FINRA Manual: Contents
|View Whole Section||Text only||Print Manager||Link|
90-56 Proposed Amendments to Subsections (b) "Definitions" and (d) ("Sales Charge Rule") of Article III, Section 26 of the NASD Rules of Fair Practice Re: Regulation By the NASD of Mutual Fund Asset-Based Sales Charges; Last Voting
*These are suggested departments only. Others may be appropriate for your firm.
The NASD invites members to vote on proposed amendments to the NASD mutual fund maximum sales charge rule that would subject asset-based sales charges to the provisions of the rule. The last voting date is October 5, 1990. The text of the amendments follows this notice.
In Notice to Members 90-26 (April 16, 1990), the NASD distributed for comment proposed amendments to subsections (b) and (d) of Article III, Section 26 of the NASD Rules of Fair Practice. If adopted, they would subject asset-based sales charges of mutual funds to the provisions of the NASD's maximum sales charge rule. Currently, the rule governs only front-end and deferred sales charges.
Fifty-eight comment letters were received from members and other interested persons. Twenty-five of the commenters were not in favor of the adoption of the amendments. The remainder, who expressed varying degrees of support for the proposals, made a number of constructive comments, many of which have been incorporated into the proposed amendments.
Several comments from those who do not support the amendments dealt with service fees. Most of these commenters consider that the proposals do not make adequate provision for service fees. The Board notes that the amendments provide for a continuing service fee to persons of up to a maximum of .25 percent per annum of the average annual net asset value of shares sold by such persons that is not subject to the asset-based sales charge caps in other sections of the proposed amendments. Thus, subject to arrangements made with a mutual fund or its underwriter, a member could continue to receive a fee for servicing mutual fund accounts it introduced for as long as such accounts are in existence. This is the rationale for defining "sales charges" and "service fees" separately in the proposal. The Board wishes to encourage members to give continuing service to their customers after the sale and believes that this activity deserves the reasonable continuing compensation provided for in the proposed amendments.
The following are the changes to the proposed amendments, suggested by commenters and recommended by the NASD Investment Companies Committee ("Committee"), which have been approved by the Board of Governors.
Definition of "Person"
In the proposed amendments, the term "investor" was used in lieu of the term "person." A number of commenters noted that an adequate definition of a person is contained in the Investment Company Act of 1940, and this definition has been added to subparagraph (b)(4) of the Definitions section. "Investor" has been changed to "person" throughout the proposal.
The Board wishes to clarify that investment management fees and profits are not subject to the jurisdiction of the Association. Consequently, members will not be required to verify whether such fees or profits are being used, directly or indirectly, to finance sales-related expenses. Members will be able to rely on disclosures in prospectuses for information about sales-related fees and charges. Subparagraph (b)(8) of the Definitions section has been amended.
Several commenters felt that the definition of service fees in the proposal is too narrow. For example, it does not cover payments of service fees to nonmembers such as banks or foreign broker-dealers. The definition of service fees in subparagraph (b)(9) therefore has been broadened to permit service fees to be used for a wide variety of services provided by members and other entities to mutual fund shareholders. Service fees as defined do not include transfer agent or custodian fees paid by mutual funds. Subparagraph (b)(8)(C) has also been amended to define more clearly the distinction between "sales charges" and "service fees" in the proposal.
The Committee decided not to use the term "maintenance fee" in lieu of "service fee" as recommended by some commenters because it lacks the connotation of personal service that the Committee wishes to encourage.
The service fee limit in various parts of the proposed amendments is defined to be not more than .25 percent per annum of the average annual net assets of an investment company. This could mean that some members might receive more than .25 percent per annum of a mutual fund's assets for which they were responsible while others might receive less — the overall amount being not more than the maximum percentage of the total net assets permitted.
The Committee believes that the maximum percentage permitted should apply to all recipients and has amended the proposal to relate the maximum percentage of .25 percent per annum to the shares sold by any person. Thus, if the proposal is adopted, a recipient would be able to receive a service fee of not more than .25 percent per annum of the average annual net asset value of the shares it sold to customers. New section (d)(5) has been added.
As originally proposed, subparagraph (d)(l)(F) would not have permitted a mutual fund without an asset-based sales charge that reinvests dividends at the offering price to pay a service fee. The Committee feels that, with an appropriate haircut, such a prohibition should not apply. Accordingly, it has amended the subparagraph to permit such a service fee if the maximum aggregate sales charge does not exceed 6.25 percent of the offering price.
Maximum Front-End and Deferred Sales Charges
Subsection (d)(2) of the proposal deals with mutual funds that have an asset-based sales charge. Many such companies also have front-end and/or deferred sales charges. Since the caps in subparagraph (2)(A) and (2)(B) are a percentage of total new gross sales, it is possible to construct a scenario whereby some investors who make large investments might pay a minimal front-end sales charge while other investors might be required to pay a very high sales charge per individual transaction even though the overall sales charges related to the net assets of the fund are within the required maximum percentages. For example, a person investing $1 million might have to pay no front-end sales charge while a person investing $10,000 might have to pay an excessive front-end sales charge even though the aggregate sales charges by the fund were within the maximum percentages of total new gross sales permitted by the proposal. The Committee has amended both subparagraphs to set maximum front-end and/or deferred sales charges per individual transaction.
A number of commenters asked how exchanges of shares between companies in the same complex, between companies with multiple classes, and between series shares of a series investment company, should be treated, i.e., should they be treated as new sales for purposes of the maximum caps. The Committee believes that such exchanges should not be treated as new sales primarily because the extensive record-keeping that would be required would be an expensive and difficult burden for many mutual funds. However, if a mutual fund wishes to keep such records, the practice would be permitted provided that the increase in the maximum aggregate sales charges for the receiving mutual fund is deducted from the maximum aggregate sales charges of the redeeming company. Subparagraphs (2)(A) and (B) have been amended, and new subparagraph (D) has been added.
Treatment of Prior Sales and Unreimbursed Expenses
Several commenters remarked that the proposal does not deal adequately with unreimbursed sales-related expenses incurred in the past that would be amortized by asset-based and/or deferred sales charges after the amendments are adopted. They also pointed out that there is no provision for interest payments on the financing necessary to fund such expenses.
A new subparagraph (d)(2)(C) has been added to the proposed amendments that would apply the maximum permitted sales charges of 6.25 percent or 7.25 percent retroactively, on sales made prior to the effective date of the proposed amendments, to the time when a mutual fund first adopted an asset-based sales charge. An interest rate of prime plus one percent per annum would be added to the amount so calculated, and the total would be reduced by any front-end, asset-based, and deferred sales charges received prior to the effective date of the proposed amendments as a result of such sales. The net total would be added to the maximum aggregate sales charges on new gross sales calculated as described in subparagraphs (d)(2)(A) and (B). The grand total would be continually reduced by sales charges received by the investment company after the effective date of the proposed amendments. The interest rate of the prime rate plus one percent per annum would be applied to the fluctuating grand total over time.
"No Load" Designation
The proposed amendments would have prohibited members or their associated persons from describing an investment company with a deferred or an asset-based sales charge as "no load." The Committee considers that this prohibition should apply to a mutual fund that has a front-end or a deferred sales charge and to a fund that has an asset-based and/or a service fee that together exceed .25 percent of its average annual net assets. Subparagraph (d)(3) has been amended.
Some commenters believe that the requirement in subparagraph (2)(E)(ii) that excess deferred sales charges be credited to the net assets of an investment company may imperil a mutual fund's status as a regulated investment company under the provisions of the Internal Revenue Code. One commenter suggested excising the term "net assets" from the subparagraph. That has been done. The NASD does not wish to adversely affect the tax status of mutual funds by any provision of the rule and is continuing to study this area. If necessary, appropriate amendments will be made prior to the adoption of the proposal.
The following recommendations made by some commenters were not adopted.
Nonconforming Mutual Funds — Procedures for Exemption
Several commenters suggested that the NASD adopt procedures for the review and approval of sales charge structures that do not conform to the provisions of the proposed amendments. The Board of Governors is unwilling, at this time, to consider including exemptive provisions in the rule. It considers that the provisions of the amended rule will provide ample scope for innovation in the financing of sales-related expenses of mutual funds.
However, the Board would be willing, in view of the importance of the proposed amendments to the mutual fund industry and the fact that the NASD has yet to experience the effect of their implementation, to consider whether any changes are necessary after the NASD has had one year's experience in administering the new provisions.
Some commenters suggested a sliding, increasing scale of service fees with appropriate further haircuts to the maximum sales charge caps of 7.25 percent or 6.25 percent of gross new sales. Others commented that if a mutual fund did not offer the maximum service fee of .25 percent per annum of a fund's net asset value, the excess should be permitted to be added to the maximum asset-based sales charge of .75 percent.
The Board of Governors considers the maximum asset-based sales charge proposed of .75 percent per annum of average net assets and the maximum service fee of .25 percent of a fund's average annual net assets to be adequate to finance sales-related expenses and to provide compensation for continued service to mutual fund shareholder accounts. In addition, the Board does not wish to add further complexity to an already complex rule.
Application of the Proposed Amendments — Multiple Classes of Shares
Some commenters requested that the proposal be amended to clarify how the maximum caps should be applied when an investment company has multiple classes of shares or is a series investment company. The Board considers each class of shares and each series to be a separate investment company for purposes of the sales charge rule. In addition, the caps will apply to each class and each series and not to the investment company as a whole. The NASD has always applied its rules governing investment companies in this way, and the Board sees no reason to further amend the proposed amendments.
A number of commenters recommended that a grace period of one year be permitted, after the SEC approves the rule, before the rule is implemented. It is the intention of the NASD that such a provision will be provided for in the NASD's rule filing seeking SEC approval after member approval has been obtained. The membership will be notified of the effective date after SEC approval.
In addition to the changes described above that have been made to the proposed amendments, a number of technical changes have been made to clarify certain terms and to ensure uniformity in the language used.
A section-by-section analysis of the proposed amendments to subsections (b) and (d) of Article III, Section 26 of the NASD Rules of Fair Practice follows:
Nominal (i.e., small or minimal) charges incurred by shareholders on redemption of mutual fund shares for special services are excluded from the definition of deferred sales charges, as are redemption charges described in a prospectus to discourage short-term trading generally within one year of purchase of shares. Such nominal and short-term charges may not be used to pay for sales-related expenses and must be returned to the mutual fund.
The term "asset-based sales charge" is not defined in terms of a specific rule, such as Rule 12(b)-l under the Act. It is intended to encompass charges against net assets, disclosed in the prospectus, that are used to pay for sales-related expenses.
The term "new gross sales" does not include sales resulting from the reinvestment of investment income or capital gains or from exchanges of shares between mutual funds in a complex of funds or between classes of shares in a fund with multiple classes or between series of a series fund. If a fund with an asset-based sales charge also has a front-end and/or a deferred sales charge, the latter two charges cannot exceed 6.25 percent of the amount invested by any person.
The amount thus calculated would be increased by an interest rate equal to the prime rate plus one percent per annum and reduced by any sales charges — front-end, deferred, or asset-based — on such sales or from net assets resulting from such sales. The net total would be added to the total calculated by the application of the provisions of subsections (d)(2)(A) or (B). The grand total would be reduced over time by sales charges received after the proposed amendments are implemented. This subsection permits past unreimbursed sales-related expenses to be accommodated within the provisions of the sales charge rule and provides for their gradual amortization.
REQUEST FOR VOTE
The NASD Board of Governors believes that the proposed rule amendments will assist the NASD in meeting its obligation, under the mandate given to it by the U.S. Congress, to prevent excessive sales charges on mutual fund shares sold to the public by NASD members.
Thus, the Board considers the proposed amendments necessary and appropriate and recommends that members vote their approval. Please mark the attached ballot according to your convictions and mail it in the enclosed, stamped envelope to The Corporation Trust Company. Ballots must be postmarked no later than October 5, 1990.
Questions concerning this notice should be directed to A. John Taylor, Vice President, Investment Companies/Variable Contracts, at (202) 728-8328.
PROPOSED AMENDMENTS TO SUBSECTIONS (B) AND (D) OF ARTICLE III, SECTION 26 OF THE NASD RULES OF FAIR PRACTICE
(Note: New text is underlined; deleted text is in brackets.)