
[Federal Register: July 11, 2008 (Volume 73, Number 134)]
[Proposed Rules]               
[Page 40124-40142]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr11jy08-18]                         

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 275

[Release Nos. IC-28327; IA-2751 File No. S7-19-08]
RIN 3235-AK19

 
References to Ratings of Nationally Recognized Statistical Rating 
Organizations

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: This is one of three releases that the Securities and Exchange 
Commission (``Commission'') is publishing simultaneously relating to 
the use in its rules and forms of credit ratings issued by nationally 
recognized statistical rating organizations (``NRSROs''). In this 
release, the Commission proposes to amend five rules under the 
Investment Company Act of 1940 and the Investment Advisers Act of 1940 
that rely on NRSRO ratings. The proposed amendments are designed to 
address concerns that the reference to NRSRO ratings in Commission 
rules may have contributed to an undue reliance on NRSRO ratings by 
market participants.

DATES: Comments should be received on or before September 5, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-19-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-19-08. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549, on official business days between the hours of 10 a.m. and 3 
p.m. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Penelope Saltzman, Acting Assistant 
Director, or Vincent Meehan, Senior Counsel, (202) 551-6792, Office of 
Regulatory Policy, or Smeeta Ramarathnam, Senior Counsel, (202) 551-
6792, Office of Special Projects, Division of Investment Management, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-5041.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public 
comment amendments to rules 2a-7 [17 CFR 270.2a-7], 3a-7 [17 CFR 
270.3a-7], 5b-3 [17 CFR 270.5b-3], and 10f-3 [17 CFR 270.10f-3] under 
the Investment Company Act of 1940 (``Investment Company Act''),\1\ and 
amendments to rule 206(3)-3T [17 CFR 275.206(3)-3T] under the 
Investment Advisers Act of 1940 (``Investment Advisers Act'' or 
``Advisers Act'').\2\
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    \1\ 15 U.S.C. 80a. Unless otherwise noted, all references to 
rules under the Investment Company Act will be to Title 17, Part 270 
of the Code of Federal Regulations [17 CFR 270], and all references 
to statutory sections are to the Investment Company Act.
    \2\ 15 U.S.C. 80b. Unless otherwise noted, all references to 
rules under the Investment Advisers Act will be to Title 17, Part 
275 of the Code of Federal Regulations [17 CFR 275], and all 
references to statutory sections are to the Investment Advisers Act.
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Table of Contents

I. Introduction
II. Background
III. Discussion
    A. Rule 2a-7
    1. Minimal Credit Risk Determination
    2. Portfolio Liquidity
    3. Monitoring Minimal Credit Risks
    4. Commission Notice of Rule 17a-9 Transactions
    B. Rule 3a-7
    C. Rule 5b-3
    D. Rule 10f-3
    E. Rule 206(3)-3T
IV. Request for Comment
V. Paperwork Reduction Act
VI. Cost-Benefit Analysis
VII. Consideration of Promotion of Efficiency, Competition and 
Capital Formation
VIII. Regulatory Flexibility Act Certification
IX. Initial Regulatory Flexibility Analysis
X. Statutory Authority
Text of Proposed Rule Amendments

I. Introduction

    On June 16, 2008, in furtherance of the Credit Rating Agency Reform 
Act of 2006,\3\ the Commission published for notice and comment two 
rulemaking initiatives.\4\ The first proposes additional requirements 
for NRSROs \5\ that were directed at reducing conflicts of interest in 
the credit rating process, fostering competition and comparability 
among credit rating agencies, and increasing transparency of the credit 
rating process.\6\ The second is designed to improve investor 
understanding of the risk characteristics of structured finance 
products. Those proposals address concerns about the integrity of the 
credit rating procedures and methodologies of NRSROs in light of the 
role they played in determining the credit ratings for securities that 
were the subject of the recent turmoil in the credit markets.
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    \3\ Public Law No. 109-291, 120 Stat. 1327 (2006).
    \4\ Proposed Rules for Nationally Recognized Statistical Rating 
Organizations, Securities Exchange Act Release No. 57967 (June 16, 
2008) [73 FR 36212 (June 25, 2008)] (``NRSRO June 16, 2008 Proposing 
Release'').
    \5\ As described in more detail below, an NRSRO is an 
organization that issues ratings that assess the creditworthiness of 
an obligor itself or with regard to specific securities or money 
market instruments, has been in existence as a credit rating agency 
for at least three years, and meets certain other criteria. The term 
is defined in section 3(a)(62) of the Securities Exchange Act of 
1934 (``Exchange Act''). A credit rating agency must apply with the 
Commission to register as an NRSRO, and currently there are ten 
registered NRSROs.
    \6\ See Press Release No. 2008-110 (June 11, 2008).
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    Today's proposals comprise the third of these three rulemaking 
initiatives relating to credit ratings by an NRSRO that the Commission 
is proposing. This release, together with two companion releases, sets 
forth the results of the Commission's review of the requirements in its 
rules and forms that rely on credit ratings by an NRSRO. The proposals 
also address recent recommendations issued by the President's Working 
Group on Financial Markets (``PWG''), the Financial Stability Forum 
(``FSF'') and the Technical Committee of the International Organization 
of Securities Commissions (``IOSCO'').\7\ Consistent

[[Page 40125]]

with these recommendations, the Commission is considering whether the 
inclusion of requirements related to ratings in its rules and forms 
has, in effect, placed an ``official seal of approval'' on ratings that 
could adversely affect the quality of due diligence and investment 
analysis. The Commission believes that today's proposals could reduce 
undue reliance on credit ratings and result in improvements in the 
analysis that underlies investment decisions.
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    \7\ See President's Working Group on Financial Markets, Policy 
Statement on Financial Market Developments (March 2008), available 
at www.ustreas.gov (``PWG Statement''); The Report of the Financial 
Stability Forum on Enhancing Market and Institutional Resilience 
(April 2008), available at www.fsforum.org (``FSF Report''); 
Technical Committee of the International Organization of Securities 
Commissions, Consultation Report: The Role of Credit Rating Agencies 
in Structured Finance Markets (March 2008), p. 9, available at 
www.iosco.org.
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II. Background

    The Commission first used the term ``NRSRO'' in our rules in 1975 
in the net capital rule for broker-dealers, Rule 15c3-1 (``Net Capital 
Rule'') \8\ under the Securities Exchange Act of 1934 (the ``Exchange 
Act'') \9\ as an objective benchmark to prescribe capital charges for 
different types of debt securities. Since then, we have used the 
designation in a number of regulations under the federal securities 
laws. Although we originated the use of the term NRSRO for a narrow 
purpose in our own regulations, ratings by NRSROs today are used widely 
as benchmarks in federal and state legislation, rules issued by other 
financial regulators, in the United States and abroad, and private 
financial contracts.
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    \8\ 17 CFR 240.15c3-1.
    \9\ 15 U.S.C. 78a.
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    Referring to NRSRO ratings in regulations was intended to provide a 
clear reference point to both regulators and market participants. 
Increasingly, we have seen clear disadvantages of using the term in 
many of our regulations. Foremost, there is a risk that investors 
interpret the use of the term in laws and regulations as an endorsement 
of the quality of the credit ratings issued by NRSROs, which may have 
encouraged investors to place undue reliance on the credit ratings 
issued by these entities. In addition, as demonstrated by recent 
events,\10\ there has been increasing concern about ratings and the 
ratings process. Further, by referencing ratings in the Commission's 
rules, market participants operating pursuant to these rules may be 
vulnerable to failures in the ratings process. In light of this, the 
Commission proposes to amend regulations under the Investment Company 
Act and the Investment Advisers Act that use the term NRSRO or refer to 
NRSRO ratings.\11\
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    \10\ See NRSRO June 16, 2008 Proposing Release, supra note 4, at 
Section I.C.
    \11\ These regulations include rules 2a-7, 3a-7, 5b-3 and 10f-3 
under the Investment Company Act and rule 206(3)-3T under the 
Investment Advisers Act.
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III. Discussion

    The credit ratings issued by NRSROs are used in four of the 
Commission's rules under the Investment Company Act--rules 2a-7, 3a-7, 
5b-3, and 10f-3--and one rule under the Investment Advisers Act--rule 
206(3)-3T. These rules use the credit ratings issued by the NRSROs in 
different contexts, and for different purposes, to distinguish among 
various grades of debt and other rated securities. We propose to amend 
each rule to omit references to NRSRO ratings and, except with respect 
to one of the rules, substitute alternative provisions that are 
designed to appropriately achieve the same purpose as the ratings. 
Below we discuss these proposals in greater detail in the context of 
each rule we propose to amend.

A. Rule 2a-7

    Rule 2a-7 under the Investment Company Act governs the operation of 
money market funds. Unlike other investment companies (``funds''), 
money market funds seek to maintain a stable share price, typically at 
$1.00 per share. To do so, most money market funds use the amortized 
cost method of valuation (``amortized cost method'') or the penny-
rounding method of pricing (``penny-rounding method'') permitted by 
rule 2a-7.\12\ The Investment Company Act and applicable rules 
generally require funds to calculate current net asset value per share 
by valuing their portfolio instruments at market value or, if market 
quotations are not readily available, at fair value as determined in 
good faith by the board of directors.\13\ These valuation requirements 
are designed to prevent unfair share pricing from diluting or otherwise 
adversely affecting the interests of investors.\14\
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    \12\ Under the amortized cost method, portfolio instruments are 
valued by reference to their acquisition cost as adjusted for 
amortization of premium or accretion of discount. See rule 2a-
7(a)(2). Share price is determined under the penny-rounding method 
by valuing securities at market value, fair value or amortized cost 
and rounding the per share net asset value to the nearest cent on a 
share value of a dollar, as opposed to the nearest one tenth of one 
cent. See rule 2a-7 (a)(18).
    \13\ See section 2(a)(41) of the Investment Company Act 
(defining value) and rules 2a-4 (defining current net asset value) 
and 2a-7(c) thereunder (money market fund share price calculations).
    \14\ If shares are sold or redeemed based on a net asset value 
which turns out to have been either understated or overstated to the 
amount at which portfolio instruments could have been sold, then the 
interests of either existing shareholders or new investors will have 
been diluted. See Investment Trusts and Investment Companies: 
Hearings on S. 3580 Before a Subcomm. of the Sen. Comm. on Banking 
and Currency, 76th Cong., 3d Sess. 136-138, 288 (1940).
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    Rule 2a-7 exempts money market funds from these provisions but 
contains maturity, quality, and diversification conditions designed to 
minimize the deviation between a money market fund's stabilized share 
price and the market value of its portfolio.\15\ Among these 
conditions, rule 2a-7 limits a money market fund's portfolio 
investments to securities that have received credit ratings from the 
``Requisite NRSROs'' in one of the two highest short-term rating 
categories or comparable unrated securities (i.e., ``Eligible 
Securities'').\16\ Rule 2a-7 further restricts money market funds to 
securities that the fund's board of directors (which typically rely on 
the fund's adviser \17\) determines present minimal credit risks, and 
specifically requires that determination ``be based on factors 
pertaining to credit quality in addition to any ratings assigned to 
such securities by an NRSRO.'' \18\
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    \15\ Rule 2a-7 contains conditions that apply to each investment 
a money market fund proposes to make, as well as conditions that 
apply to a money market fund's entire portfolio.
    \16\ The term ``Eligible Security'' is defined in rule 2a-
7(a)(10). ``Requisite NRSROs'' is defined in rule 2a-7(a)(21).
    \17\ See rule 2a-7(e).
    \18\ Rule 2a-7(c)(3)(i). Thus, under the current rule, where the 
security is rated, having the requisite NRSRO rating is a necessary 
but not sufficient condition for investing in the security and 
cannot be the sole factor considered in determining whether a 
security presents minimal credit risks. See Revisions to Rules 
Regulating Money Market Funds, Investment Company Act Release No. 
18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)], at text 
preceding n.18.
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    We propose to eliminate references to ratings by amending rule 2a-7 
in four principal ways.\19\ In combination, these proposed amendments 
are designed to offer similar protections to the current rule's 
reliance on NRSRO ratings.\20\
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    \19\ The proposed amendments would also make conforming 
amendments to rule 2a-7's record keeping and reporting requirements. 
See proposed rule 2a-7(c)(11).
    \20\ In 2003, the Commission published a concept release in 
which we sought comment on the use of NRSRO ratings in our rules. 
See Rating Agencies and the Use of Credit Ratings Under the Federal 
Securities Laws, Investment Company Act Release No. 26066 (June 4, 
2003) [68 FR 35258 (June 12, 2003)]. Comments on the concept release 
are available at: http://www.sec.gov/rules/concept/s71203.shtml. As 
discussed above, recent events have highlighted the need to revisit 
our reliance on NRSRO ratings in the context of these developments. 
See also the extensive discussion of market developments in the 
NRSRO June 16, 2008 Proposing Release, supra note 4.
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1. Minimal Credit Risk Determination
    Under the proposed amendments, we would rely on money market fund 
boards of directors to determine that each portfolio instrument 
presents minimal credit risks,\21\ and whether the

[[Page 40126]]

security is a ``First Tier Security'' or a ``Second Tier Security'' for 
purposes of the rule.\22\ We believe that money market fund boards of 
directors would still be able to use quality determinations prepared by 
outside sources, including NRSRO ratings that they conclude are 
credible, in making credit risk determinations. We expect that the 
boards of directors (or their delegates) would understand the basis for 
the rating and make an independent judgment of credit risks.
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    \21\ See proposed rule 2a-7(a)(10).
    \22\ Rule 2a-7(c)(4) addresses portfolio diversification 
requirements for money market funds, including diversification 
requirements relating to First and Second Tier Securities.
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    Under the proposed amendments, a security would be an Eligible 
Security if the board of directors determines that it presents minimal 
credit risks, which determination must be based on factors pertaining 
to credit quality and the issuer's ability to meet its short-term 
financial obligations.\23\ A security would be a First Tier Security if 
the fund's board had determined that the issuer has the ``highest 
capacity to meet its short-term financial obligations.'' \24\ A 
security would be a Second Tier Security if it is an Eligible Security 
but is not a First Tier Security.\25\ We have designed these proposed 
definitions to retain a degree of risk limitations similar to what is 
in the current rule.
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    \23\ Proposed rule 2a-7(a)(10).
    \24\ Proposed rule 2a-7(a)(12).
    \25\ See rule 2a-7(a)(22). The specific language of this 
provision would not change, but the definitions of ``Eligible 
Security'' and ``First Tier Security'' would change under the 
proposal. Consistent with the current rule, under proposed rule 2a-
7, a money market fund that is not a tax exempt fund generally must 
limit its investments in Second Tier Securities to no more than five 
percent of fund assets, with investment in the Second Tier 
Securities of any one issuer being limited to the greater of one 
percent of fund assets or one million dollars. Proposed rule 2a-
7(c)(3)(ii)(A) and (c)(4)(i)(C)(1). Tax exempt money market funds 
are subject to different limitations on investments in Second Tier 
Conduit Securities. Rule 2a-7(c)(3)(ii)(B) and (c)(4)(i)(C)(2).
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    We request comment on the proposed amendments. What are the 
advantages and disadvantages of eliminating the requirement to use 
NRSRO ratings from rule 2a-7? Would eliminating the rating requirements 
from rule 2a-7 affect the amount or nature of risks money market funds 
would be willing or able to take? What are the advantages and 
disadvantages of relying on minimum credit risk determinations? What 
are the advantages and disadvantages of having fund directors and 
investment advisers exclusively make credit quality determinations? Are 
we correct that the current rule's reliance on credit ratings 
discourages fund directors and investment advisers from performing 
independent credit risk assessments? What other alternatives could we 
adopt to encourage more independent credit risk analysis and meet the 
regulatory objectives of rule 2a-7's requirement of NRSRO ratings? Are 
the distinctions our proposed amendments would draw between First Tier 
and Second Tier Securities workable? Is there a better way to describe 
the characteristics of a First Tier Security without reference to 
ratings? Are we correct in our expectation that the proposed standards 
would not impose additional burdens on boards or investment advisers, 
or require new recordkeeping requirements?
2. Portfolio Liquidity
    Under the proposed amendments, a money market fund must hold 
securities that are sufficiently liquid to meet reasonably foreseeable 
redemptions in light of the fund's obligations under section 22(e) of 
the Investment Company Act and any commitments the fund has made to its 
shareholders.\26\ In addition, the proposed amendments would expressly 
limit a money market fund's investment in illiquid securities to not 
more than 10 percent of its total assets.\27\ The proposed amendments 
would define a Liquid Security as a security that can be sold or 
disposed of in the ordinary course of business within seven days at 
approximately the value ascribed to it by the money market fund.\28\ 
These proposed provisions should be familiar to managers of money 
market funds. Past releases proposing, adopting and amending rule 2a-7 
repeatedly emphasized the special duty of the board of directors of a 
money market fund to monitor purchases of illiquid instruments.\29\ 
Money market funds often have a greater and perhaps less predictable 
volume of redemptions than other open-end investment companies. 
Further, the portfolio management of a money market fund may be 
impaired if a fund were forced to meet redemption requests by selling 
marketable securities that it would otherwise wish to retain in order 
to avoid attempting to dispose of illiquid portfolio instruments.\30\ 
In light of these potential problems, the proposal would prohibit money 
market funds from acquiring illiquid securities representing more than 
10 percent of their total assets.\31\ In the event that changes in the 
money market fund's portfolio or other external events cause the fund's 
investments in illiquid instruments to exceed 10 percent of the fund's 
assets, the money market fund would have to take steps to bring the 
aggregate amount of illiquid securities back within the proposed 
limitations as soon as reasonably practicable. However, consistent with 
the current rule, this requirement generally would not force the money 
market fund to liquidate any portfolio security where the fund would 
suffer a loss on the sale of that instrument.\32\
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    \26\ See proposed rule 2a-7(c)(5). Section 22(e) of the 
Investment Company Act prohibits registered investment companies 
from suspending the right of redemption or postponing the date of 
payment upon redemption of any redeemable security for more than 
seven days except for certain periods specified in the provision. 
While the Investment Company Act requires only that an investment 
company make payment of the proceeds of redemption within seven 
days, most money market funds promise investors that they will 
receive proceeds much sooner, often on the same day that the request 
for redemption is received by the fund.
    \27\ The proposed standard codifies the current standard 
regarding portfolio liquidity. See Revisions to Rules Regulating 
Money Market Funds, Investment Company Act Release No. 21837 (Mar. 
21, 1996) [61 FR 13956 (Mar. 28, 1996)] (``Rule 2a-7 1996 Amending 
Release''), at text accompanying n.108 (``The limit on money fund 
holdings of illiquid securities is ten percent of fund assets.''); 
Acquisition and Valuation of Certain Portfolio Instruments by 
Registered Investment Companies, Investment Company Act Release No. 
14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] (``1986 Valuation 
Release''). Although credit ratings do not directly incorporate 
liquidity risks, they have been used as a proxy for liquidity 
because a security may lose liquidity if its credit rating falls.
    \28\ See proposed rule 2a-7(a)(17). See also 1986 Valuation 
Release, supra note 27 at text following n.21.
    \29\ See, e.g., Valuation of Debt Instruments and Computation of 
Current Price per Share by Certain Open-End Investment Companies 
(Money Market Funds), Investment Company Act Release No. 12206 (Feb. 
1, 1982) [47 FR 5428 (Feb. 5, 1982)] (proposing rule 2a-7); 
Valuation of Debt Instruments and Computation of Current Price Per 
Share by Certain Open-End Investment Companies (Money Market Funds), 
Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 
32555 (July 18, 1983)] (``Rule 2a-7 Adopting Release''); 1986 
Valuation Release, supra note 27.
    \30\ Rule 2a-7 Adopting Release, supra note 29, at text 
preceding, accompanying and following nn.37-39.
    \31\ Proposed rule 2a-7(c)(5). Money market funds must limit 
their investments in illiquid assets to not more than 10 percent of 
their net assets. See rule 2a-7 1996 Amending Release, supra note 
27, at n.108 and accompanying text. An investment company's 
portfolio security is illiquid if it cannot be disposed of in the 
ordinary course of business within seven days at approximately the 
value ascribed to it by the investment company. See id. at n.107 and 
accompanying text.
    \32\ See Rule 2a-7 Adopting Release, supra note 29, at n.38.
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    We request comment on the proposed amendments. Should we include in 
rule 2a-7 an express requirement that money market funds limit their 
exposure to illiquid securities? Do the proposed requirements provide 
money market funds sufficient flexibility to retain securities that may 
be illiquid if the disposal of those securities would not be in the 
best interests of the fund? Are there alternative or additional 
provisions that we should consider to address the way in which money 
market

[[Page 40127]]

funds should evaluate liquidity risk and determine whether to dispose 
of securities that present an increasing liquidity risk?
3. Monitoring Minimal Credit Risks
    The proposed amendments would also amend rule 2a-7's downgrade and 
default provisions. We propose that in the event the money market 
fund's investment adviser becomes aware of any information about a 
portfolio security or an issuer of a portfolio security that suggests 
that the security may not continue to present minimal credit risks, the 
money market fund's board of directors would have to reassess promptly 
whether the portfolio security continues to present minimal credit 
risks.\33\ This proposed requirement would replace the provisions in 
the current rule that generally require a money market fund board to 
promptly reassess whether a security that has been downgraded by an 
NRSRO continues to present minimal credit risks, and take such action 
as the board determines is in the best interests of the fund and its 
shareholders.\34\ We do not believe that the proposed amendments would 
require investment advisers to subscribe to every rating service 
publication in order to comply with this proposal. However, we would 
expect an investment adviser to exercise reasonable diligence in 
keeping abreast of new information about a portfolio security that is 
reported in the national financial press or in publications to which 
the investment adviser subscribes.
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    \33\ Proposed rule 2a-7(c)(7) (``In the event the money market 
fund's investment adviser (or any person to whom the fund's board of 
directors has delegated portfolio management responsibilities) 
becomes aware of any information about a portfolio security or an 
issuer of a portfolio security that may suggest that the security 
may not continue to present minimal credit risks, the board of 
directors shall reassess promptly whether such security continues to 
present minimal credit risks and shall cause the fund to take such 
action as the board of directors determines is in the best interests 
of the money market fund and its shareholders.'').
    \34\ Rule 2a-7(c)(6)(i)(A). This current assessment is not 
required, however, if the downgraded security is disposed of or 
matures within five business days of the specified event and in the 
case of events specified in rule 2a-7(c)(6)(i)(A)(2), the board is 
subsequently notified of the adviser's actions. Rule 2a-
7(c)(6)(i)(B).
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    We request comment on the proposed amendments. Would the 
requirement that the board of directors reassess the credit risk of a 
security when investment advisers become aware of information that may 
suggest the security no longer presents minimal credit risks provide 
adequate investor protections? Would investment advisers be able to 
stay abreast of new information about their portfolio securities?
4. Commission Notice of Rule 17a-9 Transactions
    Finally, the proposed amendments would require that money market 
funds provide the Commission with prompt notice when an affiliate of 
the money market fund (or its promoter or principal underwriter) 
purchases from the fund a security that is no longer an Eligible 
Security, pursuant to rule 17a-9 under the Investment Company Act.\35\ 
We believe that the current notice provisions, which are triggered when 
a security held by a fund defaults, provide us with incomplete 
information about money market funds holding distressed securities, 
particularly those that have engaged in an affiliated transaction with 
an affiliated person. The additional notice, which we believe would 
impose little burden on money market funds or their managers, would 
enhance our oversight of money market funds especially during times of 
economic stress.
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    \35\ Proposed rule 2a-7(c)(7)(iii)(B) (requiring notice to the 
Commission of any ``purchase of a security from the fund by an 
affiliated person or promoter of or principal underwriter for the 
fund or an affiliated person of such a person in reliance on rule 
17a-9''). See rule 17a-9 (exempting from section 17(a) of the Act 
the purchase of a security ``that is no longer an Eligible Security 
(as defined in [rule 2a-7(a)(10)]) under certain conditions).'' 
Notification under this proposed provision would also be amended to 
require electronic mail, instead of the other means currently listed 
in rule 2a-7(c)(6)(iii). We believe this change is appropriate in 
light of recent changes in telecommunications technology, and 
because most of the notices of default that we have received in the 
past year have been transmitted electronically.
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    We request comment on the proposed amendments.

B. Rule 3a-7

    Rule 3a-7 under the Investment Company Act excludes structured 
finance vehicles from the Act's definition of ``investment company'' 
subject to certain conditions.\36\ In a typical financing, a sponsor 
transfers a pool of assets (such as residential mortgages) to a limited 
purpose entity, which in turn issues fixed income securities that are 
rated investment grade or higher by at least one NRSRO. Payment on the 
securities depends primarily on the cash flows generated by the pooled 
assets. As a result, these are often referred to as ``asset-backed'' 
securities.
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    \36\ Structured financings meet the definition of investment 
company under section 3(a) of the Act because they issue securities 
and invest in, own, hold, or trade securities. Almost none of the 
structured financings, however, are able to operate under the Act's 
requirements. See Exclusion from the Definition of Investment 
Company for Structured Financings, Investment Company Act Release 
No. 19105 (Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] (``Rule 3a-7 
Adopting Release'').
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    Rule 3a-7 contains a number of conditions that differentiate 
investment companies from structured financings. The conditions include 
the requirement that structured financings offered to the general 
public are rated by at least one NRSRO in one of the four highest 
ratings categories.\37\ The rule contains an exception under which 
asset-backed securities sold to accredited investors \38\ and qualified 
institutional buyers \39\ may be unrated, or may be rated less than 
investment grade, if the issuer and its underwriters use reasonable 
care to ensure that all excepted sales are to such persons.\40\ We 
concluded that these persons are in a position to evaluate the 
structured financing vehicle and to take steps to protect themselves 
from the types of abusive practices against which the Investment 
Company Act was designed to protect.\41\
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    \37\ Rule 3a-7(a)(2).
    \38\ The exception permits the sale of asset backed fixed-income 
securities to ``accredited investors'' as defined in paragraphs (1), 
(2), (3) and (7) of rule 501(a) under the Securities Act [17 CFR 
230.501(a)], and includes any entity in which all of the equity 
owners come within such paragraphs. Rule 3a-7(a)(2)(i).
    \39\ The exception permits the sale of any asset backed 
securities to ``qualified institutional buyers'' as defined in rule 
144A under the Securities Act [17 CFR 230.144A] and certain other 
persons involved in the organization or operation of the issuer or 
an affiliate, as defined in rule 405 under the Securities Act [17 
CFR 230.405]. Rule 3a-7(a)(2)(ii).
    \40\ Rule 3a-7(a)(2).
    \41\ See Exclusion from the Definition of Investment Company for 
Certain Structured Financings, Investment Company Act Release No. 
18736 (May 29, 1992) [57 FR 23980 (June 5, 1992)] (proposing rule 
3a-7).
---------------------------------------------------------------------------

    We understand that today most asset-backed securities are issued by 
special purpose vehicles that do not rely on rule 3a-7 to exclude them 
from the application of the Investment Company Act. Instead, they rely 
on section 3(c)(7), which was added to the Act in 1996, after the 
Commission adopted rule 3a-7, and provides an exception from the Act 
for companies whose securities are limited to any issuer, the 
outstanding securities of which are owned exclusively by persons who 
are qualified purchasers, and that is not making and does not at that 
time propose to make a public offering of such securities. Moreover, 
asset-backed securities issued by financing vehicles that rely on rule 
3a-7, even when highly rated, generally are not marketed to retail 
investors.\42\ Accordingly, we propose to eliminate the rule's reliance 
on ratings by amending the rule to

[[Page 40128]]

eliminate the exclusion for structured financings offered to the 
general public.
---------------------------------------------------------------------------

    \42\ See Credit & Finance Risk Analysis Asset Backed Securities 
and Structural Finance, at http://www.credfinrisk.com/
assetsecure.html.
---------------------------------------------------------------------------

    In addition, we are proposing to amend the part of the rule that 
addresses substitution of eligible assets to remove the reference to 
ratings downgrades. The rule permits the issuer to acquire additional 
eligible assets or dispose of assets only if, among other conditions, 
the acquisition or disposition of the assets does not result in a 
downgrading in the rating of the issuer's outstanding fixed-income 
securities.\43\ We propose to require instead that the issuer have 
procedures to ensure that the acquisition or disposition does not 
adversely affect the full and timely payment of the outstanding fixed 
income securities.\44\
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    \43\ Rule 3a-7(a)(3)(ii).
    \44\ Proposed rule 3a-7(a)(3)(ii).
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    Finally, we propose to amend the portion of the rule that deals 
with the safekeeping of assets.\45\ Among other requirements, the rule 
provides that cash flows from the asset pool periodically be deposited 
in a segregated account, consistent with the rating of the outstanding 
fixed income securities.\46\ This provision was intended to ensure that 
the segregated account in which the cash flows are deposited and the 
length of time that the servicer holds the cash flows before depositing 
them in the segregated account would pose a minimal risk of loss to the 
fixed income security holders. We propose to change this provision to 
require that the cash flows be deposited in a segregated account 
consistent with the full and timely payment of the outstanding fixed 
income securities.\47\ The proposed amendment is designed to minimize 
the risk of loss of cash flows pending payment to the fixed income 
securities holders.
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    \45\ Rule 3a-7(a)(4).
    \46\ Rule 3a-7(a)(4)(iii).
    \47\ Proposed rule 3a-7(a)(4)(iii). The proposed amendment would 
require the issuer to take ``actions necessary for the cash flows 
derived from eligible assets for the benefit of the holders of 
fixed-income securities to be deposited periodically in a segregated 
account that is maintained or controlled by the trustee consistent 
with the full and timely payment of the outstanding fixed income 
securities.''
---------------------------------------------------------------------------

    We request comment on our proposed amendments to rule 3a-7. What 
are the advantages and disadvantages of eliminating the NRSRO rating 
requirement from the rule? Is our understanding that structured 
financings are generally not marketed to retail investors correct? If 
not, should we retain an exclusion for structured finance offerings to 
the general public? If so, what standards should we impose that could 
distinguish structured finance vehicles from investment companies for 
those investors? For example, should we permit offerings to the general 
public if a sponsor or trustee conducts an independent statistical 
analysis of the anticipated cash flows? Are we correct in our 
assumption that dropping the rating requirement from the rule will not 
blur the current distinction between structured finance vehicles and 
investment companies? If not, should the rule incorporate alternatives 
to the rule's rating requirement that would clarify the distinction? 
For example, should the rule contain specific requirements regarding 
abuses that the Act is designed to address, such as self-dealing and 
overreaching by the issuer? Does our proposal regarding the deposit of 
cash flows into a segregated account provide sufficient protection 
against the possibility of loss while the servicer is handling cash 
flows pending payment to the fixed income security holders? Would an 
alternative standard provide better protection?

C. Rule 5b-3

    Rule 5b-3 under the Investment Company Act permits a fund, subject 
to certain conditions, to treat a repurchase agreement as an 
acquisition of the securities collateralizing the repurchase agreement 
in determining whether the fund is in compliance with two provisions of 
the Act that may affect a fund's ability to invest in repurchase 
agreements.\48\ Section 12(d)(3) of the Investment Company Act 
generally prohibits a fund from acquiring an interest in a broker, 
dealer, or underwriter. Because a repurchase agreement may be 
considered to be the acquisition of an interest in the counterparty, 
section 12(d)(3) may limit a fund's ability to enter into repurchase 
agreements with many of the firms that act as repurchase agreement 
counterparties. Section 5(b)(1) of the Act limits the amount that a 
fund that holds itself out as being a diversified investment company 
may invest in the securities of any one issuer (other than the U.S. 
Government). This provision may limit the number and principal amounts 
of repurchase agreements a diversified fund may enter into with any one 
counterparty.
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    \48\ In a typical investment company repurchase agreement, a 
fund enters into a contract with a broker, dealer, or bank (the 
``counterparty'' to the transaction) for the purchase of securities. 
The counterparty agrees to repurchase the securities at a specified 
future date, or on demand, for a price that is sufficient to return 
to the fund its original purchase price, plus an additional amount 
representing the return on the fund's investment. Repurchase 
agreements provide funds with a convenient means to invest excess 
cash on a secured basis, generally for short periods of time. 
Economically, a repurchase agreement functions as a loan from the 
fund to the counterparty, in which the securities purchased by the 
fund serve as collateral for the loan and are placed in the 
possession or under the control of the fund's custodian during the 
term of the agreement. See Treatment of Repurchase Agreements and 
Refunded Securities as an Acquisition of the Underlying Securities, 
Investment Company Act Release No. 25058 (July 5, 2001) [66 FR 36156 
(July 11, 2001)] (``Rule 5b-3 Adopting Release'').
---------------------------------------------------------------------------

    Rule 5b-3 allows funds to treat the acquisition of a repurchase 
agreement as an acquisition of securities collateralizing the 
repurchase agreement for purposes of sections 5(b)(1) and 12(d)(3) of 
the Act if the obligation of the seller to repurchase the securities 
from the fund is ``collateralized fully.'' \49\ A repurchase agreement 
is collateralized fully if, among other things, the collateral for the 
repurchase agreement consists entirely of (i) cash items, (ii) 
government securities, (iii) securities that at the time the repurchase 
agreement is entered into are rated in the highest rating category by 
the ``Requisite NRSROs'' or (iv) unrated securities that are of a 
comparable quality to securities that are rated in the highest rating 
category by the Requisite NRSROs, as determined by the fund's board of 
directors or its delegate.\50\
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    \49\ Rule 5b-3(a). The term ``Collateralized Fully'' is defined 
in rule 5b-3(c)(1). An investment company investing in a repurchase 
agreement primarily looks to the value and liquidity of the 
securities collateralizing the repurchase agreement rather than the 
credit quality of the counterparty for satisfaction of the 
repurchase agreement.
    \50\ Rule 5b-3(c)(1)(iv). The term ``Requisite NRSROs'' means 
any two NRSROs that have issued a rating with respect to a security 
or class of debt obligations of an issuer or, if only one NRSRO has 
issued a rating with respect to such security or class of debt 
obligations of an issuer at the time the investment company acquires 
the security, that NRSRO. Rule 5b-3(c)(6). The term ``unrated 
securities'' means securities that have not received a rating from 
the Requisite NRSROs. Rule 5b-3(c)(8).
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    In proposing rule 5b-3, the Commission explained that the highest 
rating category requirement in the definition of collateralized fully 
was designed to ensure that the market value of the collateral would 
remain fairly stable and that the fund could more readily liquidate the 
collateral quickly in the event of a default.\51\
---------------------------------------------------------------------------

    \51\ See Treatment of Repurchase Agreements and Refunded 
Securities as an Acquisition of the Underlying Securities, 
Investment Company Act Release No. 24050 (Sept. 23, 1999) [64 FR 
52476 (Sept. 29, 1999)] (``Rule 5b-3 Proposing Release''), at n.43 
and accompanying text.
---------------------------------------------------------------------------

    We propose to eliminate the requirement that collateral other than 
cash or government securities be rated by an NRSRO. As an alternative, 
we propose to require that if the collateral is not cash or government 
securities, the fund's board of directors (or its delegate)

[[Page 40129]]

determines that the collateral securities present minimum credit risks 
and are highly liquid. Specifically, the proposal would require 
collateral other than cash or government securities to consist of 
securities that the fund's board of directors (or its delegate) 
determines at the time the repurchase agreement is entered into (i) are 
sufficiently liquid that they can be sold at or near their carrying 
value within a reasonably short period of time, (ii) are subject to no 
greater than minimal credit risk, and (iii) are issued by a person that 
has the highest capacity to meet its financial obligations.\52\ 
Although the rule would no longer require the collateral to be rated by 
an NRSRO, we anticipate that evaluating credit risk and liquidity of 
the collateral could incorporate ratings, reports, analyses, and other 
assessments issued by NRSROs and other persons.\53\
---------------------------------------------------------------------------

    \52\ Proposed rule 5b-3(c)(1)(iv)(C). Under the proposal, the 
board would make credit quality determinations for all non-
government collateral securities, rather than just unrated 
securities. As in the current rule, the proposed rule would permit 
the board to delegate this credit quality and liquidity 
determination.
    \53\ A fund that acquires repurchase agreements would have to 
adopt and implement a written policy reasonably designed to comply 
with this requirement under rule 38a-1 under the Investment Company 
Act. See rule 38a-1(a) (requiring registered funds to adopt and 
implement written policies and procedures reasonably designed to 
prevent the fund's violation of federal securities laws).
---------------------------------------------------------------------------

    NRSRO ratings are also used in a provision of rule 5b-3 that 
permits a fund to deem the acquisition of a ``refunded security'' as 
the acquisition of the escrowed government securities for purposes of 
section 5(b)(1)'s diversification requirements.\54\ Under this 
provision, a debt security must satisfy certain conditions to be 
considered a refunded security under the rule. One of these conditions 
is that an independent certified public accountant must have certified 
to the escrow agent that the escrowed securities will satisfy all 
scheduled payments of principal, interest, and applicable premiums on 
the refunded securities.\55\ This condition is not required, however, 
if the refunded security has received a debt rating in the highest 
rating category from an NRSRO.\56\
---------------------------------------------------------------------------

    \54\ Rule 5b-3(b). Under the rule, a refunded security means a 
debt security the principal and interest payments of which are to be 
paid by U.S. government securities that have been irrevocably placed 
in an escrow account and are pledged only to the payment of the debt 
security. Rule 5b-3(c)(4).
    \55\ Rule 5b-3(c)(4)(iii).
    \56\ Id.
---------------------------------------------------------------------------

    We are proposing to eliminate the exception to the certification 
requirement for securities that have received the highest rating from 
an NRSRO. Rule 5b-3 requires the certification by an independent 
certified public accountant (together with the other conditions) to 
ensure that the bankruptcy of the issuer of the pre-refunded securities 
would not affect payments on the securities from the escrow 
account.\57\ The Commission included this exception because in rating 
refunded securities, NRSROs typically require that an independent third 
party make the same determination.\58\
---------------------------------------------------------------------------

    \57\ See Rule 5b-3 Adopting Release, supra note 48, at text 
accompanying n.25 (explaining that the conditions required in the 
definition of refunded security correspond to those in the 
definition of the term in rule 2a-7); Rule 2a-7 1986 Amending 
Release, supra note 31, at section II.D.2.
    \58\ See Technical Revisions to the Rules and Forms Regulating 
Money Market Funds, Investment Company Act Release No. 22921 (Dec. 
2, 1997) [62 FR 64968 (Dec. 9, 1997)], at section I.B.2.c.
---------------------------------------------------------------------------

    We request comment on the proposed amendments. How would the 
proposed elimination of the rating requirement from the definition of 
``collateralized fully'' affect funds? Would the proposed board 
determinations sufficiently address our concerns that collateral 
securities be of high quality in order to limit a fund's exposure to 
counterparties' credit risks? If not, are there additional or 
alternative standards that would better address our concerns? How would 
the proposal to eliminate the exception for rated securities from the 
condition that refunded securities obtain a certification from an 
independent auditor affect funds? We expect that with respect to rated 
refunded securities, funds may be able to satisfy the certification 
requirement by determining that an NRSRO required an independent 
certified public accountant to make the same determination.\59\ Would 
funds incur any costs in determining that a refunded security has 
received an accountant certification rather than relying on an NRSRO 
rating? Is there an alternative standard that would provide an 
equivalent evaluation? For example, should we permit the board to rely 
on another independent third party to provide the certification?
---------------------------------------------------------------------------

    \59\ See, e.g., Standard & Poor's, Public Finance Criteria: 
Defeasance: Legal Defeasance Criteria, Cash Flow Verification (Sept. 
8, 2006).
---------------------------------------------------------------------------

D. Rule 10f-3

    Section 10(f) of the Investment Company Act prohibits a registered 
investment company from purchasing any security for which an affiliated 
underwriter is acting as a principal underwriter \60\ during the 
existence of an underwriting or selling syndicate for that 
security.\61\ The prohibition was intended to address Congress's 
concern that underwriters were ``dumping'' otherwise unmarketable 
securities on affiliated funds, either by forcing the fund to purchase 
unmarketable securities from the underwriting affiliate itself, or by 
forcing or encouraging the fund to purchase the securities from another 
member of the syndicate.\62\ Congress also expressed concern regarding 
the amount of underwriting fees earned by the sponsors and affiliated 
persons who placed the securities with the fund.\63\
---------------------------------------------------------------------------

    \60\ The term ``principal underwriter'' means (in relevant part) 
an underwriter who, in connection with a primary distribution for 
securities: (i) Is in privity of contract with the issuer or an 
affiliated person of the issuer; (ii) acting alone or in concert 
with one or more other persons, initiates or directs the formation 
of an underwriting syndicate; or (iii) is allowed a rate of gross 
commission, spread, or other profit greater than the rate allowed 
another underwriter participating in the distribution. 15 U.S.C. 
80a-2a(a)(29).
    \61\ Section 10(f) prohibits a fund from purchasing a security 
during the existence of an underwriting or selling syndicate if a 
principal underwriter of the security is an officer, director, 
member of an advisory board, investment adviser, or employee of the 
fund or is a person of which any such officer, director, member of 
an advisory board, investment adviser, or employee is an affiliated 
person. An affiliated person of a fund includes, among others: (i) 
Any person directly or indirectly owning, controlling, or holding 
with power to vote, five percent or more of the outstanding voting 
securities of the fund; (ii) any person five percent or more of 
whose outstanding voting securities are directly or indirectly 
owned, controlled, or held with power to vote by the fund; and (iii) 
any person directly or indirectly controlling, controlled by, or 
under common control with such other person. 15 U.S.C. 80a-
2(a)(3)(A), (B) and (C).
    \62\ See Report of the SEC, Investment Trusts and Investment 
Companies, H.R. Doc. No. 279, 76th Cong., 2d Sess., pt. 3, at 2581, 
2589 (1939). The sales were also used to alleviate certain of an 
affiliated underwriter's financial difficulties. For example, an 
underwriter could benefit by rapidly turning over its securities 
inventory to produce working capital and to reduce the related 
expenses of carrying the inventory.
    \63\ See Hearings on S.3580 Before a Subcommittee of the 
Commission on Banking and Currency, 76th Cong., 3d Sess. 209, 212-23 
(1940).
---------------------------------------------------------------------------

    The Commission adopted rule 10f-3 in 1958 to permit a fund that is 
affiliated with members of an underwriting syndicate to purchase 
securities from the syndicate if certain conditions are met.\64 \We 
amended rule 10f-3 in 1979 to add municipal securities to the class of 
securities that funds could purchase under the rule.\65\ The rule 
defines

[[Page 40130]]

municipal securities that may be purchased during an underwriting in 
reliance on the rule (``eligible municipal securities'') to include 
securities that have an investment grade rating from at least one NRSRO 
or, if the issuer or the entity supplying the revenues or other 
payments from which the issue is to be paid has been in continuous 
operation for less than three years (i.e., a less seasoned security), 
one of the three highest ratings from an NRSRO.\66\ The Commission 
explained that the rationale behind the rating requirement was to 
prevent the purchase of less seasoned securities and reduce the risk of 
unloading unmarketable securities on the fund.\67\
---------------------------------------------------------------------------

    \64\ Adoption of Rule N-10-F-3 Permitting Acquisition of 
Securities of Underwriting Syndicate Pursuant to Section 10(f) of 
the Investment Company Act of 1940, Release No. 2797 (Dec. 2, 1958) 
[23 FR 9548 (Dec. 10, 1958)]. The rule codified the conditions of 
orders that the Commission had granted prior to 1958 exempting 
certain funds from section 10(f) to permit them to purchase specific 
securities.
    \65\ Exemption of Acquisition of Securities During the Existence 
of Underwriting Syndicate, Investment Company Act Release No. 10736 
(June 14, 1979) [44 FR 36152 (June 20, 1979)] (``Rule 10f-3 1979 
Adopting Release''). Rule 10f-3(c)(1)(iii).
    \66\ Rule 10f-3(a)(3).
    \67\ Exemption of Acquisition of Securities During the Existence 
of Underwriting Syndicate, Investment Company Act Release No. 10592 
(Feb. 13, 1979) [44 FR 10580 (Feb. 21, 1979)] (``1979 10f-3 
Amendments Proposing Release'').
---------------------------------------------------------------------------

    We propose to eliminate the references to ratings in rule 10f-3, 
and amend the rule's definition of ``eligible municipal security'' to 
mean securities that are sufficiently liquid that they can be sold at 
or near their carrying value within a reasonably short period of time. 
In addition, the securities would have to be either: (i) Subject to no 
greater than moderate credit risk; or (ii) if they are less seasoned 
securities, subject to a minimal or low amount of credit risk.\68\
---------------------------------------------------------------------------

    \68\ Proposed rule 10f-3(a)(3). The proposed rule would define 
``eligible municipal securities'' to mean ``'municipal securities'' 
as defined in section 3(a)(29) of the Securities Exchange Act of 
1934, that have sufficient liquidity such that they can be sold at 
or near their carrying value within a reasonably short period of 
time and either (i) are subject to no greater than moderate credit 
risk or (ii) if the issuer of the municipal securities, or the 
entity supplying the revenues or other payments from which the issue 
is to be paid, has been in continuous operation for less than three 
years, including the operation of any predecessors, the securities 
are subject to a minimal or low amount of credit risk.''
---------------------------------------------------------------------------

    Unlike our proposals to amend other rules, we are not proposing to 
add a requirement that the board of directors make the determination 
regarding credit risk and liquidity. Rule 10f-3 already requires a 
fund's directors, including a majority of disinterested directors, to 
approve procedures regarding purchases made in reliance on the rule and 
to determine each quarter that all purchases were made in compliance 
with the procedures.\69\ Accordingly, the board, including a majority 
of disinterested directors, already is required to review purchases of 
municipal securities made in reliance on the rule, and would continue 
to do so under our proposal. In addition, pursuant to its oversight 
role, the board would be required to approve procedures for ensuring 
that municipal securities meet the proposed conditions for credit 
quality and liquidity. Although the rule would no longer require 
municipal securities to be rated by an NRSRO, fund boards of directors 
would still be able to incorporate quality determinations prepared by 
outside sources, including ratings, reports, analyses, and other 
assessments issued by NRSROs and other persons, in their approval of 
procedures and in their review of transactions under the rule.
---------------------------------------------------------------------------

    \69\ Rule 10f-3(c)(10). The Commission added the requirement 
that disinterested directors adopt procedures made in reliance on 
the rule and periodically review the fund's compliance with these 
procedures in 1979. See Rule 10f-3 1979 Adopting Release, supra note 
65. At the time, we stressed that in determining specific procedures 
to be included in the guidelines for transactions in reliance on the 
rule, the board should be aware generally of the nature of any 
affiliation that the investment company (or any of its officers, 
directors, employees or adviser) may have with underwriters and any 
role the affiliate person would play in mounting the underwriting of 
a particular issue. See 1979 10f-3 Amendments Proposing Release, 
supra note 67, at text preceding n.23. Our proposal would not affect 
this existing requirement with respect to the purchase of municipal 
securities.
---------------------------------------------------------------------------

    We request comment on the proposed amendment to rule 10f-3. What 
would be the effect of eliminating the rating requirement in the 
definition of ``eligible municipal securities''? Is the proposed 
standard that municipal securities purchased in reliance on rule 10f-3 
present no more than moderate credit risks and are highly liquid 
sufficient to limit the possibility underwriters may sell unmarketable 
securities to the fund? Is there an alternative that would better 
address our regulatory concerns?

E. Rule 206(3)-3T

    Rule 206(3)-3T under the Investment Advisers Act of 1940 
establishes a temporary alternative means for investment advisers who 
are registered with the Commission as broker-dealers to meet the 
requirements of section 206(3) of the Advisers Act when they act in a 
principal capacity in transactions with certain of their advisory 
clients.\70\ That section makes it unlawful for any investment adviser, 
directly or indirectly ``acting as principal for his own account, 
knowingly to sell any security to or purchase any security from a 
client * * *, without disclosing to such client in writing before the 
completion of such transaction the capacity in which he is acting and 
obtaining the consent of the client to such transaction.'' \71\ Rule 
206(3)-3T contains several conditions that are designed to prevent 
overreaching by advisers by requiring an adviser to disclose to its 
client the conflicts of interest involved in principal transactions, 
inform the client of the circumstances in which the adviser may effect 
a trade on a principal basis, and provide the client with meaningful 
opportunities to refuse to consent to a particular transaction or 
revoke the prospective general consent to these transactions.\72\
---------------------------------------------------------------------------

    \70\ Rule 206(3)-3T [17 CFR 275.206(3)-3T]. See also Temporary 
Rule Regarding Principal Trades with Certain Advisory Clients, 
Investment Advisers Act Release No. 2653 (Sept. 24, 2007) [72 FR 
55022 (Sept. 28, 2007)] (``Principal Trade Rule Release'').
    \71\ 15 U.S.C. 80b-6(3).
    \72\ See Principal Trade Rule Release, supra note 70, at text 
accompanying n.28.
---------------------------------------------------------------------------

    An adviser generally may not rely on the rule for principal trades 
of securities if the investment adviser or a person who controls, is 
controlled by, or is under common control with the adviser (``control 
person'') is the issuer or is an underwriter of the security.\73\ As we 
stated when we adopted the rule, the incentives associated with 
underwriting securities may bias the advice being provided or lead the 
adviser to exert undue influence on its client's decision to invest in 
the offering or the terms of that investment.\74\ The rule contains an 
exception to this ``underwritten securities'' exclusion for trades in 
which the adviser or a control person is an underwriter of non-
convertible investment-grade debt securities.\75\ We provided this 
exception because non-convertible investment grade debt securities may 
be less risky and therefore less likely to be ``dumped'' on 
clients.\76\ The rule defines an ``investment grade debt security'' as 
a non-convertible debt security that, at the time of sale, is rated in 
one of the four highest rating categories of at least two NRSROs.\77\
---------------------------------------------------------------------------

    \73\ Rule 206(3)-3T(a)(2).
    \74\ Principal Trade Rule Release, supra note 70, at n.35 and 
accompanying and following text.
    \75\ Id. at text accompanying n.36. There is no exception if the 
adviser or a control person is the issuer of the securities.
    \76\ Id. at text following n.36. We also noted in the Principal 
Trade Rule Release that it may be easier for clients to identify 
whether the price they are being quoted for a non-convertible 
investment grade debt security is fair given the relative 
comparability, and the significant size, of the non-convertible 
investment grade debt markets. Id.
    \77\ Rule 206(3)-3T(c).
---------------------------------------------------------------------------

    We propose to amend rule 206(3)-3(T), to eliminate an adviser's 
ability to rely exclusively on NRSRO ratings to determine whether a 
security is investment grade for purposes of the rule. Instead, the 
adviser would have to make its own assessment taking into account 
specified criteria, including that the security: (i) Has no greater 
than

[[Page 40131]]

moderate credit risk; and (ii) is sufficiently liquid that it can be 
sold at or near its carrying value within a reasonably short period of 
time.\78\
---------------------------------------------------------------------------

    \78\ Proposed rule 206(3)-3T(c). Although the proposed amendment 
would no longer require a security underwritten by an adviser or its 
control person to be rated by NRSROs to be eligible under the rule, 
investment advisers could refer to ratings, reports, analyses, and 
other assessments issued by NRSROs and other persons, for the 
purpose of evaluating credit risk and liquidity.
---------------------------------------------------------------------------

    Finally, as we stated when we adopted rule 206(3)-3T, an adviser 
subject to rule 206(4)-7 of the Advisers Act must adopt and implement 
written policies and procedures reasonably designed to prevent 
violations of the Advisers Act (and the rules thereunder) by the 
adviser or any of its supervised persons.\79\ An adviser seeking to 
rely on rule 206(3)-3T, therefore, would have to adopt and implement 
policies and procedures that address the adviser's methodology for 
determining whether a security is investment grade quality.
---------------------------------------------------------------------------

    \79\ Principal Trade Rule Release, supra note 70, at nn.56-58 
and accompanying text. In that connection, an adviser seeking to 
rely on rule 206(3)-3T, as proposed to be amended, would need to 
adopt and implement policies and procedures reasonably designed to 
ensure that the adviser's methodology for determining investment 
grade quality is consistent with the adviser's legal obligations.
---------------------------------------------------------------------------

    We request comment on our proposed revised definition of 
``investment grade debt security.'' Is it appropriate for us to allow 
advisers seeking to rely upon the rule to determine whether a security 
is investment grade based on the criteria in the rule? Is there another 
definition of ``investment grade'' elsewhere in the federal securities 
laws that we should incorporate by reference into the rule? Are there 
alternative methods to ensure that advisers seeking to rely on the 
exception to the underwriting exclusion do so only with respect to 
investment grade debt? Are there alternative or additional factors we 
should require an adviser to consider in making its determination? In 
addition, we expect that advisers, in order to establish their 
eligibility to rely on the rule, would document their determination 
that a security is investment grade quality, as well as the process for 
making such a determination. Are we correct? Should we make such 
documentation an explicit requirement of the rule, or amend rule 204-2 
under the Advisers Act \80\ (the books and records rule) to require 
such documentation?
---------------------------------------------------------------------------

    \80\ 17 CFR 275.204-2.
---------------------------------------------------------------------------

IV. Request for Comment

    We request comment on the rule amendments proposed in this release. 
We also request suggestions for additional changes to existing rules, 
and comments on other matters that might have an effect on the 
proposals contained in this release. Commenters are requested to 
provide empirical data to support their views.

V. Paperwork Reduction Act

    Certain provisions of the proposed amendments to rules 2a-7, 3a-7, 
5b-3, and 10f-3 under the Investment Company Act, and rule 206(3)-(3)T 
under the Investment Advisers Act, contain ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'').\81\ The Commission is submitting this 
proposal to the Office of Management and Budget (``OMB'') for review in 
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The titles for the 
collections of information are: ``Rule 2a-7 under the Investment 
Company Act of 1940, Money market funds'' (OMB Control No. 3235-0268); 
``Rule 10f-3 under the Investment Company Act of 1940, Exemption for 
the Acquisition of Securities During the Existence of an Underwriting 
and Selling Syndicate'' (OMB Control No. 3235-0226); and ``Temporary 
rule for principal trades with certain advisory clients, rule 206(3)-
3T'' (OMB Control No. 3235-0630). There are currently no approved 
collections for rules 3a-7 and 5b-3, and the proposed amendments would 
not create any new collections. We adopted the rules pursuant to the 
Investment Company Act and the Investment Advisers Act.
---------------------------------------------------------------------------

    \81\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------

    Our proposed amendments are designed to address the risk that the 
reference to and required use of NRSRO ratings in our rules:
     Is interpreted by investors as an endorsement of the 
quality of the credit ratings issued by NRSROs; and
     Encourages investors to place undue reliance on NRSRO 
ratings.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a 
currently valid control number.

A. Rule 2a-7

    Rule 2a-7 under the Investment Company Act exempts money market 
funds from the Act's valuation requirements, permitting money market 
funds to maintain stable share pricing, subject to certain risk-
limiting conditions. We propose to amend rule 2a-7 in four principal 
ways to: (i) Rely on money market fund boards of directors (who usually 
rely on the funds' advisers) to determine that each portfolio 
instrument presents minimal credit risks, and whether the security is a 
``First Tier Security'' or a ``Second Tier Security;'' (ii) add a 
portfolio liquidity requirement to the rule that would require that 
money market funds hold securities that are sufficiently liquid to meet 
reasonably foreseeable shareholder redemptions, and expressly limit 
their investment in illiquid securities to not more than 10% of their 
total assets; (iii) in the event the money market fund's investment 
adviser becomes aware of any new information about a portfolio security 
(or an issuer of a portfolio security) that may suggest that the 
security may not continue to present minimal credit risks, the proposal 
would amend rule 2a-7's downgrade and default provisions to require a 
money market fund's board of directors to reassess promptly whether the 
portfolio security continues to present minimal credit risks; and (iv) 
require a money market fund to notify the Commission of the purchase of 
a money market fund's portfolio security by an affiliated person in 
reliance on rule 17a-9 under the Investment Company Act.\82\ The 
proposed amendments also would make conforming amendments to rule 2a-
7's record keeping and reporting requirements.\83\
---------------------------------------------------------------------------

    \82\ See rule 17a-9.
    \83\ See proposed rule 2a-7(c)(11).
---------------------------------------------------------------------------

    The proposed amendments to rule 2a-7 would impose a new reporting 
obligation on money market funds. The proposed reporting requirement to 
notify the Commission of the purchase of a money market fund's 
portfolio securities by an affiliated person in reliance on rule 17a-9 
under the Investment Company Act is designed to assist Commission staff 
in overseeing money market funds' affiliated transactions that are 
otherwise prohibited. If adopted, the new collection of information 
would be mandatory for money market funds. Information submitted to the 
Commission related to a rule 17a-9 transaction would be accorded 
confidential treatment to the extent permitted by law.\84\
---------------------------------------------------------------------------

    \84\ See, e.g., 17 CFR 200.83.
---------------------------------------------------------------------------

    Commission staff estimates that there are 808 money market funds, 
all of whom are subject to rule 2a-7.\85\ Of these money market funds, 
Commission staff estimates that an average of 10 funds per year would 
be required to provide notice to the Commission of a rule 17a-9 
transaction, with the total

[[Page 40132]]

annual responses per fund, on average, requiring .5 hours of an 
attorney's time at a cost of $147.50.\86\ Given these estimates, we 
estimate that the total annual burden of the proposed amendments to 
rule 2a-7 for all money market funds would be approximately 5 hours and 
$1,475.\87\
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    \85\ These include registered money market funds and series of 
registered money market funds. See Investment Company Institute, 
Trends in Mutual Fund Investing April 2008, May 29, 2008. Available 
at http://www.ici.org/stats/latest/trends_04_08.html.
    \86\ Based on information provided by money market fund 
representatives, Commission staff estimates the cost would equal 0.5 
hours of an attorney's time at $295 per hour (0.5 hours x $295 per 
hour = $147.50). The estimated hourly wages used in this PRA 
analysis were derived from reports prepared by the Securities 
Industry and Financial Markets Association. See Securities Industry 
and Financial Markets Association, Report on Management and 
Professional Earnings in the Securities Industry--2007 (2007), 
modified to account for an 1800-hour work year and multiplied by 
5.35 to account for bonuses, firm size, employee benefits and 
overhead; and Securities Industry and Financial Markets Association, 
Office Salaries in the Securities Industry--2007 (2007), modified to 
account for an 1800-hour work year and multiplied by 2.93 to account 
for bonuses, firm size, employee benefits and overhead.
    \87\ These estimates are based on the following calculations: 
(10 money market funds x .5 hours) = 5 hours; (10 money market funds 
x 147.50) = $1,475.
---------------------------------------------------------------------------

    We seek comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.

B. Rule 3a-7

    Rule 3a-7 under the Investment Company Act excludes structured 
finance vehicles from the Act's definition of ``investment company'' 
subject to certain conditions. The conditions include the requirement 
that structured financings offered to the general public are rated by 
at least one NRSRO in one of the four highest rating categories. The 
proposed amendments would: (i) Eliminate rule 3a-7's reliance on 
ratings by eliminating the exclusion for structured financings offered 
to the general public; (ii) remove the reference to ratings downgrades 
in the section of the rule that addresses substitution of eligible 
assets; and (iii) amend the portion of the rule that deals with 
safekeeping of assets. Commission staff estimates that the proposal may 
result in a new collection of information but any collection of 
information would not have an associated burden. Although in the 
condition in rule 3a-7 dealing with the substitution of assets, the 
proposed amendments would require the issuer to have procedures to 
ensure that the acquisition or disposition of assets does not adversely 
affect the full and timely payment of the outstanding fixed income 
securities, Commission staff believes that almost all issuers currently 
have these procedures in place.
    We request comment on whether issuers currently have these 
procedures in place.

C. Rule 5b-3

    Rule 5b-3 under the Investment Company Act allows funds to treat 
the acquisition of a repurchase agreement as an acquisition of 
securities collateralizing the repurchase agreement for purposes of 
sections 5(b)(1) and 12(d)(3) of the Investment Company Act under 
certain conditions. We propose to amend rule 5b-3 by requiring a fund's 
board of directors, or its delegate, to determine that the securities 
collateralizing a repurchase agreement present minimum credit risks and 
are highly liquid.\88\ To that end, the fund's board of directors, 
pursuant to rule 38a-1 under the Investment Company Act, would have to 
develop procedures to ensure that at the time the repurchase agreement 
is entered into the securities meet the requirements for collateral 
outlined in the amendments to the proposed rule. These procedures are 
necessary to make sure that the market value of the collateral remains 
fairly stable and that the fund would be able to liquidate the 
collateral quickly in the event of a default.\89\ This collection of 
information would be mandatory for funds that rely on rule 5b-3. 
Records of information made in connection with this requirement would 
be required to be maintained for inspection by Commission staff, but 
the collection would not otherwise be submitted to the Commission.
---------------------------------------------------------------------------

    \88\ Proposed rule 5b-3(c)(1)(iv)(C).
    \89\ See Rule 5b-3 Proposing Release, supra note 51, at text 
accompanying n.43.
---------------------------------------------------------------------------

    The existing rule provides that unrated securities are collateral 
if the fund's board, or its delegate, makes the determination that the 
unrated securities are comparable to securities that are rated in the 
highest rating category by the Requisite NRSROs.\90\ Thus, fund boards 
may have existing procedures regarding credit quality determinations 
for unrated securities. In addition, as a matter of good business 
practice, we believe that some funds currently evaluate the credit risk 
and liquidity of rated securities. Thus, we believe that most funds 
already have procedures to evaluate collateral securities. As of March 
31, 2008, 4,714 investment companies were registered with the 
Commission. Commission staff estimates that 90% of all registered 
investment companies, or 4,243 funds, currently have procedures for 
evaluating collateral securities. Commission staff therefore estimates 
that 471 funds would need to develop procedures and evaluate collateral 
securities, and the staff estimates this would involve a one-time 
burden of 942 hours and an ongoing burden of 5,652 hours, at a cost of 
approximately $1,294,308.\91\
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    \90\ Rule 5b-3(c)(1)(iv)(D).
    \91\ Commission staff estimates that each fund board would incur 
a one-time burden of 2 hours to develop procedures for evaluating 
credit and liquidity risks (471 boards x 2 hours = 942 hours). 
Commission staff believes that any incidental costs incurred by 
boards of directors would be incorporated into funds' overall board 
costs and would not add any particular costs. In addition, staff 
estimates that a board delegate would spend an average of 1 hour to 
evaluate the credit risks for the collateral for each of an average 
of 12 repurchase agreements each year (471 funds x 12 hours = 5,652 
hours). Assuming the evaluation would be performed by a senior 
business analyst (at $229 per hour), the total cost estimate would 
be $1,294,308.
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    We seek comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.

D. Rule 10f-3

    Rule 10f-3, permits funds that are affiliated with members of an 
underwriting syndicate to purchase securities from the syndicate if 
certain conditions are met. We are proposing to amend the rule's 
definition of ``eligible municipal securities'' to include credit 
quality and liquidity requirements.
    Under the current rule, fund boards are required to approve 
procedures regarding purchases made in reliance on the rule and to 
determine each quarter that all purchases were made in compliance with 
the procedures.\92\ Accordingly, the board currently reviews purchases 
of municipal securities made in reliance on the rule, and would 
continue to do so under our proposal. Pursuant to the amendments to the 
proposed rule, fund boards would need to approve additional procedures 
for ensuring that municipal securities meet the standards for credit 
quality and liquidity. These procedures are necessary to eliminate any 
possibility that an affiliated underwriter may ``unload'' otherwise 
unmarketable securities on a fund. This collection of information would 
be mandatory for funds that rely on rule 10f-3. Records of information 
made in connection with this requirement would be required to be 
maintained for inspection by Commission staff, but the collection would 
not otherwise be submitted to the Commission.
---------------------------------------------------------------------------

    \92\ Rule 10f-3(c)(10).
---------------------------------------------------------------------------

    In our most recent PRA submission, we estimated that approximately 
350 funds engage in rule 10f-3 transactions each year. We further 
estimated that each fund would, on average, take two

[[Page 40133]]

hours to review and revise, as needed, written procedures for rule 10f-
3 transactions. We believe that any revisions funds would have to make 
to comply with the proposed amendments would be incorporated in the two 
hours of review. Accordingly, we do not believe that the proposed 
amendments to rule 10f-3 would change the burdens currently approved 
for rule 10f-3.
    We seek comment on these estimates. If commenters believe these 
estimates are not reasonable, we request they provide data that would 
allow us to make more accurate estimates.

E. Rule 206(3)-3T

    Rule 206(3)-3T under the Advisers Act establishes a temporary 
alternative means for investment advisers who are registered with the 
Commission as broker-dealers to meet the requirements of section 206(3) 
of the Advisers Act when they act in a principal capacity in 
transactions with certain of their advisory clients. So long as each 
condition of the rule is met, an eligible adviser may provide the 
transaction-by-transaction disclosure required under section 206(3) of 
the Advisers Act either orally or in writing. One condition of the rule 
is that an adviser generally may not rely on rule 206(3)-3T for 
principal trades of securities if the investment adviser or a person 
who controls, is controlled by, or is under common control with the 
adviser (``control person'') is the issuer or is an underwriter of the 
security. The rule contains an exception to this ``underwritten 
securities'' exclusion for trades in which the adviser or a control 
person is an underwriter of non-convertible investment-grade debt 
securities. The proposed amendment to rule 206(3)-3T would modify the 
definition of ``investment grade debt security'' to mean a non-
convertible debt security that, at the time of sale, the investment 
adviser has determined to be subject to no greater than moderate credit 
risk and sufficiently liquid that it can be sold at or near its 
carrying value within a reasonably short period of time.
    Under the proposed amendment to rule 206(3)-3T, there is a single 
new collection burden. Pursuant to its obligations under rule 206(4)-7 
under the Advisers Act, an adviser seeking to rely on rule 206(3)-3T 
must adopt and implement written policies and procedures reasonably 
designed to prevent violations of the Advisers Act that address the 
adviser's methodology for determining whether a security is investment 
grade quality pursuant to the definition. This collection of 
information is designed to minimize the incentives associated with 
underwriting securities that may bias the advice being provided or may 
lead the adviser to exert undue influence on its client's decision to 
invest in the offering or the terms of that investment. Although the 
rule does not call for any of the information collected to be provided 
to us, to the extent advisers include any of the information in a 
filing, such as Form ADV, the information would not be kept 
confidential.
    We anticipate that the burden associated with this collection would 
mostly be borne upfront as advisers develop their policies and 
procedures for how to identify non-convertible investment grade debt 
securities in connection with the credit risk and liquidity elements 
specified under the rule. This would require drafting the policies and 
procedures, potentially subjecting them to review of outside counsel, 
implementing them, and explaining their contours in the adviser's Form 
ADV.
    We estimate that the average burden for drafting the required 
policies and procedures for each eligible adviser that chooses to rely 
on the rule in connection with underwritten securities in particular, 
would be approximately 10 hours on average. Further, we expect the 
drafting burden would be uniform with respect to each eligible adviser 
regardless of how many individual non-discretionary advisory accounts 
that adviser administers or seeks to engage with in principal trading. 
As of June 1, 2008, there were 639 advisers that were eligible to rely 
on the temporary rule (i.e., also registered as broker-dealers), 409 of 
which indicate that they have non-discretionary advisory accounts.\93\ 
We estimate that 90% of those 409 advisers, or a total of 368 of those 
advisers, rely on the rule.\94\ Of those, we estimate that only 50% 
would seek to engage in principal trades with clients of securities 
they or a control person underwrote. Thus, we estimate that the total 
number of advisers who would rely on the non-convertible investment 
grade debt exception to the ``underwritten securities'' exclusion under 
the rule would be approximately 185.
---------------------------------------------------------------------------

    \93\ IARD data as of June 1, 2008, for Items 6.A(1) and 
5.F(2)(e) of Part 1A of Form ADV.
    \94\ We anticipate that most investment advisers that are dually 
registered as broker-dealers will make use of the rule to engage in, 
at a minimum, riskless principal transactions to limit the need for 
these advisers to process trades for their advisory clients with 
other broker-dealers. We estimate that 10% of these advisers will 
determine that the costs involved to comply with the rule are too 
significant in relation to the benefits that the adviser, and their 
clients, will enjoy.
---------------------------------------------------------------------------

    Accordingly, we estimate that the total burden for creating initial 
policies and procedures under the proposal for the estimated 185 
advisers that would rely on the rule would be 1,850 hours.\95\ We also 
estimate an average one-time cost for the preparation of the policies 
and procedures for approximately three hours of outside legal counsel 
time of $1,200 per eligible adviser on average,\96\ for a total of 
$222,000.\97\
---------------------------------------------------------------------------

    \95\ This estimate is based on the following calculation: 10 
hours per adviser x 185 eligible advisers that will rely on the rule 
= 1,850 total hours.
    \96\ Outside legal fees are in addition to the projected 10 
hours per adviser burden discussed in note 95 and accompanying text.
    \97\ This estimate is based on the following calculation: ($400 
per hour x 3 hours x 185 advisers = $222,000).
---------------------------------------------------------------------------

F. Request for Comments

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order to: (i) Evaluate whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the Commission, including whether the information would have 
practical utility; (ii) evaluate the accuracy of the Commission's 
estimate of the burden of the proposed collections of information; 
(iii) determine whether there are ways to enhance the quality, utility, 
and clarity of the information to be collected; and (iv) determine 
whether there are ways to minimize the burden of the collections of 
information on those who are to respond, including through the use of 
automated collection techniques or other forms of information 
technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed amendments should direct them to the 
Office of Management and Budget, Attention Desk Officer for the 
Securities and Exchange Commission, Office of Information and 
Regulatory Affairs, Room 10102, New Executive Office Building, 
Washington, DC 20503, and should send a copy to Florence E. Harmon, 
Acting Secretary, Securities and Exchange Commission, 100 F Street, 
NE., Washington, DC 20549-1090, with reference to File No. S7-19-08. 
OMB is required to make a decision concerning the collections of 
information between 30 and 60 days after publication of this Release; 
therefore a comment to OMB is best assured of having its full effect if 
OMB receives it within 30 days after publication of this Release. 
Requests for materials submitted to OMB by the Commission with regard 
to these collections of information should be in

[[Page 40134]]

writing, refer to File No. S7-19-08, and be submitted to the Securities 
and Exchange Commission, Public Records Management Office Room, 100 F 
Street, NE., Washington, DC 20549-1110.

VI. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. We have identified certain costs and benefits of the 
proposed amendments and request comment on all aspects of this cost-
benefit analysis, including identification and assessment of any costs 
and benefits not discussed in this analysis. We seek comment and data 
on the value of the benefits identified. We also welcome comments on 
the accuracy of the cost estimates in each section of this analysis, 
and request that commenters provide data that may be relevant to these 
cost estimates. In addition, we seek estimates and views regarding 
these costs and benefits for particular covered institutions, including 
small institutions, as well as any other costs or benefits that may 
result from the adoption of these proposed amendments.
    As discussed above, the proposed rule amendments are designed to 
address the risk that the reference to and use of NRSRO ratings in our 
rules is interpreted by investors as an endorsement of the quality of 
the credit ratings issued by NRSROs, and may encourage investors to 
place undue reliance on the NRSRO ratings. The proposed amendments to 
rules 2a-7, 3a-7, 5b-3, and 10f-3 under the Investment Company Act and 
rule 206(3)-(3)T under the Investment Advisers Act would eliminate the 
reference to and requirement for the use of NRSRO ratings in these 
rules.

A. Benefits

    The Commission anticipates that one of the primary benefits of the 
proposed amendments, if adopted, would be the benefit to investors of 
reducing their possible undue reliance on NRSRO ratings that could be 
caused by references to NRSROs in our rules. An over-reliance on 
ratings can inhibit independent analysis and could possibly lead to 
investment decisions that are based on incomplete information. The 
purpose of the proposed rule amendments is to encourage investors to 
examine more than a single source of information in making an 
investment decision. Eliminating reliance on ratings in the 
Commission's rules could also result in greater investor due diligence 
and investment analysis. In addition, the Commission believes that 
eliminating the reliance on ratings in its rules would remove any 
appearance that the Commission has placed its imprimatur on certain 
ratings.
    More specifically, the principal benefit of the proposed amendments 
to rule 2a-7 would be to emphasize the importance of money market funds 
making independent assessments of credit risks. The benefit of the 
proposed amendments to rule 3a-7 would be to emphasize that ratings are 
not necessary for accredited investors and qualified institutional 
buyers to protect themselves in evaluating structured finance vehicles 
issued under the rule. Similarly, the benefit of the proposed 
amendments to rules 5b-3 and 10f-3 would be to emphasize the importance 
to funds that acquire repurchase agreements or securities in an 
affiliated underwriting of making an independent evaluation of the 
credit risks associated with the collateral or the underwritten 
security, respectively. In addition, by moving away from a required 
reliance on credit ratings in our rules, funds may benefit by acquiring 
a wider range of securities that present attractive investment 
opportunities and the requisite level of credit risks, although they do 
not meet the current rules' ratings requirements. The principal benefit 
of the proposed amendment to rule 206(3)-3T would be to allow advisers 
to consider factors other than only a rating by NRSROs of the credit 
quality of a debt security for purposes of eligibility of the rule. 
Advisers would determine, based upon established criteria of whether 
the security presents no more than moderate credit risk and has 
sufficient liquidity, whether a security is investment grade for 
purposes of the rule. Investment advisers could, in addition to 
considering NRSRO ratings, weigh various factors and consider a 
security's credit quality based on those qualitative and quantitative 
elements it deems most relevant. An additional benefit of the proposed 
amendment would be that non-discretionary advisory clients of advisers 
also registered with us as broker-dealers may have easier access to a 
wider range of securities. This, in turn, would increase liquidity in 
the markets for these securities and promote capital formation in these 
areas. These benefits are difficult to measure quantitatively, but 
qualitatively we believe the potential benefits are significant.
    We request comment on available metrics to quantify these benefits 
and any other benefits the commenter may identify. Commenters are also 
requested to identify sources of empirical data that could be used for 
the metrics they propose.

B. Costs

    We anticipate that funds and investment advisers could incur 
certain costs if the proposed amendments are adopted. Funds and 
investment advisers may incur additional costs if they perform a more 
detailed and comprehensive analysis before making an investment 
decision. Such costs are difficult to measure, but we believe that they 
would be justified by the benefits related to a more informed 
investment decision as discussed in the previous section. In addition, 
the purpose of the proposal is to emphasize that it is not the 
Commission's intent to encourage investors to place undue reliance on 
NRSRO ratings in making investment decisions. In many cases, investors 
may still choose to rely solely on NRSRO ratings without incurring 
additional costs.
    Additionally, in proposing to remove the ratings requirements from 
our rules, we would broaden the set of potential investments available 
to funds and investment advisers. For example, under the proposed 
amendments to rule 2a-7, money market funds would be able to invest in 
securities that have received credit ratings outside of the two highest 
short-term rating categories. It is possible that some investors, 
funds, or investment advisers may incur additional costs if funds and 
investment advisers use this expanded discretion to purchase (or sell 
in the case of principal transactions under rule 206(3)-3T) risky or 
illiquid securities. We believe that these potential costs would be 
mitigated, however, by market forces, including, in the case of money 
market funds, investors' desire to maintain the principal value of 
their investments.
    We request comment on these costs. Would eliminating the rating 
requirements from our rules affect the amount or nature of risks that 
investment companies and investment advisers would be willing or able 
to take? We request comment on available metrics to quantify these 
costs and any other costs the commenter may identify. Commenters are 
also requested to identify sources of empirical data that could be used 
for the metrics they propose.
    Rule 2a-7. We anticipate that the proposed amendments to rule 2a-7 
would impose minimal new costs on a portion of money market funds. In 
general, we expect that money market fund boards of directors (or their 
delegates) would incur no additional costs in making credit and 
liquidity risk determinations regarding portfolio securities because 
the proposed rules would codify the determinations

[[Page 40135]]

regarding credit risk and liquidity that we believe boards (or their 
delegates) make under the current rule. Some money market funds, 
however, would incur costs to notify the Commission regarding rule 17a-
9 transactions. For purposes of the PRA analysis, Commission staff 
estimates that on average 10 money market funds each year are likely to 
provide notices regarding rule 17a-9 transactions, at a cost of 
approximately $1,475.\98\ We request comment on these cost estimates. 
Do commenters foresee additional or alternative costs if the proposed 
amendments to rule 2a-7 are adopted? Have we accurately estimated the 
number of money market funds that would have to report rule 17a-9 
transactions annually? Have we accurately estimated money market funds' 
potential costs in reporting rule 17a-9 transactions?
---------------------------------------------------------------------------

    \98\ See supra note 87 and accompanying text.
---------------------------------------------------------------------------

    Rule 3a-7. Our proposed amendments to rule 3a-7 under the 
Investment Company Act may impose minor costs. Specifically, retail 
investors who are able, because of the rule, to buy structured finance 
products would no longer be able to participate in the market. We 
understand that these products generally are not marketed to retail 
investors, however, and the number of retail investors affected, if 
there are any, may be quite low. The proposed amendments also may 
result in more limited access to capital for issuers of structured 
financings to the extent there is a retail market that is eliminated 
under the proposed amendments. All investors who hold structured 
finance products bought under the existing rule may bear some costs of 
reduced liquidity to the extent a retail market no longer exists 
because the pool of potential buyers in the secondary market may be 
reduced. These costs are difficult to assess given that any existing 
market may be very small.
    Commission staff estimates the following potential costs associated 
with the proposed amendments to rule 3a-7:
     Costs to retail investors--Retail investors may incur 
certain opportunity costs under the proposal because they would not be 
able to purchase the securities of structured finance vehicles that 
rely on rule 3a-7. These potential costs may be mitigated, however, 
because we understand, based on staff experience that this market, if 
it exists, represents a very small amount of all structured finance 
products (perhaps less than 1% of the $306.7 billion in asset-backed 
securities issued in 2007).\99\
---------------------------------------------------------------------------

    \99\ See Worldwide ABS Issuance, Asset-Backed Alert: The Weekly 
Update on Worldwide Securitization (June 13, 2008), p. 11.
---------------------------------------------------------------------------

     Procedures for the acquisition or disposition of assets--
Although we are proposing to remove rule 3a-7's rating requirement, we 
anticipate that structured financing vehicles would be rated by the 
NRSROs. We expect that market participants generally will continue to 
require that issuers obtain ratings. Accordingly, as a matter of good 
business practice, Commission staff estimates that almost all issuers 
will continue to have procedures in place to ensure that the 
acquisition or disposition of assets does not adversely affect the full 
and timely payments to outstanding security holders. Thus, Commission 
staff believes that the proposed amendments would not impose any new 
cost burdens on issuers.
     Deposits in segregated accounts--We believe that almost 
all issuers have already taken the actions necessary for cash flows to 
be deposited in segregated accounts consistent with the full and timely 
payment of outstanding fixed income securities in meeting the current 
rule's ratings requirement. Commission staff does not anticipate any 
new costs associated with this provision of the proposal.
We request comment on these cost estimates. Are structured financings 
offered to the retail market under rule 3a-7? If so, how large is the 
retail market for these products? What costs would retail investors 
incur if the proposed amendments are adopted? How would retail 
investors sell or dispose of their current structured finance vehicle 
holdings if the proposed amendments were adopted? How should any 
opportunity costs investors may face if the proposed amendments are 
adopted be quantified? Would there be any new costs associated with 
developing procedures for the acquisition or disposition of assets and 
deposits in segregated accounts?
    Rule 5b-3. Our proposed amendments to rule 5b-3 under the 
Investment Company Act may impose costs on funds that rely on the rule. 
Specifically, a fund's board of directors, or its delegate, pursuant to 
rule 38a-1 under the Investment Company Act, would be required to 
develop written policies and procedures to ensure that at the time the 
repurchase agreement is entered into the collateral meets the 
requirements outlined in the amendments to the proposed rule.\100\ The 
proposal would require collateral other than cash or government 
securities to consist of securities that the fund's board of directors 
(or its delegate) determines at the time the repurchase agreement is 
entered into: (i) Are sufficiently liquid that they can be sold at or 
near their carrying value within a reasonably short period of time; 
(ii) are subject to no greater than minimal credit risk; and (iii) the 
issuer of which has the highest capacity to meet its financial 
obligations. The existing rule provides that collateral may consist of 
unrated securities if the fund's board, or its delegate, makes the 
determination that the unrated securities are comparable to securities 
that are rated in the highest rating category by the Requisite NRSROs. 
Consistent with the requirements of rule 38a-1 under the Investment 
Company Act, we expect that fund boards would have existing procedures 
regarding credit quality determinations for unrated securities. In 
addition, as a matter of good business practice, we believe that most 
funds currently evaluate the credit risk and liquidity of rated 
securities. Thus, we believe that most funds already have procedures to 
evaluate collateral securities. For purposes of the PRA analysis, 
Commission staff estimates that 90% of all investment companies, or 
4,243 funds, currently have procedures for evaluating collateral 
securities.\101\ Commission staff therefore estimates that 471 funds 
would need to develop procedures and evaluate collateral securities, at 
an annual cost of approximately $1,294,308.\102\
---------------------------------------------------------------------------

    \100\ Rule 38a-1(a).
    \101\ See supra text preceding note 90.
    \102\ See supra note 91.
---------------------------------------------------------------------------

    Our proposed amendments to rule 5b-3 may result in another cost to 
affected funds. Currently, NRSRO ratings are used in a provision of 
rule 5b-3 that permits a fund to deem the acquisition of a ``refunded 
security'' as the acquisition of the escrowed government securities for 
purposes of section 5(b)(1)'s diversification requirements.\103\ Under 
this provision, a debt security must satisfy certain conditions to be 
considered a refunded security under the rule. One of these conditions 
is that an independent certified public accountant must have certified 
to the escrow agent that the escrowed securities would satisfy all 
scheduled payments of principal, interest, and applicable premiums on

[[Page 40136]]

the refunded securities.\104\ This condition is not required, however, 
if the refunded security has received a debt rating in the highest 
rating from an NRSRO.\105\
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    \103\ Under the rule, a refunded security is defined as a debt 
security the principal and interest payments of which are to be paid 
by U.S. government securities that have been irrevocably placed in 
an escrow account and are pledged only to the payment of the debt 
security. Rule 5b-3(c)(4).
    \104\ Rule 5b-3(c)(4)(iii).
    \105\ Id.
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    We propose to eliminate the exception to the certification 
requirement for securities that have received the highest rating from 
an NRSRO. As previously discussed, the Commission included this 
exception because in rating refunded securities, NRSROs typically 
require that an independent third party make the same 
determination.\106\ As previously noted, Commission staff believes that 
market pressures currently require almost all issuers to have refunded 
securities certified by an independent accountant. To the extent that 
refunded securities are rated, and the rating agency requires 
certification by an independent certified public accountant, funds 
would not incur additional costs in determining whether a security had 
been certified in accordance with the rule. Accordingly, we do not 
expect there would be a change in current costs to issuers as a result 
of this proposal.
---------------------------------------------------------------------------

    \106\ See rule 5b-3 Proposing Release, supra note 51.
---------------------------------------------------------------------------

    We request comment on these cost estimates. Do commenters foresee 
additional or alternative costs if the proposed amendments to rule 5b-3 
are adopted? Have we accurately estimated current and future costs for 
collateral procedures? Are we correct in estimating that funds are 
unlikely to incur any additional costs in determining that a refunded 
security has received an accountant certification?
    Rule 10f-3. We do not believe that our proposed amendments to rule 
10f-3 would impose costs on funds that rely on rule 10f-3 to purchase 
municipal securities. Under the current rule, fund boards are required 
to adopt procedures regarding purchases made in reliance on the rule 
and to determine each quarter that all purchases were made in 
compliance with the procedures.\107\ Commission staff estimates that 
these costs would not change. As noted above in our analysis of the 
PRA, we currently estimate that boards spend, on average, two hours 
each year to review and revise their procedures for acquiring 
securities in compliance with the conditions in rule 10f-3. We believe 
that any changes funds would make to their procedures in order to 
comply with the proposed amendments to the rule would be included in 
this annual review and revision.
---------------------------------------------------------------------------

    \107\ Rule 10f-3(c)(10).
---------------------------------------------------------------------------

    We request comment on these cost estimates. Have we accurately 
estimated the costs associated with the proposal's required additional 
procedures for purchases of municipal securities? Do commenters foresee 
additional or alternative costs if the proposed amendments to rule 10f-
3 are adopted?
    Rule 206(3)-3T. In lieu of relying exclusively on credit ratings to 
determine eligibility for principal trading of underwritten securities 
under the rule, advisers would need to make a determination of a 
security's credit risk and liquidity. This determination would impose 
some costs on advisers. Advisers seeking to rely on the exception would 
need to develop and implement procedures regarding their eligibility 
determinations in accordance with their responsibilities under Advisers 
Act rule 206(4)-7. And, in making their determinations, many advisers 
would expend resources beyond merely obtaining credit ratings from 
NRSROs, as is required under the current rule.
    Commission staff estimates that the costs of preparing the 
procedures for making the determinations of credit quality and 
liquidity under the rule would be borne upfront. Once generated, 
reviewed, and implemented by eligible advisers, advisers would be able 
to follow them for purposes of making further determinations of 
eligibility for underwritten securities under the requirements of the 
rule. For purposes of the PRA analysis, our staff has estimated the 
number of hours and costs the average adviser would spend in the 
initial preparation of its policies and procedures.\108\ Based on those 
estimates, our staff estimates that advisers would incur costs of 
approximately $1,820 on average per adviser, including legal 
consultation.\109\ Assuming there are 185 eligible advisers (i.e., 
advisers that also are registered broker-dealers) that would prepare 
relevant policies and procedures, our staff estimates that the total 
costs would be $336,700.\110\
---------------------------------------------------------------------------

    \108\ See supra note 97 and accompanying text. We estimate the 
following burdens and/or costs: (i) for drafting the policies and 
procedures, approximately 10 hours on average per eligible adviser, 
of which we estimate there are 185, for a total of 1,850 hours; and 
(ii) for utilizing outside legal professionals in the preparation of 
the policies and procedures, approximately $1,200 on average per 
eligible adviser, for a total of $222,000.
    \109\ We estimate that the internal preparation function will 
most likely be performed by a compliance clerk at $62 per hour. $62 
per hour x 10 hours = $620 on average per adviser of internal costs 
for preparation of the policies and procedures. $620 on average per 
adviser of internal costs + $1,200 on average per adviser of costs 
for outside legal counsel = $1,820 on average per adviser.
    \110\ This estimate is based on the following calculation: 
$1,820 on average per adviser x 185 advisers = $336,700 in total 
costs for preparation of the policies and procedures.
---------------------------------------------------------------------------

    We request comment on these cost estimates. Are the cost estimates 
accurate regarding the proposed procedures for making credit quality 
determinations? Do commenters foresee additional or alternative costs 
if the proposed amendments to rule 206(3)-3T are adopted?

C. Request for Comment

    We request comment on all aspects of this cost-benefit analysis, 
including comment as to whether the estimates we have used in our 
analysis are reasonable. We welcome comment on any aspect of our 
analysis, including the estimates and the assumptions we have 
described. In particular, we request comment as to any costs or 
benefits we may not have considered here that could result from the 
adoption of the proposed amendments. We also request comment on the 
numerical estimates discussed above, and request comment on specific 
costs and benefits from covered institutions that have experienced any 
of the situations analyzed above.

VII. Consideration of Promotion of Efficiency, Competition and Capital 
Formation

    Investment Company Act section 2(c) and Investment Advisers Act 
section 202(c) require us, when engaging in rulemaking where we are 
required to consider or determine whether an action is necessary or 
appropriate in the public interest, to consider, in addition to the 
protection of investors, whether the action will promote efficiency, 
competition, and capital formation.\111\ If adopted, the Commission 
believes that these amendments would reduce the potential for over-
reliance on ratings, and thereby promote investor protection. The 
Commission anticipates that these proposed amendments would improve 
investors' ability to make informed investment decisions, which would 
therefore lead to increased efficiency and competitiveness of the U.S. 
capital markets. The Commission expects that this increased market 
efficiency and investor confidence also may encourage more efficient 
capital formation.
---------------------------------------------------------------------------

    \111\ 15 U.S.C. 80a-2(c) and 15 U.S.C. 80b-2(c).
---------------------------------------------------------------------------

    Efficiency. As discussed above, the proposed amendments could 
result in additional costs for investment companies and registered 
investment advisers, which could affect the

[[Page 40137]]

efficiency of these institutions. The proposed amendments to rule 2a-7 
may slightly decrease the efficiency of certain money market funds, to 
the extent that any funds may be relying exclusively on credit ratings 
to make current minimal credit risk determinations. We believe that 
independently generated assessments of credit risks are important, 
however, and a slight decrease in efficiency may be warranted. Our 
proposed amendments to rule 3a-7 may reduce market efficiency by 
limiting the ability of retail investors who invest in structured 
financing vehicles. However, the proposal to eliminate sales of 
structured finance vehicles to the retail market would clearly 
delineate investors who are eligible to buy these products, which may 
increase market efficiency.
    Ratings provide a standard for retail investors, funds, and 
advisers alike. By eliminating reliance on ratings, the proposed 
amendments may have a negative impact on efficiency by eliminating an 
objective standard in credit quality determinations. The proposed 
amendments also could decrease efficiency to the extent that funds 
acquired securities that do not meet the particular ratings requirement 
and that result in the concerns that the rating requirements were 
designed to address. On the other hand, the proposed amendments may 
result in some increased market efficiency by affording funds access to 
securities that do not meet the rating requirements in the current 
rules, but that would satisfy the credit risk and liquidity standards 
in the proposed amendments. We do not anticipate that the proposed 
amendments to rules 2a-7, 5b-3, and 10f-3 would have other impacts on 
the efficiency of funds that rely on those rules. The proposed 
amendments to rule 206(3)-3T may increase efficiency by affording 
clients access to certain investment grade debt securities underwritten 
by the adviser or its affiliate that they might not have had access to 
under the standard requiring NRSRO ratings.
    Competition. If investors believe the proposed amendments to rule 
2a-7 would make the rule less rigorous in part because of the loss of 
an independent third party check on money market fund investments, they 
may turn to other cash investment vehicles they perceive as offering 
greater protections. In addition, investors in money market funds may 
unduly rely on ratings of the money market funds themselves as a proxy 
for the quality and safety of these funds' portfolio securities. This 
may potentially increase costs to money market funds that would not 
otherwise seek ratings. The proposed amendments to rule 3a-7, may 
impact certain issuers of structured finance vehicles that, for 
example, may specialize in the retail market if they had some 
competitive advantage, such as a distribution channel. Eliminating the 
exclusion for structured finance vehicles offered to retail investors 
may make these issuers less competitive in this market. The proposed 
amendments to rule 206(3)-3T may promote competition because, by 
providing a more subjective standard for the underwritten securities 
exception, they may increase the alternative sources of the security 
for the client without diminishing the adviser's best execution 
obligations, thereby potentially improving price. We do not believe the 
proposed amendments to rules 5b-3 or 10f-3 would significantly affect 
competition because these amendments would apply to all money market 
funds and other funds.
    Capital formation. We do not believe the proposed amendments to the 
rules would have a significant effect on capital formation. To the 
extent potential money market fund investors may react positively to 
money market funds' independent credit risk assessments and management 
of risks, we believe any effect the proposed amendments to rule 2a-7 
may have on capital formation would be positive. Our proposed 
amendments to rule 3a-7 would limit capital formation for issuers that 
offer structured finance products to retail investors in reliance on 
rule 3a-7. The proposed amendments would have no effect on the ability 
of issuers who rely on rule 3a-7 to offer structured financings to 
accredited investors and qualified institutional buyers to raise 
capital. We do not expect that the proposed amendments to rules 5b-3 or 
10f-3 would have an adverse effect on capital formation. If the 
proposed amendments to rule 206(3)-3T have any effect on capital 
formation, it is likely to be positive, although indirect. Providing a 
means for advisers, consistent with their fiduciary obligations, to 
offer their clients underwritten investment grade securities sold as 
principal, might serve to broaden the potential universe of purchasers 
of securities, opening the door to greater investor participation in 
the securities markets with a potential positive effect on capital 
formation.
    We request comment on all aspects of this analysis, and 
specifically request comment on any effect the proposed amendments 
might have on the promotion of efficiency, competition, and capital 
formation that we have not considered. Commenters are requested to 
provide empirical data and other factual support for their views to the 
extent possible.

VIII. Regulatory Flexibility Act Certification

    Section 3(a) of the Regulatory Flexibility Act of 1980 \112\ 
(``RFA'') requires the Commission to undertake an initial regulatory 
flexibility analysis (``IRFA'') of the proposed rule amendments on 
small entities unless the Commission certifies that the rule, if 
adopted, would not have a significant economic impact on a substantial 
number of small entities.\113\ Pursuant to Section 605(b) of the RFA, 
the Commission hereby certifies that the proposed amendments to rules 
2a-7 and 3a-7 under the Investment Company Act, would not, if adopted, 
have a significant economic impact on a substantial number of small 
entities. The proposal would:
---------------------------------------------------------------------------

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

    (a) Amend rule 2a-7 under the Investment Company Act to: (i) Rely 
on money market fund boards of directors (who usually rely on the 
funds' advisers) to determine that each portfolio instrument presents 
minimal credit risks, and whether the security is a ``First Tier 
Security'' or a ``Second Tier Security''; (ii) add a portfolio 
liquidity requirement to the rule that would require that money market 
funds hold securities that are sufficiently liquid to meet reasonably 
foreseeable shareholder redemptions, and expressly limit their 
investment in illiquid securities to not more than 10% of the their 
total assets; (iii) in the event the money market fund's portfolio 
manager becomes aware of any new information about a portfolio security 
(or an issuer of a portfolio security) that may suggest that the 
security may not continue to present minimal credit risks, the proposal 
would amend rule 2a-7's downgrade and default provisions to require a 
money market fund's board of directors to reassess promptly whether the 
portfolio security continues to present minimal credit risks; and (iv) 
require a money market fund to notify the Commission of the purchase of 
a money market fund's portfolio securities by an affiliated person in 
reliance on rule 17a-9 under the Investment Company Act. The proposed 
amendments also would make conforming amendments to rule 2a-7's record 
keeping and reporting requirements; and
    (b) Amend rule 3a-7 under the Investment Company Act to: (i) 
Eliminate the rule's reliance on ratings by eliminating the exclusion 
for

[[Page 40138]]

structured financings offered to the general public; (ii) remove the 
reference to ratings downgrades in the section of the rule that 
addresses substitution of eligible assets; and (iii) amend the portion 
of the rule that deals with safekeeping of assets.
    Based on information in filings submitted to the Commission, we 
believe that there are no money market funds that are small 
entities.\114\ In addition, we are not aware of any issuers that 
currently rely on rule 3a-7 that are small entities. For these reasons, 
the Commission believes the proposed amendments to rules 2a-7 and 3a-7 
under the Investment Company Act would not, if adopted, have a 
significant economic impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \114\ Under the Investment Company Act, an investment company is 
considered a small entity if it, together with other investment 
companies in the same group of related investment companies, have 
net assets of $50 million or less as of the end of its most recent 
fiscal year. See 17 CFR 270.0-10.
---------------------------------------------------------------------------

    We encourage written comments regarding this certification. The 
Commission solicits comment as to whether the proposed amendments to 
rules 2a-7 and 3a-7 could have an effect on small entities that has not 
been considered. We request that commenters describe the nature of any 
impact on small entities and provide empirical data to support the 
extent of such impact.

IX. Initial Regulatory Flexibility Analysis

    This IRFA has been prepared in accordance with 5 U.S.C. 603. It 
relates to proposed amendments to rules 5b-3 and 10f-3 under the 
Investment Company Act and rule 206(3)-(3)T under the Investment 
Advisers Act. The proposed amendments would remove references to and 
the required use of NRSRO ratings from these rules.

A. Reasons for the Proposed Action

    As discussed above, the proposed rule amendments are designed to 
address the risk that the reference to and use of NRSRO ratings in our 
rules is interpreted by investors as an endorsement of the quality of 
the credit ratings issued by NRSROs, and may encourage investors to 
place undue reliance on the NRSRO ratings.

B. Objectives of the Proposed Action

    Our proposed amendments are designed to address the risk that 
reference to and use of NRSRO ratings in our rules:
     Is interpreted by investors as an endorsement of the 
quality of the credit ratings issued by NRSROs; and
     encourages investors to place undue reliance on the NRSRO 
ratings.

C. Legal Basis

    The Commission is proposing amendments to rule 5b-3 under the 
authority set forth in sections 6(c) and 38(a) of the Investment 
Company Act [15 U.S.C. 80a-6(c) and 80a-37(a)]. The Commission is 
proposing amendments to rule 10f-3 under the authority set forth in 
sections 10(f), 31(a) and 38(a) of the Investment Company Act [15 
U.S.C. 80a-10(f), 80a-30(a) and 80a-37(a)]. The Commission is proposing 
amendments to rule 206(3)-(3)T under the authority set forth in 
sections 206A and 211(a) of the Investment Advisers Act [15 U.S.C. 80b-
6A, 80b-11(a)].

D. Small Entities Subject to the Proposed Rule Amendments

    The proposed amendments to rules 5b-3 and 10f-3 under the 
Investment Company Act and rule 206(3)-(3)T under the Investment 
Advisers Act would affect funds and registered investment advisers, 
including entities that are considered to be a small business or small 
organization (collectively, ``small entity'') for purposes of the RFA. 
Under the Investment Company Act, a fund is considered a small entity 
if it, together with other funds in the same group of related funds, 
has net assets of $50 million or less as of the end of its most recent 
fiscal year.\115\ Under the Investment Advisers Act, a small entity is 
an investment adviser that: (i) Manages less than $25 million in 
assets; (ii) has total assets of less than $5 million on the last day 
of its most recent fiscal year; and (iii) does not control, is not 
controlled by, and is not under common control with another investment 
adviser that manages $25 million or more in assets, or any person 
(other than a natural person) that has had total assets of $5 million 
or more on the last day of the most recent fiscal year.\116\ Based on 
Commission filings, we estimate that 122 investment companies may be 
considered small entities. We also estimate that as of June 1, 2008, 
572 investment advisers were small entities.\117\ The Commission 
assumes for purposes of this IRFA that 19 of these small entities 
(those that are both investment advisers and broker-dealers) could rely 
on rule 206(3)-3T,\118\ and that 50% of these, or 10 advisers, will 
seek to engage in principal trades with clients of securities they or a 
control person underwrote.
---------------------------------------------------------------------------

    \115\ 17 CFR 270.0-10.
    \116\ 17 CFR 275.0-7.
    \117\ IARD data as of June 1, 2008, for Item 12 of Part 1A of 
Form ADV.
    \118\ IARD data as of June 1, 2008, for Items 6.A(1) and 12 of 
Part 1A of Form ADV.
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed amendments to rule 5b-3 would require collateral for 
repurchase agreements other than cash or government securities to have 
minimal credit risk and be highly liquid. Specifically, the proposal 
would require collateral other than cash or government securities to 
consist of securities that the fund's board of directors (or its 
delegate) determines at the time the repurchase agreement is entered 
into: (i) Are sufficiently liquid that they can be sold at or near 
their carrying value within a reasonably short period of time; (ii) are 
subject to no greater than minimal credit risk, and (iii) the issuer of 
which has the highest capacity to meet its financial obligations.\119\ 
The proposed amendments to rule 10f-3 would amend the rule's definition 
of ``eligible municipal security'' to mean securities that are 
sufficiently liquid that they can be sold at or near their carrying 
value within a reasonably short period of time. In addition, the 
securities would have to be either: (i) subject to no greater than 
moderate credit risk; or (ii) if they are less seasoned securities, 
subject to a minimal or low amount of credit risk.\120\ The proposed 
amendments to rule 206(3)-3T would impose a new compliance requirement 
in connection with advisers' obligations relating to written policies 
and procedures under rule 206(4)-7 under the Advisers Act.
---------------------------------------------------------------------------

    \119\ Proposed rule 5b-3(c)(1)(iv)(C).
    \120\ Proposed rule 10f-3(a)(3).
---------------------------------------------------------------------------

    Small entities registered with the Commission as investment 
companies or investment advisers seeking to rely on each of the rules 
as it is proposed to be amended would be subject to the same 
requirements as larger entities. With respect to rule 206(3)-3T, in 
each case, however, an investment adviser, whether large or small, 
would only be able to rely on the rule as it is proposed to be amended 
if it also is registered with us as a broker-dealer. As noted above, we 
estimate that 19 small entities are advisers that are also registered 
as broker-dealers and therefore only those small entities are eligible 
to rely on the rule. In developing the requirements of the proposed 
amendments to each of rules 5b-3 and 10f-3 under the Investment Company 
Act, and rule 206(3)-3T under the Investment Advisers Act, we 
considered the extent to which the proposed amendments would have a 
significant impact on a substantial number of small entities.

[[Page 40139]]

    We encourage written comments regarding this analysis. We solicit 
comments as to whether the proposed amendments could have any effect 
that we have not considered. We also request that commenters describe 
the nature of any impact on small entities and provide empirical data 
to support the extent of the impact.

F. Duplicative, Overlapping, or Conflicting Federal Rules

    Rule 31a-1 under the Act requires the retention of ledger accounts 
for each portfolio security and each person through which a portfolio 
transaction is effected. Although some of the procedures under the 
proposed amendments to rules 5b-3 and 10f-3 may overlap with 
information in the ledgers, the rule 5b-3 and 10f-3 procedures would 
contain additional information specifically related to the concerns 
underlying these rules.
    The Commission believes that there are no rules that duplicate or 
conflict with the proposed amendments to rule 206(3)-3T.

G. Significant Alternatives

    The RFA directs us to consider significant alternatives that would 
accomplish our stated objective, while minimizing any significant 
adverse impact on small entities. Alternatives in this category would 
include: (i) Establishing different compliance or reporting standards 
or timetables that take into account the resources available to small 
entities; (ii) clarifying, consolidating, or simplifying compliance 
requirements under the rule for small entities; (iii) using performance 
rather than design standards; and (iv) exempting small entities from 
coverage of the rule, or any part of the rule.
    With respect to rules 5b-3 and 10f-3, the Commission preliminarily 
believes that special compliance requirements or timetables for small 
entities, or an exemption from coverage for small entities, may create 
a risk that those entities could acquire repurchase agreements with 
collateral that may not retain its market value or liquidity in the 
event of a counterparty default. We do not expect that the requirement 
that refunded securities be certified by a certified public accountant 
would result in any costs or burdens for either small or large 
entities. With respect to rule 10f-3, we preliminarily believe that 
special compliance requirements or timetables for small entities, or an 
exemption from coverage for small entities, may put those entities at 
greater risk for purchasing unmarketable municipal securities in an 
affiliated underwriting. We preliminarily believe, therefore, that it 
is important for the credit quality and liquidity considerations 
required by the proposed amendments to rules 5b-3 and 10f-3 to apply to 
all funds relying on the rules, not just those that are not considered 
small entities. Further consolidation or simplification of the 
proposals for funds that are small entities would be inconsistent with 
the Commission's goals of fostering investor protection.
    With respect to rule 206(3)-3T, the Commission preliminarily 
believes that special compliance or reporting requirements or 
timetables for small entities, or an exemption from coverage for small 
entities may create the risk that the investors who are advised by and 
effect securities transactions in underwritten securities through such 
small entities may not receive adequate protection combined with access 
to securities. We believe, therefore, that it is important for the 
investment quality consideration required by the proposed amendments to 
apply to all advisers, not just those that are not considered small 
entities. Further consolidation or simplification of the proposals for 
investment advisers that are small entities would be inconsistent with 
the Commission's goals of fostering investor protection.
    We have endeavored through the proposed amendments to rules 5b-3, 
10f-3 and 206(3)-3T to minimize the regulatory burden on all entities 
eligible to rely on the respective rules, including small entities, 
while meeting our regulatory objectives. It was our goal to ensure that 
eligible small entities may benefit from the Commission's approach to 
the proposed amendments to the same degree as other funds or eligible 
advisers, as appropriate.
    We request comment on whether it is feasible or necessary for small 
entities to have special requirements or timetables for, or exemptions 
from, compliance with the proposed amendments to each of the rules. In 
particular, could any of the proposed amendments be altered in order to 
ease the regulatory burden on small entities, without sacrificing the 
effectiveness of the proposed amendments?

H. Request for Comments

    We encourage the submission of comments with respect to any aspect 
of this IRFA. In particular, we request comments regarding: (i) The 
number of small entities that may be affected by the proposed 
amendments; (ii) the existence or nature of the potential impact of the 
proposed amendments on small entities discussed in the analysis; and 
(iii) how to quantify the impact of the proposed amendments. Commenters 
are asked to describe the nature of any impact and provide empirical 
data supporting the extent of the impact. Such comments will be 
considered in the preparation of the Final Regulatory Flexibility 
Analysis, if the proposed amendments are adopted, and will be placed in 
the same public file as comments on the proposed amendments. Comments 
should be submitted to the Commission at the addresses previously 
indicated.

X. Statutory Authority

    The Commission is proposing amendments to rules 2a-7, 3a-7, and 5b-
3 under the authority set forth in sections 6(c) and 38(a) of the 
Investment Company Act [15 U.S.C. 80a-6(c), 80a-37(a)]. The Commission 
is proposing amendments to rule 10f-3 under the authority set forth in 
sections 10(f), 31(a) and 38(a) of the Investment Company Act [15 
U.S.C. 80a-10(f), 80a-30(a), 80a-37(a)]. The Commission is proposing 
amendments to rule 206(3)-(3)T under the authority set forth in 
sections 206A and 211(a) of the Investment Advisers Act [15 U.S.C. 80b-
6A, 80b-11(a)].

List of Subjects

17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

17 CFR Part 275

    Reporting and recordkeeping requirements, Securities.

Text of Proposed Rule Amendments

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

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

    1. The authority citation for part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
    2. Section 270.2a-7 is amended by:
    a. Revising paragraphs (a)(10), (a)(12), and (a)(17);
    b. Removing paragraph (a)(19);
    c. Redesignating paragraph (a)(20) as paragraph (a)(19);
    d. Removing paragraph (a)(21);
    e. Redesignating paragraphs (a)(22) through (a)(27) as paragraphs 
(a)(20) through (a)(25);
    f. Removing paragraph (a)(28);
    g. Redesignating paragraph (a)(29) as paragraph (a)(26);

[[Page 40140]]

    h. In paragraphs (b)(1) and (b)(2), revising the phrase ``(c)(2), 
(c)(3), and (c)(4)'' to read ``(c)(2), (c)(3), (c)(4), and (c)(5)'';
    i. Revising paragraphs (c)(3)(i), (c)(3)(iii), and (c)(3)(iv)(C);
    j. Adding paragraph (c)(3)(iv)(D);
     k. In paragraph (c)(4)(v), revising the phrase ``requirements of 
paragraphs (c)(4) and (c)(5)'' to read ``requirements of paragraphs 
(c)(4) and (c)(6)'';
    l. Redesignating paragraphs (c)(5) through (c)(10) as paragraphs 
(c)(6) through (c)(11);
    m. Adding new paragraph (c)(5);
    n. In newly redesignated paragraph (c)(6), revising the phrase 
``(pursuant to paragraphs (c)(9)(ii) and (c)(10)(vi) of this section)'' 
to read ``(pursuant to paragraphs (c)(10)(ii) and (c)(11)(vi) of this 
section)'';
    o. In newly redesignated paragraph (c)(7):
    i. revising the paragraph heading;
    ii. revising paragraph (i);
    iii. in the introductory text of paragraph (ii), revising the 
phrase ``paragraphs (c)(6)(ii)(A) through (D)'' to read ``paragraphs 
(c)(7)(ii)(A) through (C)'';
    iv. adding ``or'' at the end of paragraph (ii)(B);
    v. removing paragraph (ii)(C) and redesignating paragraph (ii)(D) 
as paragraph (ii)(C);
    vi. revising paragraph (iii);
    vii. revising the heading to paragraph (iv); and
    viii. in paragraph (iv), revising the phrase ``For purposes of 
paragraphs (c)(6)(ii) and (iii)'' to read ``For purposes of paragraphs 
(c)(7)(ii) and (iii)'';
    p. Revising newly designated paragraph (c)(10)(ii);
    q. In newly redesignated paragraph (c)(11):
    i. in paragraph (i), revising the phrase ``paragraphs (c)(6) 
through (c)(9)'' to read ``paragraphs (c)(7) through (c)(10)'';
    ii. revising paragraph (iii);
    iii. in paragraph (iv), revising the phrase ``paragraph (c)(9)(iii) 
of this section'' to read ``paragraph (c)(10)(iii) of this section'';
    iv. in the introductory text of paragraph (v), in the first 
sentence, revising ``paragraph (c)(9)(iv) of this section'' to read 
``paragraph (c)(10)(iv) of this section'';
    v. in paragraph (vi), revising the phrase ``paragraph (c)(9)(ii)'' 
to read ``paragraph (c)(10)(ii)'';
    vi. in paragraph (vii), in the first sentence, revising the phrase 
``this paragraph (c)(10)'' to read ``this paragraph (c)(11)''; and
    vii. in paragraph (vii), in the second sentence, revising the 
phrase ``paragraphs (c)(6)(ii) (with respect to defaulted securities 
and events of insolvency) or (c)(7)(ii)'' to read ``paragraphs 
(c)(7)(ii) (with respect to defaulted securities and events of 
insolvency) or (c)(8)(ii)''; and
    r. Revising the introductory text of paragraph (e) and in paragraph 
(e)(2) revising the phrase ``paragraph (c)(6)(iii) of this section'' to 
read ``paragraph (c)(7)(iii) of this section''.
    These additions and revisions read as follows:


Sec.  270.2a-7  Money market funds.

    (a) * * *
    (10) Eligible Security means a security with a remaining maturity 
of 397 calendar days or less that the fund's board of directors 
determines presents minimal credit risks (which determination must be 
based on factors pertaining to credit quality and the issuer's ability 
to meet its short-term financial obligations).
* * * * *
    (12) First Tier Security means a security the issuer of which the 
fund's board of directors has determined has the highest capacity to 
meet its short-term financial obligations.
* * * * *
    (17) Liquid Security means a security that can be sold or disposed 
of in the ordinary course of business within seven days at 
approximately the value ascribed to it by the money market fund.
* * * * *
    (c) * * *
    (3) * * *
    (i) General. The money market fund shall limit its portfolio 
investments to those United States Dollar-Denominated securities that 
are at the time of Acquisition Eligible Securities.
* * * * *
    (iii) Securities Subject to Guarantees. A security that is subject 
to a Guarantee may be determined to be an Eligible Security or a First 
Tier Security based solely on whether the Guarantee is an Eligible 
Security or First Tier Security, as the case may be; Provided, however, 
that the issuer of the Guarantee, or another institution, has 
undertaken to promptly notify the holder of the security in the event 
the Guarantee is substituted with another Guarantee (if such 
substitution is permissible under the terms of the Guarantee).
    (iv) * * *
    (C) The issuer of the Demand Feature, or another institution, has 
undertaken to promptly notify the holder of the security in the event 
the Demand Feature is substituted with another Demand Feature (if such 
substitution is permissible under the terms of the Demand Feature); and
    (D) The fund's board of directors determines that the Underlying 
Security or any Guarantee of such security presents minimal credit 
risks (which determination must be based on factors pertaining to 
credit quality).
* * * * *
    (5) Portfolio Liquidity. The money market fund shall hold 
securities that are sufficiently liquid to meet reasonably foreseeable 
shareholder redemptions in light of the fund's obligations under 
section 22(e) of the Act (15 U.S.C. 80a-22(e)) and any commitments it 
has made to shareholders; Provided, however, immediately after the 
Acquisition of any security, a money market fund shall not have 
invested more than ten percent of its Total Assets in securities that 
are not Liquid Securities.
* * * * *
    (7) Monitoring, Defaults and Other Events. 
    (i) Monitoring. In the event the money market fund's investment 
adviser (or any person to whom the fund's board of directors has 
delegated portfolio management responsibilities) becomes aware of any 
information about a portfolio security or an issuer of a portfolio 
security that may suggest that the security may not continue to present 
minimal credit risks, the board of directors shall reassess promptly 
whether such security continues to present minimal credit risks and 
shall cause the fund to take such action as the board of directors 
determines is in the best interests of the money market fund and its 
shareholders.
* * * * *
    (iii) Notice to the Commission. The money market fund shall 
promptly notify the Commission by electronic mail directed to the 
Director of the Division of Investment Management of any:
    (A) Default with respect to one or more portfolio securities (other 
than an immaterial default unrelated to the financial condition of the 
issuer) or an Event of Insolvency with respect to the issuer of the 
security or any Demand Feature or Guarantee to which it is subject, 
where immediately before default the securities (or the securities 
subject to the Demand Feature or Guarantee) accounted for \1/2\ of 1 
percent or more of a money market fund's Total Assets, of such fact and 
the actions the money market fund intends to take in response to such 
situation; or
    (B) Purchase of a security from the fund by an affiliated person or 
promoter of or principal underwriter for the fund

[[Page 40141]]

or an affiliated person of such a person in reliance on Sec.  270.17a-
9.
* * * * *
    (iv) Defaults for Purposes of Paragraphs (c)(7) (ii) and (iii).* * 
*
* * * * *
    (10) * * *
    (ii) Securities Subject to Demand Features or Guarantees. In the 
case of a security subject to one or more Demand Features or Guarantees 
that the fund's board of directors has determined that the fund is not 
relying on to determine the quality (pursuant to paragraph (c)(3) of 
this section), maturity (pursuant to paragraph (d) of this section) or 
liquidity (pursuant to paragraph (c)(5) of this section) of the 
security subject to the Demand Feature or Guarantee, written procedures 
shall require periodic evaluation of such determination.
* * * * *
    (11) * * *
    (iii) Credit Risk Analysis. For a period of not less than three 
years from the date that the credit risks of a portfolio security were 
most recently reviewed, a written record of the determination that a 
portfolio security presents minimal credit risks used to determine the 
status of the security as an Eligible Security shall be maintained and 
preserved in an easily accessible place.
* * * * *
    (e) Delegation. The money market fund's board of directors may 
delegate to the fund's investment adviser or officers the 
responsibility to make any determination required to be made by the 
board of directors under this section (other than the determinations 
required by paragraphs (c)(1) (board findings); (c)(7)(ii) (defaults 
and other events); (c)(8)(i) (general required procedures: Amortized 
Cost Method); (c)(8)(ii)(A) (shadow pricing), (B) (prompt consideration 
of deviation), and (C) (material dilution or unfair results); and 
(c)(9) (required procedures: Penny Rounding Method) of this section) 
provided:
* * * * *
    3. Section 270.3a-7 is amended by:
    a. Revising paragraph (a)(2) introductory text;
    b. In paragraph (a)(2)(i) revising the phrase ``Any fixed-income 
securities may be sold'' to read ``Any fixed-income securities sold'';
    c. In paragraph (a)(2)(ii), revising the phrase ``Any securities 
may be sold'' to read ``Any securities sold'';
    d. In the undesignated paragraph after paragraph (a)(2)(ii), revise 
the phrase ``persons specified in paragraphs (a)(2) (i) and (ii) of 
this section'' to read ``persons specified in this section'';
     e. Revising paragraph (a)(3)(ii); and
    f. Revising paragraph (a)(4)(iii).
    The revisions read as follows:


Sec.  270.3a-7  Issuers of asset-backed securities.

    (a) * * *
    (2) Securities sold by the issuer or any underwriter thereof are:
* * * * *
    (3) * * *
    (ii) The issuer has procedures to ensure that the acquisition or 
disposition does not adversely affect the full and timely payment of 
the outstanding fixed-income securities; and
* * * * *
    (4) * * *
    (iii) Takes actions necessary for the cash flows derived from 
eligible assets for the benefit of the holders of fixed-income 
securities to be deposited periodically in a segregated account 
consistent with the full and timely payment of the outstanding fixed-
income securities.
* * * * *
    4. Section 270.5b-3 is amended by:
    a. Adding ``or'' at the end of paragraph (c)(1)(iv)(B);
    b. Revising paragraph (c)(1)(iv)(C);
    c. Removing paragraph (c)(1)(iv)(D);
    d. Revising paragraph (c)(4)(iii);
    e. Removing paragraphs (c)(5), (c)(6), and (c)(8); and
    f. Redesignating paragraph (c)(7) as paragraph (c)(5).
    The revisions read as follows:


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

* * * * *
    (c) * * *
    (1) * * *
    (iv) * * *
    (C) Securities that the investment company's board of directors, or 
its delegate, determines at the time the repurchase agreement is 
entered into:
    (1 ) Are sufficiently liquid that they can be sold at or near their 
carrying value within a reasonably short period of time;
    (2) Are subject to no greater than minimal credit risk; and
    (3) The issuer of which has the highest capacity to meet its 
financial obligations; and
* * * * *
    (4) * * *
    (iii) At the time the deposited securities are placed in the escrow 
account, or at the time a substitution of the deposited securities is 
made, an independent certified public accountant has certified to the 
escrow agent that the deposited securities will satisfy all scheduled 
payments of principal, interest and applicable premiums on the Refunded 
Securities.
* * * * *
    5. Section 270.10f-3 is amended by:
    a. Revising paragraph (a)(3);
    b. Removing paragraph (a)(5); and
    c. Redesignating paragraphs (a)(6), (a)(7), and (a)(8) as 
paragraphs (a)(5), (a)(6), and (a)(7).
    The revision reads as follows:


Sec.  270.10f-3  Exemption for the acquisition of securities during the 
existence of an underwriting or selling syndicate.

    (a) * * *
    (3) Eligible Municipal Securities means ``municipal securities,'' 
as defined in section 3(a)(29) of the Securities Exchange Act of 1934 
(15 U.S.C. 78c(a)(29)), that are sufficiently liquid that they can be 
sold at or near their carrying value within a reasonably short period 
of time and either:
    (i) Are subject to no greater than moderate credit risk; or
    (ii) If the issuer of the municipal securities, or the entity 
supplying the revenues or other payments from which the issue is to be 
paid, has been in continuous operation for less than three years, 
including the operation of any predecessors, the securities are subject 
to a minimal or low amount of credit risk.
* * * * *

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    6. The authority citation for part 275 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.

* * * * *
    7. Section 275.206(3)-3T is amended by revising paragraph (c) to 
read as follows:


Sec.  275.206(3)-3T  Temporary rule for principal trades with certain 
advisory clients.

* * * * *
    (c) For purposes of paragraph (a)(2) of this section, an investment 
grade debt security means a non-convertible debt security that, at the 
time of sale, the investment adviser has determined to be subject to no 
greater than moderate credit risk and sufficiently liquid that it can 
be sold at or near its carrying value within a reasonably short period 
of time.
* * * * *

[[Page 40142]]


    By the Commission.
    Dated: July 1, 2008.
Florence E. Harmon,
Acting Secretary.
[FR Doc. E8-15282 Filed 7-10-08; 8:45 am]

BILLING CODE 8010-01-P
