Proposed Recision of the Guidelines Regarding Communications With the Public About Investment Companies and Variable Contracts (Guidelines) and Proposed Amendments to Article III, Section 35 of the Rules of Fair Practice to Incorporate Items From
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MAIL VOTE
EXECUTIVE SUMMARY
The NASD invites members to vote on a proposal to rescind the Guidelines and to amend Article III. Section 35 of the Rules of Fair Practice to include items that were contained in the Guidelines and would apply to advertisements for all types of investment products. The text of the proposed amendments and a copy of the Guidelines follow this Notice.
BACKGROUND AND DESCRIPTION OF PROPOSAL
The Guidelines were adopted by the NASD in 1982 following the Securities and Exchange Commission's (SEC) 1979 repeal of its Statement of Policy on Investment Company Sales Literature and are set forth at ¶ 5286 of the NASD Manual. When the SEC amended Rule 482 under the Securities Act of 1933 and adopted Rule 34b-1 under the Investment Company Act of 1940 relating to the communication of investment company performance to the public, many of the provisions of the Guidelines became obsolete. Accordingly, the NASD is proposing to rescind the Guidelines and amend Article III, Section 35 of the Rules of Fair Practice by adding those provisions of the Guidelines that imposed general standards for communications and certain of the Guidelines' specific standards for communications concerning claims of tax-free or tax-exempt returns, comparisons, and predictions and projections would become part of Article III, Section 35. The amended provisions would apply to advertisements for all types of investments, whereas the application of the Guidelines was restricted to investment company and variable contract products.
Proposed new Subsection 35(d)(1)(D) would incorporate the entire provision set forth as "General Considerations," which is currently included in the first section of the Guidelines, under the provision contained in Section 35 that imposes general "Standards Applicable to Communications With the Public." The first standard under new paragraph 35(d)(1)(D)(i) relates to the overall context of a statement and would require members to consider that a statement may be misleading in one context while being perfectly appropriate in another context. The principal test of this standard is whether the statement adequately balances the potential risks with the potential benefits. The proposed rule language is identical to that currently contained in the Guidelines.
The standard set forth in proposed new paragraph 35(d)(1)(D)(ii) relates to the importance of the target audience as a factor in evaluating the communication. The provision would require varying levels of explanation or detail in a communication depending on the audience and the member's ability to restrict the communication to the intended audience. Members are required to consider the likelihood that the communication could be received by persons for whom the explanations or information are inadequate or misleading. The proposed rule language is identical to that currently contained in the Guidelines.
The standard set forth in new paragraph 35(d)(1)(D)(iii) would require that all statements in communications be made clearly and cautions against complex or overly technical explanations and the inclusion of material information in legends or footnotes. The proposed rule language is identical to that currently contained in the Guidelines.
New Subsections 35(d)(2)(L), (M), and (N) would incorporate concepts contained in the Guidelines into the requirements set forth in Section 35 as "Specific Standards" for communications with the public. Subsection 35(d)(2)(L) would prohibit members from calling an investment "tax free" or "tax exempt" if tax liability is merely postponed or deferred, and requires that if there are references to tax-free/tax-exempt current income or if taxes are payable on redemption, those facts and any applicable taxes must be adequately disclosed. The rule language of this provision is drawn from the last paragraph of the section in the Guidelines titled "4. Specific Considerations in Presenting Yield Data or Illustrations."
Subsection 35(d)(2)(M) would require members, when using comparisons, to ensure that the comparisons are clear, fair, balanced, and include any material differences between the subjects of the comparison such as liquidity, safety, investment objectives, and fees, among others. The rule language of this provision is drawn from the first three paragraphs of the section in the Guidelines titled "5. Considerations Regarding Comparisons."
Subsection 35(d)(2)(N) would prohibit members from predicting or projecting future performance on any basis, including past performance. Hypothetical illustrations of mathematical principles such as dollar-cost averaging, however, are not considered projections of performance. The rule language of this provision is based on that included in the section in the Guidelines titled "Adequacy of Information Concerning the Relevance of Results Illustrated to Probable Future Results."
Comments Received on Proposed Amendments
The NASD published the proposed amendments to Subsections 35 (d)(2)(L), (M), and (N) for comment in Notice to Members 91-79 (December 1991). The NASD received five comment letters with four favoring the proposal and one opposed to one provision. In response, the Board of Governors (Board) has approved a number of changes to the original version of the amendments to Article III, Section 35 as published for comment.
In one instance, the Board amended the original proposal to add new Subsection 35(d)(1)(D) relating to "General Standards" to incorporate matters from the Guidelines that the commenter believed are not expressly covered elsewhere in Section 35. The Board also modified proposed Subsection 35(d)(2)(L) relating to tax-free/tax-exempt claims to specify that adequate disclosure would require disclosure of which taxes apply or which do not (as opposed to disclosure of both).
The Board also modified proposed Subsection 35(d)(2)(M) covering comparisons to include a specific reference to differences in the safety of investments and to clarify that the requirement to disclose material differences may include those listed in the subsection thus distinguishing between differences that, although listed, may not be material. The Board, however, did not as suggested modify Subsection 35(d)(2)(M) to only require disclosure of "relevant" material differences on the basis that the terms "material" and "relevant" are synonymous.
Rejecting another recommendation, the Board retained proposed Subsection 35(d)(2)(N) to prohibit all predictions or projections of performance because such projections are likely to be speculative and, therefore, misleading under the antifraud provisions of the federal securities laws. The Board believes the proposed subsection addresses specific forms of communication, while the anti-fraud provisions are general in nature. Another suggestion called for modifying the subsection to permit statements relating to results from zero coupon bond portfolios and hypothetical illustrations (such as dollar-cost averaging or tax-free compounding charts). The Board rejected the suggestion regarding zero coupon bond portfolios because of the variety of zero coupon bond funds and because of the changes in expectations if the shares are liquidated; however, the Board agreed with the recommendation regarding hypothetical illustrations of mathematical principles. The Board also deleted the first reference to "future" in this subsection on grounds of redundancy.
REQUEST FOR VOTE
The Board believes that it is appropriate to rescind the Guidelines and amend Article III, Section 35 to incorporate and make applicable to all investment products standards that were previously applicable only to investment company/variable contract products. In addition to eliminating redundancies by rescinding the Guidelines, the incorporation of general and specific standards previously only applicable to investment company/ variable contract products would consolidate the regulations under one rule. The Board considers the proposed amendments necessary and appropriate and recommends that members vote their approval.
The text of the proposed amendments to Article III, Section 35 that requires member vote is below. The text of the Guidelines which are proposed to be deleted in their entirety follow the amendments to Article III, Section 35. Please mark the attached ballot according to your convictions and mail it in the enclosed, stamped envelope to The Corporation Trust Company. Ballots must be postmarked no later than December 21, 1992. The amendment will not be effective until it is filed with and approved by the SEC.
Questions concerning this Notice should be directed to R. Clark Hooper, Vice President, Advertising, at (202) 728-8330, or Elliott R. Curzon, Senior Attorney, Office of General Counsel (202)728-8451.
PROPOSED AMENDMENT TO ARTICLE III, SECTION 35 OF THE RULES OF FAIR PRACTICE REQUIRING MEMBER VOTE
(Note: New text is underlined; deleted text is in brackets.)
ARTICLE III
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Communications With The Public
Sec. 35.
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In addition to the foregoing general standards, the following specific standards apply:
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(Note: Entire text is proposed to be deleted.)
[GUIDELINES REGARDING COMMUNICATIONS WITH THE PUBLIC ABOUT INVESTMENT COMPANIES AND VARIABLE CONTRACTS
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.
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 investment 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.
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.
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 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.
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.
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 an 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, fluctuations 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.]