[Federal Register Volume 63, Number 216 (Monday, November 9, 1998)]
[Notices]
[Pages 60431-60435]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-29970]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40627; File No. SR-NASD-97-89, Amendment No. 1]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by the National Association of Securities Dealers, Inc. Relating
to Bond Mutual Fund Volatility Ratings
November 2, 1998.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on December 12, 1997, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') through its wholly-owned subsidiary,
the NASD Regulation, Inc. (``NASD Regulation'' or ``NASDR'') filed with
the Securities and Exchange Commission (``SEC'' or ``Commission'') the
proposed rule change as described in Items I, II, and III below, which
Items have been prepared by NASD Regulation. On October 5, 1998, NASDR
filed Amendment No. 1 which replaces and supersedes the initial
proposal.\3\ The Commission is publishing this notice to solicit
comments on the proposed rule change, as contained in Amendment No. 1,
from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ On December 12, 1997, the NASDR submitted its initial
proposal which could have limited the effectiveness of the
disclosure statement and prevented sales literature from containing
relevant explanatory information concerning bond mutual fund
volatility ratings. After discussions between NASDR and the
Commission, the NASDR filed Amendment No. 1 on October 5, 1998. The
revised proposal will: (1) permit ratings to be provided by non-
NRSROs; (2) permit funds to provide additional information in the
disclosure statement if the information would help investors
understand the rating; (3) permit funds to combine information about
different ratings when the information is the same for each rating;
(4) clarify the prohibition against using ratings that are based on
subjective factors; and (5) require the use of the most recently
issued rating.
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[[Page 60432]]
I. Self-Regulatory Organizations Statement of the Terms of
Substance of the Proposed Rule Change
NASD Regulation is proposing rules that add a new interpretation to
Rule 2210 of the Conduct Rules of the NASD to permit the use by members
and associated persons of bond mutual fund volatility ratings in
supplemental sales literature on an interim 18 month pilot basis.
Proposed new language is in italics.
IM- . Requirements for the Use of Bond Mutual Fund Volatility
Ratings
(This rule will expire on [18 months from approval], unless extended or
permanently approved by the Association at or before such date)
(a) Definition of Bond Mutual Fund Volatility Ratings
For purposes of this Rule and any interpretation thereof, the term
``bond mutual fund volatility rating'' is a description issued by an
independent third party relating to the sensitivity of the net asset
value of a bond mutual fund portfolio to changes in market conditions
and the general economy, and is based on an evaluation of objective
factors, including the credit quality of the fund's individual
portfolio holdings, the market price volatility of the portfolio, the
fund's performance, and specific risks, such as interest rate risk,
prepayment risk, and currency risk.
(b) Prohibitions on Use
Members and persons associated with a member may use a bond mutual
fund volatility rating only in supplemental sales literature and only
when the following requirements are satisfied:
(1) The rating does not identify or describe volatility by use of a
single symbol, number or letter, and the rating is not described as a
``risk'' rating.
(2) The supplemental sales literature incorporates the most
recently available rating and reflects information that, at a minimum,
is current to the most recently completed calendar quarter ended prior
to use.
(3) The criteria and methodology used to determine the rating must
be based exclusively on objective, quantifiable factors. Any other
factors, such as an analysis of investment philosophy or quality of the
fund's management, may be considered solely for purposes of determining
whether to issue the rating. The rating and the Disclosure Statement
that accompanies the rating must be clear, concise, and understandable.
(4) The supplemental sales literature conforms to the disclosure
requirements described in paragraph (c).
(5) The entity that issued the rating provides detailed disclosure
on its rating methodology to investors through a toll-free telephone
number, a web site, or both.
(c) Disclosure Requirements
(1) Supplemental sales literature containing a bond mutual fund
volatility rating shall include a Disclosure Statement containing all
the information required by this Rule. The Disclosure Statement may
also contain any additional information that is relevant to an
investor's understanding of the rating.
(2) Supplemental sales literature containing a bond mutual fund
volatility rating shall contain all current bond mutual fund volatility
ratings that have been issued with respect to the fund. Information
concerning multiple ratings may be combined in the Disclosure
Statement, provided that the applicability of the information to each
rating is clear.
(3) All bond mutual fund volatility ratings shall be contained
within the text of the Disclosure Statement. The following disclosures
shall be provided with respect to each such rating:
(A) the name of the entity that issued the rating;
(B) the most current rating and date of the current rating, with an
explanation of the reason for any change in the current rating from the
most recent prior rating;
(C) a description of the rating in narrative form, containing the
following disclosures:
(i) a statement that there is no standard method for assigning
ratings;
(ii) a description of the criteria and methodologies used to
determine the rating;
(iii) a statement that not all bond funds have volatility ratings;
(iv) whether consideration was paid in connection with obtaining
the issuance of the rating;
(v) a description of the types of risks the rating measures (e.g.,
short-term volatility);
(vi) a statement that the portfolio may have changed since the date
of the rating; and
(vii) a statement that there is no guarantee that the fund will
continue to have the same rating or perform in the future as rated.
* * * * *
2200. Communications With Customers and the Public
2210. Communications With the Public
* * * * *
(c) Filing Requirements and Review Procedures
* * * * *
(3) Sales literature concerning bond mutual funds that include or
incorporate bond mutual fund volatility ratings, as defined in Rule IM-
__, shall be filed with the 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 by the
Association, shall be withheld from publication or circulation until
any changes specified by the Association have been made or, if
expressly disapproved, until the sales literature has been refiled for,
and has received, Association approval. Members are not required to
file advertising and sales literature which have previously been filed
and which are used without change. The member must provide with each
filing the actual or anticipated date of first use. Any member filing
sales literature pursuant to this paragraph shall provide any
supplemental information requested by the Department pertaining to the
rating that is possessed by the member.\4\
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\4\ NASDR proposes to add this language to the existing test of
Rule 2210(c). The existing sections of this rule will remain
unchanged and will be renumbered, beginning with Rule 2210(c)(3)(A).
Telephone conversation between Robert J. Smith, Office of General
Counsel, NASD Regulation, Inc., and Mignon McLemore, Division of
Market Regulation, Commission, on October 30, 1998.
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* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, NASDR included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. NASDR has prepared summaries, set forth in Sections A,
B, and C below, of the most significant aspects of such statements.
A. Regulatory Organization's Statement of the Purpose of, and Statutory
Basis for, the Proposed Rule Change
Background
Bond mutual fund volatility ratings are descriptions of the
sensitivity of bond mutual fund portfolios to changing market
conditions. The rating agencies and information vendors that issue such
ratings are not NASD member firms, and mutual fund groups that purchase
the ratings use them for promotional and
[[Page 60433]]
marketing purposes. NASD rules do not apply to the use and
dissemination of bond mutual fund volatility ratings by non-members.
Currently, NASD Regulation interprets its rules to prohibit the use
by members and associated persons of bond mutual volatility ratings in
supplemental sales literature. The prohibition is based on the analysis
that judgments of how a bond mutual fund may react to changes in
various market conditions may be predictive of fund performance or
misleading and, therefore, prohibited for use by members and associated
persons in sales literature.\5\
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\5\ NASD Conduct Rule 2210 prohibits the use by members and
associated persons of information that is misleading, that contains
exaggerated, unwarranted or misleading statements or claims, or that
predicts or projects investment results.
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In Notice to Members 96-84 (December 1996) (``NTM 96-84''), NASD
Regulation requested comment on the appropriations of its current
prohibition. A majority of the commenters supported making the ratings
available, and all of the commenters representing investor groups
supported the goal of making accurate information regarding risk and
volatility characteristics of bond funds available to investors.
On April 30, 1997, the Legal Advisory Board of the NASD (``LAB'')
reviewed and discussed bond fund volatility ratings. NASD Regulation
staff proposed to the LAB that an alternative to the current
prohibition would be permitting the use of bond fund volatility ratings
subject to appropriate guidelines. After extended discussion, the LAB
favored allowing volatility ratings to be used subject to guidelines
containing sufficient prohibitions and disclosure requirements.
At its September 1997 Board meeting, NASD Regulation considered
issues regarding bond mutual fund volatility ratings and adopted
resolutions: (i) Affirming that investors can benefit from the
availability of such information, (ii) directing the staff to draft
bond fund volatility rating regulatory proposals to best serve the
public interest and address the differences among interested parties,
for presentation at the November Board meeting, and (iii) appointing
Directors Theodore A. Levine and A.A. Sommer, Jr. (``Subcommittee'') to
assist the staff in this effort. After the September Board meeting,
NASD Regulation staff and the Subcommittee met and worked to reach a
solution that was sensitive to and reflective of the concerns and
differences of all interested parties.
At its November 1997 Board meeting, NASD Regulation approved: (i) A
modification to NASD Regulation's current prohibition on the use of
bond mutual fund volatility ratings in supplemental sales literature to
permit such use by members and associated persons according to proposed
rules designed to prevent such ratings from being misleading,
predictive, or otherwise inappropriate, and (ii) the submission of the
proposed rules to the SEC for approval.
At its December 1997 Board meeting, the NASD ratified the NASD
Regulation Board's approval of the proposed rules, without change, and
their submission to the SEC for approval.
At its August 1998 Board Meeting, NASD Regulation approved
amendments to the proposed rule change as originally filed with the
SEC, and the submission of the amendments to the SEC for approval. The
amendments, incorporated in this submission: (i) Delete the requirement
that ratings be issued exclusively by nationally recognized statistical
rating organizations; (ii) add the requirement that the rating and the
Disclosure Statement be clear, concise, and understandable; (iii)
permit the Disclosure Statement to contain any additional information
that is relevant to an investor's understanding of the rating; (iv)
permit repetitive information in multiple ratings for the same fund to
be combined in the Disclosure Statement, provided the applicability of
the information to each rating is clear; and (v) delete the requirement
to use a ``Required Disclosure Statement.''
Description
Trial Period. The proposed rule change would permit, on an 18-month
pilot basis, the use of the ratings in conformance to rules that
prohibit the use of ratings unless certain requirements and disclosures
are met. After the 18-month trial term, the rules would be evaluated to
determine their efficacy in ensuring that comprehensible and useful
information is provided to investors, and in preventing the
dissemination of inappropriate or misleading information by members and
associated persons. After the evaluation, the staff will consider all
options, including prohibiting the use of ratings, permitting their use
or permitting their use with modifications to the rule.
Definition of Bond Mutual Fund Volatility Rating. Paragraph (a) of
the proposed rule change defines the term ``bond mutual fund volatility
rating'' to mean, in part, a description issued by an independent third
party relating to the sensitivity of a bond mutual fund's net asset
value to changes in market conditions and the general economy, based on
an evaluation of objective factors regarding the fund's current
characteristics and its past performance. The definition recognizes
that the rating is an opinion of a fund's potential share price
movement in response to various economic conditions or market
situations, and not a prediction of the actual movement of a fund's
share price. The definition applies only to bond mutual fund volatility
ratings provided by an independent third party. However, NASD
Regulation understands that many mutual fund complexes currently
provide various descriptions of risk and volatility for their own
funds. These descriptions may involve some of the same processes and
considerations that are used by independent rating agencies. NASD
Regulation specifically solicits comment on whether such descriptions
are similar in derivation and purpose to ratings that are issued by
independent agencies, and whether their use in supplemental sales
literature by members and their associated persons should also be
subject to the provisions of the proposed rule change.
Prohibitions. Subparagraph (b) of the proposed rule change permits
members and associated persons to use a bond mutual fund volatility
rating only in supplemental sale literature and only when certain
requirements are satisfied.
Subparagraph (b)(1) of the proposed rule change prohibits the use
of a bond mutual fund volatility rating that identifies or describes
volatility by use of a single symbol, number or letter. At the same
time, the proposed rules refrain from imposing a specific standard on
descriptions or calculations in recognition of the fact that there is
no specified or uniform range of information used by all rating
entities, and that rating entities should be free to develop completing
methods and models of assessing volatility. Subparagraph (b)(1) also
prohibits the use of a bond mutual fund volatility rating that uses the
word ``risk'' to describe the rating. Because the word ``risk'' is
capable of multiple meanings and interpretations, NASD Regulation
believes that it is more accurate to refer to such ratings as
``volatility'' rather than ``risk'' ratings.
Subparagraph (b)(2) of the proposed rule change prohibits the use
of a bond mutual fund volatility rating that does not incorporate the
most recently available rating and is not current to the most recent
calendar quarter ended prior to use. This prohibition is intended to
ensure that stale or dated
[[Page 60434]]
ratings are not provided to investors and reflects a common denominator
time frame that can be used by rating entities currently to update
their ratings.
Subparagraph (b)(3) of the proposed rule change prohibits the use
of a bond mutual fund volatility rating that is not based exclusively
on objective, quantifiable factors. Non-quantifiable, subjective
factors, such as an analysis of investment philosophy and quality of
the fund's management \6\ could be considered solely for purposes of
determining whether to issue the rating. Eliminating subjectivity from
the volatility calculation reduces the potential variability of
ratings, and thus helps eliminate the ability of funds to ``shop
around'' for the most favorable rating.
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\6\ Volatility or risk rating analysis has been described as
being comprised of three elements: (i) an analysis of the effective
duration of the fund's current portfolio--i.e., the sensitivity of
the current portfolio to interest rate changes, (ii) a comparison of
the historical risk profile of the bond fund with the risk of its
current portfolio, and (iii) an assessment of the fund manager's
policies and management style, including whether management has
established policies and systems that comport with stated objectives
for the fund, including levels of risk.
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Subparagraph (b)(3) of the proposed rule change also requires that
the rating and the Disclosure Statement that accompanies it be clear,
concise, and understandable. This addresses the need to deliver the
rating information in a way that is accessible and informative.
Subparagraph (b)(4) of the proposed rule change prohibits the use
of bond mutual fund volatility rating unless the supplemental sales
literature containing the rating conforms to the disclosure
requirements.
Subparagraph (b)(5) of the proposed rule change prohibits the use
of a bond mutual fund volatility rating unless the entity that issued
the ratings provides detailed disclosure on its rating methodology to
investors through a toll-free telephone number, a web site, or both.
NASD Regulation believes that access to such supplemental information
will enable investors to obtain answers to question regarding the
meaning of the rating or how it is calculated or derived.
Disclosure Requirements. Paragraph (c) of the proposed rule change
requires that certain disclosures accompany any bond mutual fund
volatility rating used in supplemental sales literature by members or
associated persons of members.
Subparagraph (c)(1) requires that supplemental sales literature
containing a bond mutual fund volatility rating include a Disclosure
Statement containing all the information required by the rule, but also
permits the Disclosure Statement to contain any additional information
that is relevant to an investor's understanding of the rating.
Permitting the Disclosure Statement to contain additional relevant
information could help explain the meaning of the rating. In
particular, supplemental sales literature that contains multiple
ratings could benefit from additional information that could
distinguish and clarify different methodologies and measurements of
volatility.
Subparagraph (c)(2) requires that supplemental sales literature
containing a bond fund volatility rating contain all other current
volatility ratings that have been issued with respect to the same fund.
Subparagraph (c)(2), however, permits information concerning multiple
ratings to be combined in the Disclosure Statement, provided that the
applicability of the information to each rating is clear. This serves
the purpose of avoiding redundant and potentially confusing
information, and reduces the possibility that the rating could be
buried or hidden in excess information.
Subparagraph (c)(3) requires that all bond mutual fund volatility
ratings be contained within the text of the Disclosure Statement. NASD
Regulation believes it is important that the rating not be located
separately from the Disclosure Statement to avoid the danger that
either could be read separately, or not at all, which would increase
the possibility that the rating would not be understood in the context
of the required disclosures.
Subparagraphs (c)(3)(A)-(B) of the proposed rule change require
that supplemental sales literature containing a bond mutual fund
volatility rating disclose the name of the rating entity, the most
current rating accompanied by the date of the rating and, if there is
any change in the current rating from the most recent prior rating, an
explanation of the change. NASD Regulation believes it is important for
investors to see how a fund's rating may have changed and understand
the reasons for the change.
Subparagraph (c)(3)(C) of the proposed rule change requires that
supplemental sales literature containing a bond mutual fund volatility
rating describe the rating in narrative form. Under subparagraphs
(c)(3)(C)(i)-(vii), the narrative description must also include: (i) a
statement that there is no standard method for assigning ratings; (ii)
a description of the criteria and methodologies used to determine the
rating; (iii) a statement that not all bond funds have volatility
ratings; (iv) whether consideration was paid in connection with
obtaining the issuance of the rating; (v) a description of the types of
risks the rating measures, such as short-term volatility, for example;
(vi) a statement that there is no guarantee that the fund will continue
to have the same rating or perform in the future as rated.
The disclosures required by subparagraphs (c)(3)(C)(i)-(vii) help
inform investors of certain potential limitations of a rating (i.e.,
that a rating may have been paid for, may measure only a certain type
of risk or volatility, may not reflect a comparison with all funds of a
given class or peer group, and may not be current).
NASDR intends to include in the NTM that will accompany publication
of the final rule the following Disclosure Statement as a sample to
assist members in drafting Disclosure Statements that comply with the
requirements of the rule:
The volatility rating for this fund issued by [XYZ rating
entity] (``XYZ'') is [insert narrative rating]. The rating seeks to
measure [description of what risks the rating measures, e.g., ``how
the value of the fund's current portfolio might respond to changing
market conditions'']. XYZ arrived at his rating in the following
way: [insert description of methodology]. There is no standard
method for determining volatility ratings. The rating is current as
of [date]. The fund's portfolio may have changed since this date and
there is no guarantee that the fund will continue to have the same
rating or perform in the future as rated. Not all bond mutual funds
have volatility ratings and those that do may have paid for them.
The fund [paid for][did not pay for] the volatility rating issued by
XYZ. The fact that a fund has a rating is not an indication that it
is more or less risky or volatile than a fund that does not. If you
would like more specific information on the rating or the
methodology used to determine the rating, call XYZ at 1-800-000-000
or visit XYZ's web site address at www.[address].
Filing Requirement. The proposed rule change amends NASD Rule 2210
regarding communications with the public by adding new subparagraph
(c)(3) to require sales literature containing bond mutual fund
volatility ratings to be filed with the Advertising Regulation
Department for review and approval at least 10 days prior to use.
Members would not be required to file advertising and sales literature
which had previously been filed and approved, and used without change.
Members filing sales literature containing bond mutual fund sales
literature also must provide any supplemental information requested by
the Department pertaining to the rating that is possessed by the
member.
NASD Regulation believes that the proposed rule change is
consistent with
[[Page 60435]]
the provisions of Section 15A(b)(6) \7\ of the Act, which require that
the Association adopt and amend its rules to promote just and equitable
principles of trade, and generally provide for the protection of
investors and the public interest. The proposed rule change, by
imposing certain prohibitions, disclosure and filing requirements, is
designed to permit members and associated persons of a member to
disseminate bond mutual fund volatility ratings in supplemental sales
literature according to standards designed to prevent such ratings from
being misleading, predictive, or otherwise inappropriate.
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\7\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition
NASD Regulation does not believe that the proposed rule change will
result in any burden on competition that is not necessary or
appropriate in furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Written comments were neither solicited nor received. However, NTM
96-84 requested comment on the appropriateness of the NASDR's current
prohibition on the use by members and persons associated with a member
of bond mutual fund volatility ratings in supplemental sales
literature. A copy of NTM 96-84 and a summary of the comments received
in response to NTM 96-84 are available for inspection and copying in
the Commission's Public Reference Room.
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
A. By order approve such proposed rule change, or
B. Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether the proposal is
consistent with the Act. Persons making written submissions should file
six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW, Washington, D.C. 20549. Copies of the
submission, all subsequent amendments, all written statements with
respect to the proposed rule change that are filed with the Commission,
and all written communications relating to the proposed rule change
between the Commission and any person, other than those that may be
withheld from the public in accordance with the provisions of 5 U.S.C.
552, will be available for inspection and copying in the Commission's
Public Reference Room. Copies of such filing will also be available for
inspection and copying at the principal office of the NASD. All
submissions should refer to the file number in the caption above and
should be submitted by November 30, 1998.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\8\
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\8\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-29970 Filed 11-6-98; 8:45 am]
BILLING CODE 8010-01-M