Notice To Members 86-54

Proposed Amendment to Article III, Section 26 of the NASD Rules of Fair Practice Governing the Prompt Payment for Investment Company Shares Sold to Customers by NASD Members

Published Date:

IMPORTANT MAIL VOTE

OFFICERS, PARTNERS AND PROPRIETORS

TO: All NASD Members

LAST VOTING DATE IS SEPTEMBER 2, 1986.

Enclosed is a proposed new rule (attached as Exhibit I) that will amend Article III, Section 26 of the NASD Rules of Fair Practice by the addition of new subsection (m). Proposed new subsection (m) was approved by the NASD Board of Governors and now requires membership approval. If approved by the membership, it must be filed with and approved by the Securities and Exchange Commission before becoming effective. As discussed below, the proposed rule was published for comment on August 30, 1985 (Notice to Members 85-58) and again on December 24, 1985 (Notice to Members 85-86).

BACKGROUND OF THE PROPOSED RULE

In recent years, the investment company ("mutual fund") industry has experienced unprecedented growth. In 1957, there were 143 mutual funds with $87 billion in net assets and annual sales of $1.4 billion. By 1985, there were 1,531 mutual funds with $495 billion in net assets and annual sales of $114 billion.

Almost 60 percent of investors' purchases and redemptions of mutual funds (excluding short-term funds) are processed by NASD member firms and their agents using a variety of non-uniform procedures and systems, many of which are costly and inefficient. The ever-increasing number of transactions led to the development of the FUND/SERV system. This system, which is operated by the National Securities Clearing Corporation (NSCC), will automate, standardize and centralize the processing of mutual fund transactions by interposing NSCC between broker-dealers and mutual funds. A pilot program has recently been completed and the FUND/SERV system will gradually be phased in over the next few years.

The system will provide for net settlement in a participant's account with NSCC on the fifth business day following trade date (T + 5).

For the past 29 years, prompt payment by members for mutual fund shares that they have sold to customers has been governed by the NASD Board of Governors Prompt Payment Interpretation (Paragraph 5265 of the NASD Manual). (See Exhibit II, which is attached.) The Interpretation does not include a definition of "prompt payment." It is proposed that this Interpretation will be rescinded and new subsection (m) will be adopted.

EXPLANATION OF PROPOSED RULE

New subsection (m) will contain a definition of "prompt payment."

Paragraph (1) of subsection (m) will require members, including underwriters, who engage in direct retail transactions with customers, to transmit payments to mutual funds or their agents ("payees") by the later of trade date plus five business days (T + 5) or the end of one business day following receipt of a customer's payment for such shares. However, members will be required to transmit payments to payees by the end of the seventh business day following receipt of a customer's order (T + 7) whether or not they have received payment from a customer.

Essentially, the proposed rule adopts a standard for settlement (T + 5) similar to that being used by the FUND/SERV system. However, it recognizes that for members who may not use the system, some flexibility should be permitted in the settlement procedure to allow sufficient time for customers' checks to clear.

Paragraph (2) of subsection (m) will require members that are underwriters and that engage in wholesale transactions with other members to transmit payments received from such members to payees by the end of two business days following receipt of such payments.

As time progresses and the FUND/SERV system becomes fully operative, the Board anticipates that most members that offer mutual fund shares will find it advantageous, in terms of efficiency, ease of settlement and cost, to utilize the FUND/SERV system.

COMMENTS RECEIVED

The NASD received 40 responses to Notice to Members 85-58 and 17 responses to Notice to Members 85-86. In response to commentators, the final form of the proposed rule differs considerably from that originally proposed in these earlier notices.

The major concerns expressed by commentators and to which the Board responded are:

1. Some members requested clarification of the term "transmit" in the proposed rule.
The Board believes that it is not necessary to define the term "transmit," since it has the usual and customary meaning for purposes of the rule, i.e.; to send, transfer, dispatch or convey payments to payees, by any means, within the time parameters specified in the rule.
2. The proposed rule should not be adopted until the FUND/SERV system is fully operative.
The Board understands that the FUND/SERV system has only recently commenced operations following a successful pilot program. It will be some time, probably as much as two years, before the system is fully operative and all the prospective participants have joined the system. The Board does not consider that there is any reason to delay adopting the proposed rule, particularly since its provisions will mainly affect members that will not participate in the FUND/SERV system. This is because participants in the FUND/SERV system, which uses the standard T + 5 net settlement procedure, will normally be in compliance with the provisions of the proposed rule.
3. The proposed rule should require similar prompt payment by mutual funds to members when mutual funds are redeemed.
Neither the Board's current interpretation regarding prompt payment nor the proposed rule deals with prompt payment on redemption. This is because the law that governs such, Section 22(e) of the Investment Company Act of 1940, requires mutual funds to pay redemption proceeds within seven days after the tender of the security to the fund or to its agent. The Board therefore believes that it is not in a position to amend the rule as suggested by these commentators.
4. The proposed rule does not provide enough time for customers' checks, in payment for mutual funds purchased through members, to clear. Thus, members may not be in possession of "good funds" at the expiration of the time parameters proposed in the rule.
When the rule was originally drafted, a maximum time period of T + 5 business days was proposed. This was modified subsequently, as a result of comments received, to provide the alternative and the T + 7 maximum time period as described above. The Board considers that a total time period of eight days (T + 7) from the trade date to the settlement date is adequate to deal with the majority of mutual fund transactions.
5. A time period of one business day from the day of receipt for transmittal of payments to mutual funds or their agents by underwriters engaged in wholesale transactions does not provide sufficient time for checks to clear.
In response to this comment, the Board amended proposed paragraph (2) of subsection (m) to provide for a time period of two business days from the receipt of payment to transmittal.

* * * * *

The text of the proposed rule is attached as Exhibit I. Also, attached as Exhibit n, is a copy of the current Paragraph 5265 of the NASD Manual, which is proposed to be rescinded.

The Board of Governors believes that the proposed rule is necessary and appropriate and recommends that members vote their approval. Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than September 2, 1986.

Questions concerning this notice may be directed to A. John Taylor, Vice President, NASD Investment Companies/Variable Contracts, at (202) 728-8328.

Sincerely,

Lynn Nellius
Secretary

Attachments

Exhibit I

PROPOSED AMENDMENT TO ARTICLE III, SECTION 26 OF THE NASD RULES OF FAIR PRACTICE

Prompt Payment for Investment Company Shares

(m)
(1) Members (including underwriters) who engage in direct retail transactions for investment company shares shall transmit payments for such shares, which such members have sold to customers, to payees (i.e., underwriters, investment companies or their designated agents) by (1) the end of the fifth business day following receipt of a customer order to purchase such shares or by (2) the end of one business day following receipt of a customer's payment for such shares, whichever is the later date; provided, however, that members shall transmit such payments to payees by the end of the seventh business day following receipt of a customer order to purchase such shares whether or not payment has been received from a customer.
(2) Members who are underwriters and who engage in wholesale transactions for investment company shares shall transmit payments for investment company shares, which such members have received from other members, to investment company issuers or their designated agents by the end of two business days following receipt of such payments.

Exhibit II

••• Interpretation of the Board of Governors*

¶5265

Prompt Payment by Members for Shares of Investment Companies

Failure by members to pay underwriters (who are also members) promptly, and failure by underwriters to insist upon such prompt payment by members, for investment company shares which members have sold to customers is contrary to the accepted standards of the business.

Members are required to transmit payment to underwriters (or custodians) promptly after the date of the transaction. Underwriters must pay issuers for shares acquired to fill dealers' orders promptly after the date of the transaction.

Members must maintain records, showing date of transaction, date upon which payment is received from customer, and date of payment to underwriter, as to all transactions in investment company shares.

In the event an underwriter does not receive payment from a member within ten (10) business days following the date of any transaction involving more than $100, or if any check received from a dealer for payment of an open transaction is returned by a bank as uncollectable, regardless of when the check was originally received, the underwriter must immediately notify the district office of the Association in the district where the dealer's office is located. The notice to the Association shall state that the underwriter has communicated with the member and shall contain any explanation furnished by the member for the failure to make prompt payment. A copy of this notice must be furnished to the member involved.

Failure to comply with the procedures set forth herein may be considered a violation of Section 1 of Article III of the Rules of Fair Practice.

Transactions in investment company shares between customers and members are subject to Regulation T of the Federal Reserve Board. However, the Interpretation above is in no way related to Regulation T.

[As amended effective August 3, 1978.]

* This interpretation of the NASD Board of Governors is proposed to be deleted in its entirety.