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94-14 NASD Clarifies Compensation Disclosure Requirements For Mutual Funds In Article III, Section 26 Of The NASD Rules Of Fair Practice

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Executive Summary

Article III, Section 26 of the Rules of Fair Practice prohibits members from accepting compensation from an underwriter when selling its mutual fund unless such compensation is disclosed in the fund's prospectus. To the extent investment companies are not providing adequate disclosure currently, the NASD has determined to clarify the level of disclosure necessary to comply with NASD rules.

Background

Subsection (1)(1)(C) prohibits the receipt of any discount, concession, fee, or commission (together "compensation") by members from underwriters when selling their mutual fund securities unless the compensation is disclosed in the mutual fund prospectus. The provision further clarifies that if the compensation is not uniformly paid to all members purchasing the same dollar amount of the securities from the underwriters, the disclosure must include a description of the circumstances of any general variations from the standard schedule of concessions. Moreover, if special compensation arrangements have been made with individual members that are not generally available to all members, the details of the arrangements and the identities of the members receiving the special arrangements must be disclosed.

Subsection (1)(3)(A) further prohibits members and persons associated with members from accepting any item of material value from an underwriter in connection with retail sales of mutual fund securities that is in addition to the concessions disclosed in the prospectus. Items of material value include any payment in excess of $50 per person per year for the reimbursement of travel expenses in connection with a meeting held by an underwriter and payment by an underwriter for entertainment events (such as tickets to a sporting event, a dinner, theater, or other entertainment) where, in both cases, attendance by the associated person is conditioned on sales of shares of a mutual fund. Travel expense reimbursement is not required to be disclosed in the prospectus if the meeting attended by the associated person is a business meeting held by an underwriter for informational purposes relative to any mutual fund(s) it sponsors and is not conditioned on sales of shares of any mutual fund. Thus, disclosure of compensation encompasses disclosure of both cash and non-cash forms of compensation.

Discussion

For disclosure of cash and non-cash compensation that does not involve special compensation arrangements, the usual disclosure practices relating to underwriting compensation require the disclosure of the maximum cash compensation and the type of non-cash compensation to be provided to all participating members. As stated in the rule language, any variations from the standard schedule of concessions must be disclosed if concessions are not uniformly paid to all members purchasing the same dollar amounts of securities.

The fact that a non-cash compensation program has been established must be unequivocal (e.g., the disclosure should use the words "will" or "shall" not "may be"). Further, the statement of the type of non-cash compensation should indicate whether it is "luxury merchandise" or a "trip to a luxury resort at an exotic location" or "attendance at a sales seminar at a luxury resort." It is believed that such disclosure can be sufficiently generic, without specifying the name of the resort or the item of merchandise, to not require stickers or amendments to the offering document as trips to different resorts or as different merchandise or offered over the lengthy period that the offering document is effective.

To disclose special compensation arrangements, underwriters must include an amendment or sticker to the offering document that identifies the member(s) to receive the special arrangements and the exact details of the arrangement including identification, for example, of the luxury resort and its location or the specific item of merchandise that is being offered. While it is anticipated that most special compensation arrangements would be non-cash in nature, the exact details of any special cash compensation arrangements entered into by the underwriter(s) with any member(s) and the identity of the member(s) must also be disclosed.

The NASD believes that the location of disclosure of cash and non-cash compensation, including special cash and non-cash compensation arrangements, should be consistent with SEC disclosure rules. Therefore, it is required to be made in the offering document and not in the Statement of Additional Information. Thus, all compensation, whether cash or non-cash, would be disclosed in the same part of the prospectus. As indicated above, special cash and non-cash compensation arrangements may be disclosed via a sticker to the prospectus.

Any questions regarding this Notice should be directed to R. Clark Hooper, Vice President, Investment Companies Regulation Department, (202) 728-8329.


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