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84-40 Compensation Arrangements with respect to Sale of Mutual Fund Shares
TO: All NASD Members
The Association has been, receiving an increased number of inquiries regarding the application of Article III, Section 26 of the Rules of Fair Practice to certain compensation arrangements, and proposed arrangements, between principal underwriters and dealers in open-end management investment company shares (mutual funds) and unit investment trusts. These inquiries are primarily related to subsection (k) of the rule (the Anti-Reciprocal Rule) and subsection (1) of the rule, which addresses dealer concessions and other forms of compensation.
The Anti-Reciprocal Rule
Subsection (k) of Section 26 prohibits members from favoring or disfavoring the distribution of shares of any particular investment company or group of investment companies on the basis of brokerage commissions received or expected by such member from any source. As outlined below, there are a number of additional specific prohibitions contained in the rule.
As originally adopted in 1973, the Anti-Reciprocal Rule prohibited members from seeking orders for the execution of portfolio transactions on the basis of their sales of investment company shares. Principal underwriter members were similarly prohibited from participating or influencing the investment company to consider sales of investment company shares as a qualifying or disqualifying factor in the selection of a broker-dealer to execute portfolio transactions.
The rule was amended in 1981 to specify that subject to certain restrictions it does not prohibit members from seeking or granting brokerage commissions in connections with the sale of investment company shares, and that it does not prohibit members from selling shares of investment companies which follow a disclosed policy of considering sales of their shares as a factor in the selection of broker-dealers to execute portfolio transactions, subject to best execution.
It appears from the nature of the inquiries recently received that some members may view the 1981 amendments as having altered the specific standards of the rule more extensively than was actually the case. Members should understand that the rule still prohibits:
The following examples represent a condensation of specific situations recently reviewed by the Association's Investment Companies Committee, which situations are inconsistent with the rule:
- a request by a dealer, or an offer or agreement by a principal underwriter, for a specified percentage of portfolio brokerage commissions relative to the dealer's sale of fund shares;
- a request by a dealer, or an offer or agreement by a principal underwriter, that portfolio business be placed to finance all or part of the dealer's sales contest;
- a request by a dealer, or the offer by a principal under writer, that portfolio brokerage commissions be placed as a condition to signing a sales agreement;
- a request by a registered representative, or an offer or agreement by a principal underwriter, that portfolio orders be placed in recognition of the representative's prior or future sales of fund shares; and,
- a request by a dealer, or the offer or agreement by a principal underwriter, that portfolio brokerage commissions be placed on the understanding that this would result in placement of the funds on the dealer's preferred list.
On a separate point, concern has been expressed that the language of the Anti-Reciprocal Rule could connote the Association's intention to prohibit the allocation of brokerage transactions of investment companies other than the specific investment company whose shares are sold by the broker-dealer. This issue relates to the broad question of the degree to which investment companies under common management may be viewed as a group, rather than considering each company as independent. In this respect, the language of the Anti-Reciprocal Rule should not be construed as a statement of views on this broader issue nor as interpreting the provisions of the Investment Company Act of 1940 or any other statute.
Similarly, a number of questions have been raised which relate to a broker-dealer's qualifications to execute institutional transactions. It should be understood that the Anti-Reciprocal Rule is premised on the principle of "best execution" but it does not purport to define the term or to specify the essential ingredients of an investment company's fiduciary obligations in this respect. Therefore, except as they relate to requirements for qualification examinations, net capital, recordkeeping, or similar questions involving a broker-dealer's status to execute transactions, the Association does not intend to respond to inquiries which seek to define the circumstances under which a broker-dealer is "qualified" to execute, or participate in, institutional securities transactions.
Subsection (1) of Section 26 addresses requirements with respect to the payment of dealer concessions and other compensation (including distribution fees paid pursuant to SEC Rule 12b-l under the Investment Company Act of 1940). This rule was also amended in 1981 to allow, among other things, non-uniform dealer concessions which are specifically disclosed in a fund's prospectus, and non-cash concessions or compensation if the dealer is given an option to receive the cash equivalent value of a non-cash concession. The rule also specifies certain items which will not be considered to be of material value and therefore are not dealer concessions which must be disclosed in the fund's prospectus.
Recent inquiries with respect to the dealer concession aspect of the rule also reflect that some members may not clearly understand certain of its basic principles.
First, no dealer concessions may be paid to individual registered representatives of another member. Dealer concessions, by definition, represent compensation earned by, and paid to, a dealer. Payments to another member's representatives may also raise questions with respect to the need to register those representatives directly with the paying member.
Secondly, those items specified in the rule as not constituting items of material value are presumed to be unconditional and not tied to any past or future sales quotas. A gift, for example, is assumed to be just that: an unconditional token remembrance. If a "gift" must be earned by sales of fund shares, it is a dealer concession which must be disclosed in the fund's prospectus and may not be paid to an individual representative of another member even if disclosed.
On another point, non-cash concessions earned by a dealer must be confirmed by the principal underwriter, and such concessions are subject to NASD assessments on gross income, irrespective of whether the receiving member chooses to award such non-cash concessions to individual representatives, and irrespective of whether such representatives are "independent contractors."
Examples of inquiries recently received by the Association's Investment Companies Committee, which examples are considered to be inconsistent with Section 26(1), are as follows:
- payment by a principal underwriter to a dealer to offset expenses incurred in "due diligence" or in training registered representatives;
- payment by a principal underwriter of a special concession to a dealer holding a sales contest, without prospectus disclosure of the terms of the arrangement and the identity of the dealer;
- reimbursement by a principal underwriter of a dealer's "start-up costs";
- the financing or expense reimbursement by a principal underwriter of a dealer's sales contest expense without specific prospectus disclosure;
- the exclusion of the funds of a principal underwriter from qualification for a dealer's sales contest unless the under writer pays for some portion of the contest prizes; and,
- a "business meeting" held by a mutual fund principal under writer, at a resort hotel, for dealer representatives meeting specified sales quotas.
The foregoing examples of conduct inconsistent with Section 26 are not all-inclusive. Members are urged to familiarize all personnel with the requirements and prohibitions of this rule. Formal disciplinary actions in this area have been taken, others are under consideration, and District Business Conduct Committees have been requested to pay particular attention to this area in the future.
Questions regarding this notice should be directed to Robert L. Butler at 1735 K Street, N.W., Washington, D.C. 20006. Telephone: (202) 728-8329.
Very truly yours
Gordon S. Macklin