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94-16 NASD Reminds Members Of Mutual Fund Sales Practice Obligations
The NASD reminds members of their obligations under the Rules of Fair Practice with respect to mutual fund sales practices. Members and their associated persons must ensure that their communications with customers (both oral and written) are accurate and complete regarding disclosure of material information, SIPC coverage, breakpoints, and switching. In addition, members must ensure that suitability requirements are adequately addressed; that they have comprehensive internal supervisory and compliance controls over sales practices; and that their advertising and marketing materials and programs are accurate, fair and balanced, and comply with all applicable rules. Members and their associated persons who fail to communicate information concerning mutual funds accurately and completely may be subject to NASD disciplinary action.
During the last decade, vast sums have moved into mutual funds as investors have searched for higher-yielding investment opportunities. The NASD has noted this trend recently in Notices to Members 93-87 (December 1993) and 91-74 (November 1991) discussing reinvestment of maturing certificates of deposit or other bank depository instruments. The trend has substantially increased the attention members devote to mutual fund sales and has generated explosive growth in mutual fund sales by bank-affiliated broker/dealers and broker/dealers participating in networking arrangements with banks. In light of this trend, the NASD is publishing this Notice to emphasize again to members their obligations to ensure that the investments are suitable for their customers and to disclose and discuss certain matters in the sale of mutual funds.
In recommending the purchase or sale of a mutual fund to a customer, members must disclose all material facts to the customer. To determine adequately whether a fact concerning a mutual fund investment would be material to an investor, the member must attempt to obtain information sufficient to evaluate the suitability of the proposed investment for that investor. 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 amelioration strategies. Disclosure of these and other facts concerning a proposed investment is required if the circumstances surrounding the investment decision lead one to believe the investor would regard a fact as material to his decision whether to invest in the fund.
To the extent there are sales charges associated with such a purchase or sale, such as contingent deferred sales charges on either the fund to be liquidated or the fund to be purchased, members should discuss with the customer the effect of those charges on the anticipated return on investment. Further, if a member recommends the purchase of a fund from a particular fund family based on the ability to switch easily between funds in the family, the member should disclose all fees or charges that may be imposed.
Other information that may enter into the determination of whether a particular fact concerning a proposed fund investment is material includes, but is not limited to, the relative risks and rewards of the investment being liquidated to the proposed investment, the risk aversion of the investor, and the age and/or life expectancy of the investor. While many of these enumerated items are inextricably intertwined with the suitability determination, the NASD believes merely determining that an investment may be suitable for a particular investor does not excuse the member from disclosing material information to that investor.
Members are also advised that, although the prospectus and sales material of a fund include disclosures on many matters, oral representations by sales personnel that contradict the disclosures in the prospectus or sale literature may nullify the effect of the written disclosures and may make the member liable for rule violations and civil damages to the customers that result from such oral representations.
A breakpoint is a reduction in sales charges based on the dollar volume of a purchase exceeding a certain minimum. If a proposed fund or fund family offers breakpoint discounts, members should disclose the existence of the breakpoints to enable the customer to evaluate the desirability of making a qualifying purchase. In this regard, members should be aware that recommending diversification among several funds with similar investment objectives may not be in the best interests of a customer, especially if the sales of those funds occur at prices just below the breakpoints of one or more of the funds sold.
Moreover, the delivery of a "breakpoint letter" to a customer advising the customer of the possibility of breakpoint savings is not a safe harbor for member's compliance with their obligations to their customers. Members must affirmatively advise their customers of the impact of particular breakpoints on the contemplated transactions.
Members also have an obligation to evaluate the net investment advantage of any recommended switch from one fund to another. 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. Further, recommendations to fund investors to engage in market timing transactions should be made, if at all, for transactions in a single family of funds or where there are virtually no transaction costs associated with the trade. Market-timing transactions that do not adhere to this standard may subject the member to an additional burden of proving that the transaction was suitable for the customer. Members have an obligation 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.
Members are cautioned against stating or implying that Securities Investor Protection Corporation (SIPC) provides insurance against the loss of a customer's investment. The sole purpose of SIPC is to protect customers against losses to their account that result from the financial failure of a member. SIPC insurance does not insure against market related investment losses or losses related to misrepresentations by the firm or its employees, nor is it a guarantee against the bankruptcy or default of the issuer of an investment security purchased by a customer. In other words, SIPC is not the equivalent of the Federal Deposit Insurance Corporation (FDIC) and is not a guarantor of the value of a security in the manner that the U. S. Government is the guarantor of the face value of U. S. Treasury securities. Any representation to the contrary by a member or associated person is false and will result in disciplinary action. In addition, a member that fails to inform its customers adequately about the nature of SIPC coverage and account insurance, especially where the member is aware that the customer misunderstands such issues, may face disciplinary action.
Members selling funds to elderly, retired, or first-time investors must have an adequate and reasonable basis for selling a particular fund to the investor. Further, a member should be able to demonstrate the rationale for recommending a particular fund to an investor based on the information obtained pursuant to Article III, Sections 2 and 21 of the Rules of Fair Practice for the purpose of making a suitability determination. As an added measure of care, members may wish to employ the procedures specified under SEC Rule 15g-9(b) for low-priced securities when selling funds to elderly, retired, or first-time investors. Such procedures would assist members in ensuring the suitability of funds sold to such investors.
Members must develop appropriate internal controls, supervisory and compliance, to ensure that mutual fund sales practices comply with all relevant NASD rules, and are consistent with high standards of commercial honor and just and equitable principles of trade. New account and mutual fund sales procedures must include obtaining the information required by the NASD Rules of Fair Practice and other securities laws and rules, and should include requesting information necessary to making an informed suitability determination. Members should also include procedures for supervisory personnel to review the accuracy of information gathered and the appropriateness of the suitability determinations made by their associated persons.
Compliance reviews by member firms should also include account reviews for switching and unsuitable diversification. Finally, members should conduct periodic internal audits of correspondence, advertising, and other marketing efforts to determine compliance with the securities laws and rules.
It should be emphasized that supervision involves much more than establishing written procedures. Implementation of supervisory procedures is critical. Failure to enforce established procedures is the same as having no procedures at all.
Members acting as underwriters of mutual funds must also ensure that all advertising and marketing materials have been filed with and approved by the appropriate regulatory authorities. Any material not required to be filed must, nevertheless, comply with the NASD's advertising rules at Article III, Section 35 of the Rules of Fair Practice. Particular emphasis should be given to the adequacy and prominence of disclosure of information to ensure that material information is not omitted. Members are also cautioned against making or permitting changes to the material in the prospectus or other approved material, especially if the effect of the change is to exaggerate, obscure, or minimize material information.
In addition, members must remain aware of the requirements of the Article III, Section 26 of the Rules of Fair Practice for sales-charge limitations, dealer concessions and discounts, and the maintenance of the public offering price, among others.
Questions regarding this Notice may be directed to R. Clark Hooper, Vice President, Investment Companies Regulation Department, (202) 728-8329, or Elliott R. Curzon, Senior Attorney, Office of General Counsel, (202) 728-8451.