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94-60 SEC Approves Guidelines Relating To The Use Of Rankings In Investment Company Advertisements And Sales Literature

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Executive Summary

On July 12, 1994, the Securities and Exchange Commission (SEC) approved amendments adopting Guidelines to Article III, Section 35 of the NASD Rules of Fair Practice that prohibit members from using investment company rankings in advertisements and sales literature unless certain requirements are met. The requirements include, among other things, that the ranking is accurate, is accompanied by certain minimum informational disclosures, includes certain minimum time frames, and is based on a category or subcategory that provides a sound basis for evaluating investment company performance. The text of the amendments, which took effect July 12, 1994, follows the discussion below.

Background

On July 12, 1994, the SEC approved amendments adopting Guidelines to Article III, Section 35 of the NASD Rules of Fair Practice (Guidelines) that prohibit members from using investment company rankings in advertisements and sales literature unless certain requirements are met.

Article III, Section 35(d)(2)(M) of the NASD Rules of Fair Practice requires that a member that makes investment comparisons, directly or indirectly, must ensure that the purpose of the comparison is clear. The comparison must be fair, balanced, and disclose any material differences between the subjects of the comparison. The use of investment company rankings to demonstrate performance qualifies as such a comparison.

As the number of investment companies has increased substantially in recent years, so has the number of investment company ranking entities. The NASD has observed increased references to rankings in investment company advertisements and sales literature. In response to the increased use of investment company rankings, the Investment Company Institute, the national association of the American mutual fund industry, submitted to the NASD suggested standards for the use of rankings in sales materials that served as the foundation for the NASD proposal. The NASD proposed, and the SEC approved, comprehensive Guidelines to be used when investment company advertisements and sales literature include references to investment company rankings.

Description Of The Amendments

The Guidelines apply to all registered investment companies, including open-end and closed-end management companies as defined in Sections 3,4, and 5 of the Investment Company Act of 1940.

Definition Of Ranking Entity The term "ranking entity," refers to an entity that provides general investment company information to the public, is independent of the investment company and its affiliates, and whose services are not procured by the investment company or its affiliates to assign a ranking. The definition encompasses entities formed specifically to provide such information as well as financial publications and periodicals that include such a service in their publications.

General Prohibition Members are prohibited from using investment company rankings in advertising and sales literature unless the rankings were developed by entities that meet the definition of ranking entity. When members use rankings developed by ranking entities, the rankings must conform to the requirements of the Guidelines.

Required Disclosures All advertisements and sales literature containing a ranking must disclose the name of the investment company category, the number of investment companies in the category, the name of the ranking entity, the period on which the ranking is based, the criteria on which the investment company is ranked, and, for investment companies with front-end sales loads, whether the ranking takes into account sales charges. Also, for advertisements and sales literature containing rankings based on total return or the SEC standardized yield, the advertisements and sales literature must contain a statement as to the material effect on total return or yield, if any, of fees waived or expenses advanced during the period on which the ranking is based. The amendments also require disclosure of the publisher of the ranking data.

Prominent statements and headlines that include or refer to rankings must disclose the name of the investment company category, the total number of investment companies in the category, and the period on which the ranking is based, in close proximity to the headline or prominent statement. Such statement or headline may not state or imply that an investment company is ranked first in a category when it is not.

All advertising or sales literature using a ranking system consisting of a symbol must disclose the meaning of the symbol. All advertising and sales literature containing a ranking must disclose that past performance is no guarantee of future results.

Time Periods

To ensure that rankings are based on meaningful, not misleading, information, the Guidelines require that the information be current and provide a minimum standard of what is current. Rankings should be at least current to the most recent calendar quarter, though use of more current ranking data is permissible.

For all investment companies except money market mutual funds, rankings based on a period of less than one year can be misleading and, therefore, are prohibited. Additionally, for all investment companies except money market mutual funds, rankings based on total return or the SEC standardized yield must be accompanied by rankings based on total return for the one-year period for investment companies in existence for one year; the one- and five-year periods for investment companies in existence for at least five years; and the one-, five-, and 10-year periods for investment companies in existence for at least 10 years. The ranking information for the periods must be supplied by the same ranking entity and the periods must end on the same date.

The NASD believes that a meaningful comparison of rankings in excess of one year should include multiple time periods for comparison to avoid the possibility of selecting only those time periods in which an investment company was highly ranked. Also, the required use of the one-year period prohibits a member from using a ranking that ranks investment companies over, for example, a three-year period only.

Categories

The NASD believes it is important to set standards for methods of investment company categorization that provide a sound basis for evaluating investment company performance. Generally, advertisements and sales literature must use only categories or subcategories created by a ranking entity. Advertisements or sales literature using rankings based on a sub-category must disclose the name of the full category, the investment company's ranking and the number of investment companies in the full category, unless the subcategory is based solely on the investment objectives of the investment company and is created by a ranking entity.

Categories or subcategories created by an investment company or its affiliate may be used as long as performance is measured by the same performance measurements as those used by a ranking entity. However, categories or subcategories created by an investment company or its affiliate must also prominently disclose the fact that the investment company or its affiliate has created the ranking category, the number of investment companies in the category, the basis for selecting the category, and the identity of the ranking entity that developed the performance measurements and data on which the ranking is based. Headlines and prominent statements using a ranking created by an investment company or its affiliate must indicate in close proximity to the headline or statement that the ranking is based on a category created by the investment company or its affiliate.

Advertisements or sales literature must not use any ranking category based on the investment company's asset size because such information does not provide a meaningful basis on which the investment company's performance can be evaluated.

Multiple Class/Two-Tier Investment Companies Advertisements or sales literature containing rankings for more than one class or investment company with the same portfolio must disclose the fact that the investment companies or classes have a common portfolio.

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The NASD believes that by establishing a baseline of standards for the use of investment company rankings in advertising and sales literature, the amendments will prevent the misleading use of such rankings and will help investment company investors make informed investment decisions based on information set forth in a clear and uniform manner.

Questions regarding this Notice may be directed to R. Clark Hooper, Vice President, Advertising/Investment Companies Regulation Department, at (202) 728-8325; Thomas A. Pappas, Assistant Director, Advertisement/Investment Companies Regulation Department, at (202) 728-8330; or Robert J. Smith, Attorney, Office of General Counsel, at (202) 728-8176.

Approved Amendments To Article III, Section 35 Of The NASD Rules Of Fair Practice.

(Note: New text is underlined.)

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Guidelines For The Use Of Rankings In Investment Company Advertisements And Sales Literature

I. Definition of "Ranking Entity"

For purposes of these guidelines, the term "Ranking Entity" refers to any entity that provides general information about investment companies to the public, that is independent of the investment company and its affiliates, and whose services are not procured by the investment company or any of its affiliates to assign the investment company a ranking.
II. General Prohibition

Members shall not use in investment company advertisements, sales literature or general promotional material any investment company rankings other than those developed and produced by entities that meet the definition of "Ranking Entity." and which conform to the requirements of the Guidelines herein.
III. Required Disclosures
A. Headlines/Prominent Statements
1. A headline or other prominent statement must not state or imply that an investment company is the best performer in a category unless it is actually ranked first in the category.
2. Prominent disclosure of the investment company's ranking, the total number of investment companies in the category, the name of the category, and the period on which the ranking is based (i.e., the length of the period and the ending date; or, the first day of the period and the ending date! must appear in close proximity to any headline or other prominent statement that refers to a ranking.
B. All advertisements and sales literature containing an investment company ranking must disclose, with respect to the ranking:
1. the name of the category (e.g., growth):
2. the number of investment companies in the category:
3. the name of the Ranking Entity:
4. the length of the period and the ending date, or, the first day of the period and the ending date:
5. criteria on which the ranking is
6. for investment companies which assess front-end sales loads, whether the ranking takes into account sales charges:
7. if the ranking is based on total return or the current SEC standardized yield, fees have been waived or expenses advanced during the period on which the ranking is based, and the waiver or advancement had a material effect on the total return or yield for that period, a statement to that effect: and
8. the publisher of the ranking data (e.g., "ABC Magazine. June 1993"). The disclosure required by B1. B2. B3 and B4 must be set forth prominently in the body of the advertisement or sales literature.
C. If the investment company ranking consists of a symbol (e.g., a star system) rather than a number, the advertisement or sales literature also must disclose the meaning of the symbol (e.g., a four-star ranking indicates that the investment company is in the top 30% of all investment companies).
D. All advertisements and sales literature containing an investment company ranking must disclose that past performance is no guarantee of future results.
IV. Time Periods
A. Any investment company ranking set forth in an advertisement or sales literature must be, at a minimum. current to the most recent calendar quarter ended, in the case of advertising, prior to the submission for publication, or. in the case of sales literature, prior to use.
B. Except for money market investment companies:
1. advertisements and sales literature must not use any ranking based on a period of less than one year:
2. an investment company ranking based on total return must be accompanied by rankings based on total return for the one-year period for investment companies in existence for at least one year: the one-and five-year periods for investment companies in existence for at least five years, and the one-, five-, and ten-year periods for investment companies in existence for at least ten years supplied by the same Ranking Entity in the category and based on the same time period; and.
3. an investment company ranking based on yield may be based only on the current SEC standardized yield. An investment company ranking based on the current SEC standardized yield must be accompanied by rankings based on total return for the one-year period for investment companies in existence for at least one year; the one- and five-year periods for investment companies in existence for at least five years, and the one-, five-, and ten-year periods for investment companies in existence for at least ten years supplied by the same Ranking Entity in the category and based on the same time period.
V. Categories
A. The choice of category (including a subcategory of a broader category) on which the investment company ranking is based must be one that provides a sound basis for evaluating the performance of the investment company.
B. Subject to the standards below, an investment company ranking must be based only on (1") a published category or subcategory created by a Ranking Entity or (2) a category or subcategory created by an investment company or an investment company affiliate, but based on the performance measurements of a Ranking
C. When the investment company ranking is based on a subcategory, the advertisement or sales literature must disclose the name of the full category and the investment company's ranking and the number of investment companies in the full category. This requirement does not apply if the subcategory is (1) based solely on the investment objectives of the investment companies included and (2) created by a Ranking Entity. This disclosure could be included in a footnote.
D. The advertisement or sales literature must not use any category or subcategory that is based upon the investment company's asset size (whether or not it has been created by a Ranking Entity).
E. If an advertisement uses a category created by the investment company or an investment company affiliate, including a "subcategory" of a category established by a Ranking Entity, the advertisement must prominently disclose:
1. the fact that the investment company or its affiliate has created the ranking category:
2. the number of investment companies in the category:
3. the basis for selecting the category: and
4. the Ranking Entity that developed the research on which the ranking is based.
F. An advertisement or sales literature containing a headline or other prominent statement that proclaims an investment company ranking created by an investment company or its affiliate must indicate, in close proximity to the headline or statement, that the investment company ranking is based upon a category created by the investment company or its affiliate.
VI. Multiple Class/Two-Tier Investment Companies

Investment company rankings for more than one class or investment company with the same portfolio must be accompanied by prominent disclosure of the fact that the investment companies or classes have a common portfolio.

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