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91-25 Request for Comments on Proposed Amendments to Article III, Sections 26 and 29 of The NASD Rules of Fair Practice Re: Cash and Noncash Compensation Received by Members in Connection With the Sale of Investment Company Securities and Variable Cont

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EXECUTIVE SUMMARY

The NASD requests comments on proposed amendments to Article III, Sections 26 and 29 of the NASD Rules of Fair Practice. The amendments would revise, simplify, and add a recordkeeping requirement to subsection (1) of Section 26 and add a similar requirement (new subsection (h)) to Section 29.

BACKGROUND

In July 1989, the NASD Board of Governors, in Notice to Members 89-51, requested comment on proposed amendments to subsection (1), Article III, Section 26 of the NASD Rules of Fair Practice that would have revised and simplified the rule and added a recordkeeping requirement. The NASD received six comment letters, and the Board decided not to proceed further with the adoption of the amendments at that time because it wished to give further consideration to the issue of whether members should be prohibited from receiving noncash sales incentives for the sale of investment company securities and variable contracts similar to the prohibitions contained in Section 5(e) to Appendix F, Article III, Section 34 of the Rules of Fair Practice, which applies to direct participation programs.

The Board has now decided not to recommend prohibiting such noncash sales incentives and also considers, on the recommendation of the Variable Contracts Committee, that a requirement similar to subsection (1) of Article III, Section 26 should be added to the Variable Contracts Rule (Article III, Section 29 of the NASD Rules of Fair Practice).

The proposed amendments in this notice are essentially the same as those contained in Notice to Members 89-51.

PROPOSED AMENDMENTS

Although the main purpose of the proposed amendments is to adopt a recordkeeping requirement for members with respect to noncash sales incentives, the amendments also provide an opportunity to revise the rule to reflect current practices in the offer of investment company securities.

The major requirement of the current rule, which is prospectus disclosure of compensation, cash and noncash, is retained, as are the disclosure requirements with respect to "special deals."

The requirement that a member must be given the opportunity to take cash in lieu of a noncash concession has been eliminated since experience indicates that it is rarely used.

Subsection (b)(7) — Definitions

The current rule governs the relationship between underwriters of and dealers in investment company securities with respect to concessions paid by the former to the latter for the retail sale of investment company securities. This is because the rule was adopted before the advent of asset-based and deferred sales charges, when the method of paying dealers was the reallowance to a dealer by an underwriter of part of the front-end sales charge.

Nowadays, payments to dealers may emanate from front-end, deferred, and asset-based sales charges and may be paid by underwriters and investment companies.

Thus, the term "dealer concession" in the current rule is no longer appropriate and has been replaced by the term "compensation." "Compensation" is intended to encompass every kind of payment received by a member for retailing investment company securities, regardless of the source of the payment or the payor.

The term "cash compensation" is defined to include any kind of payment in cash, by check, and by electronic means. "Non-cash compensation" is defined to include any payment received by a member that is not cash compensation. The noncash compensation items that are often used in the industry are included in the definition.

All the persons and entities likely to be pay-ors are defined collectively as "offerors."

Subsection (1)

Since the revised definitions section defines "compensation" and "offeror," most of current paragraph (1)(1) is superfluous. It has been replaced by an introductory sentence stating that the rule applies to the sale of investment company securities.
Paragraph (1)

This is a new paragraph that will require members to keep records of the receipt and distribution of all compensation, cash and noncash, from offerors. It is anticipated that this requirement will enhance a member's ability to control the flow of noncash sales incentives from offerors to registered representatives.
Paragraph (2)

The current rule prohibits an underwriter or its associated persons from paying a concession directly to an associated person of a member. Payments must be made to a member for distribution to its representatives. Since today, payments may be made by entities other than an underwriter who are not NASD members (e.g., a mutual fund) the paragraph has been revised to prohibit associated persons of members from accepting compensation for selling investment company securities from anyone other than the member with which they are registered.

In situations where compensation is in the form of merchandise, board and lodging, travel vouchers, or tickets, it would be difficult, in some circumstances, for the compensation to be routed physically through a member firm. Compliance with the rule in these situations would require that the offer be directed to the member, that the member decide whether to accept or reject the offer, and that the member record any such noncash compensation received by its registered representatives.
Paragraph (3)

This is the same provision as in the current rule with minor language changes. It prohibits a member or persons associated with a member from receiving compensation in the form of securities of any kind. The three kinds of securities — stock, warrants, and options — that appear in the current rule have been omitted in the proposed amendment. They are redundant because the rule refers to "securities of any kind." It is interesting to note that the kinds of securities most likely to be offered — mutual funds or investment management company stock — are not named in the current rule.

The proposed amendments omit the provision in the current rule that a member must be given an opportunity by the underwriter to accept cash in lieu of a noncash concession. Experience indicates that this option is rarely, if ever, chosen by a member.
Paragraph (4)

The current rule is primarily a disclosure rule. The concept of an "item of material value" is used to determine whether there must be disclosure of a concession in the prospectus. The current rule lists some items that are and some that are not considered to be items of material value.

Prior to the adoption of the current rule, the NASD had a "special deals" interpretation. From time to time, members would inquire whether a particular item was considered to be a "special deal." If it was, it was prohibited. When the current rule was being developed, it was decided to include some of the special deals that had been prohibited by interpretation as items of material value subject to disclosure in the prospectus. Similarly, those that were of limited material value and had not been prohibited were included as items not required to be disclosed in the prospectus.

The proposed amendments do not contemplate using the concept of an "item of material value" because the term "compensation" is intended to cover all forms of compensation (including, for example, loans and overrides) that a member or its associated persons may be offered for selling investment company securities.
Paragraph (5)

This paragraph describes two items that are not required to be disclosed in prospectuses provided they are not conditioned on sales. Those items are gifts of not more than $100 per person per annum and payments to members to defray the cost of educational and training meetings held at an appropriate business location. Both of these items are deemed to be compensation and would be subject to the recordkeeping requirement in paragraph (1). The Investment Companies Committee is requesting the submission of comments addressing the burden imposed on members by this recordkeeping requirement.
Paragraph (6)

This paragraph reiterates the provisions of the current rule (paragraph (4)) with minor language changes.

SUMMARY

The primary intent of the proposed amendments is to introduce a recordkeeping requirement. The fundamental purpose of the rule, to require disclosure in prospectuses of all forms of compensation paid to members for selling investment company securities to the public, is retained. The prohibitions against associated persons receiving compensation directly from offerors without the knowledge and agreement of their member firms is also retained.

In addition, the proposed amendments revise and simplify many of the current rules' provisions and modernize them to reflect current practices utilized in the investment company industry in compensating NASD members for the retail sale of investment company securities.

Currently, Section 29 does not contain a similar section dealing with cash and noncash compensation. In proposing that similar rule amendments be added to Section 29, the language has been changed where necessary to accommodate procedures and language used in the variable contracts industry. Moreover, the recordkeeping and disclosure requirements proposed to be adopted in Sections 26 and 29 differ from the prohibitions contained in Section 5(e) to Appendix F, Article III, Section 34 of the Rules of Fair Practice that apply to noncash sales incentives in connection with the sale of direct participation programs.

The NASD encourages all members and other interested parties to comment on the proposed amendments to Article III, Sections 26 and 29, of the Rules of Fair Practice. Comments should be forwarded to Stephen Hickman, Office of the Secretary, National Association of Securities Dealers, Inc., 1735 K Street, NW, Washington, D.C. 20006-1506. Comments should be received by June 4, 1991.

Questions concerning this notice should be directed to A. John Taylor, Vice President, Investment Companies/Variable Contracts, at (202) 728-8328.

PROPOSED AMENDMENT TO ARTICLE III, SECTION 26 OF THE NASD RULES OF FAIR PRACTICE

(Note: New text is underlined; deleted text is in brackets.)

Definitions

* * * * *

[(b)(7) "Associated person of an underwriter," as used in subsection (1) of this section, shall include an issuer for which an underwriter is the sponsor or a principal underwriter, any investment adviser to such issuer, or any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such underwriter, issuer, or investment adviser.]
(b)(7) The terms "offeror," "cash compensation" and "non-cash compensation" as used in subsection (1) of this section shall have the following meanings:

"Offeror" shall mean an investment company, an adviser to an investment company, an under-writer and any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such entities.

"Cash compensation" shall mean compensation received by member in cash, by check and by electronic means and shall include loans and overrides.

"Non-cash compensation" shall mean any form of compensation received by members that is not cash compensation, including but not limited to merchandise, gifts and prizes, and payment of travel expenses, meals and lodging.

* * * * *

[Dealer concessions]

[(1)(1) No underwriter or associated person of an underwriter shall offer, pay or arrange for the offer or payment to any other member in connection with retail sales or distribution of investment company securities, any discount, concession, fee or commission (hereinafter referred to as "concession") which:]
[(A) is in the form of securities of any kind, including stock, warrants or options;]
[(B) is in a form other than cash (e.g., merchandise or trips), unless the member earning the concession may elect to receive cash at the equivalent of no less than the underwriter's cost of providing the non-cash concession: or]
[(C) is not disclosed in the prospectus of the investment company. If the concessions are not uniformly paid to all dealers purchasing the same dollar amounts of securities from the underwriter, the disclosure shall include a description of the circumstances of any general variations from the standard schedule of concessions. If special compensation arrangements have been made with individual dealers, which arrangements are not generally available to all dealers, the details of the arrangements, and the identities of the dealers shall also be disclosed.]
[(2) No underwriter or associated person of an underwriter shall offer or pay any concession to an associated person of another member, but shall make such payment only to the member.]
[(3)
(A) In connection with retail sales or distribution of investment company shares, no underwriter or associated person of an underwriter shall offer or pay to any member or associated person anything of material value, and no member or associated person shall solicit or accept anything of material value, in addition to the concessions disclosed in the prospectus.]
[(B) For purposes of this paragraph (1)(3), items of material value shall include but not be limited to:]
[(i) gifts amounting in value to more than $50 per person per year.] [(ii) gifts or payments of any kind which are conditioned on the sale of investment company securities.] [(iii) loans made or guaranteed to a non-controlled member or person associated with a member.]
[(iv) wholesale overrides (commissions) granted to a member on its own retail sales unless the arrangement, as well as the identity of the member, is set forth in the prospectus of the investment company.]
[(v) payment or reimbursement of travel expenses, including overnight lodging, in excess of $50 per person per year unless such payment or reimbursement is in connection with a business meeting, conference or seminar held by an underwriter for informational purposes relative to the fund or funds of its sponsorship and is not conditioned on sales of shares of an investment company. A meeting, conference or seminar shall not be deemed to be of a business nature unless: the person to whom payment or reimbursement is made is personally present at, or is en route to or from, such meeting in each of the days for which payment or reimbursement is made; the person on whose behalf payment or reimbursement is made is engaged in the securities business; and the location and facilities provided are appropriate to the purpose, which would ordinarily mean the sponsor's office.]
[(C) For purposes of this paragraph (1)(3), items of material value shall not include:]
[(i) an occasional dinner, a ticket to a sporting event or the theater, or comparable entertainment of one or more registered representatives which is not conditioned on sales of shares of an investment company and is neither so frequent nor so extensive as to raise any question of propriety.]
[(ii) a breakfast, luncheon, dinner, reception or cocktail party given for a group of registered representatives in conjunction with a bona fide business or sales meeting, whether at the headquarters of a fund or its underwriter or in some other city.]
[(iii) an unconditional gift of a typical item of reminder advertising such as a ballpoint pen with the name of the advertiser inscribed, a calendar pad, or other gifts amounting in value to not more than $50 per person per year.]
[(4) The provisions of this subsection (1) shall not apply to:]
[(A) Contracts between principal underwriters of the same security.]
[(B) Contracts between the principal underwriter of a security and the sponsor of a unit investment trust which utilizes such security as its underlying investment.]
[(C) Compensation arrangements of an underwriter or sponsor with its own sales personnel.]

Member Compensation

(1) In connection with the sale and distribution of investment company securities:
(1) A member shall maintain records of all compensation, cash and non-cash, received from offerors and the distribution by the member of any such compensation to its associated persons. The records shall include the names of the offerors, the names of the associated persons and the amount and nature of the compensation received and distributed.
(2) Except as described in paragraph (5), no associated person of a member shall accept any compensation, cash or non-cash, from anyone other than the member with which the person is associated.
(3) No member or person associated with a member shall accept any compensation from an offeror which is in the form of securities of any kind.
(4) Except as described in paragraph (5), no member shall accept any compensation, cash or non-cash, from an offeror unless such is described in the current prospectus of the investment company. When special compensation arrangements are offered by an offeror to a member, which arrangements are not made available on the same terms to all members who distribute the investment company securities of the offeror, a member shall not enter into such arrangements unless the name of the member and the details of the arrangements are disclosed in the prospectus.
(5) Notwithstanding the provisions of subsections (2) and (4) of this section, the following items of compensation may be accepted and are not required to be disclosed in a prospectus provided that they are not conditioned on sales or the promise of sales:
(a) Gifts by an offeror to associated persons of members, with the approval of the member, that do not exceed $100 in value per annum, per person.
(b) Payment or reimbursement by offerors to members in connection with training or educational meetings where the location is appropriate to the purpose of such meetings, which would ordinarily mean a business location where the offeror or the member has an office.
(6) The provisions of this Section (1) shall not apply to:
(a) Compensation arrangements between principal underwriters of the same security.
(b) Compensation arrangements between the principal underwriter of a security and the sponsor of a unit investment trust which utilizes such security as its underlying investment.
(c) Compensation arrangements between a member and its own associated persons.

PROPOSED AMENDMENT TO ARTICLE III, SECTION 29 OF THE NASD RULES OF FAIR PRACTICE

(Note: New text is underlined.)

Definitions

* * * *

(b)(3) The terms "offeror," "cash compensation" and "non-cash compensation" as used in subsection (h) of this Section shall have the following meanings:

"Offeror" shall mean a separate account of an insurance company, an adviser to a separate account of an insurance company, an underwriter and any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such entities.

"Cash compensation" shall mean compensation received by members in cash, by check and by electronic means and shall include loans and overrides.

"Non-cash compensation" shall mean any form of compensation received by members that is not cash compensation, including but not limited to merchandise, gifts and prizes, and payment of travel expenses, meals and lodging.

* * * * *

Member Compensation

(h) In connection with the sale and distribution of variable contracts:
(1) A member shall maintain records of all compensation, cash and non-cash, received from offerors and the distribution by the member of any such compensation to its associated persons. The records shall include the names of the offerors, the names of the associated persons and the amount and nature of the compensation received and distributed.
(2) Except as described in paragraph (5), no associated person of a member shall accept any compensation, cash or non-cash, from anyone other than the member with which the person is associated. This requirement will not prohibit arrangements, agreed to by a member, where an insurance company maintains a commission account as a ministerial service for a member and, on behalf of the member, pays commission checks from such an account directly to associated persons of the member.
(3) No member or person associated with a member shall accept any compensation from an offeror which is in the form of securities of any kind.
(4) Except as described in paragraph (5), no member shall accept any compensation, cash or non-cash, from an offeror unless such is described in the current prospectus of the variable contract. When special compensation arrangements are offered by an offeror to a member, which arrangements are not made available on the same terms to all members who distribute the variable contracts of the offeror, a member shall not enter into such arrangements unless the name of the member and the details of the arrangements are disclosed in the prospectus.
(5) Notwithstanding the provisions of subsections (2) and (4) of this section, the following items of compensation may be accepted and are not required to be disclosed in a prospectus provided that they are not conditioned on sales or the promise of sales:
(a) Gifts by an offeror to associated persons of members, with the approval of the member, that do not exceed $100 in value per annum, per person.
(b) Payment or reimbursement by offerors to members in connection with training or educational meetings where the location is appropriate to the purpose of such meetings, which would ordinarily mean a business location where the offeror or the member has an office.
(6) The provisions of this Section (h) shall not apply to:
(a) Compensation arrangements between principal underwriters of the same security.
(b) Compensation arrangements between the principal underwriter of a security and the sponsor of a unit investment trust which utilizes such security as its underlying investment.
(c) Compensation arrangements between a member and its own associated persons.

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