[Federal Register Volume 76, Number 88 (Friday, May 6, 2011)]
[Proposed Rules]
[Pages 26550-26577]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-10619]
[[Page 26549]]
Vol. 76
Friday,
No. 88
May 6, 2011
Part VI
Securities and Exchange Commission
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17 CFR Parts 240, 242, and 249
Removal of Certain References to Credit Ratings Under the Securities
Exchange Act of 1934 Regulation Z; Truth in Lending; Proposed Rule
Federal Register / Vol. 76 , No. 88 / Friday, May 6, 2011 / Proposed
Rules
[[Page 26550]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240, 242, and 249
[Release No. 34-64352; File No. S7-15-11]
RIN 3235-AL14
Removal of Certain References to Credit Ratings Under the
Securities Exchange Act of 1934
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: This is one of several proposed rules that the Securities and
Exchange Commission (the ``Commission'') will be considering relating
to the use of credit ratings in Commission rules and forms. Section
939A of the Dodd-Frank Act Wall Street Reform and Consumer Protection
Act (the ``Dodd-Frank Act'') requires the Commission to remove any
references to credit ratings from its regulations and to substitute
such standard of creditworthiness as the Commission determines to be
appropriate. In this release, the Commission is proposing to amend
certain rules and one form under the Securities Exchange Act of 1934
(the ``Exchange Act'') applicable to broker-dealer financial
responsibility, distributions of securities, and confirmations of
transactions. The Commission also is requesting comment on potential
standards of creditworthiness for purposes of Exchange Act Sections
3(a)(41) and 3(a)(53), which define the terms ``mortgage related
security'' and ``small business related security,'' respectively, as
the Commission considers how to implement Section 939(e) of the Dodd-
Frank Act.
DATES: Comments should be received on or before July 5, 2011.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-15-11 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-15-11. This file number
should be included on the subject line if e-mail is used. To help the
Commission 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/concept.shtml). Comments are also available for Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. All comments received will be posted without change; we
do not edit personal identifying information from submissions. You
should submit only information that you wish to make publicly
available.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate
Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at
(202) 551-5522; Mark M. Attar, Branch Chief, at (202) 551-5889; Carrie
A. O'Brien, Special Counsel, at (202) 551-5640; and Leigh E. Bothe,
Attorney, at (202) 551-5511, Office of Financial Responsibility (Net
Capital, Customer Protection, and Books and Records Requirements, and
Section 939(e) of the Dodd-Frank Act); Josephine J. Tao, Assistant
Director, Elizabeth A. Sandoe, Senior Special Counsel, David P. Bloom,
Branch Chief, or Bradley Gude, Special Counsel, Office of Trading
Practices and Processing at (202) 551-5720 (Regulation M); and Joseph
M. Furey, Co-Acting Chief Counsel, and Ignacio Sandoval, Special
Counsel, Office of Chief Counsel at (202) 551-5550 (Confirmation of
Transactions), Division of Trading and Markets, Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION: On July 21, 2010, the President signed the
Dodd-Frank Act into law. The Commission is requesting public comment on
proposed amendments to Exchange Act Rules 15c3-1, 15c3-3, 17a-4, 101
and 102 of Regulation M, and 10b-10, and one Exchange Act form--Form X-
17A-5, Part IIB--to remove references to credit ratings and, in certain
cases, substitute alternative standards of creditworthiness as required
by Section 939A of the Dodd-Frank Act.\1\ The Commission is also
requesting public comment on potential standards of creditworthiness
for purposes of Exchange Act Sections 3(a)(41) and 3(a)(53), which
define the terms ``mortgage related security'' and ``small business
related security,'' respectively, as the Commission considers how to
implement Section 939(e) of the Dodd-Frank Act.
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\1\ See Public Law 111-203 Sec. 939A.
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I. Background
A. Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank Act was enacted to, among other things, promote the
financial stability of the United States by improving accountability
and transparency in the financial system.\2\ Title IX, Subtitle C, of
the Dodd-Frank Act \3\ includes provisions regarding statutory and
regulatory references to credit ratings in Exchange Act rules, as well
as in the Exchange Act itself.\4\
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\2\ See Public Law 111-203, 124 Stat. 1376 (2010); Public Law
111-203, Preamble.
\3\ Public Law 111-203, 124 Stat. 1376 (2010).
\4\ These provisions are designed ``[t]o reduce the reliance on
ratings.'' See Joint Explanatory Statement of the Committee of
Conference, Conference Committee Report No. 111-517, to accompany
H.R. 4173, 864-879, 870 (Jun. 29, 2010).
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Specifically, in Section 939A of the Dodd-Frank Act, Congress
requires that the Commission ``review any regulation issued by [the
Commission] that requires the use of an assessment of the credit-
worthiness of a security or money market instrument and any references
to or requirements in such regulations regarding credit ratings.'' \5\
Once the Commission has completed that review, the statute provides
that the Commission ``remove any reference to or requirement of
reliance on credit ratings, and to substitute in such regulations such
standard of credit-worthiness'' as the Commission determines to be
appropriate.\6\
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\5\ Public Law 111-203 Sec. 939A(a)(1)-(2).
\6\ See Public Law 111-203 Sec. 939A(b). The Commission has
recently proposed amendments to its rules in other contexts under
the federal securities laws to remove references to credit ratings.
See References to Credit Ratings in Certain Investment Company Act
Rules and Forms, Securities Act of 1933 (``Securities Act'') Release
No. 9193 (Mar. 3, 2011), 76 FR 12896 (Mar. 9, 2011) and Security
Ratings, Exchange Act Release No. 63874 (Feb. 9, 2011), 76 FR 8946
(Feb. 16, 2011).
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As is discussed in detail below, there are five Exchange Act
rules--Rule 15c3-1, Rule 15c3-3, Rules 101 and 102 of Regulation M, and
Rule 10b-10--administered by the Commission and one Exchange Act form--
Form X-17A-5, Part IIB--that the Commission is proposing to amend in
this release as directed by Section 939A of the Dodd-Frank Act. The
Commission is also proposing corresponding changes to Exchange Act Rule
17a-4, relating to broker-dealer recordkeeping.
[[Page 26551]]
Further, in Section 939(e) of the Dodd-Frank Act,\7\ Congress
deleted Exchange Act references to credit ratings in two sections: (1)
In Exchange Act Section 3(a)(41),\8\ which defines the term ``mortgage
related security,'' and (2) in Exchange Act Section 3(a)(53),\9\ which
defines the term ``small business related security.'' In place of the
credit rating references, Congress added language stating that a
mortgage related security and a small business related security will
need to satisfy ``standards of credit-worthiness as established by the
Commission.'' \10\ This replacement language becomes effective on July
21, 2012 (i.e., two years after the date the Dodd-Frank Act was signed
into law).
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\7\ Public Law 111-203 Sec. 939(e).
\8\ 15 U.S.C. 78c(a)(41).
\9\ 15 U.S.C. 78c(a)(53).
\10\ Public Law 111-203 Sec. 939(e).
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As is discussed in detail below, the Commission also is requesting
comment on potential standards of creditworthiness for purposes of
Exchange Act Sections 3(a)(41) and 3(a)(53), as the Commission
considers how to implement Section 939(e) of the Dodd-Frank Act.
B. Previous Commission Action
In 1975, the Commission adopted the term ``nationally recognized
statistical rating organization'' (``NRSRO'') as part of the
Commission's amendments to its broker-dealer net capital rule, Exchange
Act Rule 15c3-1 (the ``Net Capital Rule'').\11\ Although the Commission
originated the use of the term NRSRO for a narrow purpose in its own
regulations, ratings by NRSROs today are widely used as benchmarks in
federal and state legislation, rules by financial and other regulators,
foreign regulatory schemes, and private financial contracts. The
Commission's initial regulatory use of the term NRSRO was intended
solely to provide a method for determining capital charges on different
grades of debt securities under the Net Capital Rule. The Commission's
reference to NRSROs for purposes of certain rules increased over time.
Subsequent to the adoption of many of the Commission's requirements
using the NRSRO concept, the Commission--in 2006--obtained registration
and oversight authority with respect to credit rating agencies that
register to be treated as NRSROs.\12\ In response, the Commission
adopted rules to implement a registration and oversight program for
NRSROs in June 2007.\13\
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\11\ See Adoption of Uniform Net Capital Rule and an Alternative
Net Capital Requirement for Certain Brokers and Dealers, Exchange
Act Release No. 11497 (Jun. 26, 1975), 40 FR 29795 (Jul. 16, 1975)
and 17 CFR 240.15c3-1.
\12\ See Credit Rating Agency Reform Act of 2006 (``Rating
Agency Act of 2006''); Public Law 109-291 (2006). Among other
things, the Rating Agency Act of 2006 defined the terms ``credit
rating agency'' and ``nationally recognized statistical rating
organization'' in Exchange Act Sections 3(a)(61) and 3(a)(62),
respectively. See Public Law 109-291 Sec. 3. Under Section
3(a)(61), the term ``credit rating agency'' means any person: (A)
engaged in the business of issuing credit ratings on the Internet or
through another readily accessible means, for free or for a
reasonable fee, but does not include a commercial credit reporting
company; (B) employing either a quantitative or qualitative model,
or both, to determine credit ratings; and (C) receiving fees from
either issuers, investors, or other market participants, or a
combination thereof. 15 U.S.C. 78c(a)(61). Under Section 3(a)(62),
the term ``nationally recognized statistical rating organization''
means a credit rating agency that: (A) issues credit ratings
certified by qualified institutional buyers, in accordance with
section 15E(a)(1)(B)(ix) of the Exchange Act, with respect to (i)
financial institutions, brokers, or dealers; (ii) insurance
companies; (iii) corporate issuers; (iv) issuers of asset-backed
securities (as that term is defined in section 1101(c) of part 229
of title 17, Code of Federal Regulations, as in effect on the date
of enactment of this paragraph); (v) issuers of government
securities, municipal securities, or securities issued by a foreign
government; or (vi) a combination of one or more categories of
obligors described in any clauses (i) through (v); and (B) is
registered under Exchange Act Section 15E.
\13\ See Oversight of Credit Rating Agencies Registered as
Nationally Recognized Statistical Rating Organizations, Exchange Act
Release No. 55857 (Jun. 5, 2007), 72 FR 33564 (Jun. 18, 2007). The
implementing rules were Form NRSRO, Rule 17g-1, Rule 17g-2, Rule
17g-3, Rule 17g-4, Rule 17g-5, and Rule 17g-6. The Commission has
twice adopted amendments to some of these rules. See Amendments to
Rules for Nationally Recognized Statistical Rating Organizations,
Exchange Act Release No. 59342 (Feb. 2, 2009), 74 FR 6456 (Feb. 9,
2009); and Amendments to Rules for Nationally Recognized Statistical
Rating Organizations, Exchange Act Release No. 61050 (Nov. 23,
2009), 74 FR 63832 (Dec. 4, 2009). The Commission also recently
added a new NRSRO rule. See Disclosure for Asset-Backed Securities
Required by Section 943 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Securities Act Release No. 9175 (Jan. 20,
2011), 76 FR 4489 (Jan. 26, 2011).
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The Commission notes that this is not the first time that the
Commission has proposed to remove references to credit ratings in
Commission rules. The Commission issued a concept release in 1994 on
the general idea of removing references to NRSROs in its rules.\14\ In
2003, the Commission again sought comment on whether it should
eliminate the NRSRO designation from Commission rules, and, if so, what
alternatives could be adopted to meet the Commission's regulatory
objectives.\15\ Most recently, in July 2008, the Commission made
specific proposals to remove rule references to ratings by NRSROs.\16\
In response, the Commission received many comments that raised serious
concerns about removing the references.\17\ Commenters argued that
removing NRSRO references in the context of the Net Capital Rule would
decrease the transparency of broker-dealers' net capital computations
and negatively affect market confidence in the financial strength of
broker-dealers.\18\ In addition, commenters contended that the proposed
amendments would place an undue burden on broker-dealers to justify the
propriety of internal methods for determining haircuts and on
Commission examiners who might be required to review those methods.\19\
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\14\ See Concept Release: Nationally Recognized Statistical
Rating Organizations, Exchange Act Release No. 34616 (Aug. 31,
1994), 59 FR 46314 (Sep. 7, 1994).
\15\ See Concept Release: Rating Agencies and the Use of Credit
Ratings under the Federal Securities Laws, Exchange Act Release No.
47972 (Jun. 4, 2003), 68 FR 35258 (Jun. 12, 2003).
\16\ See Proposed Rule: References to Ratings of Nationally
Recognized Statistical Rating Organizations, Exchange Act Release
No. 58070 (Jul. 1, 2008), 73 FR 40088 (Jul. 11, 2008).
\17\ See Comments on References to Ratings of NRSROs, available
on the Commission's Internet Web site at http://www.sec.gov/comments/s7-17-08/s71708.shtml.
\18\ See, e.g., Letter from Jeffrey T. Brown, Senior Vice
President, Charles Schwab & Co., Inc. to Florence E. Harmon, Acting
Secretary, Commission, dated Sep. 5, 2008, stating, ``we are
concerned that the Commission's proposed amendments to remove
references to NRSRO ratings from [R]ule 15c3-1 (the Net Capital
Rule) * * * may be destabilizing and inject risk and uncertainty
into the operations of broker-dealers, investment advisers and money
market mutual funds. We urge the Commission to retain the references
to NRSRO ratings as a minimum floor of credit quality.''
\19\ See, e.g., Deborah A. Cunningham and Boyce I. Greer, SIFMA
Credit Rating Agency Task Force Co-Chair to Elizabeth M. Murphy,
Secretary, Commission, dated Dec. 9, 2009.
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In October 2009, the Commission adopted several of the proposed
reference removals and re-opened for comment the remaining
proposals.\20\ As noted above, in each of these concept releases and
rule proposals, commenters generally did not support the removal of
references to NRSRO ratings from Commission rules and provided few
possible regulatory alternatives. The Commission recognizes the
concerns raised by commenters that replacing credit ratings--which
provide an objective benchmark--with more subjective approaches could
increase costs to broker-dealers and the
[[Page 26552]]
Commission. For example, broker-dealers would be required to allocate
resources toward developing and maintaining compliance processes, and
the Commission would likewise be required to allocate resources toward
examining for compliance. The Commission also recognizes that an
alternative approach, if too rigid, could narrow the types of financial
instruments that qualify for benefits under existing rules and, if too
flexible, could broaden the types of financial instruments that qualify
for benefits under existing rules. The Commission, in proposing
alternatives to credit ratings, is seeking generally to neither narrow
nor broaden the scope of financial instruments that would qualify for
the benefits conferred in the existing rules while, at the same time,
fulfilling the statutory mandate in Section 939A of the Dodd-Frank
Act.\21\ In this regard, the Commission seeks comment below on whether
the proposed alternatives achieve this goal and whether more effective
alternatives exist.
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\20\ See References to Ratings of Nationally Recognized
Statistical Rating Organizations, Exchange Act Release No. 60789
(Oct. 5, 2009), 74 FR 52358 (Oct. 9, 2009) (adopting release). In
the adopting release, the Commission amended Exchange Act Rule 3a1-1
(17 CFR 240.3a1-1), Exchange Act Rules 300, 301(b)(5) and 301(b)(6)
of Regulation ATS (17 CFR 242.300, 242.301(b)(5) and 242.301(b)(6)),
Form ATS-R (17 CFR 249.638) and Form PILOT (17 CFR 249.821). The
Commission also adopted amendments to Rules 5b-3 and 10f-3 under the
Investment Company Act of 1940 (17 CFR 270.5b-3 and 17 CFR 270.10f-
3). See References to Ratings of Nationally Recognized Statistical
Rating Organizations, Exchange Act Release No. 60790 (Oct. 5, 2009),
74 FR 52374 (Oct. 9, 2009) (re-opening comment for Net Capital Rule
purposes and various Exchange Act rules).
\21\ See Public Law 111-203 Sec. 939.
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II. Commission Proposals
A. Proposed Amendments to Exchange Act Rule 15c3-1 and the Appendices
to the Rule
1. Amendments to Rule 15c3-1
As noted above, the Commission first developed the NRSRO concept
for use in the Net Capital Rule. The Net Capital Rule prescribes
minimum regulatory capital requirements for broker-dealers.\22\ A ``net
liquid assets test'' is the fundamental requirement of the Net Capital
Rule. This test is designed to provide that a registered broker-dealer
maintain at all times more than one dollar of highly liquid assets for
each dollar of liabilities (e.g., money owed to customers and
counterparties), excluding liabilities that are subordinated to all
other creditors by contractual agreement. Consequently, if the broker-
dealer experiences financial difficulty, it should be in a position to
meet all obligations to customers and counterparties and generate
resources to wind-down its operations in an orderly manner without the
need of a formal proceeding. The Net Capital Rule operates by requiring
a broker-dealer to perform two calculations: (1) A computation of
required minimum net capital; and (2) a computation of actual net
capital. A broker-dealer must ensure that its actual net capital
exceeds its minimum net capital requirement at all times.
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\22\ See 17 CFR 240.15c3-1(a).
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To calculate its actual net capital, a broker-dealer first computes
its net worth in accordance with generally accepted accounting
principles and then adds to this amount certain subordinated
liabilities. From that figure, the broker-dealer subtracts assets not
readily convertible into cash, such as intangible assets, fixed assets,
and most unsecured receivables. The broker-dealer then subtracts
prescribed percentages of the market value of securities owned by the
broker-dealer (otherwise known as ``haircuts'') to discount for
potential market movements. A primary purpose of these haircuts is to
provide a margin of safety against losses that might be incurred by the
broker-dealer as a result of market fluctuations in the prices of, or
lack of liquidity in, its proprietary positions. The resulting figure
is the broker-dealer's net capital.
The Net Capital Rule currently applies a lower haircut to certain
types of securities held by a broker-dealer if the securities are rated
in higher rating categories by at least two NRSROs, since those
securities typically are more liquid and less volatile in price than
securities that are rated in the lower categories or are unrated.
Currently, to receive the benefit of a reduced haircut on commercial
paper, the commercial paper must be rated in one of the three highest
rating categories by at least two NRSROs.\23\ To receive the benefit of
a reduced haircut on a nonconvertible debt security and preferred
stock, the security must be rated in one of the four highest rating
categories by at least two NRSROs.\24\
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\23\ 17 CFR 240.15c3-1(c)(2)(vi)(E).
\24\ 17 CFR 240.15c3-1(c)(2)(vi)(F)(1) and (c)(2)(vi)(H).
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In conformance with the Dodd-Frank Act, the Commission is proposing
to remove from the Net Capital Rule all references to credit ratings
and substitute an alternative standard of creditworthiness.
Specifically, in place of the current Net Capital Rule references to
credit ratings, the Commission is proposing that a broker-dealer take a
15% haircut on its proprietary positions in commercial paper,
nonconvertible debt, and preferred stock unless the broker-dealer has a
process for determining creditworthiness that satisfies the criteria
described below. However, commercial paper, nonconvertible debt, and
preferred stock without a ready market would remain subject to a 100%
haircut.\25\ The 15% haircut is derived from the catchall haircut
amount that applies to a security not specifically identified in the
Net Capital Rule as having an asset-class specific haircut, provided
the security is otherwise deemed to have a ready market.\26\ It is also
the haircut applicable to most equity securities.\27\
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\25\ The term ``ready market'' is defined in the Net Capital
Rule as ``a market in which there exists independent bona fide
offers to buy and sell so that a price reasonably related to the
last sales price or current bona fide competitive bid and offer
quotations can be determined for a particular security almost
instantaneously and where payment will be received in settlement of
a sale at such price within a relatively short time conforming to
trade custom.'' 17 CFR 240.15c3-1(c)(11).
\26\ 17 CFR 240.15c3-1(c)(2)(vi)(J). Securities without a ready
market would remain subject to a 100% haircut. 17 CFR 240.15c3-
1(c)(2)(vii).
\27\ 17 CFR 240.15c3-1(c)(2)(vi)(J).
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If a broker-dealer establishes, maintains, and enforces written
policies and procedures for determining creditworthiness under the
proposed amendments, the broker-dealer would be permitted to apply the
lesser haircut requirement currently specified in the Net Capital Rule
for commercial paper (i.e., between zero and \1/2\ of 1%),
nonconvertible debt (i.e., between 2% and 9%), and preferred stock
(i.e., 10%) when the creditworthiness standard is satisfied. Under this
proposal, in order to use these lower haircut percentages for
commercial paper, nonconvertible debt, and preferred stock, a broker-
dealer would be required to establish, maintain, and enforce written
policies and procedures designed to assess the credit and liquidity
risks applicable to a security, and based on this process, would have
to determine that the investment has only a ``minimal amount of credit
risk.''
Under the proposed amendments, a broker-dealer, when assessing
credit risk, could consider the following factors, to the extent
appropriate, with respect to each security: \28\
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\28\ This list of factors is not meant to be exhaustive or
mutually exclusive.
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Credit spreads (i.e., whether it is possible to
demonstrate that a position in commercial paper, nonconvertible debt,
and preferred stock is subject to a minimal amount of credit risk based
on the spread between the security's yield and the yield of Treasury or
other securities, or based on credit default swap spreads that
reference the security);
Securities-related research (i.e., whether providers of
securities-related research believe the issuer of the security will be
able to meet its financial commitments, generally, or specifically,
with respect to securities held by the broker-dealer);
Internal or external credit risk assessments (i.e.,
whether credit assessments developed internally by the broker-dealer or
externally by a credit
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rating agency, irrespective of its status as an NRSRO, express a view
as to the credit risk associated with a particular security);
Default statistics (i.e., whether providers of credit
information relating to securities express a view that specific
securities have a probability of default consistent with other
securities with a minimal amount of credit risk);
Inclusion on an index (i.e., whether a security, or issuer
of the security, is included as a component of a recognized index of
instruments that are subject to a minimal amount of credit risk);
Priorities and enhancements (i.e., the extent to which a
security is covered by credit enhancements, such as
overcollateralization and reserve accounts, or has priority under
applicable bankruptcy or creditors' rights provisions);
Price, yield and/or volume (i.e., whether the price and
yield of a security or a credit default swap that references the
security are consistent with other securities that the broker-dealer
has determined are subject to a minimal amount of credit risk and
whether the price resulted from active trading); and
Asset class-specific factors (e.g., in the case of
structured finance products, the quality of the underlying assets).
To establish a basis for a haircut of less than 15% for commercial
paper, nonconvertible debt, or preferred stock, a broker-dealer would
have to establish, maintain, and enforce written policies and
procedures for determining the creditworthiness of a security acquired
by the firm. The range and type of specific factors considered would
vary depending on the particular securities that are reviewed. A
broker-dealer that applies a haircut below 15%, as described above,
would have a greater burden to support its application of that haircut
when a creditworthiness finding under one factor is contradicted by a
finding under another factor. Further, any broker-dealer that
determines that application of the factors specified above do not
support a finding of a minimal amount of credit risk would apply the
15% haircut with respect to the subject security, or, if that security
does not have a ready market, a 100% haircut.\29\
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\29\ A financial instrument that possesses the necessary credit
ratings under Rule 15c3-1 is nevertheless subject to the 100%
deduction required by the rule if the financial instrument does not
have a ready market. For example, commercial paper rated in the
third highest credit rating category may not have a ready market
and, therefore, would be subject to the 100% deduction. See, e.g.,
Nandkumar Nayar and Michael S. Rozeff, Ratings, Commercial Paper,
and Equity Returns, XLIX J. of Finance 1431, 1433, n.5 (1994)
(noting that ``issuers with the lowest ratings find that they cannot
issue commercial paper in quantity''). The Commission notes that
treatment of commercial paper rated in the third highest credit
rating as discussed in this release is limited to Rule 15c3-1 only.
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Each broker-dealer would be required to preserve for a period of
not less than three years, the first two years in an easily accessible
place, the written policies and procedures that the broker-dealer
establishes, maintains, and enforces for assessing credit risk for
commercial paper, nonconvertible debt, and preferred stock. Broker-
dealers would be subject to this requirement in the Commission's
broker-dealer record retention rule, Exchange Act Rule 17a-4, which the
Commission is proposing to amend in conjunction with this
rulemaking.\30\
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\30\ Specifically, the Commission is proposing to adopt a new
paragraph (b)(13) of Rule 17a-4, which would require broker-dealers
to preserve the written policies and procedures the broker-dealer
establishes, maintains, and enforces to assess creditworthiness of
nonconvertible debt, preferred stock, and commercial paper under the
Net Capital Rule.
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A broker-dealer's process for establishing creditworthiness and its
written policies and procedures documenting that process would be
subject to review in regulatory examinations by the Commission and
self-regulatory organizations. A broker-dealer that applies a haircut
of less than 15% for commercial paper, nonconvertible debt, and
preferred stock without establishing, maintaining, and enforcing
written policies and procedures reasonably designed to assess
creditworthiness would be subject to disciplinary action for non-
compliance with the rule and could be required to recalculate its net
capital.
The Commission preliminarily believes that these new standards
would enable broker-dealers to make the net capital computations
required under the Net Capital Rule reflect the market and credit risk
inherent in particular commercial paper, nonconvertible debt, and
preferred stock.\31\ The Commission also recognizes that credit ratings
may provide useful information to institutional and retail investors as
part of the process of making an investment decision. The requirements
of the current rule are based on the practice of many NRSROs to have at
least eight categories of ratings for debt securities, with the top
four ratings commonly referred to in the industry as ``investment
grade.'' Although the proposed amendments do not use the term
``investment grade,'' they are meant to capture securities that should
generally qualify for that designation, without placing undue reliance
on third-party credit ratings.
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\31\ See Uniform Net Capital Rule, Exchange Act Release No.
13635 (Jun. 16, 1977), 42 FR 31778 (Jun. 23, 1977).
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Currently, the Net Capital Rule distinguishes between those
securities that are rated in one of the three highest categories by an
NRSRO (i.e., for commercial paper) and those securities that are rated
in one of the four highest ratings by an NRSRO (i.e., for
nonconvertible debt and preferred stock). The proposed amendments would
eliminate the distinction among types of securities. Instead, each of
the three classes of securities would be subject to the same
requirements under the proposed amendments.
According to data collected by the Commission, of the approximately
5,060 broker-dealers registered with the Commission as of year-end
2009, approximately 480 broker-dealers maintained proprietary positions
in debt securities at that time.\32\ Thus, it appears that only a small
percentage of active broker-dealers registered with the Commission
would be impacted by the proposed amendments. The Commission
preliminarily believes, based on its oversight activities, that many of
the broker-dealers with substantial proprietary positions in debt
securities already make independent assessments of creditworthiness
based on the types of factors identified in the proposed amendments.
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\32\ This number was obtained by reviewing broker-dealer
Financial and Operational Combined Single (or ``FOCUS'') Reports for
2009 year-end and then calculating how many firms reported holding
proprietary debt positions. For FOCUS Part II filers, the balances
examined were ``Bankers Acceptances'' and ``Corporate Debt.'' For
FOCUS CSE filers, the balances examined were: ``Money Market
Instruments,'' ``Private Label Mortgage Backed Securities,'' ``Other
Asset Backed Securities,'' and ``Corporate Debt.'' For Part IIA
filers, the balance examined was ``Debt Securities.'' Broker-dealers
that hold preferred stock also may hold positions in debt
securities. However, because preferred stock is not a separate line
item on the FOCUS Report, broker-dealers that hold only preferred
stock and not other debt securities are not included in this
estimate.
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As noted above, the Commission does not intend through the proposed
amendments to narrow or broaden the range of securities that generally
qualify for reduced haircuts under the Net Capital Rule as currently
written. The Commission recognizes that broker-dealers, when purchasing
for their proprietary accounts, provide a substantial source of capital
for issuers of commercial paper, nonconvertible debt, and preferred
stock. Accordingly, any significant change in practice by broker-
dealers, whether because of potential compliance costs, difficulties in
applying the proposed criteria or minimal credit risk standard, or
other factors, that results in a change in the
[[Page 26554]]
general allocation of such securities in proprietary accounts could
have unintended consequences. Accordingly, the Commission is interested
in receiving comment on the potential impact of the proposed amendments
on the capital markets generally, and on capital raising efforts by
issuers of the affected types of securities specifically, and on how
any potential effect could be mitigated or eliminated.
The Commission requests comment on all aspects of these proposed
amendments. In addition, the Commission requests comment on the
following specific questions:
Do broker-dealers that would be subject to the proposed
amendments either already have processes in place for determining
creditworthiness of commercial paper, nonconvertible debt, and
preferred stock or have the financial sophistication and the resources
necessary to adopt such processes without undue effort or expense? Are
there particular types of broker-dealers that would not be capable of
meeting this new standard without undue hardship? In what ways and to
what extent, if any, would establishing and implementing procedures for
determining creditworthiness in lieu of using a credit rating
disproportionately impact medium-sized and smaller broker-dealers?
Commenters who believe that medium-sized and smaller broker-dealers
would be disproportionately affected by these amendments, should
describe the firms that would be adversely impacted, as well as provide
suggestions as to how the proposal could be amended to accommodate
them.
With respect to the factors a broker-dealer could
consider, would the use of these factors in lieu of credit ratings
reduce undue reliance on a third party's assessment of credit risk? To
what extent, if any, is there a risk that undue reliance will shift
from relying on a credit rating to relying on some other third party
assessment of creditworthiness?
What is the potential impact of moving from an objective
standard to a more flexible standard? Is there the potential that a
broker-dealer's evaluations of creditworthiness may be second-guessed?
If so, how might the prospect of being second-guessed impact a broker-
dealer's evaluation of minimal credit risk and the appropriate haircuts
to take for purposes of the broker-dealer's net capital calculation?
If broker-dealers establish and implement procedures for
determining creditworthiness, some broker-dealers may determine that a
security qualifies for a reduced haircut when it would not have
qualified for a reduced haircut under the current NRSRO standard.
Alternatively, some broker-dealers may determine that a security does
not qualify for a reduced haircut when the security would have
qualified for a reduced haircut under the current standard. Describe
the potential impact on capitalization and the efficient allocation of
capital under these two scenarios and the likelihood of each occurring.
In addition, with respect to the first scenario, describe the potential
impact on the objective of Rule 15c3-1, which, among other things, is
to protect investors by enabling a broker-dealer, if the firm
experiences financial difficulty, to be in a position to meet all
obligations to customers and counterparties and generate resources to
wind-down its operations in an orderly manner without the need of a
formal proceeding.
What are the risks of using internal processes to make
credit determinations and how could these risks be addressed? For
example, would broker-dealers be likely to adopt procedures that
minimize the credit risk associated with a particular security in order
to minimize capital charges? How could this risk be addressed?
Are there other factors a broker-dealer should use when
determining creditworthiness? Should the Commission mandate that
broker-dealers consider each factor in this release when assessing a
security's credit risk? Should the list of factors be included in the
text of Rule 15c3-1?
Should the Commission place conditions on the ability of a
broker-dealer to outsource factors related to the determination of
creditworthiness to a third party? If the determination of factors
related to creditworthiness is outsourced, how can the Commission
determine that the outsourced determination meets the proposed
standard?
How often should a broker-dealer be required to update its
assessment of a specific security to ensure the broker-dealer's
determination of creditworthiness remains current? Should the rule
contain a requirement that the assessment be updated after a specific
period of time? Should the Commission limit the ability of a broker-
dealer to outsource the monitoring of its determination of
creditworthiness?
Should the Commission require that the persons responsible
for developing a broker-dealer's internal processes and applying them
to possible positions in individual securities for purposes of the Net
Capital Rule be separate from employees who make proprietary investment
decisions for the broker-dealer?
What would be the appropriate level of regulatory
oversight of a broker-dealer's credit determination processes? Should
the Commission describe in more detail how examiners will examine these
processes? How should a broker-dealer be able to demonstrate to
regulators the adequacy of the processes that it adopts and that it is
following them?
Should the Commission require the securities industry
self-regulatory organizations to set appropriate standards for broker-
dealers to use in evaluating creditworthiness and evaluating individual
positions in commercial paper, nonconvertible debt, and preferred stock
for net capital purposes?
Should the Commission require broker-dealers to create and
maintain records of creditworthiness determinations? If so, what
records should be required to be maintained and how should they be
described in a rule? Are there standard records that are used when
making creditworthiness determinations that the Commission could
require broker-dealers to keep? Are there other measures the Commission
could consider to reduce the risk that broker-dealers will adopt
inadequate processes or fail to adhere to them?
Rather than referencing a list of factors that broker-
dealers could consider, should the rule reference a single or limited
set of factors (e.g., credit spreads)? Could a simpler approach
adequately capture the risks of holding the full range of securities
covered by the rule?
Are there alternate and more reliable means of
establishing creditworthiness for purposes of the Net Capital Rule?
Please include detailed descriptions.
Should the Commission define ``minimal amount of credit
risk''? Commenters who believe the Commission should define this term
should include a detailed description of what should be included in the
definition.
2. Proposed Amendments to Appendix A to Rule 15c3-1
Appendix A to Rule 15c3-1 allows broker-dealers to employ
theoretical option pricing models in determining net capital
requirements for listed options and related positions.\33\ Broker-
dealers may also elect a strategy-based methodology.\34\ The purpose of
[[Page 26555]]
Appendix A is to simplify the net capital treatment of options in order
to reflect the risk inherent in options and related positions.\35\
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\33\ 17 CFR 240.15c3-1a.
\34\ Id.
\35\ See Net Capital Rule, Exchange Act Release No. 38248 (Feb.
6, 1997), 62 FR 6474 (Feb. 12, 1997).
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Under Appendix A, broker-dealers' proprietary positions in ``major
market foreign currency'' options receive more favorable treatment than
options for all other currencies when using theoretical option pricing
models to compute net capital deductions. The term ``major market
foreign currency'' is currently defined to mean ``the currency of a
sovereign nation whose short-term debt is rated in one of the two
highest categories by at least two nationally recognized statistical
rating organizations and for which there is a substantial inter-bank
forward currency market.'' \36\
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\36\ 17 CFR 240.15c3-1a(b)(1)(i)(C).
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With respect to the definition of the term ``major market foreign
currency,'' the Commission proposes to remove from that definition the
phrase ``whose short-term debt is rated in one of the two highest
categories by at least two nationally recognized statistical rating
organizations.'' The change would modify the definition of that term to
include foreign currencies only ``for which there is a substantial
inter-bank forward currency market.'' The Commission also is proposing
to eliminate the specific reference in the rule to the European
Currency Unit (ECU), which is identified by the rule as the only major
market foreign currency under Appendix A.\37\ However, because of the
establishment of the euro as the official currency of the euro-zone, a
specific reference to the ECU is no longer needed. The Commission
preliminarily believes that specific reference to the euro also is not
necessary, as it is a foreign currency with a substantial inter-bank
forward currency market.
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\37\ Id.
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The Commission requests comment on all aspects of the proposed
amendments to Appendix A to the Net Capital Rule. In addition, the
Commission requests comment on the following specific questions:
Is the proposed definition of ``major market foreign
currency'' sufficiently clear to allow broker-dealers to determine
which currencies qualify as major market foreign currencies?
It is not the intention of the Commission to change the
currencies that meet the definition of ``major market foreign
currency'' under this rule. Does the new definition of ``major market
foreign currency'' achieve this goal? Does the Commission need to keep
an example of a ``major market foreign currency'' in the definition?
How should the Commission distinguish between major market
foreign currencies and all other currencies? Should the rule provide
that broker-dealers can apply for a Commission determination (e.g., in
the form of an Order or other Commission action) that a currency be
considered a major market foreign currency under Appendix A to Rule
15c3-1? Should a list be created and published on the Commission's Web
site? Should the Commission rely on other lists, such as the list of
member countries of the Organization for Economic Co-Operation and
Development? \38\ Should the determination be made by one of the self-
regulatory organizations?
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\38\ See http://www.oecd.org/pages/0,3417,en_36734052_36761800_1_1_1_1_1,00.html.
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Should the Commission replace the language in Appendix A
to Rule 15c3-1 with a new standard? If so, what should that standard
be? Should the Commission use the same standard of creditworthiness and
require the same type of process that it has proposed above for Rule
15c3-1?
3. Proposed Amendments to Appendix E to Rule 15c3-1
Pursuant to Appendix E to Rule 15c3-1, a broker-dealer may apply to
the Commission for authorization to use an alternative method for
computing capital (i.e., the alternative net capital, or ``ANC,''
computation).\39\ Specifically, broker-dealers with internal risk
management practices that utilize certain mathematical modeling methods
to manage their own business risk, including value-at-risk (``VaR'')
models and scenario analysis, may apply to use these methods to compute
net capital requirements for market risk and derivatives-related credit
risk.
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\39\ As a condition of approval, applicants must maintain an
``early warning'' level of at least $5 billion in tentative net
capital, minimum levels of at least $1 billion in tentative net
capital, and $500 million in net capital. See 17 CFR 240.15c3-
1(a)(7) and (c)(15).
---------------------------------------------------------------------------
Under Appendix E, broker-dealers subject to the ANC computation are
required to deduct from their net capital credit risk charges that take
counterparty risk into consideration. This counterparty risk
determination is currently based on either NRSRO ratings or a dealer's
internal counterparty credit rating. To comply with Section 939A of the
Dodd-Frank Act, the Commission is proposing to remove paragraphs
(c)(4)(vi)(A) through (c)(4)(vi)(D) of Appendix E, which base credit
risk charges for counterparty risk on NRSRO ratings, and in place of
these ratings, require a broker-dealer using the ANC computation to
apply a credit risk weight of either 20%, 50%, or 150% with respect to
an exposure to a given counterparty based on the internal credit rating
the broker-dealer determines for the counterparty.
As a result, a broker-dealer that applies to use the approach set
forth in Appendix E to determine counterparty risk would be required,
as part of its initial application or in an amendment to the
application, to request Commission approval to determine credit risk
weights of either 20%, 50%, or 150% based on internal calculations and
credit ratings. The Commission notes that all of the firms approved to
use models to calculate market and credit risk charges under Appendix E
to Rule 15c3-1 have been approved to determine credit ratings using
internal ratings rather than ratings issued by NRSROs.\40\ Under the
proposal, firms that are already approved to use the ANC computation in
Appendix E would not need to seek new approval from the Commission.
Other broker-dealers applying for ANC computation in Appendix E would
be required to seek approval of their methodology for determining
internal ratings. A broker-dealer that is applying to use Appendix E
and intends to use internal ratings to determine the applicable credit
risk weights should so state in its application to the Commission.
---------------------------------------------------------------------------
\40\ Currently six broker-dealers are approved to use the ANC
computation in Appendix E to Rule 15c3-1.
---------------------------------------------------------------------------
As stated above, all of the broker-dealers approved to use Appendix
E to Rule 15c3-1 have already developed models approved for use in
performing the ANC computation, as well as internal risk management
control systems. As such, each firm already employs an internal credit
rating method (i.e., a non-NRSRO credit rating method) that would,
under the proposed amendments, become the only option for determining
the applicable credit risk weight.
The Commission generally requests comment on all aspects of the
proposed amendments to Appendix E to Rule 15c3-1. In addition, the
Commission requests comment on the following specific questions:
Should the Commission replace provisions in Appendix E to
Rule 15c3-1 with a new standard? If so, what should that standard be?
For example, should the Commission use the same standard of
creditworthiness that it has proposed above for commercial paper,
[[Page 26556]]
nonconvertible debt, and preferred stock?
Should the Commission continue to use credit risk weights
of 20%, 50%, or 150%? If not, what risk weights should the Commission
require be applied?
Should broker-dealers that are already approved to use
Appendix E be required to seek a new determination by the Commission of
the credit risk weights assigned to their internal ratings scale?
4. Proposed Amendments to Appendix F to Rule 15c3-1 and the General
Instructions to Form X-17A-5, Part IIB
Appendix F to the Net Capital Rule sets forth a program for OTC
derivatives dealers that allow them to use an alternative approach to
computing net capital deductions, subject to certain conditions.\41\
Under Appendix F, OTC derivatives dealers with strong internal risk
management practices may utilize the mathematical modeling methods used
to manage their own business risk, including VaR models and scenario
analysis, to compute deductions from net capital for market and credit
risks arising from OTC derivatives transactions.\42\
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\41\ OTC derivatives dealers are a special class of broker-
dealers that are exempt from certain broker-dealer requirements,
including membership in a self-regulatory organization (17 CFR
240.15b9-2), regular broker-dealer margin rules (17 CFR 240.36a1-1),
and application of the Securities Investor Protection Act of 1970
(17 CFR 240.36a1-2). OTC derivative dealers are subject to special
requirements, including limitations on the scope of their securities
activities (17 CFR 240.15a-1), specified internal risk management
control systems (17 CFR 240.15c3-4), recordkeeping obligations (17
CFR 240.17a-3(a)(10)), and reporting responsibilities (17 CFR
240.17a-12). They are also subject to alternative net capital
treatment (17 CFR 240.15c3-1(a)(5)). See 17 CFR 240.15a-1,
Preliminary Note.
\42\ The minimum net capital requirements for an OTC derivatives
dealer are tentative net capital of at least $100 million and net
capital of at least $20 million. See 17 CFR 240.15c3-1(a)(5) and
(c)(15).
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Under Appendix F to the Net Capital Rule, OTC derivatives dealers
are required to deduct from their net capital credit risk charges that
take counterparty risk into consideration. As part of this deduction,
the OTC derivatives dealer must apply a counterparty factor of either
20%, 50%, or 100%.\43\ In addition, the OTC derivatives dealer must
take a concentration charge where the net replacement value in the
account of any one counterparty exceeds 25% of the OTC derivatives
dealer's tentative net capital.\44\ The counterparty factor (i.e., 20%,
50%, or 100%) to apply currently is based on either NRSRO ratings or
the firm's internal credit ratings.\45\ The concentration charges also
are based on either NRSRO ratings or the firm's internal credit
ratings. All of the firms approved to use models to calculate market
and credit risk charges under Appendix F to Rule 15c3-1 have been
approved to determine credit risk charges using internal credit
ratings.\46\ To comply with Section 939A of the Dodd-Frank Act, the
Commission is proposing to amend Appendix F to Rule 15c3-1 and to make
conforming changes to Form X-17A-5, Part IIB.
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\43\ 17 CFR 240.15c3-1f(d)(2).
\44\ 17 CFR 240.15c3-1f(d)(3).
\45\ See 17 CFR 240.15c3-1f(d)(2) and (4).
\46\ Currently four firms are using Appendix F to the Net
Capital Rule.
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Specifically, the Commission is proposing to revise paragraphs
(d)(2), (d)(3)(i), (d)(3)(ii), (d)(3)(iii), and (d)(4) of Appendix F to
the Net Capital Rule, which permit the use of NRSRO ratings when
determining counterparty risk. As a result of these revisions, an OTC
derivatives dealer that applies to use the approach set forth in
Appendix F to determine counterparty credit risk charges would be
required, as part of its initial application or in an amendment to the
application, to request Commission approval to determine credit ratings
using internal ratings rather than ratings issued by NRSROs. Under the
proposal, firms that are already approved to use internal ratings
pursuant to Appendix F would not need to seek new approval from the
Commission. An OTC derivatives dealer that is applying to use Appendix
F and intends to use internal ratings to determine the applicable
credit risk weights should so state in its application to the
Commission.
As stated above, all of the approved firms have already developed
models to calculate market and credit risk under the alternative net
capital calculation methods set forth in Appendix F. As such, each firm
already employs a non-NRSRO ratings-based method that would, under the
proposed amendments, become the only option for calculating credit risk
charges.
Based on these proposed amendments to Appendix F to Rule 15c3-1,
the Commission is proposing conforming changes to the General
Instructions to Form X-17A-5, Part IIB. This form constitutes the basic
financial and operational report required of OTC derivatives dealers to
be filed with the Commission. Under the heading ``Computation of Net
Capital and Required Net Capital'' and before the section ``Aggregate
Securities and OTC Derivatives Positions,'' the Commission is proposing
conforming changes to the section ``Credit risk exposure.'' This
section explains the counterparty charges for OTC derivatives dealers
based on the language in Appendix F to Rule 15c3-1. Therefore, the
Commission is proposing that all changes made to Appendix F to Rule
15c3-1 also be made to the section ``Credit risk exposure'' under the
heading ``Computation of Net Capital and Required Net Capital'' in the
General Instructions to Form X-17A-5, Part IIB.
The Commission generally requests comment on all aspects of the
proposed amendments to Appendix F to Rule 15c3-1 and the conforming
changes to the General Instructions to Form X-17A-5, Part IIB. In
addition, the Commission requests comment on the following specific
questions:
Should the Commission replace the provisions in Appendix F
to Rule 15c3-1 with a new standard? If so, what should that standard
be? Should the Commission use the same standard of creditworthiness
that it has proposed above for commercial paper, nonconvertible debt,
and preferred stock?
Should the Commission continue to use counterparty factors
of 20%, 50%, or 100%? If not, what counterparty factors should the
Commission require be applied?
Should the OTC derivatives dealers that have been approved
to use Appendix F be required to submit an amendment to their
applications to use internal credit ratings?
5. Proposed Amendment to Appendix G to Rule 15c3-1
The Commission is also proposing a conforming amendment to Appendix
G to Rule 15c3-1. Under Appendix G, a broker-dealer that uses the ANC
computation can only do so if its ultimate holding company agrees to
provide the Commission with additional information about the financial
condition of the ultimate holding company and its affiliates. Appendix
G applies to an ultimate holding company that has a principal regulator
and is intended to ensure that the Commission can obtain certain
information designed to help the Commission assess the financial and
operational health of the ultimate holding company and its potential
impact on the risk exposure of the broker-dealer.\47\
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\47\ Currently, each broker-dealer that uses the ANC computation
has an ultimate holding company that has a principal regulator. As a
result of both changes to the Commission's regulatory programs and
the Dodd-Frank Act, the Commission is no longer regulating ultimate
holding companies.
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The proposed amendment to Appendix G would delete references in
that appendix to the provisions of
[[Page 26557]]
Appendix E that the Commission is proposing to delete as described
above. These references are found in paragraph (a)(3)(i)(F) to Appendix
G. Because of the proposed amendments to Appendix E described above,
the references to Appendix E in Appendix G would no longer be accurate.
The Commission generally requests comment on all aspects of the
proposed amendment to Appendix G to Rule 15c3-1.
B. Proposed Amendment to Exhibit A to Rule 15c3-3
Exchange Act Rule 15c3-3 (the ``Customer Protection Rule'')
protects customer funds and securities held by broker-dealers. In
general, the Customer Protection Rule has two parts. The first part
requires a broker-dealer to have possession or control of all fully
paid and excess margin securities of its customers. In this regard, a
broker-dealer must make a daily determination in order to comply with
this aspect of the rule.
The second part covers customer funds and requires broker-dealers
subject to the rule to make a periodic computation to determine how
much money it is holding that is either customer money or money
obtained from the use of customer securities (``credits''). From that
figure, the broker-dealer subtracts the amount of money which it is
owed by customers or by other broker-dealers relating to customer
transactions (``debits''). If the credits exceed debits after this
``reserve formula'' computation, the broker-dealer must deposit the
excess in a ``Special Reserve Bank Account for the Exclusive Benefit of
Customers'' (a ``Reserve Account''). If the debits exceed credits, no
deposit is necessary. Funds deposited in a Reserve Account cannot be
withdrawn until the broker-dealer completes another computation that
shows that the broker-dealer has on deposit more funds than the reserve
formula requires.
The Customer Protection Rule is designed to prevent broker-dealers
from using customer money to finance their business, except as related
to customer transactions, since customer funds (the credits) can be
offset only by customer-related transactions (the debits). As a result,
broker-dealers must provide the capital to finance their trades and
firm activities and may not use customers' funds for such purposes.
Exhibit A to Rule 15c3-3 contains the formula that a broker-dealer
must use to determine its reserve requirement. Under Note G to Exhibit
A, a broker-dealer may include required customer margin for
transactions in security futures products as a debit in its reserve
formula computation if that margin is required and on deposit at a
clearing agency or derivatives clearing organization that:
1. Maintains the highest investment-grade rating from an NRSRO;
2. Maintains security deposits from clearing members in connection
with regulated options or futures transactions and assessment power
over member firms that equal a combined total of at least $2 billion,
at least $500 million of which must be in the form of security
deposits;
3. Maintains at least $3 billion in margin deposits; or
4. Obtains an exemption from the Commission.\48\
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\48\ 17 CFR 240.15c3-3a, Note G.
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Requiring a clearing agency or a derivatives clearing organization
to meet certain minimum criteria before margin deposits with that
entity may be included as a debit in a broker-dealer's customer reserve
formula is consistent with the customer protection function of Rule
15c3-3, because margin that is posted for customer positions in
security futures products constitutes an unsecured receivable from the
clearing agency or organization. Accordingly, this requirement is
intended to provide reasonable assurance that customer margin deposits
related to security futures products are adequately protected.
The Commission is proposing to remove the first criterion described
above (i.e., the highest investment-grade rating from an NRSRO). The
Commission notes that the criteria are disjunctive and, therefore, a
clearing agency or derivatives clearing organization needs to satisfy
only one criterion to permit a broker-dealer to treat customer margin
as a reserve formula debit. Consequently, the Commission preliminarily
believes that the proposed amendment would not lessen the protections
for customer funds and securities. Furthermore, while one potential
criterion would be removed, there is only one clearing agency for
security futures products (namely, the Options Clearing Corporation)
and that clearing agency would continue to qualify under each of the
other applicable criteria. Moreover, if a new registered clearing
agency or derivatives clearing organization could not meet one of the
remaining criteria, a broker-dealer may request an exemption for the
clearing agency or organization under the rule.\49\
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\49\ The Commission may, in its sole discretion, grant such an
exemption subject to such conditions as are appropriate under the
circumstances if the Commission determines that such conditional or
unconditional exemption is necessary or appropriate in the public
interest and is consistent with the protection of investors. See
paragraph (b)(iv) of Rule 15c3-3a, Note G.
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The Commission preliminarily believes that eliminating the
reference to NRSRO ratings in Note G to Exhibit A to Rule 15c3-3 will
continue to advance the goals of the Customer Protection Rule by
ensuring the long-term financial strength of clearing agencies and
derivatives clearing organizations holding customer margin for
positions in security futures products.\50\ The Commission
preliminarily believes that requiring a registered clearing agency or
derivatives clearing organization to comply with one of the three
remaining criteria will adequately serve the customer protection
purpose of Rule 15c3-3.
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\50\ See Rule 15c3-3 Reserve Requirements for Margin Related to
Security Futures Products, Exchange Act Release No. 50295 (Aug. 31,
2004), 69 FR 54182 (Sep. 7, 2004).
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The Commission generally requests comment on all aspects of the
removal of paragraph (b)(1)(i) of Note G to Rule 15c3-3a. In addition,
the Commission requests specific comment on the following questions:
Should the Commission replace the language in paragraph
(b)(1)(i) of Note G with a new standard? If so, what should that
standard be? Should the Commission use the same standard of
creditworthiness that it has proposed above for commercial paper,
nonconvertible debt, and preferred stock?
What factors should the Commission take into account when
considering the potential regulatory compliance costs of removing
references to NRSROs from paragraph (b)(1) of Note G? Commenters should
include detailed descriptions of any potential costs.
Do the guidelines offered by current paragraphs
(b)(1)(ii)-(iv) of Note G provide sufficient means by which a
registered clearing agency or derivatives clearing organization could
be judged to meet the requirements of paragraph (b)(1) of Note G? If
not, what additional information should be added to meet the
requirements of paragraph (b)(1) of Note G?
Are there clearing agencies or derivatives clearing
organizations that would not meet the remaining standards contained in
paragraph (b)(1) of Note G?
C. Exceptions for Investment Grade Nonconvertible and Asset-Backed
Securities in Rules 101 and 102 of Regulation M
As a prophylactic anti-manipulation set of rules, Regulation M is
designed to
[[Page 26558]]
preserve the integrity of the securities trading market as an
independent pricing mechanism by prohibiting activities that could
artificially influence the market for an offered security. Rules 101
and 102 of Regulation M specifically prohibit issuers, selling security
holders, distribution participants, and any of their affiliated
purchasers, from directly or indirectly bidding for, purchasing, or
attempting to induce another person to bid for or purchase a ``covered
security'' until the applicable restricted period has ended.\51\
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\51\ ``Covered security'' is defined as ``any security that is
the subject of a distribution or any reference security,'' and
``reference security'' is defined as ``a security into which a
security that is the subject of a distribution (`subject security')
may be converted, exchanged, or exercised or which, under the terms
of the subject security, may in whole or in significant part
determine the value of the subject security.'' 17 CFR 242.100.
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Rules 101(c)(2) and 102(d)(2) currently except ``investment grade
nonconvertible and asset-backed securities.'' \52\ These exceptions
apply to nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities that are rated by at least one
NRSRO in one of its generic rating categories that signifies investment
grade. In accordance with Section 939A(b) of the Dodd-Frank Act, the
Commission is proposing to remove the references to credit ratings in
Rules 101(c)(2) and 102(d)(2) and replace them with new standards
relating to the trading characteristics of covered securities.
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\52\ 17 CFR 242.101(c)(2) and 242.102(d)(2).
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1. Background
Historically, the Rule 101(c)(2) and 102(d)(2) exceptions trace
back to a no-action position taken by the staff in 1975 regarding
Exchange Act Rule 10b-6, the predecessor to Rules 101 and 102.\53\ The
lead underwriter of an offering of debentures had written the staff
seeking interpretive guidance because Rule 10b-6 prohibited it from
making markets in the debt securities of the same issuer other than the
security being distributed, as these other securities could be
considered ``of the same class and series'' under Rule 10b-6(a) as the
security being distributed.\54\ The staff, with the Commission's
concurrence, provided no-action relief permitting dealers participating
in a distribution of debt securities of an issuer to bid for or
purchase other outstanding debt securities of such issuer, but required
that the new issue and outstanding issues be subject to certain
investment grade ratings.\55\ In granting relief, the staff emphasized
representations from the underwriter that (1) ``because the non-
convertible bonds of particular issuers are not considered unique and
because of the concept of relative value, it is simply not possible to
manipulate the price of a corporate bond that has broad investor
interest'' and (2) purchasing activities in such securities generally
are ``unlikely to materially affect the price of [a nonconvertible debt
security being offered] because of the availability of large amounts of
securities of other issuers which have comparable quality yield
[spreads].'' \56\
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\53\ Letter from Robert C. Lewis, Associate Director, the
Division of Market Regulation, the Commission to Donald M.
Feuerstein, General Partner and Counsel, Salomon Brothers (Mar. 4,
1975).
\54\ As explained below, the activity for which relief was
sought in this letter would be permissible under Rules 101 and 102
today even without the investment grade securities exceptions or no
action relief because of a change in the securities covered under
Rules 101 and 102 as compared to the securities covered under Rule
10b-6.
\55\ Letter from Robert C. Lewis, Associate Director, the
Division of Market Regulation, the Commission, to Donald M.
Feuerstein, General Partner and Counsel, Salomon Brothers (Mar. 4,
1975).
\56\ Id.
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In 1983, the Commission amended the rule to fully except all
investment grade nonconvertible debt securities from Rule 10b-6.\57\ At
that time, the Commission also added an exception for investment grade
nonconvertible preferred securities. In proposing the rule changes, the
Commission stated that ``it is very difficult, if not impossible, to
manipulate the price of investment grade debt. Investment grade debt
securities are generally thought to trade in accordance with the
concept of relative value, i.e., such securities are to a large degree
fungible,\58\ so that investors generally evaluate new offerings by
looking at comparably rated securities of other issuers.'' \59\
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\57\ Prohibitions Against Trading by Persons Interested in a
Distribution, Exchange Act Release No. 19565 (Mar. 4, 1983), 48 FR
10628 (Mar. 14, 1983). See also Prohibitions Against Trading by
Persons Interested in a Distribution, Exchange Act Release No. 18528
(Mar. 3, 1982), 47 FR 11482 (Mar. 16, 1982). The 1975 letter
included a number of other requirements that were not codified.
Letter from Robert C. Lewis, Associate Director, the Division of
Market Regulation, the Commission, to Donald M. Feuerstein, General
Partner and Counsel, Salomon Brothers (Mar. 4, 1975).
\58\ With regard to whether investment grade nonconvertible
preferred securities are largely fungible with investment grade
nonconvertible preferred securities of other issuers, the Commission
noted that ``[n]onconvertible preferred securities possess some of
the attributes of debt securities and, when rated investment grade,
generally trade on the basis of their value in relation to
comparably-rated offerings of other issuers.'' Prohibitions Against
Trading by Persons Interested in a Distribution, Exchange Act
Release No. 19565 (Mar. 4, 1983), 48 FR 10628 (Mar. 14, 1983). The
Commission further noted that the exceptions are based on the
concept ``that investment grade debt and preferred securities are
traded on the basis of their yields and financial ratings and
therefore are largely fungible.'' Id. The Commission solicits
comment below as to whether this understanding with respect to the
fungibility of nonconvertible preferred securities remains accurate.
\59\ Prohibitions Against Trading by Persons Interested in a
Distribution, Exchange Act Release No. 18528 (Mar. 3, 1982), 47 FR
11482 (Mar. 16, 1982).
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When Rules 101 and 102 of Regulation M were adopted, the Commission
substituted the concept of ``same class and series'' in Rule 10b-6 with
the concept of ``covered securities.'' The Commission clarified that as
a result of this change, ``bids for and purchases of outstanding
nonconvertible debt securities are not restricted unless the security
being purchased is identical in all of its terms to the security being
distributed.'' \60\ The effect of this change in application was that
``as a practical matter, Rule 101 and Rule 102 will have very limited
impact on debt securities, except for the rare situations where selling
efforts continue over a period of time.'' \61\ In contrast, under Rule
10b-6, bids for or purchases of debt securities of the issuer other
than those being distributed could be prohibited if they were similar
to the distributed securities in coupon interest rate and maturity
date.
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\60\ Anti-manipulation Rules Concerning Securities Offerings,
Exchange Act Release No. 38067 (Dec. 20, 1996), 62 FR 520 (Jan. 3,
1997). The Commission noted that ``Rule 101 does not apply to a
security if there is a single basis point difference in coupon rates
or a single day's difference in maturity dates, as compared to the
security in distribution.'' Id.
\61\ Id.
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Investment grade asset-backed securities were also added to the
exception with the adoption of Regulation M.\62\ The application of the
exception to these securities was based on the premise that asset-
backed securities also trade primarily on the basis of yield spread and
credit rating and that asset-backed securities investors are concerned
with ``the structure of the class of securities and the nature of the
assets pooled to serve as collateral for those securities.'' \63\
2. 2008 Proposal
---------------------------------------------------------------------------
\62\ Id.
\63\ Anti-manipulation Rules Concerning Securities Offerings,
Exchange Act Release No. 38067 (Dec. 20, 1996), 62 FR 520 (Jan. 3,
1997).
---------------------------------------------------------------------------
In 2008, the Commission proposed to eliminate NRSRO references to
address concerns that such references contributed to undue reliance on
NRSRO ratings by market participants. Specifically, the Commission
proposed to remove references to NRSRO ratings from the determination
of whether investment grade nonconvertible debt, investment grade
nonconvertible preferred, and investment grade asset-backed securities
would be eligible for
[[Page 26559]]
the Rule 101(c)(2) and 102(d)(2) exceptions, and instead except
nonconvertible debt securities and nonconvertible preferred securities
based on the ``well-known seasoned issuer'' (``WKSI'') concept of
Securities Act Rule 405 and except asset-backed securities that are
registered on Form S-3 (``2008 Regulation M Proposals'').\64\
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\64\ Proposed Rule: References to Ratings of Nationally
Recognized Statistical Rating Organizations, Exchange Act Release
No. 58070 (Jul. 1, 2008), 73 FR 40088 (Jul. 11, 2008).
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Those commenters that addressed the proposed Regulation M changes
expressed uniform opposition to the proposed amendments.\65\ Many of
these commenters stated their view that the proposal is not necessary
to address concerns about investors' undue reliance on NRSRO
ratings.\66\ Commenters also stated that, because the 2008 Regulation M
Proposals would have altered the scope of the exceptions for investment
grade nonconvertible debt securities, investment grade nonconvertible
preferred securities, and asset-backed securities, they would have
placed new burdens on issuers and underwriters by imposing the
restrictions of Regulation M on currently excepted investment grade
securities.\67\ Additionally, commenters expressed the view that
certain high yield securities that are currently subject to Regulation
M, but are arguably more vulnerable to manipulation than securities
currently excepted from Regulation M, would have been excepted from
Rules 101 and 102 of Regulation M under the 2008 Regulation M
Proposals.\68\ These commenters did not suggest any substitute to the
proposed rule changes.\69\
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\65\ We received five comment letters that specifically
addressed the Regulation M proposals and each opposed the proposals.
See Letters from Keith F. Higgins, Chair, Committee on Federal
Regulation of Securities, American Bar Association (``ABA''), to
Florence E. Harmon, Acting Secretary, dated Oct. 10, 2008 (``ABA
Letter''); Robert Dobilas, CEO and President, Realpoint LLC, to
Secretary, dated Sep. 8, 2008; Letter from Jeremy Reifsnyder and
Richard Johns, Co-chairs, American Securitization Forum (``ASF'')
Credit Rating Agency Task Force, to Florence E. Harmon, Acting
Secretary, dated Sep. 5, 2008 (``ASF Letter''); Deborah A.
Cunningham and Boyce I. Greer, Co-chairs, Securities Industry and
Financial Markets Association (``SIFMA'') Credit Rating Agency Task
Force, to Florence E. Harmon, Acting Secretary, dated Sep. 4, 2008
(``SIFMA Letter 1''); and Mayer Brown LLP to Florence E. Harmon,
Acting Secretary, dated Sep. 4, 2008 (``Mayer Brown Letter''). There
were comment letters supportive of the Commission's effort to
minimize undue reliance on NRSRO ratings by market participants,
however, these commenters did not discuss Regulation M. See, e.g.,
Letter from Suzanne C. Hutchinson, Executive Vice President,
Mortgage Insurance Companies of America, to Florence E. Harmon,
Acting Secretary, dated Sep. 5, 2008.
\66\ See, e.g., SIFMA Letter 1 (``Regulation M is primarily
directed at the actions of the issuers of securities and the
investment banks who underwrite them; in contrast, the investors
that the Commission is concerned with are not users of Regulation
M'').
\67\ ABA Letter, SIFMA Letter 1.
\68\ Id.
\69\ The ABA did, however, suggest that should the Commission
insist on using the WKSI standard for investment grade
nonconvertible debt and investment grade nonconvertible preferred
securities, it do so only as an alternative to the current
exceptions at Rules 101(c)(2) and 102(d)(2). ABA Letter. However,
the ABA expressed its ``strong[] belie[f] that the Commission should
retain the current exceptions.'' Id.
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3. 2009 Comment Period Re-Opening
In 2009, the Commission deferred consideration of the 2008
Regulation M Proposals and, in light of the uniform opposition by
commenters and continuing concern regarding the undue influence of
NRSRO ratings, the Commission reopened the comment period for the 2008
Regulation M Proposals.\70\ The Commission received three additional
comment letters.\71\ Of these, two reiterated earlier objections,\72\
and the third argued that the 2008 Regulation M Proposals would have
adverse effects on foreign sovereign issuers of debt securities.\73\
Although the Commission invited commenters to suggest alternative
proposals, no new alternatives were suggested.
---------------------------------------------------------------------------
\70\ References to Ratings of Nationally Recognized Statistical
Rating Organizations, Exchange Act Release No. 60790 (Oct. 5, 2009);
74 FR 52374 (Oct. 9, 2009).
\71\ Letter from Mary Keogh, Managing Director, Regulatory
Affairs and Daniel Curry, President, DBRS, Inc., to Elizabeth M.
Murphy, Secretary, dated Nov. 13, 2009 (``DBRS Letter''); Letter
from Steven G. Tepper, Arnold & Porter LLP, to the Honorable Mary L.
Schapiro, Chairman, dated Dec. 8, 2009 (``Arnold & Porter Letter'');
and Letter from Sean C. Davy, Managing Director, Corporate Credit
Markets Division, SIFMA, to Elizabeth M. Murphy, Secretary, dated
Dec. 8, 2009 (``SIFMA Letter 2'').
\72\ DBRS Letter and SIFMA Letter 2.
\73\ Arnold & Porter Letter.
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4. Current Proposal
In accordance with Section 939A(b) of the Dodd-Frank Act, and in
light of the opposition to the 2008 Regulation M Proposals, the
Commission is proposing new standards to replace the reference to NRSRO
credit ratings in the Regulation M exceptions. Specifically, the
Commission proposes to except nonconvertible debt securities,
nonconvertible preferred securities, and asset-backed securities from
Rules 101 and 102 if they: (1) Are liquid relative to the market for
that asset class; (2) trade in relation to general market interest
rates and yield spreads; and (3) are relatively fungible with
securities of similar characteristics and interest rate yield spreads.
The proposed standards are an attempt to codify the subset of
trading characteristics of investment grade nonconvertible debt
securities, nonconvertible preferred securities, and asset-backed
securities, that make them less prone to the type of manipulation that
Regulation M seeks to prevent. The standards are not intended as
measures of or proxies for assessments of credit risk, or to provide
substitute criteria for whether or not a security would be considered
investment grade.
The application of Rules 101 and 102 of Regulation M to debt
securities is very limited, as compared to Rule 10b-6. The Commission
is interested in comment as to whether and in what circumstances
issuers, selling shareholders, distribution participants, and their
affiliated purchasers rely on the current exception for investment
grade securities (including with respect to specific activities) and,
in particular, whether this exception serves a continuing purpose with
regard to nonconvertible debt and asset-backed securities. The
Commission further solicits comment as to whether, if the application
of Rules 101 and 102 of Regulation M to debt securities is in fact
quite limited as a practical matter, the current investment grade
exception should be eliminated or, alternatively, whether it should be
expanded to except from Rules 101 and 102 all nonconvertible debt
securities, nonconvertible preferred securities, and asset-backed
securities (or some subset thereof).
a. Standards
i. Liquid Relative to the Market for the Asset Class
In order to qualify for the proposed exception, a nonconvertible
debt, nonconvertible preferred, or asset-backed security would need to
be liquid relative to the market for that asset class. The Commission
believes that a high degree of liquidity is an important consideration
in determining which securities should be eligible for the proposed
exception from Rules 101 and 102. In general, the existence of
substantial liquidity is indicative of an established, efficient market
with a large number of participants, which is less likely to be subject
to the type of manipulation with which Regulation M is concerned. Since
this exception would apply primarily to a security for which the
distribution continues after the security begins to trade, the
Commission preliminarily believes that persons seeking to rely on this
exception would be able to adequately identify securities that meet
this standard.
[[Page 26560]]
The Commission seeks comment on the standards that may be
indicative of relative liquidity, such as the size of the issuance, the
percentage of the average daily trading volume by persons other than
the persons seeking to rely on the exception, and the number of market
makers in the security being distributed other than those seeking to
rely on the exception.\74\ Other factors that could be considered
include the overall trading volume of the security, the number of
liquidity providers who participate in the market for the security,
trading volume in similar securities or other securities from the same
issuer, overall liquidity of all outstanding debt issued by the same
issuer, how quickly an investor could be expected to be able to sell
the security after purchase, and, in the case of asset-backed
securities, the liquidity and nature of the underlying assets.\75\
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\74\ See, e.g., Letter from Larry E. Bergmann, Senior Associate
Director, Division of Market Regulation, the Commission, to Alan J.
Sinsheimer, Sullivan & Cromwell (Jan. 12, 2000).
\75\ This list is merely illustrative and should not be
considered a necessary or exhaustive list of the factors that could
reasonably be considered in evaluating liquidity.
---------------------------------------------------------------------------
ii. Trade in Relation to General Market Interest Rates and Yield
Spreads
A nonconvertible debt security, nonconvertible preferred security,
or asset-backed security also would need to trade at prices that are
primarily driven by general market interest rates and spreads
applicable to a broad range of similar securities. This standard would
limit the exception's availability to those securities that trade in
relation to changes in broader interest rates (i.e., based on their
comparable yield spreads), as opposed to securities that trade in
relation to issuer-specific information or credit quality.\76\ This
characteristic affords market participants the ability to use general
market rates to make their own estimates of the value of such a
security and whether such security is trading at prices outside of
expected ranges. It would be more difficult for market participants to
make such an independent judgment if the security traded in an
idiosyncratic fashion based primarily on its specific characteristics,
such that the traded price of the security could not readily be
compared to similar issues. As noted above, investment grade
nonconvertible debt, investment grade nonconvertible preferred, and
investment grade asset-backed securities were originally excepted in
part because they trade in relation to general market interest rates
and yield spreads.
---------------------------------------------------------------------------
\76\ This was an important distinction for the Commission when
adopting the current exceptions. ``Investors are therefore more
likely to compare yields of new non-investment grade debt offerings
with those of outstanding debt securities of the same issuer.''
Prohibitions Against Trading by Persons Interested in a
Distribution, Exchange Act Release No. 18528 (Mar. 3, 1982), 47 FR
11482 (Mar. 16, 1982).
---------------------------------------------------------------------------
iii. Relatively Fungible With Securities of Similar Characteristics and
Interest Rate Yield Spreads
Finally, a nonconvertible debt, nonconvertible preferred, or asset-
backed security would need to be relatively fungible (in terms of
trading characteristics) with similar securities, i.e., securities with
similar interest rate yield spreads, in order to qualify for the
proposed exception. This standard, along with the requirement that the
security trade in relation to general market interest rates and yield
spreads explained above, is an attempt to codify a further trading
characteristic of the investment grade securities that are currently
excepted from Rules 101 and 102. Together with the standard regarding
trading in relation to general market interest rates and yield spreads,
the Commission preliminarily believes that the fungibility requirement
would limit the proposed exception to those securities that pose little
risk of manipulation.
Being ``relatively fungible'' for these purposes would not require
that the security, for example, be deliverable for a purchase order for
a different security, but rather that a portfolio manager would be
willing to purchase the security in lieu of another security that has
similar characteristics (i.e., yield spreads, credit risk, etc.).
Securities with these characteristics would be less prone to market
squeezes or other forms of manipulation. Note that in order to satisfy
this requirement, a security need not be completely fungible for all
purposes with another security that has similar characteristics.
The Commission preliminarily believes that persons seeking to rely
on the exception would be able to objectively demonstrate these three
standards were met.
b. Evaluation of the Security
The proposal would require the person seeking to rely on the
exception to make the determination that the security in question is
liquid relative to the market for the asset class, trades in relation
to general market interest rates and yield spreads, and is relatively
fungible with securities of similar characteristics and interest rate
yield spreads. The determination must be made utilizing reasonable
factors of evaluation and must be subsequently verified by an
independent third party.
Each person seeking to rely on the exception would be required to
assess the standards laid out in the proposal with regard to the
specific nonconvertible debt, nonconvertible preferred, or asset-backed
security being distributed. Persons would be required to exercise
reasonable judgment in conducting this analysis. Sole reliance on a
third party's determination without any further analysis would not be
considered to be based on reasonable judgment. Persons seeking to rely
on the exception would need to demonstrate compliance with the
requirements of this provision.
c. Third Party Verification
In addition to making a determination that the nonconvertible debt,
nonconvertible preferred, or asset-backed security reasonably meets the
standards of the proposed exception, a person seeking to rely upon the
exception also would be required to obtain a verification of this
determination by an independent third party. Each person seeking to
rely on the exception would be required to make a reasonable
determination of the independence and qualifications of a third party
for this purpose, based on the third party's relevant professional
background, experience, knowledge, and skills. Counsel to, or other
affiliates of, the underwriter or issuer, would not meet the
independence requirement.\77\ Persons seeking to rely on the exception
may be best positioned in the first instance to evaluate all of the
factors that would be relevant to the determination, but they also
would have an inherent conflict of interest. The third party
verification requirement is intended to provide a reliable check on the
reasonableness of that determination.
---------------------------------------------------------------------------
\77\ This is not an exhaustive list of persons who would not be
considered to be independent.
---------------------------------------------------------------------------
The Commission intends by this proposal generally to except the
same types and amounts of securities that are currently excepted in
Rules 101(c)(2) and 102(d)(2) without referencing credit ratings. To
that end, the Commission is interested in comments on any added costs
or other effects that the requirement of independent third party
verification in particular may have in distributions of nonconvertible
debt, nonconvertible preferred, and asset-backed securities that would
result in making the exception less available than it is today. To the
extent that the need to obtain a third party verification increases the
costs that a person must
[[Page 26561]]
incur in order to benefit from the exception for these securities from
Rules 101 and 102 of Regulation M, the Commission seeks comment as to
what those costs are and whether such costs in at least some cases
would result in persons who currently rely on the exception determining
not to do so. This in turn may effectively expand the circumstances in
which Rules 101 and 102 of Regulation M apply, as compared to the
status quo. Thus, an increase in costs resulting from the third party
verification that is sufficient to alter the behavior of market
participants may reduce the practical benefit of the exception.
The Commission also specifically solicits comment regarding the
type of entity that would be considered an acceptable independent third
party for purposes of this exception. For example, the Commission seeks
comment as to whether to limit the acceptable independent third parties
to those who could meet the definition of ``qualified independent
underwriter'' for purposes of the SRO rules,\78\ which could provide a
familiar bright line standard. The Commission also seeks comment as to
whether to limit the acceptable independent third parties to only
entities that are registered with the Commission, which would ensure
that the Commission has examination authority over those persons acting
as independent third party verifiers. The Commission further seeks
comment as to whether the proposal should limit the number of times a
person seeking to rely on the exception could rely on the same
independent third party.
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\78\ See Financial Industry Regulatory Authority (``FINRA'')
Rule 5121(f)(12). This rule generally requires that a qualified
independent underwriter be a FINRA member, have no conflict of
interest in the offering, not be an affiliate of a FINRA member that
does have a conflict of interest, not beneficially own more than 5%
of the class of securities that would give rise to a conflict of
interest, have agreed in writing to be a qualified independent
underwriter and undertake the legal responsibilities and liabilities
of an underwriter under the Securities Act, have specific offering
experience, and not have any supervisory associated persons who are
responsible for organizing, structuring, or performing due diligence
with respect to corporate public offerings of securities that have
certain disciplinary histories.
---------------------------------------------------------------------------
5. Request for Comment
We solicit comments on all aspects of this proposal. We ask that
commenters provide specific reasons and information to support
alternative recommendations. Please provide empirical data, when
possible, and cite to economic studies, if any, to support alternative
approaches.
How often are these exceptions utilized where no other
exception from Rules 101 or 102 of Regulation M exists?
Should the Commission remove the exception from Rules 101
and 102 of Regulation M for nonconvertible debt securities,
nonconvertible preferred securities, and/or asset-backed securities
completely? Why or why not? What specific trading activities that
currently occur pursuant to the exception would then be prohibited
during the restricted period because no other exception is available?
What are the advantages and disadvantages of such trading activities?
Should the Commission explicitly except any such specific activities in
lieu of providing a generic exception for investment grade
nonconvertible debt securities, nonconvertible preferred securities,
and/or asset-backed securities? What benefits or challenges would this
approach create?
Should the Commission expand the exception to cover all
nonconvertible debt securities, nonconvertible preferred securities,
and asset-backed securities? What activities would then be allowed that
were previously prohibited under Rules 101 and 102 of Regulation M?
Would these new activities have any manipulative risk? Why or why not?
Would the nonconvertible debt, nonconvertible preferred,
and asset-backed securities excepted in the proposal be more vulnerable
to manipulation than securities that meet the existing investment grade
standard? Why or why not?
Are the proposed standards an appropriate substitute for
credit ratings in this context? Would the proposal capture the same
type and quantity of securities that fall within the current Rule
101(c)(2) and Rule 102(d)(2) exceptions? What effect(s), if any, would
the proposed modifications to the current exception have on the markets
for nonconvertible debt, nonconvertible preferred and asset-backed
securities?
How difficult and costly in practice would the
requirements of the proposed exception be to apply? If the requirements
are more difficult or costly to apply, how might this impact the scope
of securities subject to the restrictions of Regulation M? For example,
to what extent, if any, might a narrower range of securities meet the
exceptions as a result of the proposal, if adopted? If fewer securities
are excepted from the restrictions of Regulation M, in what ways and to
what extent, if any, would this impact the market for those securities
that would no longer qualify for the exception?
Will fewer nonconvertible debt securities, nonconvertible
preferred securities, and asset-backed securities issues meet the
requirements for these exceptions? If so, what impact would this
proposal have on the market for new issues of these securities?
Please discuss whether and to what extent investors rely
upon the current Rule 101(c)(2) and 102(d)(2) exceptions for investment
grade nonconvertible and asset-backed securities when making a decision
to invest in such securities. Please also discuss whether, given that
Rules 101 and 102 of Regulation M are directed at distribution
participants, issuers, and selling securities holders, Rules 101 and
102 of Regulation M pose any danger of undue reliance on NRSRO ratings.
Are there factors other than those identified in the
proposed standards that influence the trading of such securities? Are
there additional standards that the Commission should consider? Are
there any that the Commission should remove from the proposal?
Should the proposed standards apply equally to
nonconvertible debt, nonconvertible preferred, and asset-backed
securities, or are there other standards that would be relevant to
consider based on the type of security involved?
Would persons needing to use the proposed exception have
access to adequate information to determine whether a particular
security meets the exception? Why or why not?
Is the Commission's position (expressed at the time the
exception was initially adopted) \79\ that preferred securities are
generally fungible with similar quality preferred securities still
valid? Has the market for preferred securities changed to the extent
that these securities are no longer generally fungible with similar
quality preferred securities? If so, to what extent has the market
changed? Rules 101(c)(2) and 102(d)(2) of Regulation M currently except
investment grade nonconvertible preferred securities. Is this exception
still relevant in the current marketplace for preferred securities?
What would be the potential adverse consequences if preferred
securities were no longer excepted from Rules 101 and 102?
---------------------------------------------------------------------------
\79\ Prohibitions Against Trading by Persons Interested in a
Distribution, Exchange Act Release No. 19565 (Mar. 4, 1983), 48 FR
10628 (Mar. 14, 1983).
---------------------------------------------------------------------------
With regard to asset-backed securities, should the
determination on behalf of the issuer that the security meets the
proposed factors be made by the sponsor or depositor of the asset-
backed security, or some other person? Please explain. What kinds of
conflicts
[[Page 26562]]
of interest may arise in this situation relating to sponsors or
depositors? For instance, the Commission could propose the following
rule text: ``With respect to an asset-backed security, the term issuer
includes a sponsor, as defined in Sec. 229.1011 of this chapter, or
depositor, as defined in Sec. 229.1011 of this chapter, that
participates in the issuance of an asset-backed security.'' Does this
further the goal of Regulation M and the reasons for the exception?
What benefits or costs would be associated with this change?
What impact, if any, will the potential costs of obtaining
an independent third party verification have on the market for new
issues of nonconvertible debt securities, nonconvertible preferred
securities, and asset-backed securities? If these costs will have an
impact, please explain how.
Other than NRSROs, are there entities such as independent
research firms or investment banks not involved in the distribution
that would be willing and able to serve as independent third parties
for these purposes?
What additional costs, if any, will the requirement to use
an independent third party for purposes of the third party verification
proposal add to a distribution as compared to the current requirements
of Rules 101(c)(2) and 102(d)(2)?
Would the independent third party verification, if
adopted, alter the amount or types of securities that can rely on the
exception?
What factors should be considered in qualifying an
independent third party for purposes of the third party verification
proposal?
Does the independent third party verification requirement
adequately address potential issuer, selling shareholder, distribution
participant, and affiliated purchaser conflicts of interest?
Would it be appropriate to utilize the definition, in
whole or in part, of ``qualified independent underwriter'' from the SRO
rules in establishing who may be an independent third party for
purposes of the third party verification proposal? What are the
benefits or drawbacks to utilizing this standard? What other
alternatives should the Commission consider?
The Commission would expect, if such an interpretation
would be adopted, that the definition of ``qualified independent
underwriter'' for these purposes would be similar to the requirements
of FINRA Rule 5121(f)(12) and generally require that such persons (1)
be registered with an SRO; (2) have no conflict of interest in the
offering; (3) not be an affiliate of a person that does have a conflict
of interest; (4) not beneficially own more than 5% of the class of
securities that would give rise to a conflict of interest; (5) have
agreed in writing to be a qualified independent underwriter and
undertake the legal responsibilities and liabilities of an underwriter
under the Securities Act; (6) have specific offering experience; and
(7) not have any supervisory associated persons who are responsible for
organizing, structuring, or performing due diligence with respect to
corporate public offerings of securities that have certain disciplinary
histories. Would all of these requirements be appropriate? Are any of
these requirements unnecessary?
Should the Commission limit the eligibility to be an
independent third party for purposes of the third party verification
proposal to those registered with the Commission in some capacity? What
are the benefits or drawbacks to utilizing this standard? What other
alternatives should the Commission consider?
In order to protect an independent third party verifier's
independence, should the Commission limit the frequency with which a
person could rely on the same independent third party for purposes of
the third party verification proposal?
Should the Commission instead require only that persons
seeking to rely on the exception make a reasonable determination that
the proposed factors are present in the security being offered, without
any independent third party verification? If so, should the concern
about conflicts of interest be addressed and how? What benefits would
this approach provide? What other concerns could this approach raise?
What are the risks of allowing parties to use internal
processes to make determinations of reasonableness? For example, would
parties be likely to adopt procedures that maximize the opportunity to
take advantage of the exception? Would increased cost efficiencies
arising from internal processes outweigh the conflicts of interest
presented? How likely are there to be instances where a determination
under the proposed amendments would result in a party qualifying for
the exception when it would not have qualified under the current
standard? How might the Commission attempt to mitigate such risks?
Should the Commission, in lieu of the third party
verification requirement, require that any person seeking to rely on
the exception disclose in the offering documents relating to the
distribution: (1) That the person is relying on the relevant exception;
(2) that the person has undertaken diligent review and, utilizing the
factors identified in this proposal, reasonably concluded that the
security meets the proposed factors; (3) the factors identified in the
proposal and used by the person to make its conclusions; and (4) that
the person or affiliated purchasers will be purchasing or bidding
during the restricted period (if that is in fact the case)? Would this
approach also address concerns about the cost and effectiveness of
independent third party verification and have the added benefit of full
disclosure to investors? Would this approach present costs that do not
arise under the current exceptions? What other representations should
be included in the offering documents if this approach is taken? What
benefits would this approach provide? What other concerns could this
approach raise?
Should the Commission permit the third party verification
requirement to be deemed satisfied if one of the purchasers of the
security is an unaffiliated regulated entity, such as a money market
fund \80\ or a broker-dealer that determines that the lesser haircut
would apply to the security under the Net Capital Rule proposal above?
\81\ Such entities might be required to make their own determination
regarding the creditworthiness of the security. Could this
creditworthiness determination provide the benefits of an independent
third party verifier (i.e., an independent assessment of the security)
without the cost of retaining such a verifier? What benefits would this
approach provide? What other concerns could this approach raise? Would
the timing of a distribution allow for this determination to be made
prior to the beginning of the restricted period? Are there other
entities that should be included under this alternative, and if so,
which entities and why?
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\80\ See References to Credit Ratings in Certain Investment
Company Act Rules and Forms, Investment Company Act Release No.
29592 (Mar. 3, 2011), 76 FR 12896 (Mar. 9, 2011).
\81\ See Section II.A.1, supra.
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Should persons subject to Rules 101 or 102 be able to rely
on the determination of another person in the underwriting syndicate
who is seeking to rely on the exception in connection with the same
distribution or should all distribution participants, issuers, selling
security holders, or affiliated purchasers be required to make their
own determinations?
The proposed criteria that, if satisfied, would except a
specific security from Rules 101 and 102 of Regulation M, are designed
to identify those characteristics of a security that
[[Page 26563]]
would correlate with whether or not such a security was susceptible to
manipulation during a time when it was distributed. Previously these
criteria were considered to be met if the security had an investment
grade rating. In proposing the criteria above, the Commission has
focused on those trading-oriented characteristics of securities that
the Commission believes (a) may be typical of securities with an
investment grade rating, and (b) that are relevant to the question
about manipulation. However, the Commission also notes that another
common characteristic of securities with an investment grade rating is
credit quality, and hence price or yield spread. Is credit quality
alone a good determinant of whether or not a security is susceptible to
manipulation under the conditions in which Rules 101 and 102 of
Regulation M is concerned? Why or why not? If so, given the required
removal of any reference to a security's rating, how would credit
quality be measured for the purposes of this rule? Would the price or
yield of a security be a good proxy for credit quality? If so, should
the Commission except nonconvertible debt securities, nonconvertible
preferred securities, and asset-backed securities based on a specific
premium to the London Interbank Offered Rate (``LIBOR'') at pricing?
Would the defined yield spread be difficult to determine for securities
that are difficult to price? Would this approach lead to market
participants adjusting the price of securities at issuance, delaying
issuance, or engaging in other activities solely to obtain the
exception? Is LIBOR an appropriate rate on which to base this test or
would other rates be more appropriate? If such an approach was
utilized, is at pricing the appropriate time at which to compare the
rates? How should the spreads be calculated? Would nonconvertible
preferred securities and asset-backed securities be able to continue to
rely on the exception under this proposal? Would persons seeking to
rely on the exception be able to determine this information before the
beginning of the restricted period? What benefits would this approach
provide? What other concerns could this approach raise? How difficult
will it be to predict, ahead of issuance, what the new issue's yield
spread to the reference rate will be at the time the issue is priced?
What is the expected economic effect of difficulty in predicting the
yield spread at the time of pricing? Would the number of issues brought
to market be impacted?
With regard to asset-backed securities, should the
Commission, in place of or in addition to the proposed amendment,
except asset-backed securities that would meet the requirements for
shelf eligibility for such securities as recently proposed by the
Commission? \82\ This would provide a bright line test for these
securities but may alter the universe of asset-backed securities that
could rely on the exceptions. What benefits would this approach
provide? What other concerns could this approach raise? How would this
approach address potential conflicts of interest involving the issuer,
selling shareholder, distribution participant, or affiliated purchaser?
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\82\ Asset-Backed Securities, Exchange Act Release No. 61858
(Apr. 7, 2010), 75 FR 23328 (May 3, 2010). This proposal would
extend shelf eligibility to asset-backed securities where (1) a
certification is filed at the time of each offering off of a shelf
registration statement by the chief executive officer of the
depositor that the assets in the pool have characteristics that
provide a reasonable basis to believe that they will produce, taking
into account internal credit enhancements, cash flows to service any
payments due and payable on the securities as described in the
prospectus; (2) the sponsor retains a specified amount of each
tranche of the securitization, net of the sponsor's hedging; (3) a
provision in the pooling and servicing agreement requires the party
obligated to repurchase the assets for breach of representations and
warranties to periodically furnish an opinion of an independent
third party regarding whether the obligated party acted consistently
with the terms of the pooling and servicing agreement with respect
to any loans that the trustee put back to the obligated party for
violation of representations and warranties and which were not
repurchased; and (4) the issuer makes an undertaking to file
Exchange Act reports so long as non-affiliates of the depositor hold
any securities that were sold in registered transactions backed by
the same pool of assets.
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Should the Commission except nonconvertible debt
securities and nonconvertible preferred securities based on trading
volume and outstanding relevant securities of the issuer? For example,
the Commission could except nonconvertible debt securities where the
issuer has at least $1 billion in outstanding debt and the trading
volume of the outstanding debt securities of that issuer equaled or
exceeded 100% turnover over a six month period, excluding trading by
persons claiming the exception. This would have the benefit of
establishing a bright line standard and is similar to the actively-
traded securities exception found in Rule 101,\83\ but may except a
different universe of securities, be difficult to determine for
securities that are hard to value, and would not be available to
securities of new issuers. What benefits would this approach provide?
What other concerns could this approach raise? Would such an exception
tailored for nonconvertible preferred (referencing $1 billion
outstanding equity and trading volume of the issuer's nonconvertible
preferred securities) be appropriate? What other changes would need to
be made in order to make the exception available to preferred
securities generally? Are there different numerical thresholds that are
better able to replicate the universe of currently excepted
nonconvertible debt securities and preferred securities? If the
Commission replaced the current criteria with a volume test, how much
effort on the part of intermediaries would be required to demonstrate
that a volume threshold was met? How difficult would it be for
financial intermediaries to gather volume statistics? What would the
range of associated costs be? If it was necessary under the volume test
to exclude trading by persons subject to Rules 101 or 102, would that
information be available to financial intermediaries? Are there other
numerical tests of this type that would be more appropriate? How would
this approach address potential conflicts of interest involving the
issuer, selling shareholder, distribution participant, or affiliated
purchaser?
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\83\ 17 CFR 242.101(c)(1).
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Should underwriters be required to keep records
demonstrating their eligibility for the exception as modified by the
proposal? Should underwriters be required to obtain records from the
issuer or selling shareholder demonstrating eligibility for the
exception as modified by the proposal and keep them? What records
should be kept?
Please comment generally on any relevant changes to the
debt markets since Regulation M was adopted in 1996 and how these
developments should affect the Commission's evaluation of the proposed
amendments.
D. Proposed Amendments to Rule 10b-10
Exchange Act Rule 10b-10,\84\ the Commission's customer
confirmation rule, generally requires broker-dealers effecting
transactions for customers in securities, other than U.S. savings bonds
or municipal securities,\85\ to provide those customers with a written
notification, at or before completion of the securities transaction,
disclosing certain information about the terms of the transaction.
Specifically, Rule 10b-10 requires the disclosure of the date, time,
identity, and number of securities bought or sold; the capacity in
which the broker-dealer acted (e.g., as agent or
[[Page 26564]]
principal); yields on debt securities; and under specified
circumstances, the amount of compensation the broker-dealer will
receive from the customer and any other parties. By requiring these
disclosures, the rule serves a basic customer protection function by
conveying information that: (1) Allows customers to verify the terms of
their transactions; (2) alerts customers to potential conflicts of
interest; (3) acts as a safeguard against fraud; and (4) allows
customers a means of evaluating the costs of their transactions and the
quality of the broker-dealer's execution.
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\84\ 17 CFR 240.10b-10.
\85\ Municipal securities are covered by Municipal Securities
Rulemaking Board rule G-15, which applies to all municipal
securities brokers and dealers.
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Paragraph (a)(8) of Rule 10b-10, which the Commission adopted in
1994, requires a broker-dealer to inform the customer in the
confirmation if a debt security, other than a government security, is
unrated by an NRSRO.\86\ As explained in the 1994 Adopting Release,
paragraph (a)(8) was intended to alert customers to the potential need
to obtain more information about a security from a broker-dealer; \87\
it was not intended to suggest that an unrated security is inherently
riskier than a rated security. Rule 10b-10 does not require broker-
dealers to disclose in customer confirmations the NRSRO rating for
securities that are rated, although the Commission understands that
some broker-dealers may do so voluntarily. The Commission has
previously proposed, and re-proposed, the deletion of paragraph (a)(8)
from Rule 10b-10.\88\ The Commission's previous proposals to delete
paragraph (a)(8) were prompted by concerns regarding the undue reliance
on NRSRO ratings and confusion about the significance of those ratings.
Section 939A of the Dodd-Frank Act requires the Commission to replace
references to NRSRO ratings in its rules, where these act as a proxy
for creditworthiness, with a different standard of creditworthiness.
Because paragraph (a)(8) of Rule 10b-10 does not refer to NRSRO ratings
as a means of determining creditworthiness, this provision does not
come strictly within Section 939A's requirements. Nevertheless, the
Commission preliminarily believes that to the extent that the provision
is intended to focus investor attention on ratings issued by NRSROs, as
distinct from other items of information, deleting it is consistent
with the intent of the Dodd-Frank Act. Accordingly, the Commission is
now re-proposing to delete paragraph (a)(8) from Rule 10b-10.\89\
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\86\ See Confirmation of Transactions, Exchange Act Release No.
34962 (Nov. 10, 1994), 59 FR 59612 (Nov. 17, 1994) (``1994 Adopting
Release'').
\87\ Id. The Commission stated that ``[i]n most cases, this
disclosure should verify information that was disclosed to the
investor prior to the transaction. If the customer was not
previously informed on the security's unrated status, the
confirmation may prompt a dialogue between the customer and the
broker-dealer.''
\88\ See, e.g., References to Ratings of Nationally Recognized
Statistical Rating Organizations, Exchange Act Release No. 60790
(Oct. 5, 2009), 74 FR 52374 (Oct. 9, 2009); Proposed Rule:
References to Ratings of Nationally Recognized Statistical Rating
Organizations, Exchange Act Release No. 58070 (Jul. 1, 2008), 73 FR
40088 (Jul. 11, 2008).
\89\ Consistent with that change, the Commission is also
proposing to redesignate paragraph (a)(9) of the rule, related to
broker-dealers that are not members of the Securities Investor
Protection Corporation (``SIPC''), as paragraph (a)(8).
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However, the Commission wishes to consider the relative benefits of
retaining this information in the customer confirmation against the
benefits of removing it. The Commission notes that the current
requirement to disclose the unrated status of a debt security provides
investors with an item of factual information that is conveyed together
with additional factual information about the terms of the transaction.
The Commission also notes that if this provision were deleted from Rule
10b-10, broker-dealers would not be prohibited from continuing to
provide this disclosure on a voluntary basis.\90\ The Commission
requests comment on the following:
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\90\ Indeed, based on a limited review of customer
confirmations, the Commission understands that in addition to
disclosing the unrated status of a security, some broker-dealers may
also voluntarily include the NRSRO ratings for rated securities.
---------------------------------------------------------------------------
Would the investor protection function of Rule 10b-10 be,
in any way, diminished by deleting paragraph (a)(8) from the rule? Are
there are any alternative means of providing this information to
customers?
What types of securities would typically be unrated by an
NRSRO? What types of issuers would typically not have their securities
rated by an NRSRO?
Could the disclosure that a security is unrated be removed
from a customer confirmation without causing customer confusion? If so,
given the historical use and investor expectations related to this
disclosure, could it be removed without implying that a security is in
fact rated? Should broker-dealers be required to alert customers that
the unrated status of a security is no longer being disclosed? If so,
for how long?
The preliminary note to Rule 10b-10 provides: ``This
section requires broker-dealers to disclose specified information in
writing to customers at or before completion of a transaction. The
requirements under this section that particular information be
disclosed is not determinative of a broker-dealer's obligation under
the general antifraud provisions of the federal securities laws to
disclose additional information to a customer at the time of the
customer's investment decision.'' If paragraph (a)(8) were deleted,
would the preliminary note to Rule 10b-10 affect a broker-dealer's
decision to nonetheless continue to voluntarily disclose whether a
security is unrated?
If paragraph (a)(8) were deleted, is there a disclosure
that should be required in the confirmation on a transitional or
permanent basis that would help prevent customer confusion? For
example, should the Commission require broker-dealers, either
permanently or temporarily for a transition period, to disclose that
broker-dealers are no longer required to include on the confirmation
the fact that a security is unrated? Should such a disclosure be made
on the confirmation, the account statement, or in a separate document
accompanying the confirmation or account statement? What are the costs
associated with providing this disclosure on the confirmation, the
account statement or in a separate document?
If the requirement to disclose that a security is unrated
were deleted from Rule 10b-10, would broker-dealers nevertheless feel
compelled to include the disclosure in order to satisfy their sales
practice obligations?
Should the requirement to disclose that a security is
unrated be replaced by a requirement to provide a general statement
regarding the importance of considering an issuer's creditworthiness?
If the requirement to disclose that a security is unrated
were deleted from the rule, are there alternative external or objective
measures of credit risk that could be substituted for ratings by an
NRSRO? Is it practicable to replace it with a requirement to disclose
specific information regarding an issuer's creditworthiness? If so,
what specific information should the Commission consider including?
III. Requests for Comment on Section 939(e) of Dodd-Frank
Section 939(e) of the Dodd-Frank Act \91\ deleted Exchange Act
references to credit ratings by NRSROs in Exchange Act Section
3(a)(41),\92\ which defines the term ``mortgage related security,'' and
in Exchange Act Section 3(a)(53),\93\ which defines the term ``small
business related security.'' The credit rating references in Sections
3(a)(41) and 3(a)(53) effectively exclude from the respective
definitions
[[Page 26565]]
securities that otherwise meet the definitions but are not rated by at
least one NRSRO in the top two credit rating categories in the case of
mortgage related securities or in the top four credit rating categories
in the case of small business related securities. In place of the
credit rating references, Congress added language stating that a
mortgage related security and a small business related security will
need to satisfy ``standards of credit-worthiness as established by the
Commission.'' \94\ This replacement language will go into effect on
July 21, 2012 (i.e., two years after the Dodd-Frank Act was signed into
law).\95\ Thus, before that time, the Commission will need to establish
a new standard of creditworthiness for each Exchange Act definition. As
is discussed below, the Commission is requesting comment on potential
``standards of credit-worthiness'' for purposes of Sections 3(a)(41)
and 3(a)(53) as the Commission considers how to implement Section
939(e) of the Dodd-Frank Act.
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\91\ See Public Law 111-203 Sec. 939(e).
\92\ 15 U.S.C. 78a(3)(a)(41).
\93\ 15 U.S.C. 78a(3)(a)(53).
\94\ See Public Law 111-203 Sec. 939(e)(1) and (e)(2).
\95\ See Public Law 111-203 Sec. 939(g).
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A. Exchange Act Section 3(a)(41)
Congress defined the term ``mortgage related security'' in Section
3(a)(41) as part of the Secondary Mortgage Market Enhancement Act of
1984 (``SMMEA'').\96\ SMMEA was intended to encourage private sector
participation in the secondary mortgage market by, among other things,
relaxing certain regulatory burdens that affected the ability of
private-label issuers \97\ to sell their mortgage-backed
securities.\98\ For example, SMMEA removed obstacles for privately
sponsored mortgage-backed securities by, among other things, pre-
empting certain state investment laws so that state regulated
institutions might purchase privately sponsored mortgage-backed
securities to the same extent as agency securities, granting authority
for certain depository institutions to invest in these securities, and
requiring states to exempt privately sponsored mortgage-backed
securities from state registration to the same extent as agency
securities, unless the state specifically deemed otherwise.\99\ A
security that qualifies as a mortgage related security, as defined in
Section 3(a)(41), receives the benefits intended by SMMEA.\100\
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\96\ Public Law 98-440, Sec. 101, 98 Stat. 1689 (1984).
\97\ Most mortgage-backed securities are issued by the
Government National Mortgage Association (``Ginnie Mae''), a U.S.
government agency, or the Federal National Mortgage Association
(``Fannie Mae'') and the Federal Home Loan Mortgage Corporation
(``Freddie Mac''), U.S. government-sponsored enterprises. Ginnie
Mae, backed by the full faith and credit of the U.S. government,
guarantees that investors receive timely payments. Fannie Mae and
Freddie Mac also provide certain guarantees and, while not backed by
the full faith and credit of the U.S. government, have special
authority to borrow from the U.S. Treasury. Some private
institutions, such as brokerage firms, banks, and homebuilders, also
securitize mortgages, known as ``private-label'' mortgage
securities.
\98\ The legislation was aimed at encouraging participation in
the secondary mortgage market by investment banks, investment
entities, mortgage bankers, private mortgage insurance companies,
pension funds and other investors, depositary institutions and
federal credit unions. See Kenneth G. Lore & Cameron L. Cowan,
Mortgage-Backed Securities; Developments and Trends in the Secondary
Market 2-39 (2001), at 1-14. See also Edward L. Pittman, Economic
and Regulatory Developments Affecting Mortgage Related Securities,
64 Notre Dame L. Rev. 497, 499 (1989).
\99\ See Protecting Investors: A Half Century of Investment
Company Regulation, Division of Investment Management (May 1992).
\100\ See Pittman supra note 98, at 514.
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Generally, Section 3(a)(41) defines the term ``mortgage related
security'' as a ``security that is rated in one of the two highest
rating categories by at least one [NRSRO],'' which (1) represents
ownership of one or more promissory notes, or interests therein, which
notes (a) are directly secured by a first lien on a single parcel of
real estate upon which is located a dwelling or mixed residential and
commercial structure, or on a residential manufactured home or one or
more parcels of real estate upon which is located one or more
commercial structures and (b) were originated by a savings or banking
institution approved for insurance by the Secretary of the U.S.
Department of Housing and Urban Development; or (2) is secured by one
or more promissory notes, or interests therein, and provides for
payments of principal in relation to payments, or reasonable
projections of payments, on notes, or interests therein, meeting the
requirements specified above.
When Congress adopted SMMEA, it used NRSRO ratings to specify
mortgage related securities that qualify for benefits under the
legislation. As reflected in Section 939(e) of the Dodd-Frank Act,
Congress has chosen to no longer rely on credit ratings by NRSROs to
make this distinction, and instead has instructed the Commission to
establish a new standard of creditworthiness that does not rely on
credit ratings by NRSROs. Before acting on this authority, the
Commission invites interested persons to submit written comments on
potential alternatives the Commission should consider for purposes of
implementing Section 939(e) of the Dodd-Frank Act.
One potential alternative the Commission is considering is a new
rule under the Exchange Act that would apply the ``minimal amount of
credit risk'' standard the Commission is proposing with respect to the
Net Capital Rule, as described above, to persons assessing whether a
security is a mortgage related security within the meaning of Section
3(a)(41). The Commission preliminarily believes that the proposed
minimal amount of credit risk standard for mortgage related securities
would be consistent with the intended objective in Section 3(a)(41) of
excluding from the definition mortgage related securities of lesser
credit quality. The Commission further believes that the factors set
forth above for facilitating determinations by broker-dealers as to
whether a security satisfies the minimal amount of credit risk standard
under the Net Capital Rule could facilitate determinations by others as
to when mortgage related securities are subject to a minimal amount of
credit risk under Section 3(a)(41). The Commission notes, however, that
nonconvertible debt and preferred stock are currently required to be
rated in one of the four highest credit rating categories by two NRSROs
to qualify for reduced haircuts under the Net Capital Rule, and that a
mortgage related security that qualifies as such under the current
definition of that term in Section 3(a)(41) is required to satisfy a
slightly more stringent level of credit quality (i.e., to be rated in
one of the two highest rating categories of one NRSRO).
B. Exchange Act Section 3(a)(53)
Congress defined the term ``small business related security'' in
Section 3(a)(53) as part of the Riegle Community Development and
Regulatory Improvement Act of 1994 (the ``CDRI'').\101\ Among other
things, the CDRI removed limitations on purchases by national banks of
certain small business-related securities. The stated intent of
Congress in the CDRI was to increase small business access to capital
by removing impediments in existing law to the securitizations of small
business loans.\102\ The CDRI built on the framework for
securitizations established by SMMEA to create a similar framework for
these securities with the goal of stimulating the flow of funds to
small businesses.
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\101\ Public Law 103-325, Sec. 202, 108 Stat. 2198 (1994).
\102\ See Conference Report on the CDRI, Vol. 140 Cong. Record,
pp. H6685, H6690 (Aug. 2, 1994). See also Remarks of Sen. Domenici,
Vol. 140 Cong. Record, p. S11039, S11043-43 (Aug. 2, 1994)
(discussing national banks' authority to purchase commercial
mortgage related securities under conditions established by the
Office of the Comptroller of the Currency).
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Generally, Section 3(a)(53) defines the term ``small business
related security'' as ``a security that is rated in one of the four
highest rating categories by at least
[[Page 26566]]
one [NRSRO]'' and either (i) represents an interest in promissory notes
or leases of personal property evidencing the obligation of a small
business concern and originated by an insured depository institution
supervised and examined by federal or state authority or certain other
regulated types of issuers, or (ii) is secured by promissory notes or
leases of personal property (with or without recourse to the issuer or
lessee) and provides for payments of principal in relation to payments,
or reasonable projections of payments, on notes or leases of the type
described in the preceding clause.
When Congress adopted the term ``small business related security''
in the CDRI, it used NRSRO ratings to specify small business related
securities that would qualify for benefits under the legislation. As
reflected in Section 939(e) of the Dodd-Frank Act, Congress has chosen
to no longer rely on credit ratings by NRSROs to make this distinction,
and instead has instructed the Commission to establish a new standard
of creditworthiness that does not rely on credit ratings of NRSROs.
Before acting on this authority, the Commission invites interested
persons to submit written comments on potential alternatives the
Commission should consider for purposes of implementing Section 939(e)
of the Dodd-Frank Act.
One potential alternative the Commission is considering is a new
rule under the Exchange Act that would apply the ``minimal amount of
credit risk'' standard the Commission is proposing with respect to the
Net Capital Rule, as described above, to persons assessing whether a
security is a small business related security within the meaning of
Section 3(a)(53). The level of credit quality Congress intended for a
small business related security to satisfy in Section 3(a)(53) to
qualify for benefits under the CDRI is the same level of credit quality
that nonconvertible debt and preferred stock must currently satisfy to
qualify for reduced haircuts under the Net Capital Rule (i.e., NRSRO
credit ratings in one of the four highest rating categories). The
Commission preliminarily believes that the minimal amount of credit
risk standard for small business related securities would be consistent
with the intended objective of Congress in Section 3(a)(53) by
excluding from the definition small business related securities of
lesser credit quality. The Commission further preliminarily believes
that the proposed factors set forth above for facilitating
determinations by broker-dealers as to whether a security satisfies the
minimal amount of credit risk standard under the Net Capital Rule could
facilitate determinations by others as to when a small business related
security is subject to a minimal amount of credit risk under Section
3(a)(53).
C. Requests for Comment
The Commission requests comment on all aspects of how to implement
Section 939(e) with respect to the definitions of mortgage related
security and small business related security. In addition, the
Commission requests comment on the following specific questions. In
responding, commenters should distinguish between the two definitions
to the extent that they believe that the two definitions should be
treated differently for purposes of new rules.
Is the minimal credit risk standard a practical and
workable alternative for purposes of Section 3(a)(41) and Section
3(a)(53)? If not, what creditworthiness standard would be more
appropriate?
Who should be responsible for determining whether a
security is creditworthy for these purposes? For example, is the
sponsor, which is often involved in most, if not all, aspects of the
securitization process, the most appropriate person to make this
determination? Is the trustee a more appropriate person to make this
determination based on the fiduciary relationship between the trustee
and investors in the trust? Would an underwriter be an acceptable
person to make the determination? Who else would be appropriate to make
this determination?
If the sponsor or another person makes the
creditworthiness determination, could imposing disclosure obligations
on that person with respect to its creditworthiness determination
mitigate potential conflicts of interest?
Should two or more persons be able to make the
creditworthiness determination for the same security? If so, how could
potential inconsistencies in that determination be resolved?
If a sponsor or other person makes the creditworthiness
determination, should that person be potentially liable to persons who
relied on the determination? If so, what standard of liability should
be applied?
How often should creditworthiness determinations be made
under Section 3(a)(41) or Section 3(a)(53) in order to determine if a
security qualifies as a mortgage related security or small business
related security?
What objective measures could be used to determine whether
securities qualify as mortgage related securities or small business
related securities? Please explain what measures or creditworthiness
standards the Commission should consider.
Should the Commission adopt rules that are designed to
allow regulators or other persons to examine or verify that
creditworthiness determinations are consistent with the requirements of
the rules? Should creditworthiness determinations be subject to
regulatory review? Should the Commission require a person making the
determination to create, maintain, and make available for examination
certain records related to the determination?
Should the Commission impose a more stringent
creditworthiness standard than the minimal credit risk standard that is
being proposed for purposes of the Net Capital Rule? If so, what
standard should apply, and how could it be distinguished from the
minimal credit risk standard?
Would application of the minimal credit risk standard
proposed for purposes of the Net Capital Rule result in securities of
lesser credit quality qualifying as mortgage related securities or
small business related securities as compared to securities that
currently qualify as such under Section 3(a)(41) or Section 3(a)(53)?
If so, please explain why this would be the case and provide examples.
An alternative to credit ratings, if too rigid, could
narrow the types of financial instruments that qualify under Section
3(a)(41) or Section 3(a)(53) and, if too flexible, could broaden the
types of financial instruments that qualify under Section 3(a)(41) or
Section 3(a)(53). In discussing potential alternatives to credit
ratings, please analyze their potential impacts on competition and
capital formation.
IV. Paperwork Reduction Act
Certain provisions of the proposed amendments to the rules and form
contain ``collection of information requirements'' within the meaning
of the Paperwork Reduction Act of 1995 (``PRA'').\103\ The hours and
costs associated with preparing and filing the disclosure, filing the
form and schedules and retaining records required by these regulations
constitute reporting and cost burdens imposed by each collection of
information. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a currently valid control number. The titles of the affected
information forms are Rule 15c3-1 (OMB Control Number 3235-0200),
[[Page 26567]]
Rule 15c3-3 (OMB Control Number 3235-0078), Rule 17a-4 (OMB Control
Number 3235-0279) and Form X-17A-5, Financial and Operational Combined
Uniform Single Report, Part IIB, OTC Derivatives Dealer (OMB Control
Number 3235-0498); Rule 101 (OMB Control Number 3235-0464) and Rule 102
(OMB Control Number 3235-0467) of Regulation M; and Rule 10b-10
Confirmation of Transactions,'' (OMB Control Number 3235-0444). For the
reasons discussed below, the Commission does not believe the proposed
amendments, if adopted, would result in a material or substantive
revision to these collections of information.\104\ The cost estimates
contained in this section do not include any other possible costs or
economic effects beyond the costs required to be calculated for PRA
purposes.\105\
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\103\ 44 U.S.C. 3501 et seq.
\104\ 5 CFR 1320.5(g).
\105\ See discussion below in Section V.C.2.
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A. Summary of Collection of Information
As discussed above, the Commission is proposing amendments to Rule
15c3-1, Appendices A, E, F, and G to Rule 15c3-1, Exhibit A to Rule
15c3-3, Rule 17a-4, the General Instructions to Form X-17A-5, Part IIB,
Rules 101 and 102 of Regulation M, and Rule 10b-10. These amendments,
in part, are proposed to comply with Section 939A of the Dodd-Frank
Act, which requires the Commission to replace references to credit
ratings in all of its regulations with a standard of creditworthiness
that the Commission deems appropriate.
The proposed amendments to the Net Capital Rule and Rule 17a-4
create a new standard of creditworthiness that will allow broker-
dealers to establish their own policies and procedures to determine
whether a security has only a minimal amount of credit risk. If a
broker-dealer chooses to establish these policies and procedures it
would create a new ``collection of information'' burden for those
broker-dealers, as explained below. In addition, the proposed
amendments to the Customer Protection Rule remove one method for
verifying the status of a registered clearing agency or derivatives
clearing organization under Note G to Exhibit A. Broker-dealers who may
have to use a new method for verifying the status of a registered
clearing agency or derivatives clearing organization may have a new
``collection of information'' within the meaning of the PRA.
The proposed changes to Rules 101 and 102 of Regulation M would
amend the exceptions for nonconvertible debt, nonconvertible preferred,
and asset-backed securities in those rules. Under the proposed
amendments, distribution participants, issuers, selling shareholders,
and affiliated purchasers of such persons would need to assess
nonconvertible debt, nonconvertible preferred, and asset-backed
securities to determine whether that security is liquid relative to the
market for that asset class, trades in relation to general market
interest rates and yield spreads, and is relatively fungible with
securities of similar characteristics and interest rate yield spreads
in order to rely on the exception. Further, distribution participants,
issuers, selling shareholders, and affiliated purchasers of such
persons would need to obtain an independent third-party to verify their
analysis under the proposal. Persons seeking to rely on these proposed
revised exceptions would need to demonstrate compliance with the
proposed revised exceptions. These requirements would impose a new
``collection of information'' within the meaning of the PRA.
The proposed amendment to Rule 10b-10 would eliminate a requirement
for transaction confirmations for debt securities (other than
government securities) to inform customers if a security is unrated by
an NRSRO. Although Section 939A of the Dodd-Frank Act requires the
Commission to replace references to NRSRO ratings in its rules with a
different standard of creditworthiness, the reference to NRSROs in Rule
10b-10 does not come strictly within Section 939A's requirements. The
Commission believes, however, that deleting paragraph (a)(8) would make
Rule 10b-10 consistent with how references to NRSROs and their ratings
are being dealt with in other Commission rules pursuant to the
requirements of the Dodd-Frank Act.
B. Proposed Use of Information
The purpose of written policies and procedures, and the retention
of these policies and procedures, is to ensure that examination staff,
from either the Commission or an SRO, could review the policies and
procedures to determine if the broker-dealer has an acceptable process
for determining if a security has only a minimal amount of credit risk.
In addition, written policies and procedures would give the staff
consistent guidance on how to determine a minimal amount of credit
risk.
As discussed above, the proposed changes to Rules 101 and 102 of
Regulation M would amend the exceptions for nonconvertible debt,
nonconvertible preferred, and asset-backed securities in those rules.
Under the proposed amendments, distribution participants, issuers,
selling shareholders, and affiliated purchasers of such persons would
need to assess nonconvertible debt, nonconvertible preferred, and
asset-backed securities to determine whether that security is liquid
relative to the market for that asset class, trades in relation to
general market interest rates and yield spreads, and is relatively
fungible with securities of similar characteristics and interest rate
yield spreads in order to rely on the exception. Further, distribution
participants, issuers, selling shareholders, and affiliated purchasers
of such persons would need to obtain an independent third-party to
verify their analysis under the proposal. Persons seeking to rely on
these proposed revised exceptions would need to demonstrate compliance
with the proposed revised exceptions. The information collected under
the proposal would be used to ensure that the nonconvertible debt,
nonconvertible preferred, and asset-backed securities less likely to be
subject to manipulation are excepted from Rules 101 and 102 of
Regulation M, at the same time meeting the mandates of Section 939A of
the Dodd-Frank Act.
The proposed amendment to Rule 10b-10 would eliminate a requirement
for transaction confirmations for debt securities (other than
government securities) to inform customers if a security is unrated by
an NRSRO. This proposed amendment would alter neither the general
requirement that broker-dealers generate transaction confirmations and
send those confirmations to customers, nor the potential use of
information contained in confirmations by the Commission, self-
regulatory organizations, and other securities regulatory authorities
in the course of examinations, investigations and enforcement
proceedings. Moreover, the proposed amendment is not expected to change
the cost of generating and sending confirmations, and, the Commission
believes that broker-dealers may not need to incur significant costs if
they choose not to input information that a debt security is unrated
into their existing confirmation systems. Accordingly, the Commission
does not believe the proposed amendment would result in a material or
substantive revision to these collections of information if adopted.
C. Respondents
The Commission estimates that the proposed collections of
information would apply to the following number of respondents:
[[Page 26568]]
Proposed amendments to Rule 15c3-1 and Rule 17a-4: 480
broker-dealers.
Proposed amendments to Appendices A, E, F, and G to Rule
15c3-1: 172 broker-dealers.
Proposed amendments to Exhibit A to Rule 15c3-3: 90
broker-dealers.
Proposed amendments to Form X-17A-5: 4 broker-dealers.
Proposed amendments to Regulation M: 2533 respondents. The
Commission bases this estimate on the total number of respondents to
Rules 101 (1588) and 102 (945).
Proposed amendments to Rule 10b-10: 530 broker-dealers.
The Commission generally requests comment on all aspects of these
estimates for the number of broker-dealers. Commenters should provide
specific data and analysis to support any comments they submit with
respect to these estimates with respect to the number of respondents.
D. Total Initial and Annual Reporting and Recordkeeping Burden
1. Rule 15c3-1 and Rule 17a-4
The proposed amendments to Rule 15c3-1 and Rule 17a-4 would modify
broker-dealers' existing practices to impose additional recordkeeping
burdens. The proposed amendments would replace NRSRO ratings-based
criteria for evaluating creditworthiness with an option for a broker-
dealer to apply new standards based on the broker-dealer's own
evaluation of creditworthiness. A broker-dealer that did not want to
make such an evaluation could instead take the higher haircuts. A
broker-dealer that chooses to evaluate the creditworthiness of
securities would have to explain how the haircuts used for net capital
purposes meet the standards set forth in the proposed amendments. As
such, the Commission believes that firms would be required to develop
(if they have not already) criteria for assessing creditworthiness and
apply those criteria to the securities included in the net capital
calculation. The Commission preliminarily believes, however, that most
firms that deduct haircuts for purposes of the Net Capital Rule when
evaluating debt securities already have such an assessment process in
place. The Commission preliminarily believes that broker-dealers that
do not have such a system in place do not normally hold debt securities
or, if they do, would choose to take the higher haircuts rather than
create such a process. In addition, the expectation that the broker-
dealer be able to explain how its haircuts meet the standards set forth
in the proposed amendments would result in the creation and maintenance
of records of those assessments.
The Commission preliminarily believes that all broker-dealers
already have policies and procedures in place for evaluating the
overall risk and liquidity levels of the securities they use for the
purposes of the Net Capital Rule and that they retain these policies
and procedures; however, the proposed amendments, which specifically
address credit risk, could result in additional burdens for those
broker-dealers that choose to use them. The proposed amendments would
apply to the approximately 480 broker-dealers \106\ that hold debt
securities and take haircuts on these securities pursuant to paragraphs
(c)(2)(vi)(E), (c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2) and (c)(2)(vi)(H) of
Rule 15c3-1. The Commission estimates that, on average, broker-dealers
will spend 25 hours developing policies and procedures or revising
their current policies and procedures for evaluating creditworthiness
for the purposes of the Net Capital Rule, resulting in an aggregate
initial burden of 12,000 hours.\107\ This estimate is based on the
Commission's belief that many of these broker-dealers already have
their own criteria in place for evaluating creditworthiness and,
therefore, most broker-dealers will only be revising their current
policies and procedures for evaluating creditworthiness.
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\106\ This number was obtained by reviewing all FOCUS 2009 year-
end submissions and then calculating how many firms report holding
proprietary debt positions. See supra note 32.
\107\ 480 broker-dealers x 25 hours = 12,000 hours.
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The Commission further estimates that, on average, each broker-
dealer will spend an additional 10 hours a year reviewing and adjusting
its own standards for evaluating creditworthiness, for a total of 4,800
annual hours across the industry.\108\ This estimate does not reflect
the time it will take for each broker-dealer to apply and implement its
own standards for evaluating creditworthiness. This estimate reflects
the Commission's belief that these broker-dealers already have their
own criteria in place. The Commission also estimates that firms would
use a controller to review these standards, both initially and on an
annual basis. The Commission estimates the per-firm costs of the
controller to be $10,825 initially and $4,330 on an annual basis, for
an aggregate industry cost of $5,196,000 initially and $2,078,400 on an
annual basis.\109\ The Commission preliminarily believes that the
proposed requirement to retain the policies and procedures for three
years pursuant to Rule 17a-4 would result in de minimis costs. The
three year preservation requirement in Rule 17a-4 will only be
applicable once a broker-dealer changes its policies and procedures. In
addition, all broker-dealers are currently required to comply with the
three year preservation period in Rule 17a-4 for other records and
should have procedures to satisfy such preservation requirements in
place.
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\108\ 480 broker-dealers x 10 hours = 4,800 hours.
\109\ For the purposes of this analysis, the Commission is using
salary data from the Securities Industry and Financial Markets
Association (``SIFMA'') Report on Management and Professional
Earnings in the Securities Industry 2010, which provides base salary
and bonus information for middle management and professional
positions within the securities industry, as modified by Commission
staff to account for an 1800-hour work-year and multiplied by 5.35
to account for bonuses, firm size, employee benefits and overhead.
Hereinafter, references to data derived from the report as modified
in the manner described above will be cited as SIFMA Report on
Management and Professional Earnings in the Securities Industry
2010. The Commission believes that the reviews required by the
proposed amendments would be performed by the controller at an
average rate $433 per hour. Furthermore, the Commission believes
that the review process will entail twenty-five hours initially and
ten hours on an annual basis. $433 x 25 = $10,825 x 480 =
$5,196,000; $433 x 10 = $4,330 x 480 = $2,078,400.
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The proposed amendments to the appendices to Rule 15c3-1 include
amendments to certain recordkeeping and disclosure requirements that
are subject to the PRA. The proposed amendment to Appendix A to Rule
15c3-1 removes the NRSRO reference from the definition of ``major
market foreign currency.'' The Commission preliminarily believes that
158 broker-dealers trade in foreign currency and, therefore, would be
affected by the proposed amendment.\110\ However, it is not the
intention of the Commission that the currencies meeting the definition
of ``major market foreign currency'' should change. If, however, a
broker-dealer wanted to request that a new currency meet the definition
of ``major market foreign currency'' it would have to submit such a
request to the Commission. The Commission preliminarily believes that
submitting such a request to the Commission would take approximately
ten hours for a total burden of 1,580 hours.\111\ Additionally, the
Commission believes that a broker-dealer would use an attorney to
prepare this request, for a cost of $3,540 per firm
[[Page 26569]]
and an aggregate industry cost of $559,320.\112\
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\110\ To arrive at this number, the Commission requested from
the Options Clearing Corporation (``OCC'') the number of broker-
dealers that are authorized to clear foreign currency options. The
Commission was given the number of 158. Although 158 broker-dealers
are authorized to clear foreign currency options, the Commission
does not know if all of these broker-dealers are actually clearing
foreign currency options.
\111\ 158 broker-dealers x 10 hours = 1,580.
\112\ The Commission believes that the reviews required by the
proposed amendments would be performed by an attorney at an average
rate of $354 per hour. Furthermore, the Commission believes that the
review process will entail ten hours of initial work. 10 hours x
$354 = $3,540 per firm. 158 broker-dealers x $3,540 = $599,320
aggregate industry cost. SIFMA Report on Management and Professional
Earnings in the Securities Industry 2010.
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The proposed amendments to Appendices E and F to Rule 15c3-1 and
conforming amendments to Appendix G would remove the provisions
permitting reliance on NRSRO ratings for the purposes of determining
counterparty risk. As a result of these deletions, an entity that
wished to use the approach set forth in these appendices to determine
counterparty risks would be required, as part of its initial
application to use the alternative approach or in an amendment, to
request Commission approval to determine credit risk weights based on
internal calculations and make and keep current a record of the basis
for the credit risk weight of each counterparty.
The Commission does not believe that the removal of the option
permitting reliance on NRSRO ratings would affect the small number of
entities that currently elect to compute their net capital deductions
pursuant to the alternative methods set forth in Appendix E or F.
Although the collection of information obligations imposed by the
proposed amendments are mandatory, applying for approval to use the
alternative capital calculation is voluntary. To date, a total of six
entities are using the methods set forth in Appendix E, while four are
using the methods set forth in Appendix F. All of the approved firms
already have developed models to calculate market and credit risk under
the alternative net capital calculation methods set forth in the
appendices as well as internal risk management control systems.\113\ As
such, each firm already employs the non-NRSRO ratings-based method that
would, under the proposed amendments, become the only option for
determining counterparty credit risk under Appendices E and F. Since
each entity already employs its own models to calculate market and
credit risk and keeps current a record of the basis for the credit risk
weight of each counterparty, the proposed amendments would not alter
the paperwork burden currently imposed by Appendices E and F.
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\113\ See, e.g., Alternative Net Capital Requirements for
Broker-Dealers That Are Part of Consolidated Supervised Entities,
Exchange Act Release No. 49830 (Jun. 8, 2004), 69 FR 34428 at 34456
(Jun. 21, 2004).
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The Commission currently anticipates that three additional firms
may apply for permission to use Appendix E and one additional firm may
apply to use Appendix F. However, the Commission preliminarily believes
that there should be no additional paperwork burden on these firms
based on the proposed amendments. Any firm that applies to use
Appendices E or F to Rule 15c3-1 must submit its internal models to the
Commission for approval as part of that process. These models will
calculate market risk and credit risk, as well as counterparty risk,
which is not a change from the previous approval process for a firm
that is applying to use Appendix E or Appendix F. In fact, the
Commission believes that the only change to this process will be that
the Commission will assign ratings scales to these models that can be
used to determine counterparty risk when approving the models. Thus,
the Commission does not believe the proposed amendments to Appendices E
and F will alter the paperwork burden for such firms.
The instructions to Form X-17A-5 Part IIB currently include a
summary of the credit risk calculation in paragraph (d) of Rule 15c3-
1f. Paragraph (d) of Rule 15c3-1f is proposed to be amended to remove
that part of the credit risk calculation that is summarized in Form X-
17A-5 Part IIB. Accordingly, the Commission has proposed a conforming
amendment to the form that would remove the summary of the credit risk
calculation. The summary in the instructions provides additional
information for the benefit of the filer and is not related to the
information reported on the forms. Accordingly, the Commission does not
believe the proposed amendment would result in a substantive revision
to these collections of information if adopted.
The Commission requests comment on all aspects of these proposed
estimates. In addition, the Commission requests specific comment on the
following items related to these estimates:
Is the Commission correct in its hours estimates and
belief that many broker-dealers already have their own policies and
procedures in place for evaluating creditworthiness?
Is the Commission correct in its belief that broker-
dealers would engage outside counsel to review their internally
generated standards for creditworthiness? If not, how would firms
review such standards and what would be the effect of such differing
approaches on our burden estimates?
Is the Commission correct in its belief that new firms
that apply to use the standards in Appendices E and F to Rule 15c3-1
will not have an extra burden as a result of the proposed amendments?
Is the Commission correct in its estimation of the number
of broker-dealers that trade foreign currency options?
Is the Commission correct in its estimation on the number
of hours it would take for a firm to make a submission to the
Commission requesting that a currency be designated as a major market
foreign currency?
Is the Commission correct in its belief that a firm would
engage outside counsel to make this submission? Or would a firm handle
this internally?
2. Exhibit A to Rule 15c3-3
The proposed amendment to Note G to Exhibit A to Rule 15c3-3 would
potentially modify broker-dealers' existing practices to impose
additional recordkeeping burdens. Currently, Note G to Exhibit A to
Rule 15c3-3 allows a broker-dealer to include, as a debit in the
formula for determining its reserve requirements, the amount of
customer margin related to customers' positions in security futures
products posted to a registered clearing or derivatives organization
that meets one of four standards, including maintaining the highest
investment grade rating from an NRSRO.\114\ The proposed amendment
would remove the standard of a registered clearing or derivatives
organization that has the highest investment grade rating from an NRSRO
as one of the four options a broker-dealer can look at prior to keeping
customers' positions in security future products with such a firm. As
such, the Commission believes that firms that previously relied on
NRSRO ratings for the purposes of Note G would be required to use
another method for assessing the creditworthiness of registered
clearing or derivatives organizations. In addition, the expectation
that the broker-dealer be able to explain that any such clearing or
derivatives organizations it uses meet
[[Page 26570]]
the standard set forth in the proposed amendment would result in the
creation and maintenance of records of those assessments. The
Commission estimates that approximately 90 firms would be required to
comply with the provisions of Note G.\115\ In the final release adding
Note G to Exhibit A to Rule 15c3-3,\116\ the Commission estimated that
under subparagraph (c) to Note G, each broker-dealer would spend
approximately 0.25 hours to verify that the clearing organizations they
used met the conditions of Note G. Using that same hours estimate, the
Commission estimates an aggregate one-time total of 22.5 hours \117\
for broker-dealers to verify the status of a registered clearing or
derivatives organization under the proposed amendment. The Commission
believes that the proposed amendment would impose an additional one-
time burden for broker-dealers that need to change how they evaluate
the creditworthiness of a registered clearing or derivatives
organization. Given the additional options set forth in Note G, the
Commission estimates this would result in the broker-dealer spending,
on average, one hour determining whether a clearing organization meets
the remaining requirements of Note G,\118\ resulting in an aggregate
initial burden of 90 hours.\119\ The Commission also estimates that
firms would use a senior operations manager to review these standards.
The Commission estimates the one-time costs of senior operations
manager to be $331 per- firm, resulting in an aggregate industry cost
of $29,790.\120\
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\114\ A broker-dealer may also include customer margin related
to customers' positions in security futures products posted to a
registered clearing or derivatives organization (1) that maintains
security deposits from clearing members in connection with regulated
options or futures transactions and assessment power over member
firms that equal a combined total of at least $2 billion, at least
$500 million of which must be in the form of security deposits; (2)
that maintains at least $3 billion in margin deposits; or (3) which
does not meet any of the other criteria but which the Commission has
agreed, upon a written request from the broker-dealer, that the
broker-dealer may utilize. 17 CFR 240.15c3-3a, Note G, (b)(1)(ii)-
(iv).
\115\ The number 90 comes from reviewing the members of the OCC
listed in the member directory on the OCC's Web site (http://www.optionsclearing.com/membership/member-information/). Of the list
of 231 members, the Commission looked only at those who trade in
single stock futures. Of the list of members that trade in single
stock futures, the Commission deleted any members who had the exact
same firm name but different firm numbers.
\116\ See Reserve Requirements for Margin Related to Security
Futures Products, Exchange Act Release No. 34-50295 (Aug. 31, 2004),
69 FR 54182 at 54188 (Sept. 7, 2004).
\117\ 0.25 x 90 = 22.5.
\118\ Currently the OCC is the only clearing agency registered
with the Commission. The OCC maintains far more than $3 billion in
margin deposits, which is another way for a broker-dealer to verify
a registered clearing agency or derivatives clearing organization
under Note G. Thus, the Commission believes that any broker-dealer
who is currently using NRSRO ratings to verify a registered clearing
agency or derivatives clearing organization will be able to quickly
verify the registered clearing agency or derivatives clearing
organization using a different method.
\119\ 90 broker-dealers x 1 hour = 90 hours.
\120\ The Commission believes that the reviews required by the
proposed amendments would be performed by a senior operations
manager at an average rate of $331 per hour. Furthermore, the
Commission believes that the review process will entail one hour of
initial work. $331 x 1 = $331 x 90 = $29,790. SIFMA Report on
Management and Professional Earnings in the Securities Industry
2010.
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The Commission generally requests comment on all aspects of these
proposed estimates. In addition, the Commission requests specific
comment on the following items related to these estimates:
Is the Commission correct in its estimate of the number of
broker-dealers that would be affected by the proposed amendment to Note
G?
Is the Commission correct in its belief that broker-
dealers would engage a senior operations manager to review their
standards for verifying the status of a registered clearing agency or
derivatives clearing organization? If not, how would firms review such
standards and what would be the effect of such differing approaches on
its burden estimates?
3. Regulation M
As discussed above, the proposed changes to Rules 101 and 102 of
Regulation M would amend the exceptions for nonconvertible debt
securities, nonconvertible preferred securities, and asset-backed
securities in those rules. Under the proposed amendments, distribution
participants, issuers, selling shareholders, and affiliated purchasers
of such persons would need to assess nonconvertible debt,
nonconvertible preferred, and asset-backed securities to determine
whether that security reasonably is liquid relative to the market for
that asset class, trade based on yield, and fungible with securities
with similar yields in order to rely on the exception. Further,
distribution participants, issuers, selling shareholders, and
affiliated purchasers of such persons would need to obtain an
independent third-party to verify their analysis under the proposal.
Persons seeking to rely on these proposed revised exceptions would need
to demonstrate compliance with the proposed revised exceptions.
The Commission initially estimates that there are approximately 863
distributions of nonconvertible debt, nonconvertible preferred, and
asset-backed securities, on average, annually that would be subject to
the proposed revised exceptions. The Commission bases this estimate on
the average number of offerings of investment grade nonconvertible
debt, investment grade nonconvertible preferred, and investment grade
asset-backed securities over the last three years.\121\ The Commission
believes that this is a reasonable estimate since it expects that the
number of distributions eligible for the proposed revised exceptions
should be similar to the number of distributions currently excepted
under Rules 101(c)(2) and 102(d)(2).
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\121\ Rules 101 and 102 only apply to distributions, not all
offerings of securities. As a result, the Commission discounted the
actual average number of offerings of nonconvertible debt,
investment grade nonconvertible preferred, and investment grade
asset-backed securities over the last three years (1,151) by 25%.
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The Commission initially estimates that the proposed revised
exceptions would impose an average annual burden of 1 hour per
distribution.\122\ This accounts for the internal time to obtain the
information necessary to comply with the proposed revised exceptions
and conduct analysis based on this information. Further, the Commission
initially estimates that the proposed revised exceptions would impose
an outside cost burden to retain an independent third party to verify
the analysis by the person seeking to rely on the proposed revised
exceptions, resulting in an estimated average annual burden of $4,800
\123\ per distribution. Based on the total number of distributions
estimated to be subject to the proposed revised exceptions (863), the
Commission estimates that the total average annual burden is
approximately 863 hours and $4.1 million.
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\122\ We anticipate that the 1 hour would be spent by business
analysts of the person seeking to rely on the proposed revised
exceptions.
\123\ We estimate that an outside management consultant would
spend 8 hours and charge $600 per hour to verify the analysis. The
$600 per hour figure is from the 75th percentile figure for a
management consultant from http://www.payscale.com, adjusted for an
1800-hour work-year and multiplied by a 5.35 factor which is
normally used to include benefits but here is used as an
approximation to offset the fact that New York salaries are
typically higher than the rest of the country. The result is $596
per hour, which can be rounded to $600 per hour. We request comment
on this estimate.
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The collection of information would be necessary to obtain the
benefit of the proposed revised exceptions. The proposed revised
exceptions do not prescribe retention periods. All registered broker-
dealers engaged in underwriting that would be subject to the proposed
revised exceptions are currently required to retain records in
accordance with Rules 17a-2 through 17a-4. The collection of
information under the proposed revised exceptions would be provided to
Commission and SRO examiners but would not be subject to public
availability.
We specifically request comment on all aspects of these proposed
estimates.
4. Rule 10b-10
The proposed amendment to Rule 10b-10 is not expected to change the
[[Page 26571]]
cost of generating and sending confirmations, and, the Commission
believes that broker-dealers may not need to incur significant costs if
they choose not to input information that a debt security is unrated
into their existing confirmation systems. Accordingly, the Commission
does not believe the proposed amendment would result in any substantive
change in a broker-dealer's record-keeping or reporting burdens.
5. Request for Comment
Pursuant to 44 U.S.C. 3306(c)(2)(B), the Commission requests
comment on the proposed collections of information in order to: (1)
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; (2)
evaluate the accuracy of the Commission's estimates of the burden of
the proposed collections of information; (3) determine whether there
are ways to enhance the quality, utility, and clarity of the
information to be collected; (4) evaluate whether there are ways to
minimize the burden of the collection of information on those who
respond, including through the use of automated collection techniques
or other forms of information technology; and (5) evaluate whether the
proposed rule amendments would have any effects on any other collection
of information not previously identified in this section.
Persons who desire to submit comments on the collection of
information requirements should direct their comments to the OMB,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, and refer to File No. S7-15-11. OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication of this document in the
Federal Register; therefore, comments to OMB are best assured of having
full effect if OMB receives them within 30 days of this publication.
Requests for the materials submitted to OMB by the Commission with
regard to these collections of information should be in writing, refer
to File No. S7-15-11, and be submitted to the Securities and Exchange
Commission, Office of Investor Education and Advocacy, 100 F Street,
NE., Washington, DC 20549-0213.
V. Economic Analysis
As discussed above, the Dodd-Frank Act requires that the Commission
and other federal agencies replace references to credit ratings in all
of its regulations with a standard of creditworthiness that the
Commission deems appropriate. The proposed amendments to Rule 15c3-1,
Appendices A, E, F, and G to Rule 15c3-1, Exhibit A to Rule 15c3-3,
Rule 17a-4, the General Instructions to Form X-17A-5, Part IIB, Rules
101 and 102 of Regulation M, and Rule 10b-10 would accomplish this task
by eliminating the reference to and requirement for the use of NRSRO
ratings in these rules. The Commission recognizes that there are
additional external costs associated with the adoption of the proposed
amendments that are separate from the hour burdens discussed in the
Paperwork Reduction Act. Thus, the Commission has identified certain
costs and benefits of the proposed rule amendments and requests comment
on all aspects of this cost-benefit analysis, including identification
and assessment of any costs and benefits not discussed in the
analysis.\124\
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\124\ SIFMA Report on Management and Professional Earnings in
the Securities Industry 2010.
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The Commission seeks comment and data on the value of the benefits
identified. The Commission also seeks comments on the accuracy of its
cost estimates in each section of this cost-benefit analysis, and
requests those commenters to provide data, including identification of
statistics relied on by commenters to reach conclusions on cost
estimates. Finally, the Commission seeks estimates and views regarding
these costs and benefits for particular types of market participants,
as well as any other costs or benefits that may result from these
proposed rule amendments.
Under Section 3(f) of the Exchange Act,\125\ the Commission shall,
when engaging in rulemaking that requires the Commission to consider or
determine whether an action is necessary or appropriate in the public
interest, consider, in addition to the protection of investors, whether
the action will promote efficiency, competition, and capital formation.
Section 23(a)(2) of the Exchange Act \126\ requires the Commission to
consider the competitive effects of any rules the Commission adopts
under the Exchange Act. Section 23(a)(2) prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act. The Commission's preliminary view, as discussed in greater detail
with respect to each proposed amendment below, is that any potential
burden on efficiency, competition, and capital formation resulting from
the proposed rules would be consistent with the intent of Congress as
expressed by the Dodd-Frank Act.
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\125\ 15 U.S.C. 78c(f).
\126\ 15 U.S.C. 78w(a)(2).
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A. Rule 15c3-1 and Rule 17a-4
1. Benefits
The Commission anticipates that one of the primary benefits of the
proposed amendments, if adopted, would be the benefit to broker-dealers
of reducing their possible undue reliance on NRSRO ratings that could
be caused by references to NRSROs in its rules. The rule amendments
could encourage broker-dealers to examine more than a single source of
information, such as a rating, when analyzing the creditworthiness of a
financial instrument. Significantly, the Commission believes that
eliminating the reliance on NRSRO ratings in its rules would remove any
appearance that the Commission has placed its imprimatur on such
ratings. The Commission, however, also recognizes that credit ratings
may provide useful information to institutional and retail investors as
part of the process of making an investment decision.
The Commission preliminarily believes that the proposed amendments
to the Net Capital Rule and its appendices, as well as the conforming
amendment to Rule 17a-4, could result in a better overall assessment of
the risks associated with securities held by broker-dealers for the
purposes of net capital calculations as well as of the long-term
financial strength and general creditworthiness of clearing
organizations to which customers' positions in security futures
products are posted. As the NRSROs themselves have stressed, the
ratings they generate focus solely on credit risk, that is, the
likelihood that an obligor or financial obligation will repay investors
in accordance with the terms on which they made their investment.\127\
Many broker-dealers already conduct their own risk evaluation. However,
for those broker-dealers that do not, developing
[[Page 26572]]
their own means of evaluating risk--including, as would be required by
the proposed amendments to the Net Capital Rule, an evaluation of the
degree of liquidity--should allow them to better incorporate the
overall levels of various categories of risk associated with the
securities they hold for their net capital calculations and lead to a
better understanding of the risks associated with those securities. The
Commission believes that for those broker-dealers that do not currently
have their own means of evaluating risk for purposes of the Net Capital
Rule, the approach outlined in this release is the best option, outside
of using NRSRO ratings, for a broker-dealer to evaluate the risks
associated with those securities.
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\127\ See, e.g., Inside the Ratings: What Credit Ratings Mean,
Fitch, Aug. 2007 (``Inside the Ratings''), p. 1; Testimony of
Michael Kanef, Group Managing Director, Moody's Investors Service,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (Sep. 26, 2007), p. 2; Testimony of Vickie A. Tillman,
Executive Vice President, Standard & Poor's Credit Market Services,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (Sep. 26, 2007), p. 3.
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2. Costs
The Commission anticipates that broker-dealers could incur
additional costs if the proposed amendments are adopted because of the
costs associated with performing a more detailed and comprehensive
analysis of the debt securities. These costs could include
establishing, reviewing, and adjusting the various policies and
procedures needed for a comprehensive analysis of the debt securities.
There also could be costs associated with applying and implementing
these adjusted procedures.
The Commission believes that the costs of compliance with the
proposed amendments to the Net Capital Rule and its appendices, as well
as the conforming amendment to Rule 17a-4, would be minimal for those
entities that already employ their own criteria in determining credit
risk for net capital purposes. Of the approximately 480 broker-dealers
that hold proprietary debt positions, the Commission recognizes that
the level of sophistication varies widely. The institutions with less
sophisticated internal procedures for analyzing credit risk may incur
costs to establish and develop procedures that would be used to assess
financial instruments for the purposes of determining whether the lower
haircuts could appropriately be applied.
In the event the broker-dealer inaccurately evaluates the
creditworthiness and liquidity of its positions, a potential cost could
be that the broker-dealer is required to take a larger haircut on its
proprietary positions, and, therefore, reserve additional capital. This
could affect its ability to hold its positions or to add to its
positions. In addition, the proposed rule could potentially affect the
ability of issuers of commercial paper, nonconvertible debt, and
preferred stock to raise capital if broker-dealers change their
investment decisions for their proprietary accounts as a result of
potential costs or other aspects of the proposed amendments.
Some broker-dealers may determine a security qualifies for a
reduced haircut when it would not have qualified under the current
NRSRO standard. This could have a potential impact on the firm's
ability, if it experiences financial difficulties, to be in a position
to meet all obligations to customers, investors, and other
counterparties and generate resources to wind-down its operations in an
orderly manner without the need of a formal proceeding, with attendant
costs.
In addition, those broker-dealers whose internal evaluations differ
from the ratings may have extra costs during examinations to prove to
the regulators the accuracy of their internal evaluations. Those
broker-dealers that do not have their own criteria for determining
credit risk for net capital purposes will have larger start up costs
than other broker-dealers. However, the Commission believes that firms
that hold a small number of securities for net capital purposes may do
an internal cost benefit analysis and decide to take the 15% haircut
instead of creating an internal credit risk evaluation process if the
costs of creating such an evaluation process are too high. To the
extent that broker-dealers decide to take the 15% haircut instead of
creating an internal credit risk evaluation process, it is possible
that those broker-dealers may maintain more net capital than would be
required by the Net Capital Rule.
For firms that use Appendix A to Rule 15c3-1, the Commission
preliminarily believes there will be minimal costs associated with the
proposed amendments. The proposed amendments to the definition of
``major market foreign currency'' will not change what foreign
currencies meet the definition; it will only change the wording of the
definition. Therefore, the Commission does not believe there will be
any additional costs associated with the proposed amendments.
As for the firms that use Appendix E and F to Rule 15c3-1, these
firms are already using internal ratings scales to determine credit
risks for each counterparty. Any new firms that apply to use either
Appendix E or Appendix F will not incur any additional costs as a
result of the proposed amendments. Currently, firms that apply to use
these appendices must have their internal models approved by the
Commission prior to using their selected appendix. Although the
Commission will have to assign a ratings scale to the output of the
internal models during the approval process, the Commission does not
believe this step will cause broker-dealers or OTC derivatives dealers
who are applying to use these appendices to incur any additional costs.
Furthermore, because these firms have traditionally used models, as
opposed to NRSRO ratings, to compute capital charges, the Commission
does not believe these firms will incur any additional costs by
complying with the proposed amendments.
B. Exhibit A to Rule 15c3-3
1. Benefits
The Commission believes that eliminating the reliance on NRSRO
ratings in its rules would remove any appearance that the Commission
has placed its imprimatur on such ratings. The Commission preliminarily
believes that the proposed amendments to Note G to Exhibit A to Rule
15c3-3 would serve to promote efficiency and capital formation. As
noted above, the Commission believes that broker-dealers will develop
their own means of evaluating the long-term financial strength and
general creditworthiness of clearing organizations to which customers'
positions in security futures products are posted for purposes of Note
G to Exhibit A to Rule 15c3-3. These broker-dealers would be better
positioned to incorporate the overall levels of various categories of
risk associated with those organizations into their assessments,
creating a more efficient means of evaluating those organizations for
the sake of the Customer Protection Rule, rather than simply relying on
NRSRO credit ratings alone. As the NRSROs themselves have stressed, the
ratings they generate focus solely on credit risk, that is, the
likelihood that an obligor or financial obligation will repay investors
in accordance with the terms on which they made their investment.\128\
The Commission does not anticipate that the proposed amendments to Note
G to Exhibit A to Rule 15c3-3 would have any impact on competition.
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\128\ See, e.g., Inside the Ratings: What Credit Ratings Mean,
Fitch, Aug. 2007 (``Inside the Ratings''), p. 1; Testimony of
Michael Kanef, Group Managing Director, Moody's Investors Service,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (Sep. 26, 2007), p. 2; Testimony of Vickie A. Tillman,
Executive Vice President, Standard & Poor's Credit Market Services,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (Sep. 26, 2007), p. 3.
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[[Page 26573]]
2. Costs
The Commission believes that the costs of compliance with Note G to
Exhibit A to Rule 15c3-3 would be minimal because the amendment would
simply eliminate one factor a broker-dealer can use to evaluate a
clearing organization. The Commission believes that the removal of one
of these four means of complying with section (b)(1) of Note G will not
adversely affect the purpose of this section; namely to ensure that a
broker or dealer has the margin related to security futures products on
deposit only with qualified registered clearing agencies or derivatives
clearing organizations. As stated in the Paperwork Reduction Act
section, the Commission anticipates that a broker-dealer will incur a
one-time cost and an annual cost to verify that a clearing organization
or derivatives clearing organization meets the requirements of Note G.
If a broker-dealer is currently using a verification process other than
the use of NRSRO ratings, that broker-dealer will not incur any one-
time costs.
C. Rules 101 and 102 of Regulation M
The purpose of the proposed revised exceptions from Rules 101 and
102 of Regulation M for nonconvertible debt, nonconvertible preferred,
and asset-backed securities is to address Section 939A of the Dodd-
Frank Act as well as place the emphasis of the exception on the trading
aspects of the securities by those bringing it to market, ensuring that
the exception is utilized in reference to securities that are less
likely to be subject to manipulation.
The Commission preliminarily believes that the proposed amendments
to Rules 101 and 102 of Regulation M are intended to promote capital
formation. The proposed amendments should promote continued investor
trust in the offering process by proposing an exception from Regulation
M's Rule 101 and 102 prohibitions limited to those securities which are
less vulnerable to manipulation. Such investor trust in our markets
should promote continued capital formation. The Commission believes
that the proposals should foster continued market integrity which
should also translate into capital formation by only allowing for non-
manipulative buying activity during distributions. Issuers of
nonconvertible debt, nonconvertible preferred securities and asset-
backed securities who fall within the proposed exceptions may be
encouraged to engage in capital formation knowing that the proposed
exceptions are available for their buying activity as well as the
buying activity of distribution participants. For these reasons, the
Commission preliminarily believes that the proposed exceptions will
promote efficient capital formation and competition.
The Commission has considered the proposed amendments to Rules 101
and 102 of Regulation M in light of the standards cited in Section
23(a)(2) and believes preliminarily that, if adopted, they would not
likely impose any significant burden on competition not necessary or
appropriate in furtherance of the Exchange Act. The proposals would
apply equally to all distribution participants, issuers, selling
shareholders, and affiliated purchasers. Thus, no person covered by
Regulation M should be put at a competitive disadvantage and the
proposal would not impose a significant burden on competition not
necessary or appropriate in furtherance of the Act.
1. Benefits
The proposed revised exceptions should continue to promote investor
trust in the offering process and the market as a whole by excepting
only those nonconvertible debt, nonconvertible preferred, and asset-
backed securities that are less vulnerable to manipulation. Market
integrity would also continue to be promoted, which benefits the market
and all participants.
2. Costs
The Commission expects the costs of the proposal to modify Rules
101 and 102 of Regulation M to be minimal to most persons subject to
those rules. The Commission expects the number of instances in which
the proposed revised exceptions would be triggered to be limited. The
proposed revised exceptions would only be triggered when there is an
offering of nonconvertible debt, nonconvertible preferred, or asset-
backed securities that qualifies as a distribution under Regulation M
where a distribution participant, issuer, selling shareholder, or
affiliated purchaser bids for, purchases, or attempts to induce another
person to bid for or purchase the covered security during the
applicable restricted period. As there may be offerings of
nonconvertible debt, nonconvertible preferred, and asset-backed
securities that do not constitute a distribution for purposes of
Regulation M, the prohibitions of Rules 101 and 102 of Regulation M
would not be triggered and, thus, the need for reliance upon either the
current or proposed revised exceptions would not be necessary.
Additionally, even if a distribution of the nonconvertible debt,
nonconvertible preferred, or asset-backed securities exists, a person
subject to the prohibitions of Rules 101 or 102 of Regulation M could
structure buying activity before or after the applicable restricted
period so as not to incur any costs, even if minimal, associated with
relying on the proposed revised exceptions.
When the proposed revised exceptions would be used, however, the
Commission believes that there would be increased costs for
distribution participants, issuers, selling shareholders, and
affiliated purchasers under the proposed revised exceptions compared to
the expected costs under the current exceptions in Rules 101(c)(2) and
102(d)(2). Distribution participants, issuers, selling shareholders,
and affiliated purchasers would need to reasonably determine whether a
security is liquid relative to the market for that asset class, trades
in relation to general market interest rates and yield spreads, and is
relatively fungible with securities of similar characteristics and
interest rate yield spreads in order to rely on the exception. This
determination would require the distribution participant, issuer,
selling shareholder, or affiliated purchaser to train staff and devote
manpower and other resources towards making this assessment when
relying on the proposed revised exceptions. As detailed in the PRA
section above, the Commission preliminarily estimates total annual
ongoing internal costs of approximately $167,422 for distribution
participants, issuers, selling shareholders, and affiliated purchasers
seeking to rely on the exception.\129\
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\129\ This figure was calculated as follows (1 business analyst
hours x $194) = $194 per response x 863 responses = $167,422 total
cost for all respondents. The Commission estimates that the average
hourly rate for an intermediate business analyst in the securities
industry is approximately $194 per hour. SIFMA Report on Management
and Professional Earnings in the Securities Industry 2010.
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Further, distribution participants, issuers, selling shareholders,
and affiliated purchasers would need to obtain an independent third
party to verify this initial assessment. This process would create new
costs to be borne by distribution participants, issuers, selling
shareholders, and affiliated purchasers when relying on the proposed
revised exceptions to hire such a party and review this verification.
Distribution participants, issuers, selling shareholders, and
affiliated purchasers seeking an independent third party verification
that the issue meets the criteria required to obtain the proposed
exceptions may find that the price of the independent
[[Page 26574]]
third party verification could potentially lead to other economic
effects. These effects could include, for instance, the potential for
the verifier to be liable for claims if the exception is disputed after
it has been relied upon. While difficult to quantify, the Commission
preliminarily estimates that it is possible for the verifier's
potential liability to be a significant multiple of the compliance-
hours-cost-estimate provided for PRA purposes, and will depend upon the
perceived risk in asserting that the security is liquid relative to the
market for that asset class, trades in relation to general market
interest rates and yield spreads, and is relatively fungible with
securities of similar characteristics and interest rate yield spreads.
These are new costs not currently borne by distribution participants,
issuers, selling shareholders, or their affiliated purchasers. If
potential liability leads to increased costs in obtaining an
independent third party, some persons who currently rely on the
exception may determine that it is no longer cost effective to qualify
for the exception. This may have the effect of limiting the instances
in which the exception is utilized, which in turn may expand the scope
of the restrictions of Rules 101 and 102 of Regulation M. Thus, the
increase in costs resulting from the third party verification may, in
effect, narrow the exceptions for those who currently rely on them.
The Commission also expects that there could be a small number of
securities taken out of this exception as a result of the proposed
change. Costs for issuers, selling shareholders, underwriters, brokers,
dealers, any other distribution participants, or affiliated purchasers
of any of these persons affected by this change would be more
significant in that these persons may now be required to comply with
Rule 101 or 102 of Regulation M where they did not have to before. As a
result of this change, these affected parties and their affiliated
purchasers would be prohibited from bidding for, purchasing, or
attempting to induce any person to bid for or purchase the covered
security during the restricted period. However, the Commission does not
expect there to be a significant number of these persons. Further,
these persons may be able to rely on a different exception from Rule
101 or 102 depending on the circumstances.
D. Rule 10b-10
1. Benefits
The proposed amendments to Rule 10b-10 eliminate a requirement for
transaction confirmations for debt securities (other than government
securities) to inform customers if a security is unrated by an NRSRO.
The other requirements of Rule 10b-10 would remain unchanged.
Eliminating this requirement would avoid giving credit ratings an
imprimatur that may inadvertently suggest to investors that an unrated
security is inherently riskier than a rated security. Accordingly, the
Commission anticipates that investors and the marketplace would benefit
from the elimination of this requirement, in light of concerns about
promoting over-reliance on securities ratings or creating confusion
about the significance of those ratings. More generally, eliminating
this requirement is consistent with the goal of promoting a dialogue
between broker-dealers and their customers--prior to purchase--
regarding the creditworthiness of issuers, and should help avoid
promoting the use of credit ratings as an oversimplified shorthand that
replaces a more complete discussion of credit quality issues.
2. Costs
The Commission does not expect the proposed amendment to result in
any significant changes in the costs associated with Rule 10b-10.
Broker-dealers will continue to generate transaction confirmations and
send those confirmations to customers, and the proposed amendment, if
adopted, would not be expected to change the cost of generating and
sending confirmations. Moreover, the Commission believes that broker-
dealers may not need to incur significant costs if they choose not to
input information that a debt security is unrated into their existing
confirmation systems.
E. Request for Comment on Economic Analysis
The Commission requests data to quantify the costs and the benefits
above. The Commission seeks estimates of these costs and benefits, as
well as any costs and benefits not already described, which could
result from the adoption of the proposed amendments.
The Commission seeks specific comments on the economic
analysis outlined above with respect to Rule 15c3-1, its Appendices and
Rule 17a-4. Are there any additional costs associated with these
proposed amendments that were not factored into the above analysis?
Commenters should provide specific examples of cost estimates.
The Commission seeks specific comments on the economic
analysis outlined above with regard to Exhibit A to Rule 15c3-3. Are
there any additional costs associated with the proposed amendment that
were not factored into the above analysis? Commenters should provide
specific examples of cost estimates.
The Commission seeks specific comments on the economic
analysis outlined above with regard to the proposed revised exceptions
to Rules 101 and 102 of Regulation M. What new costs would the proposed
revised exceptions create for those seeking to rely on them? Are there
any costs not already accounted for in this proposal created by the
proposed revised exceptions?
The Commission seeks specific comments on the economic
analysis outlined above with regard to the Rule 10b-10. Are there any
additional costs associated with this proposal that were not factored
into the above analysis? Commenters should provide specific examples of
cost estimates.
VI. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA''), the Commission must advise OMB as to whether
the proposed regulation constitutes a ``major'' rule. Under SBREFA, a
rule is considered ``major'' where, if adopted, it results or is likely
to result in: (1) An annual effect on the economy of $100 million or
more (either in the form of an increase or decrease); (2) a major
increase in costs or prices for consumers or individual industries; or
(3) significant adverse effect on competition, investment or
innovation. If a rule is ``major,'' its effectiveness will generally be
delayed for 60 days pending Congressional review.
The Commission requests comment on the potential impact of the
proposed rules and form on the economy on an annual basis, on the costs
or prices for consumers or individual industries, and on competition,
investment, or innovation. Commenters are requested to provide
empirical data and other factual support for their view to the extent
possible.
VII. Initial Regulatory Flexibility Analysis
Section 3(a) of the Regulatory Flexibility Act of 1980 \130\
requires the Commission to undertake an initial regulatory flexibility
analysis of the proposed rule on small entities unless the Commission
certifies that the rule, if adopted, would not have a significant
economic impact on a substantial
[[Page 26575]]
number of small entities.\131\ Pursuant to Section 605(b) of the
Regulatory Flexibility Act (``RFA''), the Commission hereby certifies
that the proposed amendments to the rule, would not, if adopted, have a
significant economic impact on a substantial number of small entities.
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\130\ 5 U.S.C. 603(a).
\131\ 5 U.S.C. 605(b).
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For purposes of Commission rulemaking in connection with the RFA,
small entities include broker-dealers with total capital (net worth
plus subordinated liabilities) of less than $500,000 on the date in the
prior fiscal year as of which its audited financial statements were
prepared pursuant to Rule 17a-5(d) under the Exchange Act,\132\ or, if
not required to file such statements, a broker or dealer that had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the last day of the preceding fiscal year (or in the time that it
has been in business, if shorter); and is not affiliated with any
person (other than a natural person) that is not a small business or
small organization.\133\
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\132\ See 17 CFR 240.17a-5(d).
\133\ See 17 CFR 240.0-10(c).
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The proposed amendments to the securities haircut provisions in
paragraphs (E), (F), and (H) of Rules 15c3-1(c)(2)(vi) and the
conforming amendment to Rule 17a-4, if adopted, would not have a
significant economic impact on a small number of entities. The
Commission preliminarily believes that a broker-dealer with less than
$500,000 in total capital holds very few positions and, in particular,
a small number of debt securities. Thus, the Commission preliminarily
believes that there are few small entities that will be subject to
these new rules. In addition, if there are small broker-dealers that
hold these debt positions, they are already required to examine the
risk associated with their debt securities when taking haircuts on
these securities. The proposed amendments could alter this process but
it would not be a new process that the small broker-dealer would have
to comply with. Accordingly, the rule would not have any significant
economic impact on small entities because even if they have to change
their current process, they are still required to examine the risk
associated with their debt securities.
The proposed amendment to Appendix A to Rule 15c3-1 will not be a
burden to small entities. Although the definition of major market
foreign currency will change, the currencies that meet the definition
will not change.
The proposed amendments to the Appendices E and F to Rule 15c3-1
(which include conforming amendments to Appendix G to Rule 15c3-1 and
the General Instructions to Form X-17A-5, Part IIB), if adopted, would
not apply to small entities. Appendices E and G apply to broker-dealers
that are part of a consolidated supervised entity and Appendix F and
Form X-17A-5, Part IIB apply to OTC Derivatives Dealers that have
applied to the Commission for authorization to compute capital charges
as set forth in Appendix F in lieu of computing securities haircuts
pursuant to Rule 15c3-1(c)(2)(vi). All of these brokers or dealers
would be larger than the definition of a small broker dealer in Rule 0-
10.
The proposed amendments to Exhibit A to Rule 15c3-3, if adopted,
would not have a significant economic impact on a substantial number of
small entities. The proposed amendments to Exhibit A to Rule 15c3-3
would apply only to broker-dealers that clear and carry positions in
security futures products in securities accounts for the benefit of
customers. None of those broker-dealers affected by the rule is a small
entity as defined in Rule 0-10.\134\
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\134\ The main clearing organization, the OCC, requires its
members to have total capital of $2.5 million, far above the
$500,000 total capital threshold for a small business in Rule 0-10.
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With respect to the amendments to Rules 101 and 102 of Regulation
M, it is unlikely that any broker-dealer that is defined as a ``small
business'' or ``small organization'' as defined in Rule 0-10 could be
an underwriter or other distribution participant as they would not have
sufficient capital to participate in underwriting activities. Small
business or small organization for purposes of ``issuers'' or
``person'' other than an investment company is defined as a person who,
on the last day of its most recent fiscal year, had total assets of $5
million or less. The Commission believes that none of the various
persons that would be affected by this proposal would qualify as a
small entity under this definition as it is unlikely that any issuer of
that size had investment grade securities that could rely on the
existing exception. Therefore, the Commission believes that these
amendments would not impose a significant economic impact on a
substantial number of small entities.
The Commission believes that the proposed amendment to Rule 10b-10
will not have a significant economic impact on a substantial number of
small entities. While some broker-dealers that effect transactions in
the debt securities currently subject to paragraph (a)(8) of that rule
may be small entities, the proposed amendment should not result in any
significant change to the cost of providing confirmations to customers
in connection with those transactions.
The Commission encourages written comments regarding this
certification. The Commission solicits comment as to whether the
proposed amendments to Rule 15c3-1, Appendices A, E, F, and G to Rule
15c3-1, Exhibit A to Rule 15c3-3, Rule 17a-4, the General Instructions
to Form X-17A-5, Part IIB, Rules 101 and 102 of Regulation M, and Rule
10b-10, could have an effect on small entities that has not been
considered. The Commission requests that commenters describe the nature
of any impact on small entities and provide empirical data to support
the extent of such impact.
VIII. Statutory Basis and Text of the Proposed Amendments
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly, Sections 3(b), 15, 23(a), and 36 (15 U.S.C. 78c(b), 78o,
78w(a), and 78mm), thereof, and Sections 939 and 939A of the Dodd-Frank
Act, the Commission is proposing to amend Sec. Sec. 240.10b-10,
240.15c3-1, 240.15c3-1a, 240.15c3-1e, 240.15c3-1f, 240.15c3-1g,
240.15c3-3a, 240.17a-4, 242.101, 242.102, and Form X-17A-5 Part IIB
General Instructions under the Exchange Act.
List of Subjects in 17 CFR Parts 240, 242, and 249
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
Text of Amendment
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for part 240 is amended by adding
sectional authorities for Sec. Sec. 240.15c3-1a, 240.15c3-1e,
240.15c3-1f, 240.15c3-1g and for Sec. 240.15c3-3a in numerical order,
and by revising the sectional authorities for Sec. Sec. 240.10b-10,
240.15c3-1, and 240.17a-4.
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 78p, 78q,
78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37,
80b-3, 80b-4, 80b-11, and 7201 et seq.; 18 U.S.C. 1350 and 12 U.S.C.
5221(e)(3), unless otherwise noted.
* * * * *
[[Page 26576]]
Section 240.10b-10 is also issued under secs. 2, 3, 9, 10, 11,
11A, 15, 17, 23, 48 Stat. 891, 89 Stat. 97, 121, 137, 156, (15
U.S.C. 78b, 78c, 78i, 78j, 78k, 78k-1, 78o, 78q) and Pub. L. No.
111-203, secs. 939, 939A, 124. Stat. 1376 (2010) (15 U.S.C. 78c, 15
U.S.C. 78o-7 note).
* * * * *
Section 240.15c3-1 is also issued under secs. 15(c)(3), 15
U.S.C. 78o(c)(3) and Pub. L. No. 111-203, secs. 939, 939A, 124.
Stat. 1376 (2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7 note).
Sections 240.15c3-1a, 240.15c3-1e, 240.15c3-1f, 240.15c3-1g are
also issued under Pub. L. No. 111-203, Sec. Sec. 939, 939A, 124.
Stat. 1376 (2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7 note).
* * * * *
Section 240.15c3-3a is also issued under Pub. L. No. 111-203,
Sec. Sec. 939, 939A, 124. Stat. 1376 (2010) (15 U.S.C. 78c, 15
U.S.C. 78o-7 note).
* * * * *
Section 240.17a-4 also issued under secs. 2, 17, 23(a), 48 Stat.
897, as amended; 15 U.S.C. 78a, 78d-1, 78d-2; sec. 14, Pub. L. 94-
29, 89 Stat. 137 (15 U.S.C. 78a); sec. 18, Pub. L. 94-29, 89 Stat.
155 (15 U.S.C. 78w); and Pub. L. No. 111-203, secs. 939, 939A, 124.
Stat. 1376 (2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7 note)
Sec. 240.10b-10 [Amended]
2. Section 240.10b-10 is amended by removing paragraph (a)(8) and
redesignating paragraph (a)(9) as paragraph (a)(8).
3. Section 240.15c3-1 is amended by revising paragraphs
(c)(2)(vi)(E) introductory text, (c)(2)(vi)(F)(1) introductory text,
(c)(2)(vi)(F)(2) introductory text, and (c)(2)(vi)(H).
The revisions read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
* * * * *
(c) * * *
(2) * * *
(vi) * * *
(E) Commercial paper, bankers acceptances and certificates of
deposit. In the case of any short term promissory note or evidence of
indebtedness which has a fixed rate of interest or is sold at a
discount, which has a maturity date at date of issuance not exceeding
nine months exclusive of days of grace, or any renewal thereof, the
maturity of which is likewise limited, and has only a minimal amount of
credit risk as determined by the broker or dealer pursuant to written
policies and procedures the broker or dealer establishes, maintains,
and enforces to assess creditworthiness, or in the case of any
negotiable certificates of deposit or bankers acceptance or similar
type of instrument issued or guaranteed by any bank as defined in
section 3(a)(6) of the Securities Exchange Act of 1934, the applicable
percentage of the market value of the greater of the long or short
position in each of the categories specified below are:
* * * * *
(F)(1) Nonconvertible debt securities. In the case of
nonconvertible debt securities having a fixed interest rate and a fixed
maturity date, which are not traded flat or in default as to principal
or interest and which have only a minimal amount of credit risk as
determined by the broker or dealer pursuant to written policies and
procedures the broker or dealer establishes, maintains, and enforces to
assess creditworthiness, the applicable percentages of the market value
of the greater of the long or short position in each of the categories
specified below are:
* * * * *
(2) A broker or dealer may elect to exclude from the above
categories long or short positions that are hedged with short or long
positions in securities issued by the United States or any agency
thereof or nonconvertible debt securities having a fixed interest rate
and a fixed maturity date and which are not traded flat or in default
as to principal or interest, and which have only a minimal amount of
credit risk as determined by the broker or dealer pursuant to written
policies and procedures the broker or dealer establishes, maintains,
and enforces to assess creditworthiness, if such securities have
maturity dates:
* * * * *
(H) In the case of cumulative, non-convertible preferred stock
ranking prior to all other classes of stock of the same issuer, which
has only a minimal amount of credit risk as determined by the broker or
dealer pursuant to written policies and procedures the broker or dealer
establishes, maintains, and enforces to assess creditworthiness, and
which are not in arrears as to dividends, the deduction shall be 10% of
the market value of the greater of the long or short position.
* * * * *
Sec. 240.15c3-1a [Amended]
4. Section 240.15c3-1a is amended by removing the phrase ``whose
short term debt is rated in one of the two highest categories by at
least two nationally recognized statistical rating organizations and''
and removing the sentence ``For purposes of this section, the European
Currency Unit (ECU) shall be deemed a major market foreign currency.''
from paragraph (b)(1)(i)(C).
5. Section 240.15c3-1e is amended by:
a. Revising the introductory text in paragraph (c)(4)(vi);
b. Removing paragraphs (c)(4)(vi)(A) through (c)(4)(iv)(D);
c. Redesignating paragraphs (c)(4)(vi)(E), (F), and (G) as
paragraphs (c)(4)(vi)(A), (B), and (C), respectively; and
d. Revising newly redesignated paragraph (c)(4)(vi)(A).
The revisions read as follows:
Sec. 240.15c3-1e Deductions for market and credit risk for certain
brokers or dealers (Appendix E to 17 CFR 240.15c3-1).
* * * * *
(c) * * *
(4) * * *
(vi) Credit risk weights of counterparties. A broker or dealer that
computes its deductions for credit risk pursuant to this Appendix E
shall apply a credit risk weight for transactions with a counterparty
of either 20%, 50%, or 150% based on an internal credit rating the
broker or dealer determines for the counterparty.
(A) As part of its initial application or in an amendment, the
broker or dealer may request Commission approval to apply a credit risk
weight of either 20%, 50%, or 150% based on internal calculations of
credit ratings, including internal estimates of the maturity
adjustment. Based on the strength of the broker's or dealer's internal
credit risk management system, the Commission may approve the
application. The broker or dealer must make and keep current a record
of the basis for the credit rating of each counterparty;
* * * * *
6. Section 240.15c3-1f is amended by:
a. Removing the phrase from paragraph (d)(2), ``the counterparty
factor. The counter party factors are:'' and adding in its place ``a
counterparty factor of 20%, 50%, or 100% based on an internal credit
rating the OTC derivatives dealer determines for the counterparty.'';
and
b. Revising paragraphs (d)(3)(i), (d)(3)(ii), (d)(3)(iii), and
(d)(4).
The revisions read as follows:
Sec. 240.15c3-1f Optional market and credit risk requirements for OTC
derivatives dealers (Appendix F to 17 CFR 240.15c3-1).
* * * * *
(d) * * *
(3) * * *
(i) For counterparties for which an OTC derivatives dealer assigns
an internal rating for senior unsecured long-term debt or commercial
paper that would apply a 20% counterparty factor under (d)(2)(i) of
this section, 5% of the amount of the net replacement value in excess
of 25% of the OTC derivatives dealer's tentative net capital;
[[Page 26577]]
(ii) For counterparties for which an OTC derivatives dealer assigns
an internal rating for senior unsecured long-term debt that would apply
a 50% counterparty factor under (d)(2)(ii) of this section, 20% of the
amount of the net replacement value in excess of 25% of the OTC
derivatives dealer's tentative net capital;
(iii) For counterparties for which an OTC derivatives dealer
assigns an internal rating for senior unsecured long-term debt that
would apply a 100% counterparty factor under (d)(2)(iii) of this
section, 50% of the amount of the net replacement value in excess of
25% of the OTC derivatives dealer's tentative net capital.
(4) Counterparties may be rated by the OTC derivatives dealer, or
by an affiliated bank or affiliated broker-dealer of the OTC
derivatives dealer, upon approval by the Commission on application by
the OTC derivatives dealer. Based on the strength of the OTC
derivatives dealer's internal credit risk management system, the
Commission may approve the application. The OTC derivatives dealer must
make and keep current a record of the basis for the credit rating for
each counterparty.
* * * * *
Sec. Section 240.15c3-1g [Amended]
7. Section 240.15c3-1g(a)(3)(i)(F) is amended by removing the
phrase ``paragraphs (c)(4)(vi)(D) and (c)(4)(vi)(E)'' and adding in its
place ``paragraph (c)(4)(vi)(A) and paragraph (c)(4)(vi)(B)''.
Sec. 240.15c3-3a [Amended]
8. Section 240.15c3-3a is amended by removing paragraph (b)(1)(i)
of Note G and redesignating paragraphs (b)(1)(ii), (iii), and (iv) as
paragraphs (b)(1)(i), (ii), and (iii), respectively.
9. Section 240.17a-4 is amended by:
a. Removing the phrase from paragraph (b)(12), ``Sec. 240.15c3-
1e(c)(4)(vi)(D) and (E)'' and adding in its place ``Sec. 240.15c3-
1e(c)(4)(vi) ''; and
b. Adding paragraph (b)(13).
The addition reads as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(13) The written policies and procedures the broker-dealer
establishes, maintains, and enforces to assess creditworthiness for the
purpose of Sec. 240.15c3-1(c)(2)(vi)(E), (F)(1), (F)(2), and (H).
* * * * *
PART 242--REGULATIONS M, SHO, ATS, AC, AND NMS AND CUSTOMER MARGIN
REQUIREMENTS FOR SECURITY FUTURES
10. The general authority citation for Part 242 is revised and the
following citations are added in numerical order to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, 80a-
37, unless otherwise noted.
* * * * *
Sections 242.101 and 242.102 are also issued under Pub. L. No.
111-203, Sec. Sec. 939, 939A, 124. Stat. 1376 (2010) (15 U.S.C.
78c, 15 U.S.C. 78o-7 note).
* * * * *
11. Section 242.101 is amended by revising paragraph (c)(2) to read
as follows:
Sec. 242.101 Activities by distribution participants.
* * * * *
(c) * * *
(2) Certain nonconvertible and asset-backed securities.
Nonconvertible debt securities, nonconvertible preferred securities,
and asset-backed securities, that are determined and demonstrated by
the distribution participant or affiliated purchaser, and verified by
an independent third party, utilizing reasonable factors of evaluation
to:
(i) Be liquid relative to the market for that asset class;
(ii) Trade in relation to general market interest rates and yield
spreads; and
(iii) Be relatively fungible with securities of similar
characteristics and interest rate yield spreads; or
* * * * *
12. Section 242.102 is amended by revising paragraph (d)(2) to read
as follows:
Sec. 242.102 Activities by issuers and selling security holders
during a distribution.
* * * * *
(d) * * *
(2) Certain nonconvertible and asset-backed securities.
Nonconvertible debt securities, nonconvertible preferred securities,
and asset-backed securities, that are determined and demonstrated by
the issuer, selling security holder, or affiliated purchaser, and
verified by an independent third party, utilizing reasonable factors of
evaluation to:
(i) Be liquid relative to the market for that asset class;
(ii) Trade in relation to general market interest rates and yield
spreads; and
(iii) Be relatively fungible with securities of similar
characteristics and interest rate yield spreads; or
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
13. The authority citation for Part 249 is amended by adding the
following citation in numerical order to read as follows:
Authority: 15 U.S.C. 78a et seq., 7201 et. seq., 18 U.S.C. 1350,
unless otherwise noted.
Section 249.617 is also issued under Pub. L. 111-203, Sec. Sec.
939, 939A, 124. Stat. 1376 (2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7
note).
* * * * *
14. Amend Form X-17A-5 Part IIB General Instructions (referenced in
Sec. 249.617) by:
a. Removing Schedule IV: Internal Credit Rating Conversion; and
b. Removing all but the first sentence in the section ``Credit risk
exposure'' under the heading ``Computation of Net Capital and Required
Net Capital,'' and adding a second sentence that reads ``The counter-
party charge is computed using the credit risk weights assigned to the
OTC derivatives dealer's internal calculations by the Commission under
paragraph (d)(2) of Appendix F.''
Note: The text of Form X-17A-5 Part IIB does not, and this
amendment will not, appear in the Code of Federal Regulations
.* * * * *
Dated: April 27, 2011.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-10619 Filed 5-5-11; 8:45 am]
BILLING CODE 8011-01-P