FINRA Manual: Contents
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93-87 NASD Provides Guidance for Reinvestment of Maturing Certificates of Deposit in Mutual Funds
The NASD is publishing this Notice to remind members, particularly members affiliated with banks or participating in bank networking arrangements, of their obligations under the Rules of Fair Practice to disclose to customers the varying risks of investing the proceeds of deposits, such as a maturing Certificate of Deposit (CD), in a security, such as a mutual fund, collateralized mortgage obligation (CMO), or variable insurance product. Members and their sales persons should emphasize to customers that these securities products, while potentially providing attractive investment returns, are not the same as CDs, are not government insured, and have varying risks associated with them.
In November 1991, the NASD published Notice to Members 91-74 reminding members of their obligations to customers when marketing bond mutual funds as replacements for maturing CDs. With interest rates then at their lowest levels in 20 years, members were engaging in intensive marketing efforts offering customers with maturing CDs the opportunity to purchase bond mutual funds because of the funds' higher yields. This trend has persisted as interest rates have continued to fall.
With interest rates currently at or near 30-year lows, rolling over bank deposits or maturing CDs into new CDs or other depository instruments is unattractive to many investors. The NASD is reminding all members, and especially members with bank affiliations, members that participate in bank networking arrangements, and members that have marketed brokered CDs to their customers in the past, that they have a significant obligation in their oral as well as their written communications to provide customers, seeking non-depository alternatives to depository accounts, with full and fair disclosure of the material differences between the products, especially the greater degree of risk to capital that the customer may experience. Failure to provide adequate disclosure to customers, or engaging in certain marketing efforts with respect to replacements for depository instruments, may violate the NASD Rules of Fair Practice and subject members and their associated persons to disciplinary action.
While the advice contained in this Notice is primarily directed at mutual fund sales because the NASD believes many investors seeking alternatives to CDs or other depository instruments look first to mutual funds, members are advised that the general advice of this Notice—disclosure of risks to any customer moving from a guaranteed or insured investment such as a CD to another uninsured invest-ment—is applicable to most other categories of investment alternatives.
The NASD believes that the appropriate disclosures for certain mutual fund investment alternatives should, at a minimum, include the following:
- For money market funds, investors should be advised that, although fund managers strive to maintain a stable net-asset value, the funds are not federally insured and there is no guarantee that a stable net-asset value will be maintained.
- For fixed-income or bond funds, investors should receive clear disclosures that, although such funds may pay higher rates than CDs, their net-asset values are sensitive to interest-rate movement and a rise in interest rates can result in a decline in the value of the customer's investment.
- For equity funds, while there maybe less possibility that investors will confuse such funds with an insured product such as a CD, they should be clearly advised of the higher degree of risk to capital associated with equity mutual funds.
Bank Affiliated Members
Many first-time investors may use the services and products provided by a bank affiliated broker/dealer. This creates a higher level of responsibility on these members to ensure that investors understand the distinctions between the bank products and those offered by the broker/dealer, and that suitability and supervision standards are strictly followed. Members must develop procedures that require registered persons to reiterate to customers, in all oral and written communications, the material differences between their past dealings in insured depository instruments and investments in securities that carry risk to principal.
Further, bank affiliated members and members participating in bank networking arrangements have to be particularly sensitive to the potential for customer confusion about mutual fund purchases made at bank branch locations. To guard against customer confusion or misinformation, bank affiliated members and members participating in bank networking arrangements should consider taking certain precautions, including, but not limited to the following:
- Advertising and sales presentations should disclose that mutual fund shares purchased through banks are not deposits or obligations of, or guaranteed by, the bank and are not federally insured or otherwise guaranteed by the federal government. Members may wish to obtain signed, written acknowledgements from their customers that they have received and have understood these disclosures. Members should readvise their customers of these and other pertinent disclosures annually.
- Bank customers may enter the location with certain preconceived assumptions and expectations of the types of products and services available within the bank. Members are under a significant burden to ensure that the customer understands the differences in the products and services offered by the bank and those offered by the broker/dealer, and that the customer is not confused or misled by any misunderstanding or previous assumption, albeit inaccurate.
- Where banks permit their unregistered employees to discuss with customers the reinvestment of maturing CDs in mutual funds sold by the bank, members should advise their affiliates that unregistered employees should provide disclosures similar to those provided by members. Members should carefully review the activities of these unregistered employees to ensure that they do not require NASD registration. In addition, such members should advise their affiliates to use appropriate signs or labels near the investment area to distinguish the operation from the bank's traditional deposit-taking functions.
Finally, all members, including bank affiliated members and members participating in bank networking arrangements, are reminded that they are subject to the full scope of NASD regulations and are thus obligated to comply with various customer protection provisions in the NASD Rules of Fair Practice and other NASD Rules. Among these are the following:
- Article III, Section 1 of the Rules of Fair Practice, which requires members to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their business.
- Article III, Section 2 of the Rules of Fair Practice, which requires members to have reasonable grounds for believing that their recommendations to a customer are suitable for that customer.
- Article III, Section 15(d)(2) of the Rules of Fair Practice, which permits members to use negative-response letters in connection with certain bulk exchanges of money market mutual funds under certain conditions.
- Article III, Section 18 of the Rules of Fair Practice, the NASD's general antifraud provision, which prohibits members from employing fraud, deception, or other manipulative practices in the sale of securities.
- Article III, Section 21(c) of the Rules of Fair Practice, which requires members to obtain and to maintain certain information about their customers.
- Article III, Section 26 of the Rules of Fair Practice, which governs the distribution of mutual fund shares with respect to sales charges, concessions, discounts, selling dividends, and disclosure, among other matters.
- Article III, Section 27 of the Rules of Fair Practice, which imposes significant supervision obligations on member firms and also requires members to register branch locations with the NASD.
- Article III, Section 29 of the Rules of Fair Practice, which governs the distribution of insurance company variable contract products with respect to sales charges, selling agreements, and redemption.
- Article III, Section 35 of the Rules of Fair Practice, and the guidelines associated with the section, which sets forth advertising and sales literature filing requirements and general and specific rules governing member communications with the public.
- Paragraph 5266 of the NASD Manual, which prohibits breakpoint sales of mutual funds.
- Paragraph 5269 of the NASD Manual, which prohibits members from selling mutual fund shares at other than the public offering price.
The educational and regulatory initiatives discussed in this Notice are designed to help members meet their obligations to investors under the NASD Rules of Fair Practice and to prevent investor misunderstanding that could lead not only to dissatisfaction with mutual funds and other securities sold, but also to potential violations of NASD rules and regulations. NASD regulatory staff will be examining all members, including those who are bank affiliates and who are providing networking arrangements for banks, for compliance with such regulations.
If you have any questions concerning this Notice, please contact R. Clark Hooper, Vice President, Advertising/Investment Companies Regulation at (202) 728-8329 or your local NASD district office.