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91-40 SEC Approval of Amendment Regarding Disclosure of Contingent Deferred Sales Charges on Confirmations

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EXECUTIVE SUMMARY

The Securities and Exchange Commission has approved an amendment to Article III, Section 26 of the NASD Rules of Fair Practice that requires members selling investment company shares to disclose the existence of deferred sales charges on the front of the customer's purchase confirmation. The amendment will take effect October 1, 1991. The text of the amendment follows this notice.

BACKGROUND

On April 11, 1991, the Securities and Exchange Commission (SEC or "Commission") approved an amendment to Article III, Section 26 of the NASD Rules of Fair Practice (SEC Release No. 34-29069) that adds a new subsection (n) to Section 26. Subsection 26(n) requires member firms selling investment company shares to disclose the existence of deferred sales charges on the front of a customer's purchase confirmation.

In April 1989, the NASD published Notice to Members 89-35 advising members that it would be a violation of the NASD Rules of Fair Practice for a registered representative to state or imply to a prospective investor that an investment company with a contingent deferred sales charge is a "no load fund." The notice resulted from a number of complaints received by the NASD from investors who claimed they were unaware of the existence of a sales charge on redemption and that they had been advised that the companies were "no load" or "no initial load" funds.

In that notice, the NASD indicated that a contingent deferred sales load is a sales load that is charged on redemption on a declining-percentage basis annually and is usually reduced to zero percent by the sixth or seventh year of share ownership. The NASD stated that to assert that a mutual fund with a contingent deferred sales load is a "no load" fund is an unacceptable misrepresentation and that to state that there is "no initial load" without explanation of the nature of the contingent deferred sales load is an omission of material information.

The NASD believes that it is the responsibility of all members and their registered representatives to ensure that prospective investors understand the nature of the various charges made by mutual funds to defray sales and sales-promotion expenses, regardless of whether they are deducted from an investor's initial purchase payment, charged on redemption, or levied against the net assets of the fund. The NASD also believes that disclosure on confirmations of the possibility of a deferred sales charge on redemption would help to alert prospective investors to the existence of such charges before they have paid for the shares. Many investors apparently do not study the prospectus thoroughly before making a purchase of investment company shares and often rely on the oral representations of a registered representative. Thus, through inadvertence or design, they may not be aware of the possibility of a sales charge on redemption.

EXPLANATION

Because of the continuing potential for investors to be unaware of deferred sales charges and the NASD's continuing concern that reliance on disclosures of sales loads in prospectuses may not be sufficient to alert investors to the existence of a deferred sales charge at the time of the purchase, the NASD is adding a new subsection (n) to Section 26 of the Rules of Fair Practice. The new subsection requires that a short, simple disclosure statement be included on all confirmations for investment company shares that impose a deferred sales charge on redemption. The amendment to Section 26 was approved by a vote of the membership in Notice to Members 90-27 (May 1990).

The amendment originally was proposed as an amendment to Section 12. The comments on the amendment to Section 12 received from the membership, however, indicated that applying the requirement to insurance company variable contracts would not advance the purposes of the proposed rule change. The disclosure problem that the amendment was designed to solve was related exclusively to mutual funds, not insurance company variable contracts. Therefore, the NASD decided to make the requirement a part of Section 26, which specifically applies to investment companies.

The disclosure requirement in Section 26(n) applies only to "sales charges" — charges and fees that are used to finance sales-related expenses.

Nominal and short-term charges that are not used to pay for sales-related expenses and that are returned to the mutual fund as a credit to the net assets of the fund are not covered by the new disclosure requirement.1

In order to provide sufficient time for members to modify their procedures to comply with the new disclosure request, the amendment will take effect October 1, 1991. Any questions regarding this amendment should be directed to A. John Taylor, Vice President, Investment Companies/Variable Contracts, at (202) 728-8329.

TEXT OF NEW SUBSECTION 26(n) TO ARTICLE III, SECTION 26 OF THE NASD RULES OF FAIR PRACTICE

(Note: New language is underlined.)

Investment Companies

Sec. 26

* * * * *

Disclosure of Deferred Sales Charges

(n) In addition to the requirements for disclosure on written confirmations of transactions contained in Section 12 of the NASD Rules of Fair Practice, if the transaction involves the purchase of shares of an investment company that imposes a deferred sales charge on redemption, such written confirmation shall also include the following legend: "On selling your shares, you may pay a sales charge. For the charge and other fees, see the prospectus." The legend shall appear on the front of a confirmation and in, at least, 8-point type.

1 See SR-NASD-90-69, published for comment in Notice to Members 90-26 (April 16, 1990), proposing amendments to Article III, Section 26 of the Rules of Fair Practice relating to asset-based sales charge limits, for a discussion of the term "sales charge."


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