[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

[[Page 26553]]

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.
---------------------------------------------------------------------------

    \37\ Id.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

     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?
---------------------------------------------------------------------------

    \83\ 17 CFR 242.101(c)(1).
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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%.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \124\ SIFMA Report on Management and Professional Earnings in 
the Securities Industry 2010.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \125\ 15 U.S.C. 78c(f).
    \126\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \130\ 5 U.S.C. 603(a).
    \131\ 5 U.S.C. 605(b).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \132\ See 17 CFR 240.17a-5(d).
    \133\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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