Request for Comments on Recision of the Guidelines Regarding Communications With the Public About Investment Companies and Variable Contracts (Guidelines) And Proposed Amendments to the NASD Rules of Fair Practice to Incorporate Items From the Gu

EXECUTIVE SUMMARY

The NASD requests comments on a proposal to rescind the Guidelines and to amend Article III, Section 35 of the Association's Rules of Fair Practice to include items that were contained in the Guidelines regarding disclosure about tax free/tax exempt returns, comparisons, and projections of performance. The text of the proposed amendments and a copy of the Guidelines follow this notice.

BACKGROUND

In 1979, the Securities and Exchange Commission (SEC) rescinded the Statement of Policy on Investment Company Sales Literature (SOP) that for many years had governed the content of advertising and sales literature used in the sale of investment company shares. To provide guidance to members in the preparation of such communications with the public, the NASD developed the Guidelines, which were adopted in 1982 and are included at ¶ 5286 of the NASD Manual. Since then, the SEC has amended Rule 482 under the Securities Act of 1933 and adopted Rule 34b-1 under the Investment Company Act of 1940 regarding the portrayal of investment company performance in communications with the public. This has rendered much of the content of the Guidelines obsolete.

The remaining content, except for three areas, is covered by the standards already set forth in Article III, Section 35 of the Rules of Fair Practice. The NASD therefore proposes to rescind the Guidelines and to retain three sections (claims of tax free/tax exempt returns, comparisons, and prohibitions on projections of performance) that would become part of Article III, Section 35 of the Rules of Fair Practice, the NASD rule governing communications with the public.

THE GUIDELINES

The NASD Guidelines, published February 8, 1982, were primarily designed to assist NASD members in complying with the NASD rules governing communications with the public, especially in view of the withdrawal of the SOP. The Guidelines are divided into five sections:

The Investment Companies and Insurance Affiliated Member Committees were asked to consider the status of the Guidelines in light of the 1988 amendments to SEC Rule 482 and adoption of SEC Rule 34b-1, and in light of standards already contained in Article III, Section 35. The SEC rules created new requirements governing the presentation of performance in investment company advertising and sales literature. The revisions have made many aspects of the Guidelines obsolete as they apply to open-end investment companies and variable annuities. The rule revisions do not apply to unit investment trusts, closed-end funds, or variable life insurance. The standards in Section 35 render the remaining portions of the Guidelines redundant and duplicative, as these standards overlap with the considerations set forth in the Guidelines.

Analysis of the Guidelines

Section 1. General Considerations

This section sets forth general factors to be considered in determining whether a communication may be misleading. Those factors include:

Section 35(d)(1) requires that communications be based on principles of fair dealing and good faith. Such communications must provide a sound basis for evaluating the facts and must not mislead the reader by omitting material information. The section prohibits exaggerated, unwarranted, or misleading statements and requires that the risks inherent in any investment be considered in the preparation of a communication with the public.

The considerations set forth in Section 1 of the Guidelines are covered by the standards currently set forth in Section 35 and, thus, it is not necessary to retain them.

Section 2. Special Considerations in Presenting Investment Results

This section sets forth basic principles designed to reduce the risk of a reader attributing unwarranted predictive value to data concerning investment results.

• Investment Objectives and Policies as Related to Data Provided — This principle stresses the need for performance illustrations to show the relationship of such performance to investment objectives and cautions that material changes in objectives, policies, management, etc. during the time period illustrated should be described.
  
  SEC Rule 482, as amended, requires that performance be calculated in a specified manner, and if such changes have occurred, it requires the fund's performance to reflect such changes. Thus, the Guidelines are superseded by the requirements of the SEC rule.
  
  
• Appropriateness and Fairness of Time Periods Illustrated — This principle addresses the need to show performance for appropriate time periods and sets forth recommendations of what those periods should be.
  
  SEC Rule 482, as amended, requires that performance be shown for one-, five-, and ten-year time periods. Thus, the Guidelines are superseded by the requirements of the SEC rule.
  
  
• Adequacy of Information Concerning the Relevance of Results Illustrated to Probable Future Results — This principle stresses, "Investment results cannot be predicted or projected. . . " and it urges that long-term illustrations make clear that short-term fluctuations exist.
  
  The requirement that the risk of fluctuation be disclosed is covered by existing standards of Section 35. The prohibition on projections or predictions of investment management results is not and, therefore, it is proposed as a new standard to be incorporated into Section 35.
  
  
• The Clarity of a Chart or Table Format — This principle addresses the need to present statistical data in a clear, complete, and not misleading format.
  
  Section 35 (d) prohibits misleading information or the omission of material facts. Thus, this principle is already addressed in the current standards.
  
  
• The Adequacy of Summary Results and the Need for Supporting Data — This principle urges that summary results be accompanied by year-by-year supporting data.
  
  SEC Rule 482 requires summary results for one, five, and ten years and does not require supporting information. Thus, this section is rendered obsolete by the rule.
  
  
• Inclusion of Relevant Charges and Expenses — This principle addresses the need to show performance results net of applicable charges and expenses.
  
  SEC Rule 482 requires that performance results be calculated by a standardized formula, which takes into account expenses. In addition, Section 35 prohibits the omission of material information. Therefore, performance calculations, whether pursuant to the restrictions of Rule 482 or to the standards of Section 35, are required to reflect expenses. Thus, this section is rendered both obsolete and redundant.

Section 3. Specific Considerations in Presenting Capital Results in Total Return Illustrations

This section sets forth specific guidelines for presenting total return information, including time periods illustrated, disclosures to accompany such illustrations, and recommended components of these illustrations.

Rule 482 requires that total return information, calculated by standardized methods, be provided for specific time periods. It further sets forth specific disclosures regarding fund performance that must be included in every communication illustrating such performance. Since these disclosures satisfy the SEC, it would appear unnecessary to require any additional information as suggested by this section.

Section 4. Specific Considerations in Presenting Yield Data or Illustrations

This section sets forth principles governing income or yield illustrations. Included among these principles are disclosures concerning risk of fluctuation of income and capital value as well as information about the portfolio. The section recommends methods for calculating historic, current, and annualized yields. Finally, the section addresses the concern that yields or income should not be described as free or exempt from income taxes in situations where liability is postponed or deferred.

The provisions of Rule 482 clearly restrict the methods by which current yields may be calculated, both for money market and non-money market funds. These restrictions are in direct contradiction to the considerations set forth in the Guidelines and, therefore, the latter should be rescinded.

The principle regarding the need to disclose any relevant taxes when describing yields or income as tax-free or tax-exempt is not addressed by SEC rules. While the general standards of Section 35 prohibit the omission of material information or the inclusion of misleading standards, the recommendations set forth in this section are not clearly addressed. Therefore, the NASD proposes to incorporate this principle as a new standard in Section 35.

Section 5. Considerations Regarding Comparisons

This section of the Guidelines stresses the necessity that comparisons of investment products or services be complete, fair, and balanced, and that they clearly explain any material differences between the subjects in order to make the comparisons not misleading.

While these recommendations concerning comparisons are supported by the general standards of Section 35, the Board believes that a section should be added to the rule that clearly explains specific points to be addressed when developing complete and fair comparisons.

SUMMARY

The Board of Governors believes that it is appropriate to withdraw the Guidelines altogether and amend Article III, Section 35 to incorporate standards addressing the three areas mentioned directly above. In addition to eliminating the inconsistencies and redundancies by rescinding the Guidelines, the incorporation of the three outstanding issues would consolidate the regulations under one rule. Also, the standards relating to tax free/lax exempt claims, comparisons, and predictions or projections would equally apply to all types of securities, not just to registered investment companies.

The NASD encourages all members and other interested parties to comment on the proposal to rescind the Guidelines and to simultaneously amend Article III, Section 35 of the Rules of Fair Practice to include standards addressing these three concerns. The new standards would be included as Specific Standards under Section (d)(2) of Section 35, as (d)(2)(L), (d)(2)(M), and (d)(2)(N). Comments should be forwarded to:

Stephen Hickman
Office of the Secretary
National Association of
Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506.

Comments should be received no later than January 20, 1992.

Questions concerning this notice should be directed to R. Clark Hooper, Director, Advertising Department, at (202) 728-8330.

GUIDELINES REGARDING COMMUNICATIONS WITH THE PUBLIC ABOUT INVESTMENT COMPANIES AND VARIABLE CONTRACTS

(Note: The entire text of the Guidelines is proposed to be deleted.)

1. General Considerations

In judging whether a communication, or a particular element of a communication, may be misleading, several factors should be considered, including, but not limited to:

The Overall Context in Which the Statement or Statements Are Made

A statement made in one context may be misleading even though such a statement could be perfectly appropriate in another context. An essential test in this regard is the balance of treatment of risks and potential benefits.

The Audience to Which the Communication is Directed

Different levels of explanation or detail may be necessary depending on the audience to which a communication is directed, and the ability of the member, given the nature of the media used, to restrict the audience appropriately. If the statements made in a communication would be applicable only to a limited audience, or if additional information might be necessary for other audiences, it should be kept in mind that it is not always possible to restrict the readership of a particular communication.

The Overall Clarity of the Communication

A statement or disclosure made in an unclear manner obviously can result in a lack of understanding of the statement, or in a serious misunderstanding. A complex or overly technical explanation may be worse than too little information. Likewise, material disclosure relegated to legends or footnotes realistically may not enhance the reader's understanding of the communication.

2. Special Considerations in Presenting Investment Results

Presentations of investment results require special care to insure that they are not misleading. While it is not possible to prevent every reader of a communication which illustrates investment results from attributing unwarranted predictive value to the data, adequate consideration of certain basic principles can reduce this risk. Among these basic principles are:

Investment Objectives and Policies as Related to Data Provided

Generally speaking, illustrations of investment results should be designed to illustrate the relationship of investment performance to stated investment objectives over meaningful periods. If material changes in objectives, policies, management, or other characteristics have occurred during or since the time period illustrated, these changes should be described.

Appropriateness and Fairness of the Time Periods Illustrated

In general, the appropriate time periods for illustrations of results are those which are of sufficient duration that the relevance of the data to the investment objectives can be determined. Thus yield or performance data may cover a variety of different periods for different types of investments. The selection of a specific time period solely for the purpose of illustrating performance "at its best" is likely to mislead. Illustrations should generally include the last full calendar or fiscal year, or the last twelve months.

Adequacy of Information Concerning the Relevance of Results Illustrated to Probable Future Results

Investment results cannot be predicted or projected and historical illustrations should reflect this. Presentations of investment results should be made in a context that makes clear that within the longer periods illustrated there have been short term fluctuations, often counter to the overall trend of investment results, and that no single period of any length is to be taken as "typical" of what may be expected in future periods. This is a simple principle, and not one which should require a great deal of boiler plate language but rather a simple, straightforward explanation.

The Clarity of a Chart or Table Format

In selection of a format for illustration of investment results in either chart or table form, consideration should be given not only to the completeness and accuracy of the data, but also to the clarity and meaningfulness of the overall presentation. Careful consideration should be given to the overall visual impact of data presented in chart form, since the reader may not go beyond a scanning of the "trend" shown by a chart. It should be recognized that the reader who is confused by having been buried in masses of unclear, although statistically relevant, data may be misled just as badly as the reader who is given too little information.

The Adequacy of Summary Results and the Need for Supporting Data

While a summary of investments results is often necessary in order to make sales literature readable and understandable, it must be recognized that the reader may not look beyond the summary data presented. Consequently, the preparer of such illustrations should take into account that the summary data must be fair in all respects and not likely to mislead, either directly or by distracting the reader from other necessary information. Generally speaking, all summary data covering periods longer than one year should be supported by full year-by-year data over the same or longer periods and should include reference to that supporting data. If supporting data is not included in the same piece of sales literature, members should carefully consider supplying the data in another document.

Inclusion of Relevant Charges and Expenses

Illustrations of income and/or capital results should reflect the results which would have been achieved by the reader for whom the illustration is designed. Actual sales charges, account charges or deductions, and any other relevant expenses which would have been applicable should be taken into account in the illustration, unless such current charges are different, in which case the current charges should be described. Illustrations of gross investment results may be appropriate under certain limited circumstances, but such illustrations should normally be accompanied by an explanation of how such results would be affected by all applicable charges and expenses.

3. Specific Considerations in Presenting Capital Results in Total Return Illustrations

Application of the foregoing principles to illustrations involving capital results, either alone or as part of a "total return" illustration, results in the following specific considerations.

Capital results illustrations, including "total return" data, should generally cover a period long enough to reflect variations in value through different market conditions. A period of ten years, or if shorter, the life of the company or account, is the recommended minimum illustration period, with periods longer than ten years being in five year increments. In illustrations of other periods, particularly shorter periods, members should consider whether to include with such illustration an explanation of the reason for selecting such period and whether data for the recommended ten year or life minimum period should be included with such illustration or in another specifically referenced document, such as a prospectus or shareholder report. Generally, data for full calendar or fiscal years should be reflected. A discussion of the general trends of relevant securities prices during the period may be desirable to lend proper perspective to such illustrations. Illustrations dealing solely with capital results should explain the relative significance of income.

Illustrations of "total return" (i.e. illustrations which reflect the combined results of capital and income) should reflect dollar and/or percentage changes for each year covered by the illustration, as well as for the total period. The illustration should, except for variable contracts, show the breakdown of the income and capital components at least for the total period covered. Where such a breakdown for the total period would not adequately convey the significance of annual variations in the components, consideration should be given to including annual income and capital data. If dividends are assumed to have been reinvested, the illustration should reflect the actual frequency and results of such reinvestments during the period. Illustrations of performance results in chart form may be misleading because of the scale on which they are displayed. Generally, if an illustration of capital results or of total return is in chart form, a semi-log (ratio) format is recommended.

4. Specific Considerations in Presenting Yield Data or Illustrations

Application of the foregoing general principles to income or yield illustrations results in the following specific considerations.

Any illustration or statement of yield should be accompanied by an explanation of how the yield is computed, along with any additional information necessary to fairly evaluate the yield, including a reference to such risks as may be involved in ownership of the security. Depending on the circumstances, one or more of the following may be appropriate:

• a statement concerning the variability of income;
  
  
• a statement of the variability of capital value, e.g., the net asset value at the beginning and end of the previous calendar or fiscal year, or during a recent market advance or decline;
  
  
• information about the general characteristics of the portfolio and any material portfolio changes which are anticipated.

Historic yields should be calculated by dividing the company's annual dividends from net investment income by the maximum offering price of the company's shares, using either the average price during the year or the price at the beginning or end of the year.

Current yields should generally be calculated by dividing the company's dividend income for the previous twelve months by the current maximum offering price. However, annualized yields based on periods of less than one year may be appropriate in some cases, e.g., money market funds, funds with less than a full year's history, and funds where the current rate of dividend income varies significantly from the dividends paid in the previous twelve months. Such annualized yield should be based on the company's gross income less actual expenses for the period.

Yields or income should not be characterized as tax sheltered or as free or exempt from income tax where tax liability is merely postponed or deferred. Unless income is free from all income taxes, references to tax exemption should indicate which taxes apply or specify which taxes do not apply. For example, if income from an investment company investing in municipal bonds may be subject to state or local income taxes, this should be stated, or the illustration should otherwise make it clear that income is free from federal income tax.

5. Considerations Regarding Comparisons

Comparisons of investment products or services may be, valuable or useful to investors but care must be taken to insure that comparisons are fair and balanced. Comparisons generally should include explanation of the purpose of the comparison and explanation of any material differences between the subjects of the comparison.

Comparisons involving investment companies and variable contracts are often related to yield or performance, but may also relate to structure, fees, tax features and other matters. It is essential that a comparison be as complete as practicable and that no fact be omitted which, if disclosed, would likely alter materially the conclusions reasonably drawn or implied by the comparison. This point is particularly important with respect to selection of time periods for comparison of investment results. Data for each subject of the comparison should also be presented on the same basis, i.e., for the same period in terms of both aggregate and year by year data.

Comparisons with alternative investment or savings vehicles should explain clearly any relevant differences in guarantees, fluctuation of principal and/or return, insurance, tax features, and any other factors necessary to make such comparisons fair and not misleading.

A comparison of investment performance with a market index or average generally should, if appropriate in view of the nature of the comparison, include a clear indication of the purpose of the comparison and the reason or purpose for selection of the index or average, and a description of the index and the fact that it is unmanaged. The extent of the explanation necessary will vary, depending upon the degree of general recognition of the particular index. If there are material differences between the composition of the index and the composition of the portfolio, this should be pointed out. If the comparison is not on a total return basis, the relative impact of differences in income or capital changes, whichever is applicable, should also be explained.

Unless the comparison clearly explains the material relevant differences, a comparison with an index, average, or group of investment companies or accounts should relate to an index, average, or group of investment companies or accounts with investment objectives similar to that of the company compared. Where possible, it is advisable to use an independently prepared and published index, average or group. The smaller or less widely recognized the group or category selected, the greater the importance of explaining the reason for the selection. Since overall investment company industry averages generally include diverse portfolios and objectives, comparisons with such averages should generally not be used.

PROPOSED AMENDMENTS TO ARTICLE III, SECTION 35 OF THE NASD RULES OF FAIR PRACTICE

(Note: New text is underlined.)

COMMUNICATIONS WITH THE PUBLIC

Sec. 35

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