Legal & Compliance
*These are suggested departments only. Others may be appropriate for your firm.
REQUEST FOR COMMENTS
The NASD requests comments 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.
Before 1980, the primary method used by mutual funds, the shares of which are offered to the public by NASD members, to finance sales-related expenses was a front-end sales charge deducted from the offering price of shares. In 1980, the Securities and Exchange Commission (SEC) adopted Rule 12(b)-l under the Investment Company Act of 1940 ("the Act") that permitted mutual funds to use their assets to finance sales-related expenses.
During the 1980s, a further method of paying for sales and sales promotion expenses — the deferred sales charge on redemption — was introduced. In its most common form — the contingent deferred sales charge (CDSC) — a charge, which declines each year and eventually disappears, is made against redemption proceeds.
Thus, there are now three major methods utilized, either alone or in combination, by mutual funds to finance sales-related expenses. For the purposes of this proposed rule amendment, they are described as front-end, deferred, and asset-based sales charges.
REGULATION OF SALES CHARGES
In 1970, amendments to the Act (Section 22(b)) by the U.S. Congress gave the NASD broad power to prohibit excessive sales charges on mutual fund shares offered by NASD members to investors. At that time, deferred and asset-based sales charges had not been introduced, and the resulting NASD maximum sales charge rule, which was adopted in 1976, was couched in terms of a front-end sales charge. Since then, its provisions also have been applied to deferred but not to asset-based sales charges.
The NASD has always considered that it is anomalous to have a sales charge rule that does not encompass all charges that are sales-related (see letter to the SEC, September 15, 1978, in response to SEC Release IC-10252). The Association viewed with interest proposed amendments to Rule 12(b)(l), published for comment by the SEC in 1988, that, among other things, would require mutual fund directors to consider whether asset-based sales charges under Rule 12(b)(l) would exceed the sales charges permitted by the NASD sales charge rule and to disclose in the prospectus if and when this might occur.
In December 1988, in its response to the SEC's request for comments on the proposed Rule 12(b)-l amendments (see letter dated December 29, 1988), the NASD reiterated its view that the Association should seek to expand the scope of its sales charge rule to govern asset-based sales charges. After researching the legality of such a course of action, the NASD determined that no legal impediment exists to prevent such an expansion of its authority.
If adopted, the proposed amendments will subject asset-based sales charges to the NASD rule, and no NASD member will be permitted to offer the shares of mutual funds that do not comply with the provisions of the amended rule.
THE NASD'S APPROACH TO REGULATION OF ASSET-BASED SALES CHARGES
The thrust of the NASD's approach to the regulation of asset-based sales charges is to ensure, to the extent possible, that a majority of mutual fund shareholders who own shares of funds with asset-based sales charges pay no more for sales and sales-promotion expenses than is permitted by the provisions of the current NASD maximum sales charge rule.
The current rule permits a maximum front-end sales charge of not more than 8.5 percent of the offering price of a mutual fund share graded down to 6.25 percent if one or more of three benefits are not offered. These benefits are dividends reinvested at net asset value, quantity discounts, and rights of accumulation.
When a mutual fund has a front-end sales charge, investors incur, and pay for sales-related expenses at the time of the sale. Funds with only an asset-based and/or a deferred sales charge incur sales-related expenses at the time of the sale, but the revenue stream to defray these expenses is delayed. Underwriters that pay for up-front sales-related expenses incur liability that is amortized eventually by the revenue flowing from asset-based and/or deferred sales charges. Today, many funds use combinations of the three sales charges. Two popular variations are (1) a relatively low front-end sales charge and an asset-based sales charge and (2) no front-end sales charge, a CDSC, and an asset-based sales charge.
Thus, to achieve approximate economic equivalency with a maximum permitted front-end sales charge, several variables must be considered — e.g., the percentage amount of an asset-based charge on fluctuating net assets, the interest charge on liability incurred by an underwriter that fronts sales expenses, the length of time investors own shares ("shareholder persistency"), and the frequency and amount of sales charges received on redemption.
With so many variables, the time frames during which economic equivalency may be reached are infinite in their variety. For example, economic equivalency with a sales charge of 6.25 percent of gross sales, assuming an annual appreciation rate of 4 percent, interest rate of 10 percent, and asset-based charge of 75 basis points would be reached in 11.8 years. This does not take into account revenue from any deferred sales charges on redemption that would shorten the time period, as would any increase in the appreciation rate. Conversely, a decrease in the appreciation rate would lengthen the time period.
One way to approach the issue would be to require individual shareholder accounting so that, when a shareholder has paid the economic equivalent of a front-end maximum sales charge, he or she would pay no further sales charges — deferred or asset-based. In the example above, when the aggregate of all sales charges exceeded 6.25 percent of the amount invested, no further charges would be assessed. Thus, a person investing $10,000 would never pay more than $625 in sales charges.
The alternative would be to require fund-level accounting in which all sales charges terminate when a percentage of gross sales is reached. For example, assume a fund has $1 million of sales. In the example above, the maximum it could charge for sales-related expenses would be $62,500.
The difference between the two methods is that, with individual shareholder accounting, each shareholder would never pay more than the economic equivalent of a front-end charge whereas, with fund-level accounting, long-term shareholders might pay more than the economic equivalent.
Requiring mutual funds to introduce individual shareholder accounting would mandate extensive and expensive changes in the record-keeping methods and procedures utilized by mutual funds, disrupt current processing of sales and redemptions, and take several years to achieve. It would, initially, result in there being three classes of a fund's shares — those currently owned, those sold after the the rule is adopted, and those owned after a shareholder has paid the maximum sales charge permitted.
The introduction of fund-level accounting could proceed rapidly and would not prevent the investment company industry from moving towards the adoption of individual shareholder accounting eventually. Indeed, the forces of competition might promote such an evolutionary trend.
The NASD Board of Governors recognizes that, if a fund-level accounting requirement is adopted, an unknown and unpredictable minority of long-term shareholders might eventually pay more than the economic equivalent of the maximum sales charge permitted by the current NASD sales charge rule. A study of shareholder persistency, recently conducted by the Wyatt Company for the NASD, indicated that somewhere between 75 percent and 80 percent of mutual fund shareholders are likely to redeem their shares within 15 years of original purchase and that there is no statistically significant difference between the persistency ratios of shareholders in funds with traditional front-end sales charges and those with asset-based sales charges.
The NASD Board of Governors considers that, if fund-level accounting were to be utilized, the fact that long-term shareholders might pay more than the economic equivalent of a front-end sales charge should be prominently disclosed in a mutual fund's prospectus.
Fund-level accounting would, in the NASD Board's opinion, be the most practical and least burdensome way to proceed. It would provide maximum flexibility to the industry in the financing of sales-related expenses and ensure that most investors in mutual funds, regardless of the method of financing used, would pay no more for the expenses incurred for distribution than the current NASD rule permits.
In the Board's view, adopting the proposed amendments to the rule would ensure continued compliance by the NASD and its members with the Congressional intent, expressed in Section 22(b)(l) of the Act, that such a rule "shall allow for reasonable compensation for sales personnel, broker/dealers and underwriters and for reasonable sales loads to investors."
A section-by-section analysis of the proposed amendments to Subsections (b)(4) and (d) of Article III, Section 26 of the NASD Rules of Fair Practice follows:
(b)(4) The term "any person," as used in the current rule, is changed to "Investor" or "Investors." The current rule defines "any person" as it is defined in Rule 22(d)-l under the Act, which no longer contains such a definition. The term "investor" is used in Section 22(b)-(l) of the Act, which gives authority to the NASD to regulate excessive sales charges. The proposed amendment defines the term "investor" broadly.
(8) Sales charges are defined in this subsection to include all charges and fees that are used to finance sales-related expenses. Included in the definition are front-end, deferred, and asset-based sales charges. Excluded from the definition are charges that are used to defray ministerial, recordkeeping, or administrative activities, and investment management fees. The definition contemplates that any fee or charge that is used, directly or indirectly, to finance sales-related expenses is a sales charge regardless of how it is charged. For example, a situation in which a charge is described as a management fee in a prospectus and part of the fee is used to pay for sales or sales promotion expenses would fall within the definition of a sales charge.
Nominal charges incurred on redemption of shares for specific services in connection with a redemption are excluded from the definition of deferred sales charges as are redemption charges that are described in a prospectus as being levied to discourage short-term trading 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 investment company.
The term "asset-based sales charge" is not defined in terms of a specific rule such as Rule 12(b)-l. It is intended to encompass all charges against net assets that are utilized to pay for sales and sales promotion expenditures.
(9) A service fee is defined to include a continuing payment, made by an investment company or its affiliates, to a member for personal service to investors who own shares of the investment company. Thus, it is not made in connection with a primary distribution of investment company securities.
(d) This subsection reiterates the general obligation of the NASD under Section 22(b) of the Act to prevent excessive sales charges. A major restructuring of the rule was required to expand its provisions to include deferred and asset-based sales charges. This was accomplished by dividing the rule into two parts. Part one deals with funds that do not have an asset-based sales charge, and part two deals with funds that have such a sales charge.
(1) Investment Companies Without an Asset-Based Sales Charge
Part one, for the most part, reiterates the current rule with minor changes to expand the rule's provisions to include deferred sales charges. Subsections (1)(E) and (F) are new. Subsection (E) would not permit a member to offer a mutual fund that has an aggregate sales charge of more than 7.25 percent of the offering price if the fund offers a service fee, which could not be more than .25 percent of net assets per annum. Section (F) would not permit a member to receive a service fee from a mutual fund that does not reinvest dividends at net asset value.
These new sections incorporate a principle underlying the sales charge rule that if charges are made for services, or if services are not offered but charges are incurred, an appropriate reduction will be made from the maximum permitted sales charge.
(2) Investment Companies with an Asset-Based Sales Charge
This part is new and expands the rule to govern mutual funds with asset-based sales charges that members offer to the public.
(A) This paragraph places a cap of 6.25 percent of new gross sales, plus an appropriate interest rate, on the total sales charges — asset-based, front-end, and deferred — levied by a mutual fund that offers a service fee to members. The reduction from 8.5 percent, the maximum permitted sales charge under the rule, to 6.25 percent occurs because asset-based sales charges do not provide quantity discounts or rights of accumulation and because a member is offered a service fee for which a charge, not subject to the cap, is made.
The amount of an appropriate interest rate has not been decided but the prime rate plus .25 percent has been recommended.
(B) This paragraph permits mutual funds that do not offer a service fee to increase the cap described in paragraph 2(A) to 7.25 percent of total new gross sales plus an appropriate interest rate.
(C) (i) This subparagraph would limit the amount of an asset-based sales charge levied by mutual funds sold by NASD members to .75 percent per annum of the net assets of the mutual fund. This would mean that, after the amendments are adopted, no mutual fund offered by NASD members could have an asset-based sales charge in excess of 75 basis points of net assets per annum. Underwriters that have outstanding liabilities from sales, made prior to the date of the adoption of the rule, under which current asset-based sales charges are in excess of 75 basis points of net assets per annum, would probably find that it would take a longer time than anticipated to amortize their prior liability. Essentially, the prior liability and the new cap (under paragraphs 2(A) or (B)) would be combined and amortized over time by an asset-based sales charge of not more than 75 basis points per annum of net assets and any CDSC.
(C) (ii) This subparagraph would require that any deferred sales charges after the maximum caps described in paragraphs 2(A) or (B) are reached must flow into the mutual fund.
(C) (iii) This subparagraph would not permit a member to offer a mutual fund that pays a service fee in excess of 25 basis points per annum of net assets.
(C) (iv) Interest charges on any liability incurred in connection with sales made prior to the date of the adoption of the amendments would not be permitted to be added to the maximum percentages of gross sales described in paragraphs 2(A) and (B).
(d) (3) This subsection would not permit the use of "no load" or "no sales charge" language, orally or in writing, in the offer of a fund that has an asset-based or deferred sales charge. The subsection assumes that no one would claim that a fund with a front-end sales charge does not have a sales charge.
(4) As explained in the background information section, when fund-level accounting is utilized, it is possible that some long-term shareholders of funds with asset-based charges may pay more than the economic equivalent of the maximum sales charge permitted by the rule. Because of the number of variable factors that affect the length of time it would take to achieve economic equivalency, it is not possible to determine with any accuracy when such instances could occur. Thus, this sub-paragraph would require funds with asset-based sales charges to disclose that information in prospectuses in an area close to the fee table.
The Board of Governors asks all members and interested persons to comment on the proposed amendment. Comments should be addressed to:
Mr. Lynn Nellius, Secretary
National Association of
Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506
Comments must be received no later than May 31, 1990. Amendments to NASD Rules of Fair Practice must be approved by the Board of Governors and by a vote of the membership and filed and approved by the SEC before becoming effective.
Questions concerning this notice may be directed to A. John Taylor, Vice President, Investment Companies/Variable Contracts, at (202) 728-8329.
Proposed Amendments to Subsections (b)(4) and (d) of Article III, Section 26 of the NASD Rules of Fair Practice
(Note: New text is underlined; deleted text is in brackets)
(b) (4) ["Any person" shall mean "any person" as defined in subsection (a), or "purchaser" as defined in subsection (b), of Rule 22d-l under the Investment Company Act of 1940.] "Investor" or "Investors" as used in subsection (d) of this section shall mean any natural person or persons, a partnership, a corporation, an association or any other legal entity.
(8) "Sales charge" and "sales charges" as used in subsection (d) of this section shall mean all charges or fees that are used to finance sales or sales promotion expenses, including front-end, deferred and asset-based sales charges, excluding expenses incurred for ministerial, record-keeping, or administrative activities and management fees.
(A) a "front-end sales charge" is a sales charge that is included in the public offering price of the shares of an investment company.
(B) a "deferred sales charge" is a sales charge that is deducted from the proceeds of the redemption of shares by an investor, excluding any such charges that are nominal and are for services in connection with a redemption, or to discourage short-term trading, that are not used to finance sales-related expenses and that are credited to the net assets of the investment company.
(C) an "asset-based sales charge" is a sales charge that is deducted from the net assets of an investment company.
(9) "Service fees" as used in subsection (d) of this section shall mean payments to a member by an investment company or its affiliates for the provision, by the member, of personal, continuing service to investors in the shares of the investment company.
(d) No member shall offer or sell the shares of any open-end investment company or any "single payment" investment plan issued by a unit investment trust (collectively "investment companies")
registered under the Investment Company Act of 1940 [if the public offering price includes a sales charge which is excessive, taking into consideration all relevant circumstances.] if the sales charges described in the prospectus are excessive. Aggregate
ales charges shall be deemed excessive if they do not conform to the following provisions:
(1) Investment Companies Without an Asset-Based Sales Charge
[(1)] (A) [The maximum sales charge on any transaction] Front-end and/or deferred sales charges described in the prospectus which may be imposed by an investment company without an asset-based sales charge shall not exceed 8.5% of the offering price.
(A)] (B) (i) Dividend reinvestment shall be made available at net asset value per share to ["any person"] an investor who requests such reinvestment, [at least ten days prior to the record date subject only to the right to limit the availability of dividend reinvestment to holders of securities of a stated minimum value, not greater than $1200.]
[(B)] (ii) If dividend reinvestment is not made available [on terms at least as favorable as those] as specified in subparagraph [(2)(A)](B)(i), the maximum aggregate sales charge [on any transaction] shall not exceed 7.25% of the offering price.
(A)] (C) (i) Rights of accumulation (cumulative quantity discounts) shall be made available to ["any person"] an investor [for a period of not less than ten (10) years from the date of first purchase] in accordance with one of the alternative quantity discount schedules provided in subparagraph
(A)] (D)(i) below, as in effect on the date the right is exercised.
If rights of accumulation are not made available on terms at least as favorable as those specified in subparagraph [(3)(A)](C)(i),t
he maximum aggregate
sales charge [on any transaction] shall not exceed:
[(i)] (a) 8% of the offering price if the provisions of subparagraph [(2)(A)](B)(i) are met; or
[(ii)] (b) 6.75% of the offering price if the provisions of subparagraph [(2)(A)](B)(i) are not met.
(A)] (D) (i)
Quantity discounts shall be made available on single purchases by ["any person"] an investor
in accordance with one of the following two alternatives:
[(i)] (a) A maximum aggregate sales charge of 7.75% on purchases of $10,000 or more and a maximum aggregate sales charge of 6.25% on purchases of $25,000 or more, or
[(ii)] (b) A maximum aggregate sales charge of 7.50% on purchases of $15,000 or more and a maximum aggregate sales charge of 6.25% on purchases of $25,000 or more.
If quantity discounts are not made available on terms at least as favorable as those specified in subparagraph [(4)(A)] (D)(i),
the maximum aggregate
sales charge [on any transaction] shall not exceed:
[(i)] (a) 7.75% of the offering price if the provisions of subparagraphs [(2)(A) and (3)(A)] (B)(i) and (C)(i) are met.
[(ii)] (b) 7.25% of the offering price if the provisions of subparagraph [(2)( A)] (B)(i) are met but the provisions of subparagraph [(3)(A)] (C)(i) are not met.
[(iii]] (c) 6.50% of the offering price if the provisions of subparagraph [(3)(A)] (C)(i) are met but the provisions of subparagraph [(2)(A)] (B)(i) are not met.
[(iv)] (d) 6.25% of the offering price if the provisions of subparagraphs [(2)(A) and (3)(A)] (B)(i) and (C)(i) are not met.
(E) If an investment company without an asset-based sales charge offers a service fee, which may not be in excess of .25 of 1% per annum of the net assets of the investment company, the maximum aggregate sales charge shall not exceed 7.25% of the offering price.
(F) If an investment company without an asset-based sales charge reinvests dividends at offering price, it shall not offer or pay a service fee to members.
(2) Investment Companies With an Asset-Based Sales Charge
(A) The aggregate asset-based, front-end and deferred sales charges described in the prospectus which may be imposed by an investment company with an asset-based sales charge, if the investment company or its affiliates have adopted a plan under which service fees are offered or paid to members, shall not exceed 6.25% of total new gross sales (excluding sales from the reinvestment of distributions) plus interest charges on such amount equal to (to be decided).
(B) If an investment company with an asset-based sales charge does not offer a service fee to members, the aggregate sales charge shall not exceed 7.25% of total new gross sales (excluding sales from the reinvestment of distributions) plus interest charges on such amount equal to (to be decided).
(C) No member shall offer or sell the shares of an investment company with an asset-based sales charge if:
(i) The amount of the asset-based sales charge exceeds .75 of 1 % per annum of the net assets of the investment company.
(ii) Any deferred sales charges deducted from the proceeds of a redemption after the maximum cap described in subsections (2)(A) and (B) has been attained are not credited to the net assets of the investment company.
(iii) The investment company offers a service fee in excess of .25 of 1% per annum of the net assets of the investment company, or
(iv) The maximum permitted sales charge described in subsections(2)(A) and (B) are increased by interest charges on any liability incurred in connection with sale of investment company shares prior to (the date of adoption of this rule amendment).
(3) No member or person associated with a member who offers or sells the shares of an investment company shall, either orally or in writing, describe such investment company as being "no load" or as having "no sales charge" if the investment company has an asset-based or deferred sales charge.
(4) The prospectus of an investment company with an asset-based sales charge shall disclose that long-term shareholders may pay more than the economic equivalent of a front-end sales charge. Such disclosure shall be adjacent to the fee table in the front section of a prospectus.