SEC Approves Collateralized Mortgage Obligations Advertising Guidelines for Communications With the Public

Executive Summary

On January 27, 1993, the Securities and Exchange Commission (SEC) approved the NASD's Collateralized Mortgage Obligations Advertising Guidelines (Guidelines). The Guidelines provide a framework for members to assess the accuracy and appropriateness of Collateralized Mortgage Obligations (CMO) advertising. The NASD's Advertising Regulation Department will use the Guidelines to evaluate CMO advertising submitted for review pursuant to Article III, Section 35 of the Rules of Fair Practice or Section 8 of the Government Securities Rules. The full text of the Guidelines, which are effective immediately, follows this Notice.

Background

As short-term interest rates have come down in recent years, the NASD has observed an increasing emphasis by member firms on sales of investment products that are alternatives to certificates of deposit (CDs) and government securities for investors seeking to maximize returns while maintaining a high degree of safety. Asset-backed securities, specifically collateralized mortgage obligations (CMOs), appear to be one of the leading alternatives being actively promoted. Substantiating this observed trend is the NASD Advertising Regulation Department's receipt of an increasing number of advertisements for review relating to CMOs. These advertisements generally emphasize high yields, safety, government guarantees, and liquidity allegedly associated with these securities, and frequently compare them with CDs.

Concurrent with the increase in the number of filings related to CMOs, the NASD is receiving increasing numbers of complaints about CMO advertisements. In light of this trend, the NASD is concerned that the sales practices employed by members in retailing CMOs as alternatives to CDs or government securities imply that CMOs are the equivalent of such instruments in safety and guarantees of interest and principal. The NASD is also concerned about the suitability of CMOs for certain investors, the disclosure of risks, and other sales-practice abuses.

The NASD has taken a number of steps to address the issues relating to CMOs in addition to adopting the Guidelines contained herein. In the September 1991 edition of the

NASD Regulatory & Compliance Alert, the NASD cautioned members about misleading CMO advertising and stated its position on various aspects of such advertising. In Notice to Members 92-27 (May 1992) the NASD restated its previous pronouncement relating to CMO advertisements, and recommended that members adhere to several enumerated standards and file CMO advertisements with the NASD before use. Finally, on October 28, 1992, the SEC approved amendments to Article III, Section 35 of the Rules of Fair Practice and Section 8 of the Government Securities Rules to require members to file CMO advertisements with the NASD's Advertising Regulation Department before use.¹

CMO Advertising Guidelines

The Guidelines contained herein are complementary to, and complete, the previous actions taken by the NASD on CMOs. The Guidelines set forth extensive and detailed standards for CMO advertisements. They will serve not only to govern advertising communications with potential customers, but will also augment the business conduct framework for all communications and sales practices relating to CMOs.

The Guidelines contain General Considerations relating to Product Identification, Safety Claims, Claims About Government Guarantees, Simplicity Claims, and Claims About Predictability. The Guidelines also contain standards relating specifically to print advertising, including a standardized CMO advertisement, and standards for radio and television advertising.

For example, under Product Identification, the Guidelines warn against comparing CMOs to other products. Under Claims About Government Guarantees, the Guidelines emphasize that referring to CMOs as "government guaranteed" is probably misleading, even if the collateral is guaranteed, unless the CMO itself is guaranteed by a government agency. Finally, under Claims About Predictability, the Guidelines caution that it is misleading to state that the yield and average life of a CMO are assured.

The NASD believes that CMOs are complex investment vehicles and communications must fully and fairly disclose all material aspects of CMOs to avoid misleading investors. Further, in the NASD's view all CMOs are not equal, and it is difficult to distinguish between them based on the content of an advertisement. Therefore, communications about CMOs should disclose all information necessary to show the features of the particular CMO being promoted. For example, two CMOs might have the same underlying collateral, yet differ greatly in their likely prepayment rates — the so-called "prepayment assumptions." Further, the advertisement of a CMO yield alone could be misleading without extensive disclosure, such as illustrations showing that yield predictions vary greatly if differing prepayment assumptions, average life, and maturities are used. Finally, terms such as "interest only CMO" or "principal only CMO" are usually not adequately explained in advertisements and should be avoided unless adequate discussion and disclosure is included.

Standardized CMO Advertisement

The Guidelines also provide a standardized CMO advertisement for print advertising that permits members to advertise CMO yields and sets forth the information the NASD deems necessary to prevent the communication from being misleading. Members are not required to use the standardized advertisement; however, members using a non-standardized format should provide the same information and comply with the same conditions as the standardized advertisement. A copy of the standardized advertisement follows the Guidelines at the end of this Notice.

Among the features of the standardized advertisement are: 1) essential information (coupon rate, anticipated yield/average life, specific tranche, final maturity date, and underlying collateral); 2) a disclosure statement indicating that the yield and average life are based on certain prepayment assumptions that may not be realized; 3) optional product features; and 4) broker/dealer information. The Guidelines require that the information in items 1 and 2 appear in all CMO advertising, while item 3 is optional and item 4 may be tailored to the member's preference.

Among the most important of the Guidelines for print advertisements, whether a member uses the standardized advertisement or its own, are the standards relating to statements of the yield and average life. They require that the statements of yield and average life be based on consensus prepayment assumptions from a nationally recognized service, such as Bloomberg, or the member must be able to justify the assumption used. This standard is designed to prevent advertisements which mislead investors by relying on unrealistic or excessively optimistic yield and average-life projections. Finally, the Guidelines also require the disclosure of the specific tranche so that investors may evaluate the quality and characteristics of the security and underlying collateral, features that are unique to each CMO.

Radio/Television Advertising

Finally, the Guidelines set forth standards for radio and television advertising. Because radio and television advertising is subject to much more variability than print advertising, the NASD has not attempted to develop a standardized format. Instead, the Guidelines require that all radio and television advertising contain certain statements or information, including: an oral notice recommending that interested individuals contact their representative for information on CMOs and how CMOs react to certain market conditions; an oral notice regarding prepayment assumptions identical to that required for print advertisements; and, standard information on the CMO being advertised (coupon rate, anticipated yield, average life, final maturity date, specific tranche, underlying collateral and, if applicable, accrual bond disclosure).

The Guidelines will be published in the NASD Manual following Article III, Section 35 of the Rules of Fair Practice. Questions concerning this Notice may be directed to the NASD's Advertising Regulation Department at (202) 728-8330, or to Elliott R. Curzon, Senior Attorney, Office of General Counsel at (202) 728-8451.

¹ See Notice to Members 92-59 (November 1992).

Guidelines Regarding Communications With the Public About Collateralized Mortgage Obligations (CMOs)

1. General Considerations

In order to prevent a communication about CMOs from being false or misleading, there are certain factors to be considered, including, but not limited to, the following.

Product Identification

In order to assure that investors understand exactly what security is being discussed, all communications concerning CMOs should clearly describe the product as a "collateralized mortgage obligation." Member firms should not use proprietary names for CMOs as they do not adequately identify the product.

To prevent confusion and the possibility of misleading the reader, communications should not contain comparisons between CMOs and any other investment vehicle, including Certificates of Deposit.

Safety Claims

A communication should not overstate the relative safety offered by the CMO. Although CMOs generally offer low investment risk, they are subject to market risk like all investment securities and there should be no implication otherwise. Accordingly, references to liquidity should be balanced with disclosure that, upon resale, an investor may receive more or less than his original investment.

Claims About Government Guarantees

Communications should accurately depict the guarantees associated with CMO securities. For example, in most cases it would be misleading to state that CMOs are "government guaranteed" securities. A government agency issue could instead be characterized as government agency backed. Of course, private-issue CMO advertisements should not contain references to guarantees or backing, but may disclose the rating.

If the CMO is offered at a premium, the communication should clearly indicate that the government agency backing applies only to the face value of the CMO, and not to any premium paid. Furthermore, communications should not imply that either the market value or the anticipated yield of the CMO is guaranteed.

Simplicity Claims

CMOs are complex securities and require full, fair and clear disclosure in order to be understood by the investor. A communication should not imply that these are simple securities that may be suitable for any investor seeking high yields. All CMOs do not have the same characteristics and it is misleading to indicate otherwise. Even though two CMOs may have the same underlying collateral, they may differ greatly in their prepayment speed and volatility.

Claims About Predictability

A communication would be misleading if it indicated that the anticipated yield and average life of a CMO were assured. It should disclose that the yield and average life will fluctuate depending on the actual prepayment experience and changes in current interest rates.

2. Print Advertising

Educational advertising, discussing generally the features of CMOs, can be a very useful and informative tool in explaining these securities to the investing public. However, such "generic" advertising should not contain anticipated yields or coupon rates.

Advertising relating to CMOs must be filed with the NASD's Advertising Department for review at least ten days prior to use, pursuant to requirements in Article III, Section 35 of the NASD Rules of Fair Practice and Section 8 of the NASD Government Securities Rules (NASD Rules).

The NASD has developed a standardized CMO yield advertisement that provides information deemed necessary to prevent the communication from being misleading. Members must file the standardized advertisement, ten days prior to its first use, with the NASD Advertising Department.

Members are not required to use the standardized advertisement. If firms do not elect to use the standardized advertisement, they should ensure that their advertising contains the same information and meets the same conditions as the standardized advertisement. Members using a non-standardized format must file the advertisement ten days prior to first use.

After an advertisement has been filed prior to initial use, subsequent use of the identical advertisement, changed only to reflect the updated information for the security being advertised, does not require re-filing with the NASD. Such advertisements must be approved by a principal (or designee) and maintained in the member firm's files as required by NASD Rules.

Standardized CMO Advertisement

The standardized advertisement contains four sections, each of which must be given an equal portion of space in the ad. The information in Sections 1 and 2 is required to be included in advertising for CMOs. The information suggested for Section 3 is optional; therefore, the member may elect to include any, all or none of this information in the advertisement. The information in Section 4 may be tailored to the member's preferred signature.

An example of the standardized format may be found at the end of these Guidelines.

Section 1:

• Title — Collateralized Mortgage Obligations
  
  
• Coupon Rate
  
  
• Anticipated Yield/Average Life
  
  
• Specific Tranche — Number & Class
  
  
• Final Maturity Date
  
  
• Underlying Collateral

Section 2

• Disclosure Statement:
  
  

"The yield and average life shown above consider prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life. Please contact your representative for information on CMOs and how they react to different market conditions."

Section 3

• Product Features (Optional):
  
  
• Minimum Denominations
  
  
• Rating Disclosure
  
  
• Agency/Government Backing
  
  
• Income Payment Structure
  
  
• Generic Description of Tranche (e.g., PAC, Companion)

Section 4

• Company Information:
  
  
• Name, Address, Telephone Number, Representative's Name, Memberships

If this standardized advertisement is used, the following conditions must also be met:

No additional information may be included in the standardized advertisement.

3. Radio/Television Advertising

Radio and television advertising alternatives are too varied to attempt to provide standardized formats for either medium. Such advertisements must be filed with the NASD at least ten days prior to first use. The storyboard or other description should accompany the filing of a television ad.

If an advertisement is filed with the NASD prior to its initial use, it is not necessary to subsequently refile the advertisement if the only changes are to update the information relating to the security being advertised. A copy of each advertisement should be approved by a principal (or designee) and should be maintained, along with a copy of the listing for the CMO or the firm's justification, in the member firm's files in accordance with NASD Rules.

The following guidelines should be followed when developing radio and television advertisements:

Collateralized Mortgage Obligations
8.50% Coupon
8.75% Anticipated Yield to 10-Year Average Life
FNMA 9532X, Final Maturity March 2010
Collateral 100% FNMA 8.50%
The yield and average life shown above consider prepayment assumptions that may or may not be met.
Changes in payments may significantly affect yield and average life.
Please contact your representative for information on CMOs and how they react to different market conditions.
$5,000 Minimum
Income Paid Monthly
AAA (Implied Rating)/V-1 (Fitch Volatility Rating)
U.S. Gov't Agency Backed Generic Description (e.g., PAC, Companion, Sequential Pay Bonds)
Company Name
Contact Person
Address
City, State, ZIP Code
Phone Number
Offered subject to prior sale and price change.
Member SIPC