NASD Further Explains Members Obligations And Responsibilities Regarding Mutual Funds Sales Practices

Executive Summary

The obligation of NASD^® members under the Rules of Fair Practice with respect to mutual fund sales practices is a continuing concern of the NASD. The proliferation of new mutual funds and varied fee structures has significantly increased the options available for investors. As a result, the mutual fund selection process has become more complex.

To make appropriate recommendations, members and their associated persons, collectively referred to herein as "members," must know the key points regarding the mutual funds they recommend or sell. Members must ensure:

• complete and balanced disclosure is made to investors regarding the distinctions among classes of a multi-class fund or feeders of a master-feeder fund;
  
  
• if an expense ratio is represented as an advantage of a particular fund, it is explained in the context of and compared with other mutual fund expense ratios;
  
  
• if a mutual fund portfolio may include financial derivatives, the potential risks involved are fully disclosed and explained;
  
  
• when performance information is presented, the concepts of total return, yield, and distribution rates are explained to and understood by the investor;
  
  
• any recommendation made is suitable and based on the investor's investment objectives;
  
  
• any recommendation that a customer switch mutual funds is made with the investor's best interest in mind, rather than based on incentives received by the associated person;
  
  
• materials designed for internal or "dealer only" use are not distributed in any manner to the public, orally or in writing; and
  
  
• electronic communications are treated the same as any other advertising and/or sales literature, and are supervised and used only under the same parameters.

Members who fail to carry out these obligations and responsibilities, or who do not communicate information concerning mutual funds accurately and completely, may be subject to NASD disciplinary action.

Background

In Notice to Members 94-16 (March 1994), the NASD reminded members of their obligations under the Rules of Fair Practice with respect to mutual fund sales practices. Members were instructed to ensure that their communications with the public (oral and written) were accurate and complete regarding disclosure of material information, SIPC coverage, breakpoints, and switching. Comprehensive internal supervisory and compliance controls are needed to ensure that mutual fund sales practices comply with all relevant NASD Rules and are consistent with just and equitable principals of trade. Previous Notices to Members 93-87 (December 1993) and 91-74 (November 1991) also addressed sales practice issues relating to the growth of mutual fund sales as a result of the reinvestment of maturing certificates of deposit or other bank depository instruments.

Due to the development of innovative and more complex mutual fund products, and to expanding channels of distribution, additional concerns have arisen since the publication of Notice to Members 94-16. The NASD has observed, commensurate with the increasing complexity of the structure of mutual funds, an increase in the varieties of sales charges and service charges associated with fund sales. The NASD is concerned that investors may not understand the distinctions among and ramifications of these various products, their fee structures and charges. It is imperative that the associated person recommend the most suitable mutual fund, based on the goals, investment objectives, and financial status of the investor, without being influenced by incentive arrangements.

Disclosure

Material facts must be disclosed to investors in recommending the purchase of a mutual fund. The member must attempt to obtain information sufficient to determine the suitability of the recommendation for the investor and to evaluate whether factors concerning that mutual fund recommendation are material to the investor. As addressed in Notice to Members 94-16, material facts may include, but are not limited to, the fund's investment objective; the fund's portfolio, historical income, or capital appreciation; the fund's expense ratio and sales charges; risks of investing in the fund relative to other investments; and the fund's hedging or risk management strategies. Disclosure of these and other facts concerning a recommended investment is required because this information is material to the investor's investment decision.

As indicated earlier, sales charges and service charges associated with fund sales have become increasingly complex. In multi-class funds, each class of the fund participates in the same underlying portfolio but may have different expenses, levels of service, and other options. Consequently, each class generates a different share price and performance record, and appears as a separate fund in newspaper fund listings.

Master-feeder funds are two-tiered structures in which one or more registered open-end funds (feeder) invest in a single investment company (master). Similar to the various classes of a multi-class fund, the feeder funds may have various distribution configurations tailored to specific markets.

Prospectuses disclose many of the details of these products. However, members are reminded that they must provide sufficient information for investors to understand and evaluate the structure of multi-class and master-feeder funds. As the number of share classes continues to increase, it is imperative that investors are told the differences among a front-end load, a spread load (deferred sales charge and 12b-1 fee), and a level load, and that they are instructed about why one type of fee may be higher or lower than another. Another important disclosure relates to explaining how factors such as the amount invested, the rate of return, the amount of time the investor remains in the fund, and the fund's conversion features affect an investor's overall costs.

To the extent that members declare expense ratios as material to an investor purchasing fund shares, these expense ratios need to be explained and compared with those of other mutual funds. Expense ratios are derived by dividing a fund's annual operating expenses by average net assets. Operating expenses may include management fees, investment advisory fees, director fees, 12b-1 fees, and expenses for preparing and mailing prospectuses and financial reports.

Concerning tax issues, members should remind investors, where appropriate, that distributions of interest, dividends, and capital gains are subject to federal income tax even though the customer chooses to have the funds reinvested. A high portfolio turnover also generates higher transaction costs and may affect taxes.

In offering funds that invest in financial derivatives, members must make clear to investors the risks involved. For example, funds that use repurchase agreements, purchase mortgage-related securities, purchase securities on a "when issued" basis, or purchase or sell securities on a "forward commitment" basis all involve special risks. Such risks are material to an investor's decision as to whether the mutual fund is a suitable investment. Members should familiarize themselves with a fund's investment objective, portfolio techniques, and policies as noted in the prospectus, and should convey such information to investors.

Performance Information

When recommending mutual funds, members should make certain that investors understand the concept of total return. When explaining total return, members should ensure that investors understand that total return measures overall performance of a mutual fund, whereas current yield is based only on interest or dividend income received by the fund. Relatedly, where appropriate, members should explain to investors the difference between return of principal and return on principal.

Members are reminded that the Securities and Exchange Commission (SEC) requires that a yield quotation in an advertisement be restricted to a quotation of current yield based on the SEC formula, as calculated in the Statement of Additional Information, and the quotation must be accompanied by quotations of total return. Thus, when presenting information to customers regarding distribution rates, members must fully explain the difference between distribution rate and current yield.

Suitability

A starting point in a member's recommendation of a mutual fund is to clearly define the investor's objectives and financial situation. The need for current income, liquidity, diversification, and acceptable levels of risk are important considerations common to most investors. In recommending mutual funds, the member should match the investor's objective with the stated objective and investment strategy of a particular fund. An added concern relative to funds having multiple fee structures is not only matching the type of fund to the investor's objective, but also recommending the appropriate fee structure. Article III, Section 2 of the Rules of Fair Practice states that, in recommending to the investor the purchase, sale, or exchange of any security, the member must have reasonable grounds for believing that the recommendation is suitable for such investor, based on the facts disclosed by the investor. A member should be able to demonstrate the rationale for its recommendation and suitability determination, based on the information in Article III, Sections 2 and 21 of the Rules of Fair Practice.

Switching

In Notice to Members 94-16, members were reminded of their obligation to ensure that any recommendation to switch mutual funds is evaluated with regard to the net investment advantage to the investor. Switching among certain fund types may be difficult to justify if the financial gain or investment objective to be achieved by the switch is undermined by the transaction fees associated with the switch. For example, if a member recommends that an investor redeem a mutual fund purchased with a front-end sales load, and then purchase another fund with a contingent deferred sales charge, it would be inappropriate to assert that no sales charge will be paid relative to the new fund purchase because the investor may redeem the shares before the contingent period ends. Additionally, many funds with contingent deferred sales charges also assess asset-based sales charges. Thus, the member must disclose that an investor who holds the fund long term may pay more than the economic equivalent of a front-end sales charge. Further, recommendations to engage in market timing transactions should be made for transactions in a single family of funds or where there are virtually no transaction costs associated with the trade.

Members must not recommend that a customer switch from one mutual fund to another based on the compensation that the member or its associated persons will receive for effecting the switch. Members are obligated to ensure that their supervisory and compliance procedures are adequate to monitor switching of customers among funds, and should be prepared to document their reasons for switching a customer from one fund to another.

Dealer-Use-Only Material

Members must make certain that material intended for distribution only to dealers and registered representatives is not delivered to the public unless the material is in compliance with all Rules applicable to communication with the public.

Fund sponsors, dealers and wholesalers often use this material to educate sales personnel about the benefits of a fund and to provide marketing ideas. This material is not required to be filed with the NASD as "sales literature" because it is considered an internal communication and thus it is exempt from NASD filing requirements. Consequently, the material is not reviewed by the NASD for compliance with applicable rules. If such material is ever passed on to investors, the material would be considered sales literature and must be filed with the NASD. The NASD will review the material under the same standards as other material used with the public.

Members preparing and distributing dealer-use-only material are urged to label all such material clearly and prominently, indicating that it is not approved for distribution to the public, and must not be copied or used with the public. Members should limit the extent of distribution of such material and be aware of who it has been given to, including how many copies are sent to each location.

The NASD is also concerned about oral presentations based on information contained in dealer-use-only material. This practice could present a potential regulatory problem if the material has not been filed with and reviewed by the NASD, as there can be no assurance that the information provided to investors is in accordance with applicable rules.

Electronic Communications

Members are reminded that they have the same obligations under the NASD Rules of Fair Practice, specifically Article III, Section 35, relative to communications with the public sent electronically via computer as they do with regard to any other type of communication covered by these rules. Communications available to network subscribers, including items displayed over network bulletin boards, are considered to be advertising, while personalized messages sent directly to targeted individuals or groups are considered to be sales literature.

Members also have substantial supervisory obligations in this area, as they are responsible for the content of any computer interactive communications with the public, just as they would be responsible for the content of advertising, sales literature, or correspondence. Therefore, members must establish internal controls and procedures to ensure that the approval, recordkeeping, and filing requirements are satisfied. Where relevant, members' written supervisory procedures should describe the firm's policies and practices relative to the use of electronic communications. For example, a firm may wish to prohibit its associated persons from using electronic communications for any securities-related activities, or a firm could adopt procedures to require firm personnel to obtain the firm's prior approval before using the Internet or other on-line service.

Questions concerning this Special Notice should be directed to Clark Hooper, Vice President, Advertising/ Investment Companies Regulation Department, at (202) 728-8325 or Lawrence Kosciulek, Assistant Director, Advertising/Investment Companies Regulation Department, at (202) 728-8329.

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