Request for Comments on Proposed Amendments to Article III, Sections 26 and 29 of The NASD Rules of Fair Practice Re: Cash and Noncash Compensation Received by Members in Connection With the Sale of Investment Company Securities and Variable Cont
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EXECUTIVE SUMMARY
The NASD requests comments on proposed amendments to Article III, Sections 26 and 29 of the NASD Rules of Fair Practice. The amendments would revise, simplify, and add a recordkeeping requirement to subsection (1) of Section 26 and add a similar requirement (new subsection (h)) to Section 29.
BACKGROUND
In July 1989, the NASD Board of Governors, in Notice to Members 89-51, requested comment on proposed amendments to subsection (1), Article III, Section 26 of the NASD Rules of Fair Practice that would have revised and simplified the rule and added a recordkeeping requirement. The NASD received six comment letters, and the Board decided not to proceed further with the adoption of the amendments at that time because it wished to give further consideration to the issue of whether members should be prohibited from receiving noncash sales incentives for the sale of investment company securities and variable contracts similar to the prohibitions contained in Section 5(e) to Appendix F, Article III, Section 34 of the Rules of Fair Practice, which applies to direct participation programs.
The Board has now decided not to recommend prohibiting such noncash sales incentives and also considers, on the recommendation of the Variable Contracts Committee, that a requirement similar to subsection (1) of Article III, Section 26 should be added to the Variable Contracts Rule (Article III, Section 29 of the NASD Rules of Fair Practice).
The proposed amendments in this notice are essentially the same as those contained in Notice to Members 89-51.
PROPOSED AMENDMENTS
Although the main purpose of the proposed amendments is to adopt a recordkeeping requirement for members with respect to noncash sales incentives, the amendments also provide an opportunity to revise the rule to reflect current practices in the offer of investment company securities.
The major requirement of the current rule, which is prospectus disclosure of compensation, cash and noncash, is retained, as are the disclosure requirements with respect to "special deals."
The requirement that a member must be given the opportunity to take cash in lieu of a noncash concession has been eliminated since experience indicates that it is rarely used.
Subsection (b)(7) — Definitions
The current rule governs the relationship between underwriters of and dealers in investment company securities with respect to concessions paid by the former to the latter for the retail sale of investment company securities. This is because the rule was adopted before the advent of asset-based and deferred sales charges, when the method of paying dealers was the reallowance to a dealer by an underwriter of part of the front-end sales charge.
Nowadays, payments to dealers may emanate from front-end, deferred, and asset-based sales charges and may be paid by underwriters and investment companies.
Thus, the term "dealer concession" in the current rule is no longer appropriate and has been replaced by the term "compensation." "Compensation" is intended to encompass every kind of payment received by a member for retailing investment company securities, regardless of the source of the payment or the payor.
The term "cash compensation" is defined to include any kind of payment in cash, by check, and by electronic means. "Non-cash compensation" is defined to include any payment received by a member that is not cash compensation. The noncash compensation items that are often used in the industry are included in the definition.
All the persons and entities likely to be pay-ors are defined collectively as "offerors."
Since the revised definitions section defines "compensation" and "offeror," most of current paragraph (1)(1) is superfluous. It has been replaced by an introductory sentence stating that the rule applies to the sale of investment company securities.
This is a new paragraph that will require members to keep records of the receipt and distribution of all compensation, cash and noncash, from offerors. It is anticipated that this requirement will enhance a member's ability to control the flow of noncash sales incentives from offerors to registered representatives.
The current rule prohibits an underwriter or its associated persons from paying a concession directly to an associated person of a member. Payments must be made to a member for distribution to its representatives. Since today, payments may be made by entities other than an underwriter who are not NASD members (e.g., a mutual fund) the paragraph has been revised to prohibit associated persons of members from accepting compensation for selling investment company securities from anyone other than the member with which they are registered.
In situations where compensation is in the form of merchandise, board and lodging, travel vouchers, or tickets, it would be difficult, in some circumstances, for the compensation to be routed physically through a member firm. Compliance with the rule in these situations would require that the offer be directed to the member, that the member decide whether to accept or reject the offer, and that the member record any such noncash compensation received by its registered representatives.
This is the same provision as in the current rule with minor language changes. It prohibits a member or persons associated with a member from receiving compensation in the form of securities of any kind. The three kinds of securities — stock, warrants, and options — that appear in the current rule have been omitted in the proposed amendment. They are redundant because the rule refers to "securities of any kind." It is interesting to note that the kinds of securities most likely to be offered — mutual funds or investment management company stock — are not named in the current rule.
The proposed amendments omit the provision in the current rule that a member must be given an opportunity by the underwriter to accept cash in lieu of a noncash concession. Experience indicates that this option is rarely, if ever, chosen by a member.
The current rule is primarily a disclosure rule. The concept of an "item of material value" is used to determine whether there must be disclosure of a concession in the prospectus. The current rule lists some items that are and some that are not considered to be items of material value.
Prior to the adoption of the current rule, the NASD had a "special deals" interpretation. From time to time, members would inquire whether a particular item was considered to be a "special deal." If it was, it was prohibited. When the current rule was being developed, it was decided to include some of the special deals that had been prohibited by interpretation as items of material value subject to disclosure in the prospectus. Similarly, those that were of limited material value and had not been prohibited were included as items not required to be disclosed in the prospectus.
The proposed amendments do not contemplate using the concept of an "item of material value" because the term "compensation" is intended to cover all forms of compensation (including, for example, loans and overrides) that a member or its associated persons may be offered for selling investment company securities.
This paragraph describes two items that are not required to be disclosed in prospectuses provided they are not conditioned on sales. Those items are gifts of not more than $100 per person per annum and payments to members to defray the cost of educational and training meetings held at an appropriate business location. Both of these items are deemed to be compensation and would be subject to the recordkeeping requirement in paragraph (1). The Investment Companies Committee is requesting the submission of comments addressing the burden imposed on members by this recordkeeping requirement.
This paragraph reiterates the provisions of the current rule (paragraph (4)) with minor language changes.
SUMMARY
The primary intent of the proposed amendments is to introduce a recordkeeping requirement. The fundamental purpose of the rule, to require disclosure in prospectuses of all forms of compensation paid to members for selling investment company securities to the public, is retained. The prohibitions against associated persons receiving compensation directly from offerors without the knowledge and agreement of their member firms is also retained.
In addition, the proposed amendments revise and simplify many of the current rules' provisions and modernize them to reflect current practices utilized in the investment company industry in compensating NASD members for the retail sale of investment company securities.
Currently, Section 29 does not contain a similar section dealing with cash and noncash compensation. In proposing that similar rule amendments be added to Section 29, the language has been changed where necessary to accommodate procedures and language used in the variable contracts industry. Moreover, the recordkeeping and disclosure requirements proposed to be adopted in Sections 26 and 29 differ from the prohibitions contained in Section 5(e) to Appendix F, Article III, Section 34 of the Rules of Fair Practice that apply to noncash sales incentives in connection with the sale of direct participation programs.
The NASD encourages all members and other interested parties to comment on the proposed amendments to Article III, Sections 26 and 29, of the Rules of Fair Practice. Comments should be forwarded to Stephen Hickman, Office of the Secretary, National Association of Securities Dealers, Inc., 1735 K Street, NW, Washington, D.C. 20006-1506. Comments should be received by June 4, 1991.
Questions concerning this notice should be directed to A. John Taylor, Vice President, Investment Companies/Variable Contracts, at (202) 728-8328.
PROPOSED AMENDMENT TO ARTICLE III, SECTION 26 OF THE NASD RULES OF FAIR PRACTICE
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Definitions
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"Offeror" shall mean an investment company, an adviser to an investment company, an under-writer and any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such entities.
"Cash compensation" shall mean compensation received by member in cash, by check and by electronic means and shall include loans and overrides.
"Non-cash compensation" shall mean any form of compensation received by members that is not cash compensation, including but not limited to merchandise, gifts and prizes, and payment of travel expenses, meals and lodging.
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[Dealer concessions]
Member Compensation
PROPOSED AMENDMENT TO ARTICLE III, SECTION 29 OF THE NASD RULES OF FAIR PRACTICE
(Note: New text is underlined.)
Definitions
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"Offeror" shall mean a separate account of an insurance company, an adviser to a separate account of an insurance company, an underwriter and any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such entities.
"Cash compensation" shall mean compensation received by members in cash, by check and by electronic means and shall include loans and overrides.
"Non-cash compensation" shall mean any form of compensation received by members that is not cash compensation, including but not limited to merchandise, gifts and prizes, and payment of travel expenses, meals and lodging.
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Member Compensation