MFP and remove from Forms N-1A, N-2 and N-3 the requirement that NRSRO credit ratings be used when portraying credit quality in shareholder reports
estment Company Act—to establish a credit-worthiness standard to replace the credit rating reference in section 6(a)(5) of that Act that the Dodd-Frank Act eliminates. 11 Finally, we propose to eliminate required disclosures of credit ratings in Form N-MFP and remove from Forms N-1A, N-2 and N-3 the requirement that NRSRO credit ratings be used when portraying credit quality in shareholder reports. We discuss our proposed amendments and new rule in greater detail below.
10 Rule 2a-7 defines the term NRSRO to have the same meaning as in section 3(a)(62) of the Exchange Act [15 U.S.C. 78c(a)(62)]. Rule 5b-3 defines NRSRO with reference to Exchange Act rule 15c3-1(c)(2)(vi)(E), (F), and (H) [17 CFR 240.15c3-1(c)(2)(vi)(E), (F), (H)].
11 We intend to propose amendments to rule3a-7 in a separate release.
A. Rule 2a-7
Rule 2a-7 under the Investment Company Act governs the operation of money market funds. Unlike other investment companies (“funds”), money market funds seek to maintain a stable share price, typically at $1.00 per share. To do so, most money market funds use the amortized cost method of valuation (“amortized cost method”) and the penny-rounding method of pricing (“penny-rounding method”) permitted by rule 2a-7. 12 The Investment Company Act and applicable rules generally require funds to calculate current net asset value per share by valuing their portfolio instruments at market value or, if market quotations are not readily available, at fair value as determined in good faith by the board of directors. 13 These valuation requirements are designed to prevent unfair share pricing from diluting or otherwise adversely affecting the interests of investors. 14
12 Under the amortized cost method, portfolio instruments are valued by reference to their acquisition cost as adjusted for amortization of premium or accretion of discount. See rule 2a-7(a)(2)
termined in good faith by the board of directors. 13 These valuation requirements are designed to prevent unfair share pricing from diluting or otherwise adversely affecting the interests of investors. 14
12 Under the amortized cost method, portfolio instruments are valued by reference to their acquisition cost as adjusted for amortization of premium or accretion of discount. See rule 2a-7(a)(2). Share price is determined under the penny-rounding method by valuing securities at market value, fair value or amortized cost and rounding the per share net asset value to the nearest cent on a share value of a dollar, as opposed to the nearest one tenth of one cent as otherwise would be required. See Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)] (“1983 Money Market Fund Adopting Release”) at n.6 (“Release 9786 sets the amount of less than 1/10 of one cent on a share value of one dollar as the benchmark for materiality.”); Valuation of Debt Instruments by Money Market Funds and Certain Other Open-End Investment Companies, Investment Company Act Release No. 9786 (May 31, 1977) [42 FR 28999 (June 7, 1977)] at text accompanying n.11; rule 2a-7(a)(20) (defining penny-rounding method).
13 See section 2(a)(41) of the Investment Company Act (defining value) and rules 2a-4 (defining current net asset value) and 22c-1 (generally requiring open-end funds to sell and redeem their shares at a price based on the funds' current net asset value as next computed after receipt of a redemption, purchase or sale order).
14 If shares are sold or redeemed based on a net asset value that turns out to have been either understated or overstated compared to the amount at which portfolio instruments could have been sold, then the interests of either existing shareholders or new investors will have been diluted
n the funds' current net asset value as next computed after receipt of a redemption, purchase or sale order).
14 If shares are sold or redeemed based on a net asset value that turns out to have been either understated or overstated compared to the amount at which portfolio instruments could have been sold, then the interests of either existing shareholders or new investors will have been diluted. See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Sen. Comm. on Banking and Currency, 76th Cong., 3d Sess. 136-138, 288-289 (1940).
Rule 2a-7 exempts money market funds from these provisions but contains conditions designed to minimize the amount of risk a money market fund may assume and thus reduce the deviation between a money market fund's stabilized share price and the market value of its portfolio. 15 Among these conditions, rule 2a-7 limits a money market fund's portfolio investments to securities that have received credit ratings from the “requisite NRSROs” in one of the two highest short-term rating categories or comparable unrated securities ( i.e., “eligible securities”). 16 A requisite NRSRO must be one of the NRSROs that a money market fund's board of directors has designated (“designated NRSRO”) for use, and determines at least annually issues credit ratings that 17 Rule 2a-7 further restricts money market funds to securities that the fund's board of directors (or its delegate 18 ) determines present minimal credit risks, and specifically requires that determination “be based on factors pertaining to credit quality in addition to any ratings assigned to such securities by an NRSRO.” 19
15 Rule 2a-7 contains conditions that apply to each investment a money market fund proposes to make, as well as conditions that apply to a money market fund's entire portfolio.
16 The term “eligible security” is currently defined in rule 2a-7(a)(12).
17 See rule 2a-7(a)(11) (defining “designated NRSRO”); 2a-7(a)(23) (defining “requisite NRSRO”).
18 See rule 2a-7(e)
urities by an NRSRO.” 19
15 Rule 2a-7 contains conditions that apply to each investment a money market fund proposes to make, as well as conditions that apply to a money market fund's entire portfolio.
16 The term “eligible security” is currently defined in rule 2a-7(a)(12).
17 See rule 2a-7(a)(11) (defining “designated NRSRO”); 2a-7(a)(23) (defining “requisite NRSRO”).
18 See rule 2a-7(e).
19 Rule 2a-7(c)(3)(i). Thus, under the current rule, where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor considered in determining whether a security presents minimal credit risks. See Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)] (“1991 Money Market Fund Adopting Release”) at text preceding n.18.
We are proposing to remove references to credit ratings in rule 2a-7, which would affect five elements of the rule: Determination of whether a security is an eligible security; determination of whether a security is a first tier security; credit quality standards for securities with a conditional demand feature; requirements for monitoring securities for ratings downgrades and other credit events; and stress testing. 20 The proposed amendments to rule 2a-7, which are similar to those we proposed in 2008, are designed to offer protections comparable to those provided by the NRSRO ratings. 21
20 The proposed rule also would make conforming amendments to rule 2a-7's recordkeeping and reporting requirements. See proposed rule 2a-7(c)(11)(iii).
21 We previously adopted certain of the amendments that we proposed in 2008 as part of the 2010 money market fund reforms. See Money Market Fund Reform Adopting Release, supra note 8, at Sections II.C.2, II.G.2. Specifically, we expressly limited money market funds' investments in illiquid securities. See rule 2a-7(c)(5)(i)
dkeeping and reporting requirements. See proposed rule 2a-7(c)(11)(iii).
21 We previously adopted certain of the amendments that we proposed in 2008 as part of the 2010 money market fund reforms. See Money Market Fund Reform Adopting Release, supra note 8, at Sections II.C.2, II.G.2. Specifically, we expressly limited money market funds' investments in illiquid securities. See rule 2a-7(c)(5)(i). We also required money market funds to notify the Commission promptly when an affiliate has purchased certain securities, including a security that is no longer an eligible security, from the fund in reliance on rule 17a-9, which permits certain affiliated persons to purchase certain portfolio securities from a money market fund under certain conditions. See rule 2a-7(c)(7)(iii)(B). See also 2008 Ratings Removal Proposing Release, supra note 6, at Sections III.A.2, III.A.4.
1. Eligible Securities
Under the proposed amendments, a money market fund would continue to be limited to investing in securities that money market fund boards of directors (or their delegates) determine present minimal credit risks, 22 and each of which is either a “first tier security” or a “second tier security” under the rule. 23 Fund boards of directors (which typically rely on the fund's adviser) would still be able to consider quality determinations prepared by outside sources, including NRSRO ratings, that fund advisers conclude are credible and reliable, in making credit risk determinations. We would expect the fund advisers to understand the method for determining the rating and make an independent judgment of credit risks, and to consider an outside source's record with respect to evaluating the types of securities in which the fund invests.
22 See proposed rule 2a-7(a)(11)
NRSRO ratings, that fund advisers conclude are credible and reliable, in making credit risk determinations. We would expect the fund advisers to understand the method for determining the rating and make an independent judgment of credit risks, and to consider an outside source's record with respect to evaluating the types of securities in which the fund invests.
22 See proposed rule 2a-7(a)(11).
23 The proposal would not change current rule 2a-7 limitations on money market fund investments in second tier securities, under which a money market fund cannot acquire second tier securities with remaining maturities greater than 45 days, generally must limit its investments in second tier securities to no more than three percent of fund assets, and limit investments in the second tier securities of any one issuer to one half of one percent of fund assets. Rule 2a-7(c)(3)(ii); 2a-7(c)(4)(i)(C).
We propose to eliminate the requirement that an eligible security be rated by an NRSRO or be of comparable quality while maintaining the two-step analysis currently required by rule 2a-7. Under the proposed amendments, a security would be a first tier security (regardless of the ratings it has received from any credit rating agency) if the fund's board (or its delegate) determines that the issuer (or in the case of a security subject to a guarantee, the guarantor) 24 has the “highest capacity to meet its short-term financial obligations.” 25 A security would be a second tier security if it is an eligible security but is not a first tier security. 26 In addition, a security would be an eligible security only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations
rity would be a second tier security if it is an eligible security but is not a first tier security. 26 In addition, a security would be an eligible security only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations. 27
24 See rule 2a-7(c)(3)(iii) (allowing the credit quality of a guarantee to substitute for the credit quality of the security subject to the guarantee); 2a-7(a)(17) (defining “guarantee” to mean “an unconditional obligation of a person other than the issuer of the security to undertake to pay, upon presentment by the holder of the guarantee (if required), the principal amount of the underlying security plus accrued interest when due or upon default, or, in the case of an unconditional demand feature, an obligation that entitles the holder to receive upon exercise the approximate amortized cost of the underlying security or securities, plus accrued interest, if any.”).
25 Proposed rule 2a-7(a)(13). As under the current rule, government securities and securities issued by a money market fund also would be first tier securities. Proposed rule 2a-7(a)(13); see rule 2a-7(a)(14).
Our proposed amendments would eliminate the defined terms “designated NRSRO,” “rated security,” “requisite NRSRO,” and “unrated security” from the rule. As a result, under the proposal, fund boards would no longer be required to designate NRSROs and funds would not have to disclose designated NRSROs in their statements of additional information (“SAI”)
sed rule 2a-7(a)(13); see rule 2a-7(a)(14).
Our proposed amendments would eliminate the defined terms “designated NRSRO,” “rated security,” “requisite NRSRO,” and “unrated security” from the rule. As a result, under the proposal, fund boards would no longer be required to designate NRSROs and funds would not have to disclose designated NRSROs in their statements of additional information (“SAI”). See rule 2a-7(a)(11) (defining “designated NRSRO” as one of at least four NRSROs that, among other things, the fund's board has designated as an NRSRO whose credit ratings will be used by the fund to determine the eligibility of portfolio securities, the board determines at least annually issues credit ratings sufficiently reliable for such use, and the fund discloses in its SAI is a designated NRSRO, including any limitations on the fund's use of the designation). We note that after enactment of the Dodd-Frank Act, money market funds received Commission staff assurances that the staff would not recommend enforcement action if a money market fund board did not designate NRSROs and did not make related disclosures in its SAI before the Commission had completed its review of rule 2a-7 required by the Dodd-Frank Act and made any modifications to the rule. See Investment Company Institute, SEC No-Action Letter (Aug. 19, 2010).
26 See proposed rule 2a-7(a)(21). The specific language of this provision would not change ( compare current rule 2a-7(a)(24)), but the definitions of “eligible security” and “first tier security” would change under the proposal.
27 Proposed rule 2a-7(a)(11). Currently, the requirement that the fund board (or its delegate) determine that a security presents minimal credit risks is contained in paragraph (c)(3)(i) of the rule
1). The specific language of this provision would not change ( compare current rule 2a-7(a)(24)), but the definitions of “eligible security” and “first tier security” would change under the proposal.
27 Proposed rule 2a-7(a)(11). Currently, the requirement that the fund board (or its delegate) determine that a security presents minimal credit risks is contained in paragraph (c)(3)(i) of the rule. In connection with the amendments discussed above, we propose to restructure the rule to incorporate the minimal credit risk determination into the definition of “eligible security,” currently in paragraph (a)(12) of the rule, but which would be renumbered as paragraph (a)(11).
We have designed these amendments to retain a degree of risk limitation on money market funds similar to the current rule. The proposed amendments would continue to require that funds invest at least 97 percent of their total assets in the highest quality short-term debt securities. 28 Money market fund holdings of these first tier securities would have to satisfy a standard similar to the credit quality standards that have been articulated by the credit ratings agencies. 29 An issuer of a first tier 30 The credit risk associated with a second tier security, which would continue to be limited to three percent of total fund assets, 31 would differ from that associated with first tier securities only to a small degree. Thus, the issuer of a second tier security that would satisfy our proposed standard should have a very strong ability to repay its short-term debt obligations, and a very low vulnerability to default. 32 Finally, we propose to eliminate the requirement that guarantors or guarantees of securities held by a money market fund be rated by an NRSRO. 33
28 See proposed rule 2a-7(a)(13) (defining first tier security); rule 2a-7(c)(3)(ii) (prohibiting money market funds from acquiring second tier securities if, as a result of the acquisition, second tier securities would comprise more than three percent of the fund's total assets)
nate the requirement that guarantors or guarantees of securities held by a money market fund be rated by an NRSRO. 33
28 See proposed rule 2a-7(a)(13) (defining first tier security); rule 2a-7(c)(3)(ii) (prohibiting money market funds from acquiring second tier securities if, as a result of the acquisition, second tier securities would comprise more than three percent of the fund's total assets).
29 See, e.g., Standard & Poor's Ratings Definitions, Short-Term Issue Credit Ratings, http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245219848760 (“S&P Ratings Definitions”) (a short-term obligation rated “A-1” is rated in the highest category, and the obligor's capacity to meet its financial commitment on the obligation is strong; obligations within the category designated with a plus sign (+) indicates that the obligor's capacity to meet its financial commitment on these obligations is extremely strong); Moody's Investors Service Rating Symbols and Definitions, http://v3.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004 (“Moody's Ratings Definitions”) at 5-6 (issuers rated Prime-1 “have a superior ability to repay short-term debt obligations.”); FitchRatings, International Issuer and Credit Rating Scales, http://www.fitchratings.com/creditdesk/public/ratings_definitions/index.cfm?rd_file=ltr (“Fitch Ratings Definitions”) (stating that a rating of F1 is the highest short-term rating, indicating the “strongest intrinsic capacity for
30 We note that all money market fund portfolio securities also must be eligible securities (i.e., present minimal credit risks under the proposed amendments). See proposed rule 2a-7(a)(13). Thus, even if the issuer had the highest capacity to meet its short-term financial obligations, a security, such as a subordinated short-term security secured by assets that are not of high credit quality, likely would not present minimal credit risks to a money market fund's portfolio and therefore likely would not be an eligible security.
31 Rule 2a-7(c)(3)(ii)
. See proposed rule 2a-7(a)(13). Thus, even if the issuer had the highest capacity to meet its short-term financial obligations, a security, such as a subordinated short-term security secured by assets that are not of high credit quality, likely would not present minimal credit risks to a money market fund's portfolio and therefore likely would not be an eligible security.
31 Rule 2a-7(c)(3)(ii).
32 Nothing in the proposed rule would prohibit a money market fund from relying on policies and procedures it has adopted to comply with the current rule as long as the board (or its delegate) concluded that the ratings specified in the policies and procedures establish similar standards to those proposed, and are credible and reliable for that use. A fund also would be able to revise its policies and procedures to change or eliminate the use of specific NRSRO ratings or to incorporate other third party evaluations of credit quality.
33 See rule 2a-7(a)(12)(iii)(A). We also propose to move the provision that conditions the eligibility of a demand feature or guarantee of the issuer, or another institution, on an undertaking promptly to notify the fund in the event of a substitution of a demand feature or guarantee, which is currently in paragraph (a)(12)(iii)(B), to paragraphs (c)(3)(iii) (permitting money market funds to substitute the credit quality of a guarantee for the credit quality of the security subject to the guarantee in determining whether a security is an eligible or first tier security) and (c)(3)(iv)(D) (conditions under which a security subject to a conditional demand feature may be determined to be an eligible security or first tier security).
Our proposal would eliminate the objective standard provided by credit ratings in the definitions of eligible security and first tier security and instead require a subjective determination of both eligible securities and first tier securities. We request comment on this proposed approach
ubject to a conditional demand feature may be determined to be an eligible security or first tier security).
Our proposal would eliminate the objective standard provided by credit ratings in the definitions of eligible security and first tier security and instead require a subjective determination of both eligible securities and first tier securities. We request comment on this proposed approach.
• Would our proposed approach achieve the goal of retaining a degree of risk limitation on money market funds similar to the current rule?
• Are there alternatives to our proposed approach that would provide a more robust or objective evaluation of credit quality?
• Is there a better way to describe the characteristics of a first tier security?
• Should we instead simply limit money market funds to investing in securities solely based on a minimal credit risk determination, i.e., establish a single test for determining whether a fund could invest in a security?
• Would such an approach allow money market funds to invest a large portion of their portfolios in what are currently second tier securities?
2. Securities With a Conditional Demand Feature
Under rule 2a-7, a security subject to a conditional demand feature 34 may be determined to be an eligible security or a first tier security if, among other conditions, (i) the conditional demand feature is an eligible security or a first tier security, and (ii) the underlying security (or its guarantee) has received either a short-term rating or a long-term rating, as the case may be, within the highest two categories from the requisite NRSROs or is a comparable unrated security. 35 We propose to remove the credit rating requirement from this provision of the rule and amend the provision to require that the fund's board (or its delegate) determine that the underlying security be of high quality and subject to very low credit risk. 36 The proposed standard is designed to retain a similar degree of risk limitation to that in the current rule
is a comparable unrated security. 35 We propose to remove the credit rating requirement from this provision of the rule and amend the provision to require that the fund's board (or its delegate) determine that the underlying security be of high quality and subject to very low credit risk. 36 The proposed standard is designed to retain a similar degree of risk limitation to that in the current rule. An issuer that is determined to have a very strong capacity to meet its financial commitments, a very low risk of default, and a capacity for payment of its financial commitments that is not significantly vulnerable to reasonably foreseeable events would satisfy the proposed definition. 37 In making the credit quality determinations required under the proposed amendment, a fund board (or its delegate) would continue to be able to consider analyses provided by third parties, including ratings provided by ratings agencies, that it concludes are credible and reliable for such purposes. 38
34 A conditional demand feature is a demand feature that a fund may be precluded from exercising because of the occurrence of a condition. See rule 2a-7(a)(6) (defining “conditional demand feature” as a demand feature that is not an unconditional demand feature); 2a-7(a)(28) (defining “unconditional demand feature” as a demand feature that by its terms would be readily exercisable in the event of a default in payment of principal or interest on the underlying security). For purposes of rule 2a-7, a demand feature allows the security holder to receive, upon exercise, the approximate amortized cost of the security, plus accrued interest, if any. In addition, a demand feature must be exercisable either: (i) At any time on no more than 30 calendar days' notice; or (ii) at specified intervals not exceeding 397 calendar days and upon no more than 30 calendar days' notice. Rule 2a-7(a)(9)(i)
a-7, a demand feature allows the security holder to receive, upon exercise, the approximate amortized cost of the security, plus accrued interest, if any. In addition, a demand feature must be exercisable either: (i) At any time on no more than 30 calendar days' notice; or (ii) at specified intervals not exceeding 397 calendar days and upon no more than 30 calendar days' notice. Rule 2a-7(a)(9)(i). If an asset-backed security is subject to a demand feature, the feature must permit the security holder unconditionally to receive principal and interest within 397 calendar days of making demand. Rule 2a-7(a)(9)(ii).
35 Rule 2a-7(c)(3)(iv).
36 Proposed rule 2a-7(c)(3)(iv)(C). The rule references both short-term and long-term ratings because most money market fund portfolio securities with demand features are long-term securities (that would not meet the portfolio maturity requirements of rule 2a-7 without the demand feature). Under current rule 2a-7, a money market fund must limit its investments in securities subject to a demand feature or guarantee of the same issuer that are second tier securities to 2.5% of the fund's total assets. Rule 2a-7(c)(4)(iii). If, as a result of a downgrade, a fund exceeds this limitation on such securities, the fund must reduce its investment in the securities to no more than 2.5% of total assets by exercising the demand feature at the next succeeding exercise date(s). Rule 2a-7(c)(7)(i)(C). In a conforming change, we propose to amend this provision to require the fund to reduce its investment in securities subject to a demand feature or guarantee of a single issuer that are second tier securities, if, as a result of a portfolio security that ceases to be a first tier security, the fund exceeds the 2.5% investment limit on such securities. Proposed rule 2a-7(c)(7)(i)(B).
37 These credit quality characteristics are similar to credit quality standards that have been articulated by credit rating agencies
ject to a demand feature or guarantee of a single issuer that are second tier securities, if, as a result of a portfolio security that ceases to be a first tier security, the fund exceeds the 2.5% investment limit on such securities. Proposed rule 2a-7(c)(7)(i)(B).
37 These credit quality characteristics are similar to credit quality standards that have been articulated by credit rating agencies. See, e.g., S&P Ratings Definitions, supra note 29 (describing the capacity of an issuer of long-term obligations rated “AA” as “very strong”); Moody's Ratings Definitions, supra note 29 (describing Aa-rated long-term obligations as “judged to be of high quality and are subject to very low credit risk.”); Fitch Ratings Definitions, supra note 29 (describing AA-rated long-term obligations as denoting expectations of very low default risk and indicating that the issuer's capacity for payment of financial commitments is very strong and “not significantly vulnerable to foreseeable events”).
38 The proposed amendment would not prohibit a money market fund from relying on policies and procedures it has adopted to comply with the current rule regarding the credit quality of securities with conditional demand features as long as the board (or its delegate) concluded that the ratings specified in the policies and procedures establish similar standards to those proposed, and that the agencies providing ratings used in the policies and procedures are credible and reliable for that use. A fund also could revise its policies and procedures to change or eliminate the consideration of specific NRSRO ratings or to incorporate other third party evaluations of credit quality.
We request comment on the proposed credit quality standard for securities with a conditional demand feature.
• Does our proposed standard retain the same or similar degree of risk limitation as that under the current rule?
• Are there alternative standards that would provide a more robust or objective evaluation of credit quality?
3
orporate other third party evaluations of credit quality.
We request comment on the proposed credit quality standard for securities with a conditional demand feature.
• Does our proposed standard retain the same or similar degree of risk limitation as that under the current rule?
• Are there alternative standards that would provide a more robust or objective evaluation of credit quality?
3. Monitoring Minimal Credit Risks
Rule 2a-7 currently requires a money market fund board (or its delegate) promptly to reassess whether a security that has been downgraded by an NRSRO continues to present minimal credit risks, and take such action as it 39 We propose to amend the rule to require that, in the event the money market fund's adviser (or any person to whom the board has delegated portfolio management responsibilities) becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier security or a second tier security, as the case may be, the board or its delegate would have to reassess promptly whether the portfolio security continues to present minimal credit risks. 40 To satisfy the proposed standard, an investment adviser would be required to exercise reasonable diligence in keeping abreast of new information about a portfolio security that the adviser believes to be credible. We understand that most money market fund advisers currently exercise a similar degree of diligence in monitoring their portfolios in order to meet the rule 2a-7 requirement that portfolio investments be limited to securities that the board determines present minimal credit risks.
39 Rule 2a-7(c)(7)(i)(A). This current reassessment is not required, however, if the downgraded security is disposed of or matures within five business days of the specified event and in the case of events specified in rule 2a-7(c)(7)(i)(A)(2), the board is subsequently notified of the adviser's actions. Rule 2a-7(c)(7)(i)(B)
to securities that the board determines present minimal credit risks.
39 Rule 2a-7(c)(7)(i)(A). This current reassessment is not required, however, if the downgraded security is disposed of or matures within five business days of the specified event and in the case of events specified in rule 2a-7(c)(7)(i)(A)(2), the board is subsequently notified of the adviser's actions. Rule 2a-7(c)(7)(i)(B).
40 Proposed rule 2a-7(c)(7)(i)(A). As under the current rule, the proposal would not require reassessment in certain circumstances. See supra note 39. Our proposed standard differs slightly from our proposal in 2008, which would have required the board's reassessment if the money market fund's investment adviser became aware of any information about a portfolio security or an issuer of a portfolio security that suggested that the security might not have continued to present minimal credit risks. See 2008 Ratings Removal Proposing Release, supra note 6, at Section III.A.3. We believe that requiring the relevant information to relate to whether the portfolio security may no longer be first or second tier (as compared with the standard proposed in 2008) is more similar to the current standard. In addition, as noted by several commenters on the standard proposed in 2008, without limiting the information to be monitored in any way, the standard could be interpreted to require monitoring of all information regarding portfolio securities, including unreliable sources or unsubstantiated market rumors. See, e.g., Comment Letter of CFA Institute Centre for Financial Market Integrity (Mar. 26, 2009); Comment Letter of Charles Schwab & Co., Inc. (Sept. 5, 2008); Comment Letter of Federated Investors, Inc. (Sept. 5, 2008).
We request comment on the proposed amendments for monitoring minimal credit risks
regarding portfolio securities, including unreliable sources or unsubstantiated market rumors. See, e.g., Comment Letter of CFA Institute Centre for Financial Market Integrity (Mar. 26, 2009); Comment Letter of Charles Schwab & Co., Inc. (Sept. 5, 2008); Comment Letter of Federated Investors, Inc. (Sept. 5, 2008).
We request comment on the proposed amendments for monitoring minimal credit risks.
• Would our proposed approach to describing when reassessment of whether a portfolio security presents minimal credit risks is required achieve the objective of retaining a degree of risk limitation on money market funds similar to the current rule?
• Is there an alternative or more objective standard for determining when the board must reassess the credit risk of a security that would provide adequate investor protections?
• Are we correct in our understanding of current monitoring practices?
4. Stress Testing
Rule 2a-7 currently requires money market funds to adopt written procedures for stress testing their portfolios. Specifically they must test the fund's ability to maintain a stable net asset value per share based on certain hypothetical events, including a downgrade of portfolio securities. 41 We propose to replace this reference to ratings downgrades with a hypothetical event that is designed to have a similar impact on a money market fund's portfolio. Our proposal would require that money market funds stress test for an adverse change in the ability of a portfolio security issuer to meet its short-term financial obligations. 42 Under the proposed rule, funds could continue to test their portfolios by treating a downgrade as a credit event that might adversely affect the value or liquidity of the portfolio security (and affect the fund's ability to maintain a stable net asset value per share).
41 Rule 2a-7(c)(10)(v)(A).
42 Proposed rule 2a-7(c)(10)(v)(A).
We request comment on our proposed amendment to the stress testing requirements
rule, funds could continue to test their portfolios by treating a downgrade as a credit event that might adversely affect the value or liquidity of the portfolio security (and affect the fund's ability to maintain a stable net asset value per share).
41 Rule 2a-7(c)(10)(v)(A).
42 Proposed rule 2a-7(c)(10)(v)(A).
We request comment on our proposed amendment to the stress testing requirements.
• Does the standard we propose adequately address the same concerns that arise when a security is downgraded?
• Is the proposed standard too broad?
• Would the proposed standard provide adequate guidance to funds?
• Is there a narrower standard that we should specify?
B. Form N-MFP
As part of the money market fund reforms we adopted in 2010, money market funds must provide to the Commission a monthly electronic filing of portfolio holdings information on Form N-MFP. 43 The information money market funds must disclose with respect to each portfolio security (and any guarantee, demand feature or other enhancement associated with the portfolio security) includes the name of each designated NRSRO for the portfolio security and the rating assigned to the security. 44 We propose to eliminate the items requiring disclosure of ratings information from the form. We also propose to amend Item 33 of Form N-MFP to remove the reference to a rating in this item so that funds would only disclose whether a portfolio security is first or second tier or no longer an eligible security. 45
43 See rule 30b1-7. See also Money Market Fund Reform Adopting Release, supra note 8, at n.301 and accompanying and preceding text
sclosure of ratings information from the form. We also propose to amend Item 33 of Form N-MFP to remove the reference to a rating in this item so that funds would only disclose whether a portfolio security is first or second tier or no longer an eligible security. 45
43 See rule 30b1-7. See also Money Market Fund Reform Adopting Release, supra note 8, at n.301 and accompanying and preceding text.
44 See Items 34 (requiring disclosure of each designated NRSRO for a portfolio security and the credit rating given by the designated NRSRO for each portfolio security); 37b-c (requiring disclosure of each designated NRSRO and the credit rating given by the designated NRSRO for each portfolio security demand feature); 38b-c (requiring disclosure of each designated NRSRO and the credit rating given by the designated NRSRO for each portfolio security guarantee); 39c-d (requiring disclosure of each designated NRSRO and the credit rating given by the designated NRSRO for each portfolio security enhancement) of Form N-MFP.
45 See Item 33 of Form N-MFP (requiring money market funds to disclose whether a security is a “rated” first or second tier security, an unrated security, or no longer an eligible security).
We request comment on the proposed form amendments.
C. Rule 5b-3
Rule 5b-3 under the Investment Company Act permits a fund, subject to certain conditions, to treat a repurchase agreement as an acquisition of the securities collateralizing the repurchase agreement in determining whether the fund is in compliance with two provisions of the Investment Company Act that may affect a fund's ability to invest in repurchase agreements. In a typical investment company repurchase agreement, a fund enters into a contract with a broker, dealer or bank (the “counterparty” to the transaction) for the purchase of securities
rities collateralizing the repurchase agreement in determining whether the fund is in compliance with two provisions of the Investment Company Act that may affect a fund's ability to invest in repurchase agreements. In a typical investment company repurchase agreement, a fund enters into a contract with a broker, dealer or bank (the “counterparty” to the transaction) for the purchase of securities. The counterparty agrees to repurchase the securities at a specified future date, or on demand, for a price that is sufficient to return to the fund its original purchase price, plus an additional amount representing the return on the fund's investment. 46
46 Repurchase agreements provide funds with a convenient means to invest excess cash on a secured basis, generally for short periods of time. Economically, a repurchase agreement functions as a loan from the fund to the counterparty, in which the securities purchased by the fund serve as collateral for the loan and are placed in the possession or under the control of the fund's custodian during the term of the agreement. See Treatment of Repurchase Agreements and Refunded Securities as an Acquisition of the Underlying Securities, Investment Company Act Release No. 25058 (July 5, 2001) [66 FR 36156 (July 11, 2001)] (“Rule 5b-3 Adopting Release”). Various issues arose during the market events of 2007 to 2009 that affected the market for repurchase agreements. In response, a task force of participants in the market for tri-party repurchase agreements was formed and issued a report setting forth its findings and recommendations for improvements. See Report of Task Force on Tri-Party Repo Infrastructure, (May 17, 2010) at http://www.ny.frb.org/prc/report_100517.pdf.
Section 12(d)(3) of the Investment Company Act generally prohibits a fund from acquiring an interest in a broker, dealer, or underwriter
market for tri-party repurchase agreements was formed and issued a report setting forth its findings and recommendations for improvements. See Report of Task Force on Tri-Party Repo Infrastructure, (May 17, 2010) at http://www.ny.frb.org/prc/report_100517.pdf.
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
Rule 5b-3 allows funds to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of sections 5(b)(1) and 12(d)(3) of the Investment Company Act if the obligation of the seller to repurchase the securities from the fund is “collateralized fully.” 47 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” 48 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. 49 In proposing rule 5b-3, the Commission explained that the highest rating category requirement in the definition of collateralized fully was designed to help ensure that the market value of the collateral would remain stable and that the fund could more readily liquidate the collateral quickly in the event of a default. 50
47 Rule 5b-3(a). The term “collateralized fully” is defined in rule 5b-3(c)(1). In general, a fund investing in a repurchase agreement looks to the value and liquidity of the securities collateralizing the repurchase agreement rather than the credit quality of the counterparty for satisfaction of the repurchase agreement
more readily liquidate the collateral quickly in the event of a default. 50
47 Rule 5b-3(a). The term “collateralized fully” is defined in rule 5b-3(c)(1). In general, a fund investing in a repurchase agreement looks to the value and liquidity of the securities collateralizing the repurchase agreement rather than the credit quality of the counterparty for satisfaction of the repurchase agreement. See Rule 5b-3 Adopting Release, supra note 46, at Section II.A.3. But see rule 2a-7(c)(4)(ii)(A) (requiring money market funds to evaluate the counterparty's credit-worthiness).
48 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).
49 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). We note, however, that as a result of our recent money market fund reforms, money market funds seeking similar treatment with respect to the diversification requirements under rule 2a-7 are subject to stricter limitations. In order to qualify for such special treatment, a repurchase agreement is collateralized fully only if the collateral for the repurchase agreement consists entirely of cash or government securities. Rule 2a-7(a)(5). See Money Market Fund Reform Adopting Release, supra note 8, at Section II.D.
50 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
ed fully only if the collateral for the repurchase agreement consists entirely of cash or government securities. Rule 2a-7(a)(5). See Money Market Fund Reform Adopting Release, supra note 8, at Section II.D.
50 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 (noting that the high quality requirement is designed to limit a fund's exposure to the ability of the counterparty to maintain sufficient collateral, and that securities of lower quality may be subject to greater price fluctuation).
We propose 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, we propose to require 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 the highest 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. 51 For purposes of rule 5b-3, an issuer would be defined to include an issuer of an unconditional guarantee of the security. 52 Thus, a collateral security with an unconditional guarantee, the issuer of which meets the proposed credit quality test, would satisfy that element of the proposed standard.
51 Proposed rule 5b-3(c)(1)(iv)(C). Under the proposal, the board would make credit quality determinations for all collateral securities that are not government securities, rather than just unrated securities. As in the current rule, the proposed rule would permit the board to delegate the credit quality and liquidity determination
ality test, would satisfy that element of the proposed standard.
51 Proposed rule 5b-3(c)(1)(iv)(C). Under the proposal, the board would make credit quality determinations for all collateral securities that are not government securities, rather than just unrated securities. As in the current rule, the proposed rule would permit the board to delegate the credit quality and liquidity determination. The proposed amendment to rule 5b-3 would not affect a money market fund that seeks special treatment 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. See supra note 49. We are proposing to amend rule 2a-7(a)(5), which defines “collateralized fully,” to conform the references in that provision to the proposed amendments to rule 5b-3.
The first element of this proposed standard reflects the same standard as that proposed for the definition of first tier security under rule 2a-7. See proposed rule 2a-7(a)(13).
52 Proposed 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.”).
We have designed the proposed amendments to retain a degree of credit quality similar to that under the current rule. An 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, as appropriate, the lowest expectation of default, and a capacity for repayment of its financial commitments that is the least susceptible to adverse effects of changes in circumstances would satisfy the proposed standard. 53
53 See supra text accompanying note 30
es that the board (or its delegate) determined has an exceptionally strong capacity to repay its short or long-term debt obligations, as appropriate, the lowest expectation of default, and a capacity for repayment of its financial commitments that is the least susceptible to adverse effects of changes in circumstances would satisfy the proposed standard. 53
53 See supra text accompanying note 30.
Our proposal also would require that at the time the repurchase agreement is entered into, collateral could be sold at approximately its carrying value in the ordinary course of business within seven calendar days. 54 We expect that securities that trade in a secondary market at the time of the acquisition of the repurchase agreement would satisfy this liquidity standard. We also understand that most securities that are currently used to collateralize repurchase agreements 55 generally trade in a secondary market.
54 The proposed liquidity standard is the same as that we use for rule 2a-7. See, e.g., 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).
55 See Tri-Party Repo Infrastructure, Reform Task Force, Tri-Party Repo Margin Data, Summary Statistics for the U.S. Tri-Party Repo Market (as of Jan. 11, 2011), http://www.newyorkfed.org/tripartyrepo/margin_data.html (describing 98.7% of tri-party repurchase agreement collateral as composed of asset-backed securities, 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)
2011), http://www.newyorkfed.org/tripartyrepo/margin_data.html (describing 98.7% of tri-party repurchase agreement collateral as composed of asset-backed securities, 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).
We have designed the proposed amendments to be clear enough to permit a fund board or fund investment adviser to make a determination regarding credit quality and liquidity that would 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 fairly stable market value and that, under ordinary circumstances, the fund would be able to liquidate quickly in the event of a counterparty default. 56 We believe that fund advisers have experience with or knowledge of the evaluation of securities and would be qualified to make the credit and liquidity 57
56 See supra note 50. A fund that acquires repurchase agreements would, under rule 38a-1, have to adopt and implement a written policy reasonably designed to comply with the conditions of rule 5b-3, including any credit quality and liquidity requirements we might adopt under the rule. See rule 38a-1(a) (requiring registered funds to adopt and implement written policies and procedures reasonably designed to prevent the fund's violation of Federal securities laws).
57 We note that under the current rule, if collateral securities are unrated, fund boards of directors (or their delegates) must determine that the securities are of comparable quality to securities rated in the highest category by an NRSRO. Rule 5b-3(c)(iv)(D).
Under the proposal, the board could delegate day-to-day determinations regarding the quality and liquidity of collateral if it chooses, provided that the board retained sufficient oversight
securities are unrated, fund boards of directors (or their delegates) must determine that the securities are of comparable quality to securities rated in the highest category by an NRSRO. Rule 5b-3(c)(iv)(D).
Under the proposal, the board could delegate day-to-day determinations regarding the quality and liquidity of collateral if it chooses, provided that the board retained sufficient oversight. In addition, although the rule would no longer require the collateral to be rated by an NRSRO, fund boards (or their delegates) would still be able to consider analysis provided by outside sources, including credit agency ratings, that they conclude are credible and reliable, for purposes of making these credit quality evaluations. 58
58 We understand that credit quality standards for securities collateralizing repurchase agreements are typically contained in the agreements between funds and counterparties. We expect that those standards include a rating (for rated collateral securities) and any additional criteria 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 proposed amendment would not prohibit fund boards (or their delegates) from relying on the credit quality standards in current repurchase agreements and policies and procedures adopted to comply with the current rule regarding the credit quality of collateral securities as long as they conclude that the ratings specified in the repurchase agreements and policies and procedures establish similar standards to those proposed, 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 NRSRO ratings or to incorporate other third party evaluations of credit quality.
We request comment on our proposed amendment to rule 5b-3
oposed, 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 NRSRO ratings or to incorporate other third party evaluations of credit quality.
We request comment on our proposed amendment to rule 5b-3.
• Would the proposed determinations sufficiently address our concerns that collateral securities be of high quality in order to limit a fund's exposure to counterparties' credit risks? If not, are there additional or alternative standards that do not use credit ratings that would better address our concerns?
• Should a fund board (or its delegate) be permitted to consider assessments issued by third parties, as we anticipate? What, if any, criteria or standards should be imposed on the use of such assessments? Would the use of third party assessments help fund boards (or their delegates) arrive at consistent determinations regarding the credit quality of collateral under the rule?
• We propose to allow the credit quality of an issuer of an unconditional guarantee to substitute for the credit quality of the issuer of a collateral security subject to the guarantee. 59 This is designed 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. Should we instead limit collateral to securities that alone satisfy the proposed credit quality standard regardless of whether the security is subject to an unconditional guarantee?
59 See proposed rule 5b-3(c)(1)(iv)(C)(4).
• Would the proposed standard adequately address our concern that a fund be able to readily liquidate collateral securities in the event of a counterparty default?
• As noted above, we expect that, in general, securities that trade in secondary markets and most securities that are used as collateral for repurchase agreements would meet the proposed liquidity requirement
e 5b-3(c)(1)(iv)(C)(4).
• Would the proposed standard adequately address our concern that a fund be able to readily liquidate collateral securities in the event of a counterparty default?
• As noted above, we expect that, in general, securities that trade in secondary markets and most securities that are used as collateral for repurchase agreements would meet the proposed liquidity requirement. Are there securities typically used for collateral that would not meet the proposed liquidity standard?
• We have noted before that high quality securities generally are more liquid than lower quality securities. 60 Would the proposed credit quality requirement alone be sufficient to address concerns regarding liquidity of the collateral?
60 See Rule 5b-3 Proposing Release, supra note 50, at n.43.
• We acknowledge that securities that may be liquid at the time of acquisition of the repurchase agreement may be less liquid when the counterparty defaults. 61 Would a different standard of liquidity provide any greater protection? For example, if we required that collateral could be sold at carrying value almost immediately, would it be more likely to remain liquid if many holders of the security are trying to sell at the same time? Would such a standard limit collateral securities to U.S. Treasury securities as a practical matter?
61 We have noted before the difficulties of liquidating collateral in the case of a default by a large counterparty when many investors in repurchase agreements seek to liquidate similar collateral at the same time. See Money Market Fund Reform Proposing Release, supra note 8, at n.229 and accompanying and preceding text
it collateral securities to U.S. Treasury securities as a practical matter?
61 We have noted before the difficulties of liquidating collateral in the case of a default by a large counterparty when many investors in repurchase agreements seek to liquidate similar collateral at the same time. See Money Market Fund Reform Proposing Release, supra note 8, at n.229 and accompanying and preceding text.
• In light of the potential for decreased liquidity of collateral securities at the time of a counterparty default, should we limit the exemption to repurchase agreements that are collateralized only by cash or government securities?
• Would we better achieve the goals of rule 5b-3 if the rule provided that a fund could no longer rely on rule 5b-3 if, at any point after the time a fund enters into a repurchase agreement, the collateral no longer met the proposed liquidity standard?
D. Proposed Rule 6a-5
Business and industrial development companies (“BIDCOs”) are companies that operate under state statute that provide direct investment and loan financing, as well as managerial assistance, to state and local enterprises. 62 Because they invest in securities, BIDCOs frequently meet the definition of “investment company” under the Investment Company Act. 63 In 1996, the Investment Company Act was amended to add section 6(a)(5) to exempt these companies from most provisions of the Act subject to certain conditions. 64 The statutory exemption was premised on states having a strong interest in overseeing the structure and operations of these companies, thus rendering regulation under the Investment Company Act largely duplicative and unnecessary. 65
62 See S. Rep. No. 103-166, at 11 (1993) (“1993 Senate Report”)
6(a)(5) to exempt these companies from most provisions of the Act subject to certain conditions. 64 The statutory exemption was premised on states having a strong interest in overseeing the structure and operations of these companies, thus rendering regulation under the Investment Company Act largely duplicative and unnecessary. 65
62 See S. Rep. No. 103-166, at 11 (1993) (“1993 Senate Report”).
63 For purposes of the Investment Company Act, an “investment company” means any issuer that (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of government securities and cash items) on an unconsolidated basis. 15 U.S.C. 80a-3(a)(1).
64 15 U.S.C. 80a-6(a)(5); Pub. L. 104-290 § 501, 110 Stat. 3416, 3444 (1996). Section 6(a)(5)(B) provides that section 9 and, to the extent necessary to enforce section 9, sections 38 through 51, apply to a BIDCO as though the company were a registered investment company. Among other conditions to reliance on the exemption in section 6(a)(5), a BIDCO may not issue redeemable securities.
65 See 1993 Senate Report, supra note 62, at 19 (further stating that states are well positioned to monitor these companies and address the needs of resident investors). Prior to the addition of section 6(a)(5), the Commission had granted orders to exempt BIDCOs from regulation under the Act. See, e.g., The Idaho Company, Investment Company Release Nos. 18926 (Sept. 3, 1992) (notice) and 18985 (Sept. 30, 1992) (order)
port, supra note 62, at 19 (further stating that states are well positioned to monitor these companies and address the needs of resident investors). Prior to the addition of section 6(a)(5), the Commission had granted orders to exempt BIDCOs from regulation under the Act. See, e.g., The Idaho Company, Investment Company Release Nos. 18926 (Sept. 3, 1992) (notice) and 18985 (Sept. 30, 1992) (order).
BIDCOs that seek to rely on the exemption in section 6(a)(5) are limited with respect to the types of securities issued by investment companies and companies exempt from the definition of investment company under section 3(c)(1) or 3(c)(7) of the Act (“private funds”) that they may purchase. Specifically, section 6(a)(5)(A)(iv) limits these BIDCOs from purchasing securities issued by investment companies and private funds other than debt securities that are rated investment grade by at least one NRSRO and securities issued by registered open-end investment companies that invest at 66 This provision was intended to provide limited flexibility to invest capital not immediately needed for the company's long-term commitments. 67 Although the legislative history of the provision does not specifically explain why Congress restricted BIDCOs to acquiring “investment grade” debt of investment companies and private funds, it may have been designed to limit BIDCOs to investing in debt securities of sufficiently high credit quality that they are likely to maintain a fairly stable market value and that could be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities.
66 15 U.S.C
stricted BIDCOs to acquiring “investment grade” debt of investment companies and private funds, it may have been designed to limit BIDCOs to investing in debt securities of sufficiently high credit quality that they are likely to maintain a fairly stable market value and that could be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities.
66 15 U.S.C. 80a-6(a)(5)(A), as in effect prior to July 21, 2012 (exempting any company that is not engaged in the business of issuing redeemable securities, the operations of which are subject to regulation by the State in which the company is organized under a statute governing entities that provide financial or managerial assistance to enterprises doing business, or proposing to do business in that state if, among other things, the company does not purchase any security issued by an investment company or by any company that would be an investment company except for the exclusions from the definition of the term “investment company” under sections 3(c)(1) or 3(c)(7), other than (I) any debt security that is rated investment grade by not less than 1 nationally recognized statistical rating organization; or (II) any security issued by a registered open-end fund that is required by its investment policies to invest not less than 65% of its total assets in securities described in subclause (I) or securities that are determined by such registered open-end fund to be comparable in quality to securities described in subclause (I)).
67 See 1993 Senate Report, supra note 62, at 20.
As described above, section 939(c) of the Dodd-Frank Act eliminates the credit rating reference in section 6(a)(5)(A)(iv) of the Investment Company Act
its total assets in securities described in subclause (I) or securities that are determined by such registered open-end fund to be comparable in quality to securities described in subclause (I)).
67 See 1993 Senate Report, supra note 62, at 20.
As described above, section 939(c) of the Dodd-Frank Act eliminates the credit rating reference in section 6(a)(5)(A)(iv) of the Investment Company Act. Instead of limiting BIDCOs to purchasing debt securities issued by investment companies and private funds that are rated “investment grade,” the amendment requires such debt securities to meet “such standards of credit-worthiness as the Commission shall adopt.”
We are proposing new rule 6a-5 to establish this standard of credit-worthiness. Proposed rule 6a-5 would deem a BIDCO to have met the requirements for credit-worthiness of certain debt securities under section 6(a)(5)(A)(iv)(I) if the board of directors or members of the company (or its delegate) determines that the debt security is (i) subject to no greater than moderate credit risk and (ii) sufficiently liquid that the security can be sold at or near its carrying value within a reasonably short period of time. 68 The proposed standard is designed to limit BIDCOs to purchasing debt securities issued by investment companies or private funds of sufficiently high credit quality that they are likely to maintain a fairly stable market value and may be liquidated easily, as appropriate, for the BIDCO to support its investment and financing activities. The board of directors or members of a BIDCO (or its delegate) would have to make the determination at the time of acquisition. 69 As a result of the proposed rule, section 6(a)(5) of the Act would also limit a BIDCO's investments in registered open-end funds to those funds that invest at least 65 percent of their assets in debt securities that meet our proposed standard. 70
68 Proposed rule 6a-5
he board of directors or members of a BIDCO (or its delegate) would have to make the determination at the time of acquisition. 69 As a result of the proposed rule, section 6(a)(5) of the Act would also limit a BIDCO's investments in registered open-end funds to those funds that invest at least 65 percent of their assets in debt securities that meet our proposed standard. 70
68 Proposed rule 6a-5. The standard for credit-worthiness that we are proposing in rule 6a-5 is similar to the standard that we adopted in rule 10f-3 under the Investment Company Act. See 2009 Ratings Removal Adopting Release, supra note 7, at Section II.B.2; rule 10f-3(a)(3). This credit quality standard differs from those we propose for rules 2a-7 and 5b-3 because it reflects the different standard of credit quality associated with the ratings referenced in rule 10f-3 and section 6(a)(5)(A)(iv)(I) of the Act before the amendment of each provision. Compare supra notes 16, 48, and accompanying text with supra note 66 and accompanying text and rule 10f-3(a)(3), as in effect before November 12, 2009 (conditioning an exemption to permit an investment company that is affiliated with members of an underwriting syndicate to purchase securities from the syndicate if certain conditions are met, including if the securities are municipal securities, that have received an investment grade rating, or if the securities are less seasoned, one of the three highest ratings, from an NRSRO).
69 Proposed rule 6a-5. From our review of the state statutes under which BIDCOs are formed and operate, we understand that BIDCOs must be organized as corporations with boards of directors or limited liability companies that are managed by members or managers. See, e.g., Mich. comp. Laws § 301 (2010) (stating that a company other than a Michigan corporation or a limited liability company cannot apply for a license to be a BIDCO); Mont. Code Ann
ate statutes under which BIDCOs are formed and operate, we understand that BIDCOs must be organized as corporations with boards of directors or limited liability companies that are managed by members or managers. See, e.g., Mich. comp. Laws § 301 (2010) (stating that a company other than a Michigan corporation or a limited liability company cannot apply for a license to be a BIDCO); Mont. Code Ann. § 102 (2010) (defining a BIDCO as a corporation that is licensed under the act to provide financial and management assistance to businesses); Alaska Stat. § 20 (2010) (stating that a license to operate a BIDCO will be issued to a corporation if certain conditions are met); Tenn. Code Ann. § 208 (2010) (stating that a person other than a Tennessee corporation cannot apply for a license to be a BIDCO).
70 Section 6(a)(5)(A)(iv)(II) (permitting a BIDCO to purchase any security issued by a registered open-end fund that is required by its investment policies to invest not less than 65% of its total assets in securities described in subclause (I) ( i.e., securities that meet the standards of credit-worthiness that the Commission adopts) or securities that are determined by such registered open-end fund to be comparable in quality to securities described in subclause (I)).
Moderate credit risk would denote current low expectations of default risk, with an adequate capacity for payment of principal and interest. 71 Debt securities (or their issuers) subject to a moderate level of credit risk would demonstrate at least average credit-worthiness relative to other similar debt issues (or issuers of similar debt). 72 In making these determinations, a BIDCO's board of directors, members or managers would be able to consider credit quality reports prepared by outside sources, including NRSRO ratings, that they conclude are credible and reliable for this purpose.
71 See 2009 Ratings Removal Adopting Release, supra note 7, at n.86.
72 Id.
We request comment on proposed rule 6a-5
issuers of similar debt). 72 In making these determinations, a BIDCO's board of directors, members or managers would be able to consider credit quality reports prepared by outside sources, including NRSRO ratings, that they conclude are credible and reliable for this purpose.
71 See 2009 Ratings Removal Adopting Release, supra note 7, at n.86.
72 Id.
We request comment on proposed rule 6a-5.
• Does the standard we have proposed provide BIDCOs with flexibility to invest in certain debt securities that are likely to retain their value and that a BIDCO could sell quickly if necessary to support its investment and financing activities? If not, are there additional or alternative standards that do not use credit ratings that would be more appropriate to the statutory intent of section 6(a)(5)?
• Is our understanding that BIDCOs are organized as corporations with a board of directors or limited liability companies with members or managers correct? Are there BIDCOs that are formed as partnerships or other structures?
• Do BIDCO directors or members have sufficient experience with or knowledge of evaluating securities to allow them to make the determinations called for by proposed rule 6a-5 or to oversee decisions made by a delegate?
E. Forms N-1A, N-2 and N-3
We are proposing to amend 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. 73
73 Form N-1A is used by open-end management investment companies, commonly known as mutual funds. Form N-2 is used by closed-end management investment companies. Form N-3 is used by separate accounts, organized as management investment companies, that offer variable annuity contracts
mutual funds, closed-end funds, and certain insurance company separate accounts that offer variable annuities. 73
73 Form N-1A is used by open-end management investment companies, commonly known as mutual funds. Form N-2 is used by closed-end management investment companies. Form N-3 is used by separate accounts, organized as management investment companies, that offer variable annuity contracts.
Currently, Forms N-1A, N-2 and N-3 each 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). 74 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
74 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.
We are proposing to amend 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. If a fund chooses to use NRSRO credit ratings to depict credit quality of portfolio holdings, the proposal, like the current forms, generally would require the fund to use the credit ratings of a single NRSRO. This requirement is intended to eliminate the possibility that a fund could choose to use NRSRO credit ratings and then select the most favorable ratings among credit ratings assigned by multiple NRSROs. The proposal would clarify that, if credit ratings of the NRSRO selected by a fund are not available for certain holdings, the fund must briefly discuss the methodology for determining credit quality for those holdings, including, if applicable, the use of credit ratings assigned by another NRSRO. 75 Funds typically provide this discussion in their shareholder reports today
ned by multiple NRSROs. The proposal would clarify that, if credit ratings of the NRSRO selected by a fund are not available for certain holdings, the fund must briefly discuss the methodology for determining credit quality for those holdings, including, if applicable, the use of credit ratings assigned by another NRSRO. 75 Funds typically provide this discussion in their shareholder reports today. 76
75 Proposed Item 27(d)(2) of Form N-1A; proposed Instruction 6(a) to Item 24 of Form N-2; proposed Instruction 6(i) to Item 28(a) of Form N-3. In these items, we are also proposing to define NRSRO by reference to the Exchange Act definition, rather than by reference to Exchange Act rule 15c3-1 as is currently the case, and to replace the use of the term “rating” with “credit rating” as defined under the Exchange Act. See sections 3(a)(60) [15 U.S.C. 78c(a)(60)] and 3(a)(62) [15 U.S.C. 78c(a)(62)] of the Exchange Act, which define “credit rating” and “nationally recognized statistical rating organization,” respectively.
76 This statement is based on a staff review of a sample of fund shareholder reports filed with the Commission.
We request comment on the proposal to eliminate the required use of NRSRO credit ratings by funds that choose to use credit quality categorizations in shareholder reports.
• Are there better methods than the proposal by which funds could portray credit quality for purposes of the required table, chart or graph that presents portfolio holdings?
• Does the proposal adequately address situations where a fund would choose to portray credit quality using NRSRO ratings and there is no single NRSRO that has rated all of the fund's portfolio holdings?
III. Request for Comment
We request comment on the rule and form amendments and new rule proposed in this release. We also request suggestions for additional changes to existing rules, and comments on other matters that might have an effect on the proposals contained in this release
it quality using NRSRO ratings and there is no single NRSRO that has rated all of the fund's portfolio holdings?
III. Request for Comment
We request comment on the rule and form amendments and new rule proposed in this release. We also request suggestions for additional changes to existing rules, and comments on other matters that might have an effect on the proposals contained in this release. Commenters are requested to provide empirical data to support their views.
IV. Paperwork Reduction Act
Certain provisions of our proposal contain “collections of information” within the meaning of the Paperwork Reduction Act of 1995 (“PRA”). 77 The titles for the existing collections of information are: (1) “Rule 2a-7 under the Investment Company Act of 1940, Money market funds”; (2) “Rule 30e-1 under the Investment Company Act of 1940, Reports to Stockholders of Management Companies”; 78 (3) “Rule 38a-1 under the Investment Company Act of 1940, Compliance procedures and practices of registered investment companies”; and (4) “Form N-MFP under the Investment Company Act of 1940, Portfolio Holdings of Money Market Funds.” We adopted the rules and form pursuant to the Investment Company Act. The Commission is submitting these 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.
77 44 U.S.C. 3501-3520.
78 The proposed 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 andN-3.
There is currently no approved collection of information for rule 5b-3 and the proposed amendments would not create any new collections under that rule. The proposed amendments to rule 5b-3 would, however, affect the collection of information burden for rule 38a-1
den associated with the collection of information for rule 30e-1 under the Investment Company Act rather than Forms N-1A, N-2 andN-3.
There is currently no approved collection of information for rule 5b-3 and the proposed amendments would not create any new collections under that rule. The proposed amendments to rule 5b-3 would, however, affect the collection of information burden for rule 38a-1. Proposed rule 6a-5 also would not create any new collections of information.
An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number. The approved collection of information associated with rule 2a-7 displays control number 3235-0268. The approved collection of information associated with rule 30e-1 displays control number 3235-0025. The approved collection of information associated with rule 38a-1, which would be revised by the proposed amendments to rule 5b-3, displays control number 3235-0586. The approved collection of information associated with Form N-MFP displays control number 3235-0657.
A. Money Market Funds
1. Rule 2a-7
As discussed above, we are proposing to remove references to credit ratings in rule 2a-7, which would affect five elements of the rule. First, we propose to eliminate the requirement that an eligible security be rated by an NRSRO or be of comparable quality, while maintaining the two-step analysis currently required by rule 2a-7. A security would be an eligible security only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations
ed by an NRSRO or be of comparable quality, while maintaining the two-step analysis currently required by rule 2a-7. A security would be an eligible security only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations. 79 Second, we propose to define first tier security as a security whose issuer the fund's board (or its delegate) determines has the “highest capacity to meet its short-term financial obligations.” 80 Third, we propose to require that with respect to a security (or its guarantee) subject to a conditional demand feature, in addition to other conditions, the underlying security (or its guarantee) must itself be of high quality and subject to very low credit risk as determined by the fund's board (or its delegate). 81 Fourth, we propose to eliminate the use of credit ratings in the rule's downgrade and default provisions. The proposed amendment would require that in the event the money market fund's investment adviser (or any person to whom the fund's board of directors has delegated portfolio management responsibilities) becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier security or a second tier security, as the case may be, the money market fund's board of directors would have to reassess promptly whether the portfolio security continues to present minimal credit risks. 82 Finally, we propose to eliminate the reference to portfolio securities' downgrades in the stress testing provisions. Under the proposal, a money market fund's stress testing procedures would be required to include as a hypothetical event, “an adverse change in the ability of the issuer of a portfolio security to meet its 83 The respondents to these collections of information are money market funds
Finally, we propose to eliminate the reference to portfolio securities' downgrades in the stress testing provisions. Under the proposal, a money market fund's stress testing procedures would be required to include as a hypothetical event, “an adverse change in the ability of the issuer of a portfolio security to meet its 83 The respondents to these collections of information are money market funds. A fund must comply with the requirements of rule 2a-7, including the collections of information, in order to obtain the exemptive relief provided under the rule and to operate as a money market fund.
79 Proposed rule 2a-7(a)(11). See supra Section II.A.1.
80 Proposed rule 2a-7(a)(13). See supra Section II.A.1.
81 Proposed rule 2a-7(c)(3)(iv)(C). See supra Section II.A.2.
82 Proposed rule 2a-7(c)(7)(i)(A). See supra Section II.A.3.
83 Proposed rule 2a-7(c)(10)(v)(A). See supra Section II.A.4. As a result of eliminating the term “designated NRSRO,” the proposal would eliminate the requirement that boards of directors designate NRSROs and disclose such designated NRSROs in their SAIs. See supra note 25. We believe that the deletion of the disclosure requirement would not affect the collection of information requirements in the SAI, however, and therefore would not change current paperwork burden estimates. When we adopted the requirement to disclose designated NRSROs in the SAI, we stated that we anticipated that making this disclosure would not result in additional hourly burdens or printing costs beyond those currently approved in the existing collection of information for Form N-1A. See Money Market Fund Reform Adopting Release, supra note 8, at 106. The proposed amendments also would make conforming amendments to rule 2a-7's recordkeeping and reporting requirements. See proposed rule 2a-7(c)(11)(iii). These conforming changes would not result in changes in the estimated hourly burden associated with the recordkeeping and reporting requirements
ally, staff also understands that money market funds stress test for credit events other than downgrades that might affect the fund's portfolio. As we have noted above, with respect to each of the amendments we propose today, money market funds could continue to consider evaluations of outside sources, including credit ratings, in making credit quality determinations, monitoring and stress testing. Moreover, we anticipate that funds would likely continue to rely on their current policies and procedures with respect to credit quality determinations, monitoring for credit events and stress testing because that is likely to be less costly than revising policies. Accordingly, we do not expect the proposed amendments would significantly change current collection of information burden estimates for rule 2a-7. 85 Nevertheless, money market funds may make technical changes to their policies and procedures in response to the proposed amendments, if adopted. Staff estimates that it would take, on average, 1.5 hours of a senior business analyst's time to make any technical changes for an individual money market fund, for an estimated one-time burden of 978 hours for all money market funds at a total cost of $226,896. 86 Amortized over three years, we estimate that the total annual burden would be 326 hours at a cost of $75,632.
84 See rules 2a-7(c)(3); 2a-7(c)(11)(ii); 2a-7(e); 38a-1.
85 The current approved annual burden for rule 2a-7 under the PRA is 395,779 hours. The estimated number of respondents is 652 money market funds as of December 31, 2010. The estimated number of money market funds is based on the Investment Company Institute, Trends in Mutual Fund Investing, December 2010 (Jan. 27, 2011), http://www.ici.org/research/stats/trends/trends_12_10.
86 These estimates are based on the following calculation: (652 money market funds × 1.5 hours = 978 hours); (978 hours × $232 per hour = $226,896). The staff estimates that the internal cost of a senior business analyst is $232 per hour
ased on the Investment Company Institute, Trends in Mutual Fund Investing, December 2010 (Jan. 27, 2011), http://www.ici.org/research/stats/trends/trends_12_10.
86 These estimates are based on the following calculation: (652 money market funds × 1.5 hours = 978 hours); (978 hours × $232 per hour = $226,896). The staff estimates that the internal cost of a senior business analyst is $232 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 2010, 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.
• We request comment on these assumptions. If commenters believe these assumptions are not accurate, we request they provide specific data that would allow us to make more accurate estimates.
2. Form N-MFP
Rule 30b1-7 requires money market funds to file electronically a monthly report on Form N-MFP within five business days after the end of each month. The information required by the form must be data-tagged in XML format and filed through EDGAR. Preparing Form N-MFP is a collection of information under the PRA. 87 The respondents to the requirement to prepare Form N-MFP are investment companies that are regulated as money market funds under rule 2a-7. Compliance with the requirement to prepare Form N-MFP is mandatory for any fund that holds itself out as a money market fund in reliance on rule 2a-7. Responses to the disclosure requirement of Form N-MFP are not kept confidential.
87 For purposes of the PRA analysis, the current burden associated with the requirements of rule 30b1-7 is included in the collection of information requirements of Form N-MFP. The current approved annual burden for Form N-MFP under the PRA is 94,189 hours
itself out as a money market fund in reliance on rule 2a-7. Responses to the disclosure requirement of Form N-MFP are not kept confidential.
87 For purposes of the PRA analysis, the current burden associated with the requirements of rule 30b1-7 is included in the collection of information requirements of Form N-MFP. The current approved annual burden for Form N-MFP under the PRA is 94,189 hours.
As discussed previously, the proposed amendments would eliminate the items requiring disclosure for each portfolio security (and any guarantee, demand feature or enhancement associated with the portfolio security) of the designated NRSROs for the security and the rating assigned to the security in Items 34, 37, 38 and 39 of the Form. The proposed amendments would also eliminate the requirement in Item 33 that a money market fund disclose whether a security is a rated security or an unrated security.
The staff estimates that, as of December 31, 2010, there are approximately 652 money market funds that are required to file Form N-MFP. 88 The staff estimates that our proposed amendments would reduce the time it takes money market funds to complete Form N-MFP by 0.5 hours. Because Form N-MFP is completed 12 times a year, the staff estimates that each respondent would save approximately 6 hours annually (at an internal cost of $301 per hour). 89 The staff therefore estimates that our proposed amendments to Form N-MFP would result in total incremental time savings of approximately 3912 hours (and $1,177,512) annually. 90
88 See supra note 85.
89 The staff estimates that the internal cost of a senior database administrator is $301 per hour.
90 These estimates are based on the following calculation: (652 × 6 hours = 3912 hours); (3912 hours × $301 per hour = $1,177,512). We understand that some money market funds may outsource all or a portion of their responsibilities regarding Form N-MFP to a filing agent, software consultant, or other third-party service provider
internal cost of a senior database administrator is $301 per hour.
90 These estimates are based on the following calculation: (652 × 6 hours = 3912 hours); (3912 hours × $301 per hour = $1,177,512). We understand that some money market funds may outsource all or a portion of their responsibilities regarding Form N-MFP to a filing agent, software consultant, or other third-party service provider. We believe that a fund would engage third-party service providers at an external cost similar to or less than the estimated internal costs so the amount of the savings would be comparable.
• We request comment on these estimates. If commenters believe these estimates are not accurate, we request they provide specific data that would allow us to make more accurate estimates.
B. Rule 5b-3
Rule 5b-3 under the Investment Company Act allows funds to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of sections 5(b)(1) and 91 To that end, the fund's board of directors, pursuant to rule 38a-1 under the Act, would have to develop procedures to ensure that at the time the repurchase agreement is entered into, the securities meet the requirements for collateral outlined in the proposed amendments to the rule. 92 As discussed above, these procedures are 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 collection of information would be mandatory for funds that rely on rule 5b-3. Records of information made in connection with this requirement would be required to be maintained for inspection by Commission staff, but the collection would not otherwise be submitted to the Commission. The information, when provided to the Commission in connection with staff examinations or investigations, would be kept confidential to the extent permitted by law.
91 Proposed rule 5b-3(c)(1)(iv)(C)
of information made in connection with this requirement would be required to be maintained for inspection by Commission staff, but the collection would not otherwise be submitted to the Commission. The information, when provided to the Commission in connection with staff examinations or investigations, would be kept confidential to the extent permitted by law.
91 Proposed rule 5b-3(c)(1)(iv)(C). See supra Section II.C.
92 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.
We do not anticipate that the proposed amendments would significantly change collection of information burdens under rule 38a-1 because we believe funds would likely rely on their current policies and procedures to determine the credit quality of collateral securities to comply with rule 5b-3, as we propose to amend it. We understand that credit quality standards for securities collateralizing repurchase agreements are contained in the repurchase agreements between funds and counterparties. We expect that those standards currently include a rating 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 could 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 proposed rule
omparable 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 could 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 proposed rule. We expect that funds would 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 proposed amendments would significantly change the current collection of information burden estimates for rule 38a-1. 93 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 proposed amendments, if adopted. Staff estimates 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 burden of 12,690 hours for all fund portfolios (other than money market fund portfolios) 94 at a total cost of $2,944,080. 95 Amortized over three years, we estimate that the total burden would be 4230 hours at a cost of $981,360. We anticipate that the fund's board would review the fund manager's recommendation, but that the cost of this review would be incorporated in the fund's overall annual board costs and would not result in any particular additional cost.
93 The current approved annual burden for rule 38a-1 under the PRA is 254,703 hours.
94 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 under rule 2a-7, as noted above. See supra note 49
icular additional cost.
93 The current approved annual burden for rule 38a-1 under the PRA is 254,703 hours.
94 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 under rule 2a-7, as noted above. See supra note 49. The staff's estimate of the number of fund portfolios is based on staff examination of industry data as of December 31, 2010.
95 These estimates are based on the following calculation: (8,460 fund portfolios × 1.5 hours = 12,690 hours); (12,690 hours $232 per hour = $2,944,080). The staff estimates that the internal cost for time spent by a senior business analyst is $232 per hour.
• We request comment on these estimates. If commenters believe these estimates are not accurate, we request they provide specific data that would allow us to make more accurate estimates.
• Is our expectation that funds would continue to consider ratings in their credit quality standards to evaluate rated collateral securities for repurchase agreements correct? If funds choose not to continue this consideration of ratings, we request comment on how long it would take a fund to confirm that collateral securities satisfy the credit quality standards in a repurchase agreement under our proposed standard.
C. Rule 30e-1
The proposed 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. If a fund chooses to use NRSRO credit ratings to depict credit quality of portfolio holdings, the proposed amendments, like the current forms, generally would require the fund to use the credit ratings of a single NRSRO
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. If a fund chooses to use NRSRO credit ratings to depict credit quality of portfolio holdings, the proposed amendments, like the current forms, generally would require the fund to use the credit ratings of a single NRSRO. The proposed amendments would clarify that, if credit ratings of the NRSRO selected by a fund are not available for certain holdings, the fund must briefly discuss the methodology for determining credit quality for those holdings, including, if applicable, the use of credit ratings assigned by another NRSRO.
The Commission believes that the proposed amendments to Forms N-1A, N-2 and N-3 would not affect the current PRA burden under rule 30e-1, because funds would remain obligated to provide a table, chart, or graph of portfolio holdings by reasonably identifiable categories. The proposed amendments only eliminate the required use of NRSRO credit ratings by funds that choose to use credit quality categorizations. The Commission further believes that the proposed clarification for cases when credit ratings of the NRSRO selected by a fund are not available for certain holdings would not impose any additional PRA burden because funds typically provide this disclosure in their shareholder reports today. 96
96 This assessment is based on a staff review of a sample of fund shareholder reports filed with the Commission.
• We request comment on this analysis. If commenters believe this analysis is not accurate, we request that they provide specific data that would allow us to make a more accurate analysis.
D. Request for Comments
We request comment on whether the estimates provided in this PRA analysis are accurate. Pursuant to 44 U.S.C
eview of a sample of fund shareholder reports filed with the Commission.
• We request comment on this analysis. If commenters believe this analysis is not accurate, we request that they provide specific data that would allow us to make a more accurate analysis.
D. Request for Comments
We request comment on whether the estimates provided in this PRA analysis are accurate. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (i) Evaluate whether the proposed collections of information are necessary for the proper
Persons wishing to submit comments on the collection of information requirements of the proposed amendments should direct them to the Office of Management and Budget, Attention Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Room 10102, New Executive Office Building, Washington DC 20503, and should send a copy to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090, with reference to File No. S7-7-11. OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this Release; therefore a comment to OMB is best assured of having its full effect if OMB receives it within 30 days after publication of this Release. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7-7-11, and be submitted to the Securities and Exchange Commission, Office of Investor Education and Advocacy, 100 F Street, NE., Washington, DC 20549-0213.
V. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by its rules. We have identified certain costs and benefits of the proposed rule and form amendments and proposed rule, and we request comment on all aspects of this cost-benefit analysis, including identification and assessment of any costs and benefits not discussed in this analysis
hington, DC 20549-0213.
V. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by its rules. We have identified certain costs and benefits of the proposed rule and form amendments and proposed rule, and we request comment on all aspects of this cost-benefit analysis, including identification and assessment of any costs and benefits not discussed in this analysis. We seek comment and data on the value of the benefits identified. We also welcome comments on the accuracy of the cost estimates in each section of this analysis, and request that commenters provide data that may be relevant to these cost estimates. In addition, we seek estimates and views regarding these costs and benefits for particular funds, including funds that are small entities, as well as any other costs or benefits that may result from the adoption of the proposed rule and rule and form amendments. Where possible, we request commenters provide empirical data to support any positions advanced.
As discussed above, to implement provisions of the Dodd-Frank Act, we propose to (i) remove the references to credit ratings in rules 2a-7 and 5b-3 and replace them with alternative standards of credit-worthiness that are designed to appropriately achieve the same purposes as the ratings, (ii) eliminate references to credit ratings in Form N-MFP, and (iii) remove from Forms N-1A, N-2 and N-3 the requirement that NRSRO credit ratings be used when portraying credit quality in shareholder reports. We are also proposing rule 6a-5 to replace a statutory reference to credit ratings that the Dodd-Frank Act removes from the Investment Company Act and for which the Dodd-Frank Act anticipates the Commission will adopt a replacement standard. Thus, the benefits and costs associated with the replacement of credit rating references with alternative standards of credit-worthiness are attributable to the Dodd-Frank Act
sing rule 6a-5 to replace a statutory reference to credit ratings that the Dodd-Frank Act removes from the Investment Company Act and for which the Dodd-Frank Act anticipates the Commission will adopt a replacement standard. Thus, the benefits and costs associated with the replacement of credit rating references with alternative standards of credit-worthiness are attributable to the Dodd-Frank Act. The Commission has discretion, however, in adopting the alternative standards of credit-worthiness, and we undertake below to discuss the costs and benefits of the rule and form amendments and new rule that we are proposing.
A. Money Market Funds
1. Rule 2a-7
As discussed above, we are proposing to remove references to credit ratings in rule 2a-7, which would affect five elements of the rule. First, we propose to eliminate the requirement that an eligible security be rated by an NRSRO or be of comparable quality, while maintaining the two-step analysis currently required by rule 2a-7. A security would be an eligible security only if the board of directors (or its delegate) determines that it presents minimal credit risks, which determination must be based on factors pertaining to credit quality and the issuer's ability to meet its short-term financial obligations. 97 Second, we propose to define first tier security as a security whose issuer the fund's board (or its delegate) determines has the “highest capacity to meet its short-term financial obligations.” 98 Third, we propose to require that with respect to a security (or its guarantee) subject to a conditional demand feature, in addition to other conditions, the underlying security (or its guarantee) must itself be of high quality and subject to very low credit risk as determined by the fund's board (or its delegate). 99 Fourth, we propose to remove the reference to credit ratings in the rule's downgrade and default provisions
e that with respect to a security (or its guarantee) subject to a conditional demand feature, in addition to other conditions, the underlying security (or its guarantee) must itself be of high quality and subject to very low credit risk as determined by the fund's board (or its delegate). 99 Fourth, we propose to remove the reference to credit ratings in the rule's downgrade and default provisions. The proposed amendment would require that, in the event the money market fund's investment adviser (or any person to whom the fund's board of directors has delegated portfolio management responsibilities) becomes aware of any credible information about a portfolio security or an issuer of a portfolio security that suggests that the security is no longer a first tier security or a second tier security, as the case may be, the money market fund's board of directors would have to reassess promptly whether the portfolio security continues to present minimal credit risks. 100 Finally, we propose to eliminate the reference to portfolio securities' downgrades in the stress testing provisions. Under the proposal, a money market fund's stress testing procedures would be required to include as a hypothetical event, “an adverse change in the ability of the issuer of a portfolio security to meet its short-term financial obligations.” 101
97 Proposed rule 2a-7(a)(11). See supra Section II.A.1.
98 Proposed rule 2a-7(a)(13). See supra Section II.A.1.
99 Proposed rule 2a-7(c)(3)(iv)(C). See supra Section II.A.2.
100 Proposed rule 2a-7(c)(7)(i)(A). See supra Section II.A.3.
101 Proposed rule 2a-7(c)(10)(v)(A). See supra Section II.A.4. As noted above, see supra note 20, the propo

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Source: Frix Law Library, https://www.frixlaw.com/law-library/statutes/FR_PRORULE_2011-5184. Check the current official text before relying on it. Not legal advice.