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92-59 SEC Approval of Amendments Requiring Prefiling of Advertisements for Collateralized Mortgage Obligations

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EXECUTIVE SUMMARY

On October 28, 1992, the Securities and Exchange Commission (SEC) approved an amendment to Article III, Section 35 of the Rules of Fair Practice and Section 8 of the NASD's Government Securities Rules requiring members to prefile advertisements relating to collateralized mortgage obligations (CMOs). The amendments take effect on November 16, 1992. The text of the new rule language follows this Notice.

BACKGROUND AND DESCRIPTION OF THE AMENDMENTS

On October 28, 1992, the SEC approved a rule change amending Article III, Section 35 of the Rules of Fair Practice and Section 8 of the NASD's Government Securities Rules requiring members to file advertisements concerning CMOs issued by a corporation or an agency of the United States government with the NASD prior to use. The requirement will be temporary, lasting for a period of one year until November 15, 1992. Before the end of the first year, the Association will evaluate the efficacy of the rule and determine whether to extend the rule, propose changes, or eliminate it.

The amendments reflect the NASD's increasing concern over misleading advertisements for CMOs and an increase in the number of complaints associated with such advertisements. The NASD believes that CMOs are extremely complex and require full and fair disclosure to assist the investor in understanding them. CMO advertisements generally are brief and emphasize high yields, safety, government guarantees (where applicable), and liquidity. The NASD has found, however, that it is difficult to distinguish between CMOs based on the content of such advertisements. Even though two CMOs have the same underlying collateral, they may differ substantially in their prepayment predictability or volatility. In particular, the terms "interest only" or "principal only" are generally inadequately explained.

As a result of these concerns, the NASD issued Notice to Members 92-27 (May 1992) detailing the problems relating to CMO advertising and recommending that members' CMO advertisements comply with certain standards set forth in the Notice. For example, the NASD believes that an advertisement which includes the "yield" of a CMO is misleading without disclosure of the prepayment assumption used to calculate the yield and that the anticipated yield and average life of the security will fluctuate depending on the actual prepayment experience and current interest rates.

The NASD also recommended in Notice to Members 92-27 (May 1992) that CMO advertisements not contain comparisons between CMOs and any other investment vehicles. The NASD is particularly concerned that advertising CMOs as alternatives to certificates of deposit (CDs) falsely implies that CMOs offer the same level of safety and guarantee of interest and principal as CDs.

In light of these concerns, the NASD has amended its rules to subject CMO advertisements to pre-use filing to provide NASD staff an opportunity to comment on the fairness and reasonableness of such advertisements prior to use and permit potentially misleading advertisements to be identified and withheld from publication.1

The new rule with respect to CMO advertising is set forth in new Subsection (c)(2) of Section 35 requires that all advertisements concerning corporate CMOs be filed with the NASD's Advertising Department at least 10 days prior to first use unless the Department permits a shorter period in particular circumstances. The advertisement must be approved before use. If changed or expressly disapproved by the NASD, it cannot be published or circulated until the member makes the changes specified by the Association. A disapproved advertisement must be refiled and receive Association approval prior to publication or circulation. The NASD also added a new Subsection 8(c)(1)(B) to its Government Securities Rules to require prefiling of advertisements relating to CMOs issued by an agency of the United States government. A technical amendment also deletes current Subsection 8(c)(2)(B) which applied to filing advertisements concerning government securities during the first year of the operation of the Government Securities Rules which were adopted by the NASD in 1989.

While the NASD believes that a pre-use filing requirement for CMO advertisements is appropriate, the NASD recognizes that it diminishes the flexibility of member firm advertising programs. Accordingly, the rule will be in effect for one year only. During that year, the NASD's Fixed Income Committee will review the rule's impact to determine the need for changes to ensure that CMO advertising is not misleading.

The NASD has also amended Article III, Section 35 of the Rules of Fair Practice to consolidate the current filing requirements for registered investment companies and public direct participation programs set forth in Subsections (c)(1) and (2), respectively, into new Subsection (c)(1). The requirements themselves are unchanged.

The amendments take effect on November 16, 1992. Questions concerning this Notice should be directed to R. Clark Hooper, Vice President, Advertising at (202) 728-8330, or Elliott R. Curzon, Senior Attorney, Office of General Counsel at (202) 728-8451.


1 At present, advertisements concerning government securities must be filed with the NASD within 10 days of first use or publication. Additionally, advertisements and sales literature concerning registered investment companies and direct participation programs currently must be filed within 10 days of first use. Advertising and sales literature pertaining to options currently must be approved in advance of its use or publication.


TEXT OF AMENDMENTS TO ARTICLE III, SECTION 35 OF THE RULES OF FAIR PRACTICE

(Note: New text is underlined; deleted text is in brackets.)

Communications With the Public Sec. 35.

(c) Filing Requirements and Review Procedures
[(1) Advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts and unit investment trusts) 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.
(2) Advertising and sales literature concerning 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 for review within 10 days of first use or publication. Filing in advance of use is recommended. Members need not file for review advertising and sales literature which has been filed by the sponsor, general partner or underwriter of the program or by another member.]
(1) Advertisements and sales literature concerning registered investment companies (including mutual funds, variable contracts and unit investment trusts) 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.
(2) Advertisements concerning collateralized mortgage obligations registered under the Securities Act of 1933 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 or sales literature has been refiled for, and has received, Association approval. 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.

GOVERNMENT SECURITIES RULES

Communications With the Public

Sec. 8

(c) Filing Requirements And Review Procedures
(1) Members shall file advertisements for review with the Association's Advertising Department as follows:
(A) Advertisements concerning government securities (as defined in Section 3(a)(42) of the Securities Exchange Act of 1934) other than collateralized mortgage obligations shall be filed by members with the Association's Advertising Department for review within 10 days of first use or publication[.]; and
(B) Advertisements concerning collateralized mortgage obligations 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 or sales literature 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.
(2) [(A)] No change.
[(B) Each member that, on the effective date of this section, had been filing advertisements with the Association for a period of less than one year shall continue to file its advertisements concerning government securities at least 10 days prior to use, until the completion of one year from the date the first advertisement was filed with the Association.]

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