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93-76 Mail Vote—NASD Solicits Member Vote On Filing Requirements For Use of Mutual Fund Rankings and Elimination Of Sunset Provisions in Prefiling Requirements For CMO Advertisements;

Last Voting Date: December 31, 1993

SUGGESTED ROUTING

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Mutual Fund

Executive Summary

The NASD invites members to vote on an amendment to Article III, Section 35(c) of the Rules of Fair Practice that would require a member using mutual fund rankings in advertisements or sales literature to submit copies of the rankings and the data on which the rankings are based to the NASD Advertising Regulation Department for review. The amendment will also eliminate the sunset provisions in Article III, Subsection 35(c)(2) of the Rules of Fair Practice and in Subsection 8(c)(1)(B) of the Government Securities Rules, thereby making the prefiling requirement for advertisements relating to collateralized mortgage obligations (CMOs) permanent. The text of the proposed rule changes follow this Notice.

Background and Description Of the Proposal

The increasing number of mutual funds in recent years has been accompanied by an increasing number of mutual fund ranking entities (Ranking Entities). Ranking Entities, as well as mutual funds and fund affiliates, categorize and rank mutual funds by various criteria, including fund type; performance over a given period of years; total return; standardized yield calculated pursuant to Securities and Exchange Commission (SEC) rules; the variations in sales charges; and, risk/reward. References to such rankings in mutual fund advertisements and sales literature have also increased substantially in recent years as members try to sell mutual fund shares by promoting fund performance.

The NASD Board of Governors believes that it is important for the NASD to be able to review and regulate the use of ranking materials and the development of customized rankings to prevent the misleading use of such rankings. The NASD is, therefore, proposing to amend Article III, Section 35(c) of the NASD Rules of Fair Practice to require that copies of mutual fund rankings and the data on which the rankings are based be submitted to the NASD Advertising Regulation Department for review.

The NASD is also adopting mutual fund ranking guidelines (Guidelines) governing the NASD review. Although attached to this Notice, the Guidelines do not require member vote.

Subsection 35(c)(1) is proposed to be amended to require any member that files advertisements or sales literature pursuant to Subsection 35(c)(1) that include or incorporate rankings or comparisons of the investment company with other investment companies, to include a copy of the ranking or comparison used in the advertising or sales literature. The requirements of this provision will permit the NASD staff to determine immediately whether the use of the ranking complies with the Guidelines and to avoid the need to research the ranking or obtain a copy of the source information to verify the accuracy of the material.

Subsection 35(c)(2) currently requires that certain advertisements be filed 10 days before use. The NASD is proposing to amend the section to apply the preuse requirement to all investment company advertisements or sales literature that incorporate rankings or comparisons either generally published or created directly or indirectly by the investment company, its underwriter, or an affiliate.1 While the NASD is concerned about permitting investment companies or their affiliates to create ranking categories, rather than a Ranking Entity, it recognizes that a customized ranking may provide meaningful information to the investor. Such filings must also include a copy of the data, ranking, or comparison on which the ranking or comparison is based.

The NASD is also proposing to amend Article III, Subsection 35(c)(2) of the Rules of Fair Practice and Subsection 8(c)(1)(B) of the Government Securities Rules to eliminate sunset provisions that cause the prefiling requirements relating to CMOs to expire on November 16, 1993. This change will make the prefiling requirement for CMO advertisements permanent.2

Request for Vote

The Board of Governors believes that requiring members to include rankings, comparisons, and data used when submitting for review advertisements and sales literature that incorporate mutual fund rankings or comparisons will enhance member compliance. The information provided to the NASD Advertising Regulation Department will assist it in assuring that the use of such information is accurate and presents investors with fair and meaningful data on which to make an informed investment decision. The NASD considers the proposed rule change necessary and appropriate and recommends that members vote their approval.

As to the proposed elimination of the sunset provisions for the prefiling of collateralized mortgage obligation advertisements, the Board believes that the positive regulatory benefits seen since implementation of the provision (i.e., the reduction in misleading advertising) justifies a permanent prefiling requirement.

The text of the proposed rule change that requires member vote is below. 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 by no later than December 31, 1993. The amendment will not be effective until it is filed with and approved by the SEC.

Also included below is the text of the Guidelines For the Use of Rankings in Mutual Fund Advertisements and Sales Literature being filed separately with the SEC. The Guidelines are included for members' information and do not require member vote before submission to the SEC.

Questions regarding this Notice should be directed to Thomas A. Pappas, Assistant Director, Advertising/Investment Companies Regulation Department, at (202) 728-8330; Elliott R. Curzon, Senior Attorney, Office of General Counsel, at (202) 728-8451; and Robert J. Smith, Attorney, Office of General Counsel, at (202) 728-8176.


1 The proposed Guidelines permit the use of a ranking based on a category or subcategory created by a fund affiliate rather than by a Ranking Entity, so long as the ranking is based on the performance measurements of a Ranking Entity.

2 To provide sufficient time for membership vote and SEC approval of the elimination of the sunset provisions, the NASD has submitted a rule change to the SEC to extend the sunset provisions temporarily.


Text of Proposed Amendment to Section 35(c) of the Rules of Fair Practice

Communications With the Public

(Note: New language is underlined; deletions are in brackets.)

Sec. 35.

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(c) Filing Requirements and Review Procedures
(1) Advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts and unit investment trusts) not included within the requirements of Subsection (c)(2) of this Section, and public direct participation programs (as defined in Article III, Section 34 of the Rules of Fair Practice) shall be filed with the Association's Advertising Department within 10 days of first use or publication by any member. Filing in advance of use is recommended. Members are not required to file advertising and sales literature which have previously been filed and which are used without change. Any investment company filing any advertisement or sales literature pursuant to this Subsection that includes or incorporates rankings or comparisons of the investment company with other investment companies shall include a copy of the ranking or comparison used in the advertisement or sales literature.
(2) Advertisements concerning collateralized mortgage obligations registered under the Securities Act of 1933, and advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts and unit investment trusts) that include or incorporate rankings or comparisons of the investment company with other investment companies where the ranking or comparison category is not generally published or is the creation, either directly or indirectly, of the investment company, its underwriter or an affiliate, shall be filed with the Association's Advertising Department for review at least 10 days prior to use (or such shorter period as the Department may allow in particular circumstances) for approval and, if changed or expressly disapproved by the Association, shall be withheld from publication or circulation until any changes specified by the Association have been made or, in the event of disapproval, until the advertisement has been refiled for, and has received, Association approval. Any investment company filing any advertisement or sales literature pursuant to this Subsection shall include a copy of the data, ranking or comparison on which the ranking or comparison is based. [This subsection (c)(2) shall remain in effect for one year from November 16, 1992 unless modified or extended prior thereto by the Board of Governors.]

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Text of Proposed Amendment To Section 8(c)(1)(B) of the Government Securities Rules

Communications With the Public

Sec. 8.

(c) Filing Requirements and Review Procedures

* * * * *
(B) advertisements concerning collateralized mortgage obligations shall be filed with the Association's Advertising Regulation Department for review at least 10 days prior to use (or such shorter period as the Department may allow in particular circumstances) for approval and, if changed or expressly disapproved by the Association, shall be withheld from publication or circulation until any changes specified by the Association have been made or, in the event of disapproval, until the advertisement has been refiled for, and has received, Association approval. [This subsection (c)(1)(B) shall remain in effect for one year from November 16, 1992 unless modified or extended prior thereto by the Board of Governors.]

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Guidelines for the Use of Rankings in Mutual Fund 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 mutual funds to the public, that is independent of the mutual fund and its affiliates, and whose services are not procured by the mutual fund or any of its affiliates to assign the fund a ranking. Examples of "Ranking Entities" include services such as Morningstar and Lipper and financial publications such as Money and Barron's.
II. Required Disclosures
A. Headlines/Prominent Statements
1. A headline or other prominent statement must not state or imply that a mutual fund is the best performer in a category unless it is actually ranked first in the category.
2. Prominent disclosure of the mutual fund's ranking, the total number of mutual funds 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 a mutual fund ranking must disclose, with respect to the ranking:
1. the name of the category (e.g., growth funds);
2. the number of funds 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 based;
6. for load funds, whether the ranking takes into account sales charges;
7. if 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 ranking, 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, and B3 must be set forth prominently in the body of the advertisement or sales literature.
C. If the mutual fund 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 fund is in the top 30 percent of all mutual funds).
D. All advertisements and sales literature containing a mutual fund ranking must disclose that past performance is no guarantee of future results.
III. Time Periods
A. Any mutual fund ranking set forth in an advertisement or sales literature must be, at a minimum, current to the most recent calendar quarter ended prior to the submission for publication.
B. Except for money market mutual funds:
1. advertisements and sales literature must not use any ranking based on a period of less than one year;
2. a mutual fund ranking based on total return must be accompanied by rankings based on total return for the one-, five-, and ten-year periods (or life of the fund) supplied by the same Ranking Entity in the category and based on the same time period; and,
3. a mutual fund ranking based on the current SEC standardized yield must be accompanied by rankings based on total return for the one-, five-, and ten-year periods (or life of the fund) supplied by the same Ranking Entity in the category and based on the same time period.
IV. Categories
A. The choice of category (including a subcategory of a broader category) on which the mutual fund ranking is based must be one that provides a sound basis for evaluating the performance of the fund.
B. Subject to the standards below, a mutual fund 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 a fund or a fund affiliate, but based on the performance measurements of a Ranking Entity.
C. When the mutual fund ranking is based on a subcategory, the advertisement or sales literature must disclose the name of the full category and the fund's ranking and the number of funds in the full category. This requirement does not apply if the subcategory is (1) based solely on the investment objectives of the funds 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 mutual funds' asset size (whether or not it has been created by a Ranking Entity).
E. If an advertisement uses a category created by the mutual fund or a fund affiliate, including a "subcategory" of a category established by a Ranking Entity, the advertisement must prominently disclose:
1. the fact that the fund or its affiliate has created the ranking category;
2. the number of funds 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 a mutual fund ranking created by a fund or its affiliate must indicate, in close proximity to the headline or statement, that the mutual fund ranking is based upon a category created by the fund or its affiliate.
V. Multiple Class/Two-Tier Funds

Mutual Fund rankings for more than one class or fund with the same portfolio must be accompanied by prominent disclosure of the fact that the funds or classes have a common portfolio.

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