[Federal Register Volume 62, Number 172 (Friday, September 5, 1997)]
[Notices]
[Pages 47080-47096]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-23540]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38993; File No. SR-NASD-97-35]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by the National Association of Securities Dealers, Inc. Relating
to the Regulation of Non-Cash Compensation in Connection With the Sale
of Investment Company Securities and Variable Contracts
August 29, 1997.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'')\1\, and Rule 19b-4 \2\ thereunder, notice is hereby given
that on May 7, 1997,\3\ the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') filed with the Securities and
Exchange Commission (``Commission'') the proposed rule change as
described in Items I, II and III below, which Items have been prepared
by the self-regulatory organization. The Commission is publishing this
notice to solicit comments on the proposed rule change from interested
persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ On July 15, 1997, the NASD filed Amendment No. 1 to the
proposed rule change. On July 23, 1997, the NASD filed Amendment No.
2 to the proposed rule change. On August 28, 1997, the NASD filed
Amendment No. 3 to the proposed rule change. Amendment No. 1 made
several changes to the proposed rule language and the rule filing.
See letter from John Ramsay, Deputy General Counsel, NASD
Regulation, Inc. (``NASD Regulation'') to Katherine A. England,
Assistant Director, Commission, dated July 11, 1997. The changes
made by Amendment No. 1 are incorporated into and published in this
notice. Amendment No. 2 makes a technical change to Amendment No. 1.
See letter from John Ramsay, NASD Regulation to Katherine A.
England, Commission, dated July 22, 1997. Amendment No. 3 states
that the NASD Board of Governors has reviewed the proposed rule
change and that no other action by the NASD is necessary for
Commission consideration of the rule proposal. See letter from John
Ramsay, NASD Regulation to Katherine A. England, Commission, dated
August 27, 1997.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The NASD is filing a proposed rule change to NASD Conduct Rules
2820 and 2830 relating to the regulation of non-cash compensation in
connection with the sale of investment company securities and variable
contracts. Below is the text of the proposed rule change. Proposed new
language is italicized; proposed deletions are in brackets.
Conduct Rules
2820. Variable Contracts of an Insurance Company
(a) Application.
Unchanged.
(b) Definitions.
(1)-(2) Unchanged.
(3) The terms ``affiliated member,'' ``compensation,'' ``cash
compensation,'' ``non-cash compensation'' and ``offeror'' as used in
paragraph (h) of this Section shall have the following meanings:
``Affiliated Member'' shall mean a member which, directly or
indirectly, controls, is controlled by, or is under common control with
a non-member company.
``Compensation'' shall mean cash compensation and non-cash
compensation.
``Cash compensation'' shall mean any discount, concession, fee,
service fee, commission, asset-based sales charge, loan, override, or
cash employee benefit received in connection with the sale and
distribution of variable contracts.
``Non-cash compensation'' shall mean any form of compensation
received in connection with the sale and distribution of variable
contracts that is not cash compensation, including but not limited to
merchandise, gifts and prizes, travel expenses, meals and lodging.
``Offeror'' shall mean an insurance company, a separate account of
an insurance company, an investment company that funds a separate
account, any adviser to a separate account of an insurance company or
an investment company that funds a separate account, a fund
administrator, an underwriter and any affiliated person (as defined in
Section 2(a)(3) of the Investment Company Act of 1940) of such
entities.
(c)-(g).
Unchanged.
(h) Member Compensation.
In connection with the sale and distribution of variable contracts:
(1) Except as described below, no associated person of a member
shall accept any compensation from anyone other than the member with
which the person is associated. This requirement
[[Page 47081]]
will not prohibit arrangements where a non-member company pays
compensation directly to associated persons of the member, provided
that:
(A) the arrangement is agreed to by the member;
(B) the member relies on an appropriate rule, regulation,
interpretive release, interpretive letter, or ``no-action'' letter
issued by the Securities and Exchange Commission that applies to the
specific fact situation of the arrangement;
(C) the receipt by associated persons of such compensation is
treated as compensation received by the member for purposes of NASD
rules; and
(D) the recordkeeping requirement in subparagraph (h)(3) is
satisfied.
(2) No member or person associated with a member shall accept any
compensation from an offeror which is in the form of securities of any
kind.
(3) Except for items as described in subparagraphs (h)(4) (A) and
(B), a member shall maintain records of all compensation received by
the member or its associated persons from offerors. The records shall
include the names of the offerors, the names of the associated persons,
the amount of cash, the nature and, if known, the value of non-cash
compensation received.
(4) No member or person associated with a member shall directly or
indirectly accept or make payments or offers of payments of any non-
cash compensation, except as provided in this provision.
Notwithstanding the provisions of subparagraph (h)(1), the following
non-cash compensation arrangement are permitted:
(A) Gifts that do not exceed an annual amount per person fixed
periodically by the Board of Governors \4\ and are not preconditioned
on achievement of a sales target.
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\4\ The current annual amount fixed by the Board of Governors in
$100.
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(B) An occasional meal, a ticket to a sporting event or the
theater, or comparable entertainment which is neither so frequent nor
so extensive as to raise any question of propriety and is not
preconditioned on achievement of a sales target.
(C) Payment or reimbursement by offerors in connection with
meetings held by an offeror or by a member for the purpose of training
or education of associated persons of a member, provided that:
(i) the recordkeeping requirement in subparagraph (h)(3) is
satisfied;
(ii) associated persons obtain the member's prior approval to
attend the meeting and attendance by a member's associated persons is
not preconditioned by the member on the achievement of a sales target
or any other incentives pursuant to a non-cash compensation arrangement
permitted by subparagraph (h)(4)(D);
(iii) the location is appropriate to the purpose of the meeting,
which shall mean an office of the offeror or the member, or a facility
located in the vicinity of such office, or a regional location with
respect to regional meetings;
(iv) the payment or reimbursement is not applied to the expenses of
guests of the associated person; and
(v) the payment or reimbursement by the offeror is not
preconditioned by the offeror on the achievement of a sales target or
any other non-cash compensation arrangement permitted by subparagraph
(h)(4)(D).
(D) Non-cash compensation arrangements between a member and its
associated persons or a non-member company and its sales personnel who
are associated persons of an affiliated member, provided that:
(i) the member's or non-member's non-cash compensation arrangement,
if it includes variable contracts, is based on the total production of
associated persons with respect to all variable contracts distributed
by the member;
(ii) the non-cash compensation arrangement requires that the credit
received for each variable contract is equally weighted;
(iii) no unaffiliated non-member company or other unaffiliated
member directly or indirectly participates in the member's or non-
member's organization of a permissible non-cash compensation
arrangement; and
(iv) the recordkeeping requirement in subparagraph (h)(3) is
satisfied.
(E) Contributions by a non-member company or other member to a non-
cash compensation arrangement between a member and its associated
persons, provided that the arrangement meets the criteria in
subparagraph (h)(4)(D).
* * * * *
2830. Investment Company Securities
(a) Application.
Unchanged.
(b) Definitions.
(1) [``Associated person of an underwriter,'' as used in paragraph
(1), shall include an issuer for which an underwriter is the sponsor or
a principal underwriter, any investment adviser to such issuer, or any
affiliated person (as defined in Section 2(a)(3) of the Investment
Company Act of 1940) of such underwriter, issuer, or investment
adviser.] The terms ``affiliated member,'' ``compensation,'' ``cash
compensation,'' ``non-cash compensation'' and ``offeror'' as used in
paragraph (l) of this section shall have the following meanings:
``Affiliated Member'' shall mean a member which, directly or
indirectly, controls, is controlled by, or is under common control with
a non-member company.
``Compensation'' shall mean cash compensation and non-cash
compensation.
``Cash compensation'' shall mean any discount, concession, fee,
service fee, commission, asset-based sales charge, loan, override or
cash employee benefit received in connection with the sale and
distribution of investment company securities.
``Non-cash compensation'' shall mean any form of compensation
received in connection with the sale and distribution of investment
company securities that is not cash compensation, including but not
limited to merchandise, gifts and prizes, travel expenses, meals and
lodging.
``Offeror'' shall mean an investment company, an adviser to an
investment company, a fund administrator, an underwriter and any
affiliated person (as defined in Section 2(a)(3) of the Investment
Company Act of 1940) of such entities.
(2)-(10) Unchanged.
* * * * *
(c)-(k).
Unchanged.
* * * * *
(l) [Dealer Concessions] Member Compensation.
[(1) No underwriter or associated person of an underwriter shall
offer, pay or arrange for the offer or payment to any other member in
connection with retail sales or distribution of investment company
securities, any discount, concession, fee or commission (hereinafter
referred to as ``concession'') which:]
[(A) is in the form of securities of any kind, including stock,
warrants or options;]
[(B) is in a form other than cash (e.g., merchandise or trips),
unless the member earning the concession may elect to receive cash at
the equivalent of no less than the underwriter's cost of providing the
non-cash concession: or]
[(C) is not disclosed in the prospectus of the investment company.
If the concessions are not uniformly paid to all dealers purchasing the
same dollar amounts of securities from the underwriter, the disclosure
shall include a description of the circumstances of any general
variations from the standard schedule of concessions. If special
compensation arrangements have been made with
[[Page 47082]]
individual dealers, which arrangements are not generally available to
all dealers, the details of the arrangements, and the identities of the
dealers, shall also be disclosed.]
[(2) No underwriter or associated person of an underwriter shall
offer or pay any concession to an associated person of another member,
but shall make such payment only to the member.]
[(3)(A) In connection with retail sales or distribution of
investment company shares, no underwriter or associated person of an
underwriter shall offer or pay to any member or associated person,
anything of material value, and no member or associated person shall
solicit or accept anything of material value, in addition to the
concessions disclosed in the prospectus.]
[(B) For purposes of this paragraph (l)(3), items of material value
shall include but not be limited to:]
[(i) gifts amounting in value to more than $50 per person per
year.]
[(ii) gifts or payments of any kind which are conditioned on the
sale of investment company securities.]
[(iii) loans made or guaranteed to a non-controlled member or
person associated with a member.]
[(iv) wholesale overrides (commissions) granted to a member on its
own retail sales unless the arrangement, as well as the identity of the
member, is set forth in the prospectus of the investment company.]
[(v) payment or reimbursement of travel expenses, including
overnight lodging, in excess of $50 per person per year unless such
payment or reimbursement is in connection with a business meeting,
conference or seminar held by an underwriter for informational purposes
relative to the fund or funds of its sponsorship and is not conditioned
on sales of shares of an investment company. A meeting, conference or
seminar shall not be deemed to be of a business nature unless: the
person to whom payment or reimbursement is made is personally present
at, or is en route to or from, such meeting in each of the days for
which payment or reimbursement is made; the person on whose behalf
payment or reimbursement is made is engaged in the securities business;
and the location and facilities provided are appropriate to the
purpose, which would ordinarily mean the sponsor's office.]
[(C) For purposes of this paragraph (l)(3), items of material value
shall not include:]
[(i) an occasional dinner, a ticket to a sporting event or the
theater, or comparable entertainment of one or more registered
representatives which is not conditioned on sales of shares of an
investment company and is neither so frequent nor so extensive as to
raise any question of propriety.]
[(ii) a breakfast, luncheon, dinner, reception or cocktail party
given for a group of registered representatives in conjunction with a
bona fide business or sales meeting, whether at the headquarters of a
fund or its underwriter or in some other city.]
[(iii) an unconditional gift of a typical item of reminder
advertising such as a ballpoint pen with the name of the advertiser
inscribed, a calendar pad, or other gifts amounting in value to not
more than $50 per person per year.]
[(4) The provisions of this subsection (1) shall not apply to:]
[(A) Contracts between principal underwriters of the same
security.]
[(B) Contracts between the principal underwriter of a security and
the sponsor of a unit investment trust which utilizes such security as
its underlying investment.]
[(C) Compensation arrangements of an underwriter or sponsor with
its own sales personnel.]
In connection with the sale and distribution of investment company
securities:
(1) Except as described below, no associated person of a member
shall accept any compensation from anyone other than the member with
which the person is associated. This requirement will not prohibit
arrangements where a non-member company pays compensation directly to
associated persons of the member, provided that:
(A) the arrangement is agreed to by the member:
(B) the member relies on an appropriate rule, regulation,
interpretive release, interpretive letter, or ``no-action'' letter
issued by the Securities and Exchange Commission or its staff that
applies to the specific fact situation of the arrangement;
(C) the receipt by associated persons of such compensation is
treated as compensation received by the member for purposes of NASD
rules; and
(D) the recordkeeping requirement in subparagraph (l)(3) is
satisfied.
(2) No member or person associated with a member shall accept any
compensation from an offeror which is in the form of securities of any
kind.
(3) Except for items described in subparagraphs (l)(5) (A) and (B),
a member shall maintain records of all compensation received by the
member or its associated persons from offerors. The records shall
include the names of the offerors, the names of the associated persons,
the amount of cash, the nature and, if known, the value of non-cash
compensation received.
(4) No member shall accept any cash compensation from an offeror
unless such compensation is described in a current prospectus of the
investment company. When special cash compensation arrangements are
made available by an offeror to a member, which arrangements are not
made available on the same terms to all members who distribute the
investment company securities of the offeror, a member shall not enter
into such arrangements unless the name of the member and the details of
the arrangements are disclosed in the prospectus. Prospectus disclosure
requirements shall not apply to cash compensation arrangements between:
(A) principal underwriters of the same security; and
(B) the principal underwriter of a security and the sponsor of a
unit investment trust which utilizes such security as its underlying
investment.
(5) No member or person associated with a member shall directly or
indirectly accept or make payments or offers of payments of any non-
cash compensation, except as provided in this provision.
Notwithstanding the provisions of subparagraph (l)(1), the following
non-cash compensation arrangements are permitted:
(A) Gifts that do not exceed an annual amount per person fixed
periodically by the Board of Governors \5\ and are not preconditioned
on achievement of a sales target.
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\5\ The current annual amount fixed by the Board of Governors is
$100.
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(B) An occasional meal, a ticket to a sporting event or the
theater, or comparable entertainment which is neither so frequent nor
so extensive as to raise any question of propriety and is not
preconditioned on achievement of a sales target.
(C) Payment or reimbursement by offerors in connection with
meetings held by an offeror or by a member for the purpose of training
or education of associated persons of a member, provided that:
(i) the recordkeeping requirement in subparagraph (l)(3) is
satisfied;
(ii) associated persons obtain the member's prior approval to
attend the meeting and attendance by a member's associated persons is
not preconditioned by the member on the achievement of a sales target
or any other incentives pursuant to a non-cash compensation arrangement
permitted by subparagraph (l)(5)(D);
(iii) the location is appropriate to the purpose of the meeting,
which shall
[[Page 47083]]
mean an office of the offeror or the member, or a facility located in
the vicinity of such office, or a regional location with respect to
regional meetings;
(iv) the payment or reimbursement is not applied to the expenses of
guests of the associated person; and
(v) the payment or reimbursement by the offeror is not
preconditioned by the offeror on the achievement of a sales target or
any other non-cash compensation arrangement permitted by subparagraph
(l)(5)(D).
(D) Non-cash compensation arrangements between a member and its
associated persons or a non-member company and its sales personnel who
are associated persons of an affiliated member, provided that:
(i) the member's or non-member's non-cash compensation arrangement,
if it includes investment company securities, is based on the total
production of associated persons with respect to all investment company
securities distributed by the member;
(ii) the non-cash compensation arrangement requires that the credit
received for each investment company security is equally weighted;
(iii) no unaffiliated non-member company or other unaffiliated
member directly or indirectly participates in the member's or non-
member's organization of a permissible non-cash compensation
arrangement; and
(iv) the recordkeeping requirement in subparagraph (l)(3) is
satisfied.
(E) Contributions by a non-member company or other member to a non-
cash compensation arrangement between a member and its associated
persons, provided that the arrangement meets the criteria in
subparagraph (l)(5)(D).
* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for the Proposed Rule Change
In its filing with the Commission, the NASD 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. NASD Regulation has prepared summaries, set forth in
Sections A, B, and C below, of the most significant aspects of such
statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
Introduction
The NASD is proposing to amend Rules 2820 and 2830 of the NASD
Conduct Rules to establish new rules applicable to the sale of variable
contracts (``Variable Contracts Rule'') and revise existing rules
applicable to the sale of investment company securities (``Investment
Company Rule'').
Generally, the proposed rule change would: (1) Adopt definitions of
the terms ``affiliated member,'' ``compensation,'' ``cash
compensation,'' ``non-cash compensation,'' and ``offeror''; (2)
prohibit, except under certain circumstances, associated persons from
receiving any compensation from anyone other than the member with which
the person is associated; (3) require that members maintain records of
compensation received by the member or its associated persons from
offerors; (4) with respect to the Investment Company Rule, prohibit
receipt by a member of cash compensation from the offeror unless such
arrangement is described in the current prospectus; (5) retain the
prohibition, with respect to the Investment Company Rule, against a
member receiving compensation in the form of securities; and (6)
prohibit, with certain exceptions, members and persons associated with
members from directly or indirectly accepting or paying any non-cash
compensation in connection with the sale of investment company and
variable contract securities.
The exceptions from the non-cash compensation prohibition would
permit: (1) Gifts of up to $100 per associated person annually; (2) an
occasional meal, ticket to a sporting event or theater, or comparable
entertainment; (3) payment or reimbursement for training and education
meetings held by a broker-dealer or a mutual fund or insurance company
for the purpose of educating associated persons of broker-dealers, as
long as certain conditions are met; (4) in-house sales incentive
programs of broker-dealers for their own associated persons; (5) sales
incentive programs of mutual funds and insurance companies for the
associated persons of an affiliated broker-dealer; and (6)
contributions by any non-member company or other member to a broker-
dealer's permissible in-house sales incentive program.
Background
The proposed rule change is the latest in a series of NASD
proposals designed to control the use of non-cash compensation in
connection with a public offering of securities. Previous rule
amendments established restrictions on non-cash compensation in
connection with transactions in direct participation program
securities, real estate investment trusts, and corporate debt and
equity offerings.
In developing the proposed rule change, the staff and NASD
Regulations's Investment Companies Committee, the Insurance Affiliated
Member Committee, and the Variable Insurance Products Committee (a
successor to the Insurance Affiliated Committee) (collectively, the
``Committees'') have considered the current environment in which
investment company and variable contract securities are sold. The NASD
believes that the increased use of non-cash compensation for the sale
of investment company and variable contract securities heightens the
potential for loss of supervisory control over sales practices and
increase the perception on inappropriate practices, which may result in
a loss of investor confidence. The NASD also believes that the
increased use of non-cash compensation creates significant point-of-
sale incentives that may compromise the requirement to match the
investment needs of the customer with the most appropriate investment
product. The NASD determined, therefore, that the adoption of
limitations on non-cash compensation is appropriate at this time.
In 1992, the NASD submitted to the Commission proposed rule change
SR-NASD-92-36, which proposed recordkeeping and disclosure requirements
on the receipt of non-cash compensation in connection with the sale of
investment company and variable contract securities. As as result of
Commission staff concerns regarding the proposal, the NASD withdrew SR-
NASD-92-36 in April 1994. In March 1995, the NASD submitted SR-NASD-95-
10 to the Commission, which proposed substantive prohibitions on the
receipt of non-cash compensation in connection with sale of investment
company and variable contract securities. The NASD withdrew that
proposal in 1995. In December 1995, the NASD submitted to the
Commission proposed rule change SR-NASD-95-61, which proposed
substantive prohibitions regarding non-cash compensation and incentive-
based cash compensation in connection with the
[[Page 47084]]
sale of investment company and variable contract securities. SR-NASD-
95-61 was published by the Commission for public comment on July 8,
1969.\6\
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\6\ Release No. 34-37374 (June 26, 1996), 61 FR 35822 (July 8,
1996.)
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SR-NASD-96-51 raised significant issues among commenters regarding
the nature and treatment of certain incentive-based cash compensation
arrangements, in particular those cash compensation arrangements of
insurance-affiliated member firms. NASD Regulation has prepared a
summary of the comments, which is attached as Exhibit A. Most of the
commenters opposed the proposed provisions to regulate incentive-based
cash compensation. In response to the commenters, the NASD determined
to delete those provisions proposing to impose substantive prohibitions
regarding incentive-based cash compensation. Therefore, the NASD has
withdrawn SR-NASD-95-61 and has replaced it with this proposed rule
change, which does not contain provisions imposing substantive
regulations on the receipt of cash compensation arrangements.
Nevertheless, the NASD is aware of a broad range of cash
compensation practices by which investment company and variable
contract issuers or their affiliates provide various incentives and
rewards to individual broker-dealers and their registered
representatives for selling the issuers' products. NASD staff believes
that various cash incentive compensation practices, which create an
incentive to favor one product over another, also may compromise the
ability of securities salespersons to render advice and services that
are in the best interests of customers. The NASD has determined to
solicit comment pertaining to these issues before proposing any new
rules to require either disclosure or substantive regulation of cash
compensation for the sale of investment company and variable contract
securities. Accordingly, the NASD intends to issue a Request for
Comment that would inquire primarily about the nature of various cash
compensation arrangements and structures within the mutual fund and
variable product industries, the potential harms and benefits of such
arrangements and structures, and the appropriate regulatory approach to
such arrangements and structures.\7\ The Request for Comment will
explore issues such as: (1) The nature of various cash compensation
arrangements, particularly within the mutual fund and variable product
industries (such as ``revenue sharing'' and payments of differential
compensation for proprietary versus non-proprietary products); (3) the
current best practices being followed by each industry regarding cash
compensation arrangements; (3) the potential harms and benefits of such
arrangements; and (4) the appropriate regulatory approach to such
arrangements (such as disclosure versus substantive prohibitions).
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\7\ The NASD issued a Notice to Members regarding the regulation
of payment and receipt of cash compensation incentives in August
1997. The comment period expires on October 15, 1997. See NASD
Notice to Members 97-50 (August 1997).
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In addition, the Request for Comment will explore the general
applicability of such issues mentioned above across all product lines
to address broader issues regarding compensation practices, including
disparate compensation practices in general, how fare NASD rules
regarding incentive-based compensation should reach, the effects at
point-of-sale of incentive-based compensation in general, and which
regulatory approaches, if any, would be appropriate in addressing
disparate compensation practices.
Description of the Proposed Rule Change
The current requirements of paragraph (l) of the Investment Company
Rule regulate the disclosure and form of dealer concessions between
principal underwriters and retail dealers of investment company
securities. These provisions prohibit dealer concessions in the form of
securities, require that members may elect to receive cash in lieu of
the receipt of non-cash compensation, and prohibit the payment of
concessions directly to associated persons of a member. The provisions
also set forth requirements with respect to the disclosure of
compensation arrangements between underwriters and dealers in the
investment company's prospectus.\8\
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\8\ In Notice to Members 94-14 (March 1994), the NASD clarified
the obligations of members in complying with the compensation
disclosure requirements for investment companies in subparagraph
(l)(1)(C) to Conduct Rule 2830. See also NASD Notice to Members 94-
41 (May 1994).
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With respect to the regulation of variable contract securities, the
requirements of the Variable Contract Rule currently do not contain
similar provisions regulating dealer concessions. Thus, the proposed
amendments to the Investment Company Rule would modify current
requirements, and the proposed amendments to the Variable Contracts
Rule would establish new requirements that address compensation
arrangements between an offeror and any member participating in the
distribution of the company's securities. The discussion below address
each proposed provision in the Investment Company Rule and its
counterpart in the Variable Contracts Rule.
Definitions. ``Affiliated Member'': The NASD is proposing to adopt
a definition of the term ``affiliated member'' for both the Investment
Company and Variable Contract Rules to include a member that directly
or indirectly controls, is controlled by, or is under common control
with a non-member company. The term is used in the sections of the
proposed rule change that address incentive compensation arrangements
in order to identify a common type of relationship existing in the
investment company and variable contracts industries whereby a non-
member owns or controls one or more subsidiary broker-dealer member
firms used for underwriting and/or wholesale and retail distribution
services.
``Compensation'': For ease of reference in appropriate paragraphs
of the proposed rules, the NASD is also proposing to include in the
Variable Contracts Rule and the Investment Company Rule a new
definition of ``compensation'' to mean ``cash compensation and non-cash
compensation,'' and to amend the appropriate paragraphs in the proposed
rule language accordingly.
``Cash Compensation'': As proposed to be defined in both the
Investment Company and Variable Contracts Rules, this term would
include any discount, concession, fee, service fee, commission, asset-
based sales charge, loan, override or cash employee benefit received in
connection with the sale and distribution of investment company
securities or variable contracts. This term would encompass
compensation arrangements currently covered under the Investment
Company Rule in subparagraph (l)(1), to Conduct Rule 2830 as well as
asset-based sales charges and service fees as currently defined in
subparagraphs (b) (8) and (9) of the Investment Company Rule. As a
result, the proposed new term would apply to all compensation
arrangements that would be covered under the current provisions of the
Investment Company Rule, with the addition of asset-based sales charges
and service fees. The proposed new term also includes cash employee
benefits to make clear that certain payments of ordinary employee
benefits as part of an overall compensation package are not included in
the definition of non-cash compensation.
[[Page 47085]]
``Non-Cash Compensation'': This definition is proposed to be
identical in applicability to both the Investment Company and Variable
Contract Rules, and would encompass any form of compensation received
by a member in connection with the sale and distribution of investment
company and variable contract securities that is not cash compensation,
including but not limited to merchandise, gifts and prizes, travel
expenses, meals and lodging. Thus, the definition of ``non-cash
compensation'' encompasses reimbursement for costs incurred by a member
or person associated with a member in connection with travel, meals and
lodging.
``Offeror'': The NASD is proposing to define the term ``offeror''
in the Investment Company Rule to include an investment company, an
adviser to an investment company, a fund administrator, an underwriter
and any affiliated person of such entities, and in the Variable
Contracts Rule to include an insurance company, a separate account of
an insurance company, an investment company that funds a separate
account, any advisor to a separate account of an insurance company or
an investment company that funds a separate account, a fund
administrator, an underwriter and any affiliated person of such
entities. With the exception of ``fund administrator,'' the enumerated
entities included in the proposed definition of ``offeror'' in the
Investment Company Rule are currently included in the definition of
``associated person of an underwriter,'' which is proposed to be
deleted.\9\ The definition of the term ``associated person of an
underwriter'' in the Investment Company Rule, which is proposed to be
deleted, encompasses the issuer, the underwriter, the investment
advisor to the issuer, and any affiliated person of such entities.\10\
The term ``affiliated person'' in the proposed definition of
``offeror'' is defined in accordance with Section 2(a)(3) of the 1940
Act. The term ``underwriter'' is defined in Section 2(a)(40) of the
1940 Act and is intended to reference the principal underwriter through
which the investment and insurance company distributes securities to
participating dealers for sale to the investor.
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\9\ There are no current similar terms in the Variable Contracts
Rule.
\10\ The term is significantly different from the term ``person
associated with a member'' as used throughout the NASD's rules and
regulations. Any reference to persons associated with an NASD member
firm is defined by the definition of ``person associated with a
member'' or ``associated person of a member'' in Article I, Section
(m) to the NASD By-Laws.
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Regulation of the receipt of cash and non-cash compensation.
Introduction--The NASD is proposing to adopt as paragraph (l) to the
Investment Company Rule (replacing the current provisions of that
section) and paragraph (h) of the Variable Contracts Rule new
provisions governing the receipt of non-cash compensation by members
and associated persons of members. The proposed amendments would be
applicable to both variable annuity and variable life products under
the Variable Contracts Rule. With respect to the Investment Company
Rule, the proposed amendments would be applicable to sales of
securities of an investment company registered under the 1940 Act.
Thus, the proposed rules would be applicable to sales of securities by
a face-amount certificate company, a unit investment trust, and open-
end and closed-end management companies.\11\
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\11\ Closed-end management companies are also subject to the
prohibition on non-cash compensation contained in the Corporate
Financing Rule in Conduct Rule 2710.
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The preamble to the new rules provides that such compensation must
be received ``in connection with the sale and distribution'' of
investment company or variable contract securities, as applicable. The
preamble is intended to clarify that the provisions relate only to cash
and non-cash compensation received in connection with the sale and
distribution of the security covered by the rule, but not to other
forms of payment that are not related to sales and distribution
activities.
Subparagraphs (l)(1) and (h)(1): Limitation on Receipt of
Compensation by Associated Persons, and Exception From Limitations--The
NASD is proposing in new subparagraph (l)(1) of the Investment Company
Rule and new subparagraph (h)(1) of the Variable Contracts Rule
generally to prohibit a person associated with a member from accepting
any compensation from any person other than the member with which the
person is associated. The provision is based on current subparagraph
(l)(2) of the Investment Company Rule.
An exception from this general prohibition is proposed that would
allow the receipt of compensation by an associated person directly from
a non-member company if: the member agrees to the arrangement, the
receipt is treated as compensation received by the member for purposes
of NASD rules, the recordkeeping requirement in the proposed rule
change is satisfied, and, the member relies on an appropriate rule,
regulation, interpretive release, interpretive letter or applicable
``no-action'' letter issued by the Commission or its staff that applies
to the specific fact situation of the arrangement. Also, the proposed
rule change treats such direct payments to associated persons as
compensation in order to ensure that the member views such payments in
the same manner as payments made directly to the member for purposes of
NASD rules and posts such payments to the member's books.
The proposed exception is particularly intended to reflect those
situations where Commission interpretations permit direct payments by
the insurance company to associated persons as a ``ministerial
service'' or because state insurance law prohibits payments of
commissions on variable products to a broker-dealer.\12\ The exception
reflects the view of the Commission staff that under certain
circumstances such commission payments to associated persons may be
made by a life insurance company acting on behalf of a subsidiary
broker-dealer.\13\ The NASD also notes that the Commission has issued a
number of ``no-action'' letters permitting, among other things,
associated persons of members to receive compensation for the sale of
variable contract products from a license corporate insurance agent
acting on behalf of one or more insurance companies.\14\
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\12\ The exception is not, however, restricted to these
situations, but is intended to be available in any situation where a
member relies on any appropriate rule, regulation, interpretive
release or applicable ``no-action'' position issued by the
Commission that applies to the specific fact situation of the
arrangements.
\13\ See Release No. 34-8389 (August 29, 1968) (``Distribution
of Variable Annuities by Insurance Companies, Broker-Dealer
Registration and Regulation Problems under the Securities Exchange
Act of 1934''). The Commission stated that no question will be
raised by Commission staff regarding an arrangement where a life
insurance company makes commission payments directly to its life
insurance agents who are also persons associated with the insurance
company's subsidiary broker-dealer, so long as: (1) such payments
are made as a purely ministerial service and properly reflected on
the books and records of the broker-dealer; (2) a binding agreement
exists between the insurance company and the broker dealer that all
books and records are maintained by the insurance company as agent
on behalf of the broker-dealer and are preserved in conformity with
the requirements of Rules 17a-3 and 17a-4 under the Act; (4) all
such books and records are subject to inspection by the Commission
in accordance with Section 17(a) of the Act; and (5) the subsidiary
broker-dealer has assumed full responsibility for the securities
activities of all persons engaged directly or indirectly in the
variable annuity operation.
\14\ See no-action letters issued by Division of Market
Regulation, Commission to Traditional Equinet (January 8, 1992) and
Mariner Financial Services (December 16, 1988). The Traditional
Equinet and Mariner Financial Services letters requesting Commission
no-action include references to other Commission no-action letters.
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[[Page 47086]]
Although the need to recognize such direct payments arose in
connection with the sale of variable contract products, the Investment
Company Rule includes the same exception in order to recognize
Commission no-action letters that permit an insurance company to
establish a commission account as a ministerial service to make
payments of commission overrides for sales of insurance and investment
company securities products.\15\ Moreover, the language of the proposed
provision in the Investment Company and Variable Contract Rules permits
such direct payments by any ``non-member company'' in order to
recognize that any entity may be permitted to make such payments.\16\
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\15\ See, e.g., no action letter issued by the Division of
Market Regulation, Commission to Commission to The Mutual Benefit
Life Insurance Company (December 20, 1984), and other Commission no-
action letters cited herein.
\16\ See no action letter issued by Division of Market
Regulation, Commission to Chubb Securities Corporation (November 24,
1993).
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Subparagraph (1)(2): Securities as Compensation--The NASD is
proposing to retain as new subparagraph (1)(2) of the Investment
Company Rule the provision currently in subparagraph (l)(1)(A) that
prohibits members and associated persons of members from receiving
compensation in the form of securities of any kind. The NASD is also
proposing a similar provision as subparagraph (2) to paragraph (h) of
Rule 2820.
Subparagraphs (l)(3) and (h)(3): Recordkeeping Requirement--The
NASD is proposing to adopt as new paragraph (l)(3) of the Investment
Company Rule and paragraph (h)(3) of the Variable Contracts Rule the
general requirement that members must maintain records of all
compensation, cash and non-cash, received from offerors. The records
must include the names of the offerors, the names of the associated
persons, and the amount of cash and the nature and, if known, the value
of non-cash compensation received.
With respect to the requirement that the actual value of non-cash
compensation be recorded, if it is known, the NASD believes that the
value of a non-cash item is usually not known where unaffiliated third
parties contribute to a training and education program sponsored by a
member. In this case, it would be appropriate to include only a
description of the nature of the non-cash item of compensation. In
comparison, the value of non-cash items provided by member firms and/or
their affiliates is generally readily known or determinable.
The requirement in the proposed rule to maintain a record of the
``nature'' of the non-cash compensation received requires that the
member disclose, in addition to the names of the offerors and the names
of the associated persons, whether the non-cash compensation is paid in
connection with a sales incentive program or a training and education
meeting. The NASD further expects such records to retain all
information necessary to determine that the rule is being complied
with. Thus, for example, with respect to non-cash compensation received
by a member for a training and education meeting, it would be expected
that the records would include information demonstrating that the
requirements of a training and education meeting were complied with,
including the date and location of the meeting, the fact that
attendance at the meeting is not conditioned on the achievement of a
previously specified sales target, the fact that payment is not applied
to the expenses of guests of associated persons of the member, and any
other information required to enable NASD Regulation to determine
compliance with the rule.
The recordkeeping requirement is not applicable to two types of de
minimis non-cash compensation allowable under subparagraphs (l)(5) (A)
and (B) to the Investment Company Rule and subparagraphs (h)(4) (A) and
(B) of the Variable Contracts Rule, discussed more fully below under
the exceptions to the prohibition on non-cash compensation.
Subparagraph (l)(4): Prospectus Disclosure of Cash Compensation--
The NASD is proposing to adopt a new subparagraph (l)(4) in the
Investment Company Rule a requirement that prohibits the acceptance of
cash compensation by a member from an offeror unless such compensation
is disclosed in a prospectus. In the case where special cash
compensation arrangements are made available by an offeror to a member,
which arrangements are not made available on the same terms to all
members to distribute the securities, the disclosure shall include the
name of the recipient member and the details of the special
arrangements. This requirement is similar to the current requirement in
subparagraph (l)(1)(C) of the Investment Company Rule to disclose all
compensation in the prospectus, but has been modified to reference only
``cash compensation'' because non-cash compensation is proposed to be
prohibited in a manner that would obviate the need for disclosure of
any such non-cash compensation.
The proposed rule change includes two exceptions from the
prospectus disclosure requirement in the Investment Company Rule. The
two exceptions in new subparagraphs (l)(4) (A) and (B) track the
language in current subparagraphs (l)(4) (A) and (B) of the Investment
Company Rule, with minor language changes for clarification. These two
provisions provide an exception from disclosure for compensation
arrangements between: (1) principal underwriters of the same security;
and (2) the principal underwriter of a security and the sponsor of a
unit investment trust that utilizes such security as its underlying
investment. By their terms, these provisions describe arrangements that
would not trigger the proposed recordkeeping requirements.
The NASD will reconsider the appropriateness of prospectus
disclosure in light of the Commission's recent initiatives for
simplified prospectus disclosure as well as the responses to NASD's
publication of a Request for Comment on cash compensation issues.\17\
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\17\ See supra note 7.
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Subparagraphs (l)(5) and (h)(4): Prohibition on Non-Cash
Compensation--The NASD is proposing to adopt as new subparagraph (l)(5)
to the Investment Company Rule and new subparagraph (h)(4) to the
Variable Contracts Rule a general prohibition, with certain exceptions,
on the receipt of non-cash compensation in connection with the sale and
distribution of investment company and variable contract securities.
The new provision would prohibit a member or person associated with a
member from directly or indirectly accepting or making payments or
offers of payments of any non-cash compensation, unless the payment is
specifically excepted. The proposed rule change contains several
exceptions from the general prohibition on the receipt of non-cash
compensation.
Subparagraphs (l)(5) (A) and (B) and (h)(4) (A) and (B): The NASD
is proposing to adopt exceptions that would permit an associated person
to accept from a person other than his or her member-employer: (1)
gifts that do not exceed an annual amount per person, currently $100
per person, fixed periodically by the Board of Governors; and (2) an
occasional meal, a ticket to a sporting event or the theater, or
comparable entertainment for persons associated with a member and, if
appropriate their guests, which is neither so frequent nor so extensive
as to raise any question of propriety. These provisions are based on
the current
[[Page 47087]]
provisions of subparagraphs (l)(3)(B)(i) and (C)(i) of the Investment
Company Rule. Since such gifts and entertainment are considered non-
cash items, they are not required to be disclosed in the prospectus. In
addition, these two forms of non-cash compensation are specifically
excepted from the recordkeeping requirement of the proposed rules.
The proposed provisions would require that the receipt of such non-
cash items not be preconditioned on the achievement by the associated
person of a sales target. This language replaces the current
requirement in subsection (l)(3)(B)(v) of the Investment Company Rule
that entertainment ``not be conditioned on sales of shares of
investment companies.'' The revised language is intended to clarify
that such gifts and entertainment are permitted to be provided as
recognition for past sales or as encouragement for future sales, but
shall not be part of an incentive program or plan that requires that
the recipient reach a specific sales goal as a prior condition to
receive the entertainment or gift.
The proposed exceptions for $100 gifts and entertainment are
intended to permit the continuation of long-established, normal
business practices, involving benefits with relatively small value such
that they are unlikely to impact overall compensation incentives. The
exceptions also recognize that NASD Regulation has not detected or been
aware of any history of abuses in connection with the receipt of such
items of compensation by associated persons of a member firm in
connection with the sale of investment company or variable contract
securities.
Subparagraphs (l)(5)(C) and 29(h)(4)(C): The NASD is also proposing
an exception to the prohibition on non-cash compensation for training
and education meeting. This exception is contained in subparagraph
(l)(5)(C) of the Investment Company Rule and subparagraph (h)(4)(C) of
the Variable Contracts Rule. The proposed exception would, under
certain conditions, permit payment or reimbursement by offerors in
connection with meetings held by the offeror or by a member for the
purpose of training or education of associated persons of a member.\18\
It is not unusual for offerors to pay for such meetings in order to
discuss their products and to reimburse certain expenses related to
meetings held by members in exchange for the opportunity to make a
presentation to the associated persons of the member on a particular
training or education topic.
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\18\ A member holding a training or education meeting for its
associated persons (in comparison to the associated persons of
another member) would not be required to comply with this provision
if the member does not receive a payment or reimbursement from an
offeror for the expenses of the meeting. In any event, the member
would not be prohibited from permitting offerors to make a
presentation at the meeting.
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This provision is intended to continue to permit members and
offerors to hold training or education meetings for associated persons
of one or more members, where an offeror or a number of offerors pay
for or reimburse the expenses of the meeting. Since investment company
and variable contract products are continuously offered, it is
particularly important that associated persons receive education
opportunities with respect to the investment company and variable
contract industries generally, updates on any portfolio changes or
structural changes to a current product, and explanations of new
products.
Since the proposed prospectus disclosure provision only requires
disclosure of cash compensation, the proposed exception would not
trigger the disclosure requirements because the payment or
reimbursement of expenses by an offeror for a member's training and
education meeting is considered to be non-cash compensation.
The NASD anticipates that the agenda of a bona fide training or
education meeting will reflect the business purpose of the meeting. In
order to establish circumstances that will encourage such a business
purpose, the NASD is proposing that the exception for training or
education meetings be subject to five conditions that are intended to
ensure that the meeting is held for the purpose of training and
education and is not, in fact, a prohibited non-cash sales incentive.
The first condition is that the payment or reimbursement by
offerors in connection with such meetings is subject to the proposed
recordkeeping requirement in subparagraph (l)(3) of the Investment
Company Rule and subparagraph (h)(3) of the Variable Contracts Rule.
This provision is designed to ensure that information on such payments
and reimbursements is maintained in the records of the member and,
therefore, capable of examination and regulatory oversight by NASD
Regulation.
The second condition is that associated persons must obtain the
member's prior approval to attend the meeting. It is anticipated that
members will establish a procedure so that their records reflect that
appropriate approval has been provided to associated persons in
connection with such meetings. This provisions assists members in
maintaining supervisory control over their associated persons.
Moreover, the second condition also requires that attendance by the
member's associated persons may not be based by the employer-member on
the achievement of a sales target or any other incentives that would
otherwise be permitted under subparagraphs (l)(5)(D) or (h)(4)(D) of
the proposed rule. That provision would permit non-cash compensation
arrangements between a member and its associated persons or between a
non-member company and its sales personnel who are associated persons
of an affiliated member, as more fully discussed below. This condition
is intended to ensure that the member does not treat a training or
education meeting as a non-cash incentive item. The provision is not,
however, intended to prevent a member from designating persons to
attend a meeting held by the member or by an offeror to recognize past
performance or encourage future performance, so long as attendance at
the meeting is not earned through a member's in-house sales incentive
program, through the sales incentive program of a member's non-member
affiliate, or through the achievement of a sales target.
The third condition is that the location of the meeting must be
appropriate to its purpose. A showing of appropriate purpose is
demonstrated where the location is the office of the offeror or the
member, or a facility located in the vicinity of such office. In order
to address meetings where the attendees are from a number of offices in
a region of the country, the meeting location may be in a regional
location.
The fourth condition is that the payment or reimbursement by an
offeror must not be applied to the expenses of guests of the associated
person.
The fifth and final condition is that the payment or reimbursement
by the offeror must not be conditioned by the offeror on the
achievement of a sales target or any other non-cash arrangement
permitted by subparagraphs (l)(5)(D) or (l)(4)(D) of the proposed rule.
This requirement is intended to ensure that the offeror making the
payment or reimbursement does not participate in any manner in a
member's decision as to which associated persons will attend a member's
or offeror's meeting.
The fifth condition and the second provision, which prohibits a
member from basing the associated person's attendance at a training or
education meeting on achievement of a previously specified sales target
or a permissible in-house non-cash incentive arrangement, collectively
are intended to clarify that
[[Page 47088]]
attendance at a training or education meeting by an associated person
is permitted to be approved by a member as a recognition for past
sales, but shall not be part of a member's or offeror's incentive
program or plan that requires that the recipient or the member reach a
sales goal as a prior condition to attending the training or education
meeting.
Subparagraphs (l)(5) (D) and (E) and (h)(4) (D) and (E): The NASD
is proposing to adopt exceptions from the prohibition on non-cash
compensation that will permit: (1) Non-cash compensation arrangements
between a member and its associated persons; (2) non-cash compensation
arrangements between a non-member company and its sales personnel who
are associated persons of an affiliated member; and (3) contributions
by a non-member company or other member to a non-cash compensation
arrangement between a member and its associated persons.
The three permissible arrangements are subject to four conditions:
(1) The member's or non-member's non-cash compensation arrangement, if
it includes investment company or variable product securities, must be
based on the total production of associated persons with respect to all
investment company or variable product securities distributed by that
member; (2) the credit received for each investment company or variable
contract security must be equally weighted; (3) no unaffiliated non-
member company or other unaffiliated member may directly or indirectly
participate in the member's or non-member's organization of a
permissible non-cash compensation arrangement; and (4) the
recordkeeping requirements must be satisfied. However, the
applicability of the total production and equal weighting requirements
to variable contract securities does not require that variable annuity
and variable life products be combined in the same incentive
arrangement. Because of the substantially different commission
structures that presently apply in the case of each product, the NASD
intends that the equal weighting requirement would apply separately to
variable annuity and variable life products.
The proposed rule change is intended, in part, to address non-cash
compensation that acts as a significant incentive at the point-of-sale
to the investor. Such non-cash incentive programs, in addition to
creating the potential to undermine the supervisory control of the
member over its associated person sales practices when offered by third
parties, also may motivate salespersons at the point-of-sale to
recommend a specific product on the basis of the incentive rather than
a desire to meet the investment needs of the customer.
The NASD's proposed rule change, therefore, attempts to limit non-
cash sales incentives regarding the sale of one investment company
security over another or one variable contract security over another to
situations where such non-cash incentives do not contain the potential
to impact the point-of-sale recommendation by an associated person to a
customer or to undermine the supervisory control of the member firm
with respect to its associated person' sales of these products.
The proposed rule change is designed to eliminate the point-of-sale
impact of non-cash sales incentives on the sales practices of an
associated person with respect to the sale of investment company and
variable contract securities by prohibiting third-party non-cash sales
incentive programs and by requiring that all securities of the same
product type be included in the member's (or its affiliate's) in-house
incentive program and be equally weighted. The proposed rule change,
therefore, would prohibit a third-party offeror from conducting a non-
cash sales incentive program for associated persons of member firms, in
that such programs provide incentives at the point-of-sale to influence
a salesperson to sell the proprietary products of the offeror to the
exclusion of other products and have the potential to undermine the
supervisory control of members with respect to their associated
persons. The proposed rule change would, however, continue to permit
non-cash incentive programs by a member for its associated persons or
by an insurance or investment company for the associated persons of an
affiliated member, under the four conditions discussed more fully
below. This provision is based on a determination that non-cash
compensation arrangements that are internal to the employer-employee
relationship do not raise the same supervisory concerns that are
present in the compensation arrangements between a non-member and the
associated persons of unaffiliated broker-dealers selling its product.
As noted above, another exception permits a non-member affiliate to
grant non-cash incentives to the associated persons of its affiliated
broker-dealer, subject to the same conditions described above.
Particularly in the life insurance industry, non-member insurance
companies may hold non-cash sales incentive programs for their sales
personnel who are also associated persons of the non-member's
affiliated broker-dealer and are licensed to sell both non-securities
insurance products and variable contract securities. It is common
practice, for example, for a member's parent life insurance company to
award ``points'' for the sale of all insurance products--including
securities--toward attendance at the insurance company's annual
``leadership conference.'' \19\ Moreover, the exception recognizes
that, as a practical matter, an insurance company or investment company
affiliated with a broker-dealer is in a position through intra-
corporate transfers to contribute to and through its relationship to
affect the structure of its affiliated broker-dealer's in-house
incentive compensation program.
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\19\ As set forth above, arrangements by insurance companies for
compensating salespersons for variable product sales are generally
part of a total compensation package based on the sale of non-
securities insurance products as well as variable contract
securities.
---------------------------------------------------------------------------
The permissible in-house non-cash arrangements by a member or its
affiliate are subject, moreover, to the first two conditions described
above (that the program is based on total production and credit for
different products is equally weighted). These conditions help to
ensure that a non-cash sales incentive earned by a member's associated
person is received on a delayed basis and does not influence the
associated person's point-of-sale relationship with the investor. Thus,
the proposed provisions would allow for sales incentive programs based
on such measures as overall gross production, new accounts opened or
assets under management. Such measures are not precluded by the
proposed rule language and are based on the same intent to align the
interests of associated persons, broker-dealers and investors.\20\
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\20\ See Report of the Committee on Compensation Practices
(April 10, 1995) (``Tully Report''), p. 13.
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In proposing the second condition, requiring equal weighting, the
NASD recognizes that differential payouts at all levels is common
industry practice and that current methods for determining compensation
credits vary, including measurements based on gross production to the
firm or net commissions to the associated person. Either practice, as
well as other arrangements, would be acceptable under the proposed rule
so long as the concept of ``equal weighting'' is met and not skewed by
disparate commission, payout or re-allowance structures for individual
products. It is believed that these requirements will ensure that
[[Page 47089]]
members and their affiliates selling proprietary investment company and
variable contracts products do not structure in-house non-cash
arrangements that are biased in favor of any one specific product or
proprietary products as a group.
A member's or its affiliate's non-cash compensation arrangement is
also subject to the restriction that no unaffiliated non-member entity
(usually an offeror) or another member can participate directly or
indirectly in the member's or its affiliate's organization of a
permissible non-cash sales incentive program. This provision is
intended to ensure that third-party offerors are not involved in and do
not influence the organization of a permissible non-cash sales
incentive program by a member or a member's affiliate. The restriction
on participation is not, however, intended to prevent a non-member
company from making a presentation on its products at a member's or its
affiliate's in-house sales incentive meeting at the member's or
affiliate's request.
Finally, the non-cash incentive program of a member or its
affiliate for a member's associated persons is also subject to the
recordkeeping requirements of the proposed rule. Thus, where the member
or its associated persons is in receipt of payments or non-cash sales
incentives from its affiliated entity, such payments or non-cash sales
incentives must be recorded on the books and records of the member
firm.
The NASD is also proposing in subparagraph (l)(5)(E) of the
Investment Company Rule and subparagraph (h)(4)(E) of the Variable
Contracts Rule that any non-member entity (usually an offeror) or
another member continue to be permitted to contribute to any member's
in-house non-cash sales incentive program, subject to the same four
conditions identified above. This provision is intended to permit
third-party offerors, and their affiliates, to contribute to the non-
cash incentive program of a member in order to benefit the associated
persons of the member that sell the offeror's securities.\21\ The
proposed rule change does not, similarly, permit third-party entities
to make contributions to the non-cash incentive program of an affiliate
of a member because such non-member affiliates are not subject to the
recordkeeping requirements of the proposed rule change. Thus,
contributions by third-parties for a non-cash incentive program for
associated persons of a member firm may only be made directly to the
member.
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\21\ The provision would also permit a member's affiliate to
contribute to the member's in-house non-cash incentive program.
---------------------------------------------------------------------------
Relationship of the proposed rule change to the Tully Report. The
Tully Report reviewed industry compensation practices in connection
with the sale of all forms of securities for associated persons of
members, identified conflicts of interests inherent in such practices
and identified the ``best practices'' used in the industry to
eliminate, reduce or mitigate such conflicts of interest.\22\ The rule
change proposed herein is limited to addressing certain compensation
issues only in connection with the sale of investment company
securities and variable contracts. The NASD believes that the proposed
rule change is consistent with the characteristics of ``best
practices'' identified in the Tully Report in that the requirements in
the proposed rule for the receipt of non-cash incentives address the
point-of-sale impact of such incentives on the sales practices of an
associated person, thereby helping to better align the interests of
associated persons, broker-dealers and investors with respect to the
sale of investment company securities and variable contracts.
---------------------------------------------------------------------------
\22\ See supra note 20.
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The NASD recognizes, however, that this proposal does not address
many significant issues raised by that report and, as noted, will seek
public comment on the appropriate regulatory treatment of other types
of compensation arrangements. Nonetheless, the NASD believes that this
proposal should not be delayed by consideration of these other
compensation issues in that this proposal addresses non-cash
arrangements that have been generally identified and regarded as
potentially abusive practices.
Proposed implementation of new rules. The NASD is proposing that
the amendments to the Investment Company and Variable Contracts Rules
be implemented in the following manner. The proposed rule change will
be effective on the date stated in a Notice to Members announcing
Commission approval, which date will be no later than 60 days after
Commission approval. As of that date, members will be required to
comply with the proposed rule change. With respect to the non-cash and
cash sales incentive provisions, no new sales incentive programs may be
commenced after the announced effective date. Sales incentive programs
that are on-going on the date of effectiveness would be permitted to
continue for a period not to exceed six months following the announced
effective date. Thus, during the six-month implementation period, no
new incentive programs could commence, although sales could be applied
to existing incentive programs. Non-cash and cash sales incentives
earned by associated persons would be permitted to be received for a
period not to exceed twelve months following the expiration of the six-
month implementation period.
Statutory Basis
The NASD believes that the proposed rule change is consistent with
the provisions of Section 15A(b)(6) of the Act, which require that
Association adopt and amend its rules to promote just and equitable
principles of fair trade, and generally provide for the protection of
investors and the public interest in that the proposed rule change is
designed: (1) to adopt new regulations with respect to the sales of
variable contract securities in Rule 2820 of the NASD Conduct Rules to
regulate the direct payment of compensation to associated persons by
persons other than the member with which a person is associated with,
to establish recordkeeping requirements; and to regulate the receipt of
non-cash compensation by members and their associated persons; and (2)
to amend current regulations with respect to the sale of investment
company securities in Rule 2830 of the NASD Conduct Rules to clarify
the circumstances under which associated persons may receive direct
payments of compensation from persons other than the member with which
a person is associated with, to establish recordkeeping requirements,
to retain current disclosure requirements and a prohibition on the
receipt of securities as compensation, and to regulate the receipt of
non-cash compensation by members and their associated persons.
Moreover, the proposed rule change is designed to minimize the point-
of-sale impact of non-cash sales incentives on the recommendations of
associated persons to their customers with respect to the sale of
investment company and variable contract securities and eliminate any
potential that third-part non-cash incentives may undermine the
supervisory control of the member with respect to their associated
persons, which would increase the possibility for the perception of
impropriety that may result in a loss of investor confidence.
B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD does not believe that the proposed rule change will result
in any burden on competition that is not
[[Page 47090]]
necessary or appropriate in furtherance of the purposes of the Act, as
amended.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
The proposed rule change has not been published for member comment.
However, SR-NASD-95-61 was published by the Commission for comment on
July 8, 1996.\23\ SR-NASD-95-61 requested public comment on amendments
to Rules 2820 and 2830 of the NASD's Conduct Rules that, among other
things, would have prohibited the acceptance, directly or indirectly,
of non-cash compensation, with certain exceptions, and would have also
prohibited the acceptance, directly or indirectly, of cash compensation
preconditioned on achieving a sales target (incentive-based cash
compensation provision), with certain exceptions. The exceptions to the
incentive-based cash compensation provision would have permitted
members to accept cash compensation preconditioned on achieving a sales
target so long as the compensation, among other things: (1) was based
on total sales of all investment company or variable contract
securities offered; and (2) required that the credit received for each
investment company or variable contract security sold carries equal
weight in structuring the compensation arrangement.
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\23\ SR-NASD-95-61 contained a summary of comments in response
to the publication by the NASD of Notice to Members 94-67 (August
22, 1994). Those comments, and the NASD's response thereto, are not
reproduced in this rule filing, but are contained in the
Commission's publication of SR-NASD-95-61. See supra note 6.
---------------------------------------------------------------------------
The Commission received comment letters from 30 commenters, 7 of
whom were supportive, 18 of whom were opposed, and 5 of whom were
neither for nor against the proposal. A summary of the comments is
attached as Exhibit A. Most of the commenters were insurance-affiliated
members that distributed proprietary variable insurance products of
their parent insurance companies and also offered some non-proprietary
variable insurance products to accommodate their customers. In addition
to ordinary sales commissions, sales of proprietary products often
generate other incentive-based cash compensation such as contributions
from the parent insurance company to its sales agents' pension plan,
health insurance plan, 401(k) plan, and similar fringe benefits. Most
commenters regarded the total sales and equal credit requirements of
the incentive-based cash compensation provision as very problematic,
and stated that the requirements appear to mandate equal treatment of
incentive compensation paid for both proprietary and non-proprietary
products. Commenters stated that there is not enough profit margin
built in to non-proprietary products to fund equal compensation. The
commenters also stated that it would be too difficult operationally and
practically to implement such an equal treatment system. The commenters
also stated that the internal differential compensation practices of
member firms ought not to be regulated by the NASD.
The Investment Companies Committee (``ICC''), at its meeting on
October 2, 1996, and the Insurance Affiliated Committee (``IAC''), at
its meeting on October 8, 1996, reviewed and discussed the comment
letters. Both Committees concluded that the incentive-based cash
compensation provisions in SR-NASD-95-61 were generally intended by the
NASD to prohibit the circumvention of the non-cash prohibition by
monetizing the non-cash payment, and were not intended to regulate
broader compensation and recognition programs of insurance companies.
However, both Committees also agreed with the commenters that the
language of the incentive-based cash compensation provision was capable
of being interpreted broadly and voted unanimously to either amend the
incentive-based cash compensation provision to clarify its intended
scope or delete the provision in its entirety.
In subsequent discussions, NASD staff determined to delete the
incentive-based cash compensation provision in its entirety. In
addition, because of the complexity of issues regarding the variety of
cash compensation arrangements in the mutual fund and variable products
industry, and the need to explore the nature of these arrangements more
thoroughly, NASD staff also determined to solicit the Committees' views
on the publication of a Request for Comment requesting general comments
on cash compensation issues.\24\
---------------------------------------------------------------------------
\24\ See supra note 7.
---------------------------------------------------------------------------
The ICC, at its meeting on February 11, 1997, and the Variable
Insurance Products Committee (``VIPC''), a successor to the IAC, at its
meeting on February 24, 1997, both agreed with the views of NASD staff
and voted unanimously to amend the proposal by deleting the cash
compensation provision and to issue the Request for Comment on cash
compensation issues.
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. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., 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. Sec. 552, will be available for inspection and copying at
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 File No. SR-NASD-97-35 and should
be submitted by September 26, 1997.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\25\
---------------------------------------------------------------------------
\25\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Jonathan G. Katz,
Secretary.
Exhibit A--NASD's Summary of Comments Received in Response to the
Publication of SR-NASD-95-61
Background
SR-NASD-96-51 requested public comment on amendments to Rules 2830
and 2820 of the NASD's Conduct Rules (formerly, Article III, Sections
26 and 29, respectively, of the NASD Rules of Fair Practice) that would
revise existing rules applicable to the sale of investment company
securities (``Investment Company Rule'') and
[[Page 47091]]
establish new rules applicable to the sale of variable contract
securities (``Variable Contracts Rule''). Generally, the proposed rule
change would, in connection with the sale and distribution of
investment company securities and variable contracts: (1) adopt
definitions of the terms ``affiliated member'', ``cash compensation'',
``non-cash compensation'' and ``offeror''; (2) prohibit, except under
certain circumstances, associated persons from receiving any
compensation, cash or non-cash, from anyone other than the member with
which the person is associated; (3) required that members maintain
records of compensation received by the member or its associated
persons from offerors; (4) with respect to the Investment Company Rule,
prohibit receipt by a member of cash compensation from the offeror
unless such arrangement in described in the current prospectus; (5)
retain the prohibition, only with respect to the Investment Company
Rule, against a member receiving compensation in the form of
securities; (6) prohibit, with certain exceptions, members and persons
associated with members from accepting, directly or indirectly, any
non-cash compensation in connection with the sale of investment company
and variable contract securities; and (7) prohibit, with certain
exceptions, a person associated with a member from accepting, directly
or indirectly, any cash compensation in connection with the sale of
investment company and variable contract securities.
The exceptions from the non-cash compensation prohibition would
permit: (1) gifts of up to $100 per associated person annually; (2) an
occasional meal, ticket to a sporting event or theater, or
entertainment for associated persons and their guests; (3) payment or
reimbursement for training and education meetings held by a broker-
dealer or a mutual fund or insurance company for associated persons of
broker-dealers, as long as certain conditions are met; (4) in-house
sales incentive programs of broker-dealers for their own associated
persons; (5) sales incentive programs of mutual funds and insurance
companies for the associated persons of an affiliated broker-dealer;
and (6) contributions by any non-member company or other member to a
broker-dealer's permissible in-house sales incentive program.
The exceptions from the cash compensation prohibition would permit:
(1) in-house sales incentive programs of broker-dealers for their own
associated persons; (2) sales incentive programs of mutual funds and
insurance companies for the associated persons of an affiliated broker-
dealer; and (3) contributions by any non-member company or other member
to a broker-dealer's permissible in-house sales incentive program.
The Commission received comment letters from the following
commentators:
1. American Council of Life Insurance
2. American Council of Life Insurance
3. American Funds Distributors, Inc.
4. American General Securities Incorporated
5. Banc One Corporation
6. BMA Financial Services, Inc.
7. Carillon Investments, Inc.
8. Cigna Financial Advisors, Inc.
9. Cova Financial Services Life Insurance Company
10. The Equitable Life Assurance Society of the United States
11. First Investors Corporation
12. Investment Company Institute
13. John Hancock Mutual Life Insurance Company
14. John Hancock Mutual Life Insurance Company
15. Locust Street Securities, Inc.
16. Merrill Lynch, Pierce, Fenner & Smith Incorporated
17. M Financial Group
18. The Minnesota Mutual Life Insurance Company
19. The Minnesota Mutual Life Insurance Company
20. MML Investors Services, Inc.
21. National Life of Vermont
22. The New England
23. The Princor Financial Services Corporation
24. Security Benefit Life Insurance Company
25. Sunset Financial Services, Inc.
26. The Union Central Life Insurance Company
27. Walnut Street Securities
28. WS Griffith and Co., Inc.
29. Investment Company Institute
30. SAFECO Life Insurance Company
Of the 30 commenters, 7 were supportive (Comments 2, 3, 5, 10, 12,
16, 29), 18 were opposed (Comments 4, 6, 7, 8, 11, 13, 14, 18, 19, 20,
21, 23, 24, 25, 26, 27, 28, 30), and 5 were neither for nor against the
proposal (Comments 1, 9, 15, 17, 22).
General Comments
Those commenters supporting the proposed rule generally applauded
the efforts of the NASD and the Commission to provide consistent rules
for the sale of investment company securities and variable annuity
contracts, supported sensible regulatory enhancements that facilitate
the ability of members to execute compliance and supervisory
responsibilities, recognized that certain non-cash practices may raise
the perception of impropriety and potentially undermine the confidence
of investors, such as contests offering lavish trips and expensive
prizes, and supported initiatives reasonably targeted to reducing or
eliminating potential conflicts of interest in these situations. Some
of these commenters, however, also stated that additional work is
necessary to ensure that the proposed rules adequately meet the needs
expressed and are not overbroad (Comments 2, 3, 5, 10, 12, 16).
The most common general criticism, primarily from insurance-
affiliated members distributing proprietary products through the career
agency system, was that the proposed rules appear to mandate equal
treatment of both proprietary and non-proprietary commission payments
and/or cash and non-cash compensation arrangements for the sale of
variable products and mutual funds. According to the commenters, this
would, among other things, restrict the ability of member firms and
their affiliated insurance companies to pay higher commissions for
their proprietary products, give an unfair advantage to broker-dealers
that do not manufacture their own variable products, lead to the sale
of only proprietary variable products, lead to the sale of only fixed
insurance products, produce an anti-competitive environment, cause the
demise of the traditional insurance career agency system, and conflict
with the current practice of treating career agents under IRS rules as
``statutory employees'' when selling proprietary products and
``independent contractors'' when selling non-proprietary products, thus
requiring fundamental changes to the compensation structure within
parent life insurance companies who continue to offer proprietary and
non-proprietary variable insurance contracts (Comments 4, 8, 10, 11,
13, 14, 17, 19, 20, 21, 22, 23, 24, 25, 26, 27, 28).
Specific Comments
Conflicts of Interest
Point of Sale Incentives
Some commenters stated that the proposed rule overemphasized point-
of-sale conflicts (Comments 10, 14, 17, 27). One commenter disputed
that non-cash incentives are currently influencing a salesperson's
product recommendation at the point of sale and stated that therefore
the need for the proposed changes does not exist (Comment 27). Another
commenter stated that there is little in a proprietary sales force
distribution model that distributes an overwhelmingly proprietary
product
[[Page 47092]]
line, particularly variable insurance products, that seems to raise the
prospect of meaningful point-of-sale conflicts, and that if the
proposed rules regulate the manner in which non-cash incentives are
awarded in situations which don't present a significant conflict of
interest, they represent in inappropriate and unwarranted regulatory
intrusion into the internal compensation arrangements between a member
and its associated persons (Comment 10). Two commentators stated that
point-of-sale incentives for variable products are mitigated by the
fact that agents selling variable insurance products, as compared to
mutual funds, tend to receive a higher percentage commission on premium
payments in the early years and to have a greater expectation of future
premium payments that will result in additional compensation in
subsequent years (Comment 14), and that since a portion of the
registered representative's compensation remains dependent upon the
continuance of the policy in force, the agent has an intrinsic
motivation to place an appropriate and suitable product at inception
(Comment 17).
Disclosure
Other commenters argued that the dangers of conflicts of interest
at point-of-sale can be addressed through disclosure (Comments 11, 17).
One commenter noted that the Commission Release did not suggest that
any actual abuses have occurred that justify such substantive
regulation of in-house incentive programs, and stated that even
assuming that in-house incentive programs favoring proprietary products
created the ``possibility'' of a conflict of interest, there is no
explanation in the Commission Release why disclosure of possible
conflicts would not be sufficient to cure the problem (Comment 11).
Another commenter stated that complete prospectus disclosure of the
terms of any kind of incentive compensation would provide the customer
with complete notice of the incentives, is a far better solution to
NASD concerns regarding consumer protection, and would accomplish the
NASD's goals without the unintended market impact the proposed rules
will have (Comment 17).
Supervision
Other commenters thought conflicts of interest could be properly
addressed through supervision (Comments 6, 8). One commenter stated
that the proposed rules are too restrictive and specific, and do not
adequately recognize the success of members in existing control over
their associates and managing their control environments in a manner
that sensibly balances legitimate business objectives and potential
conflicts of interest (Comment 8). The same commenter further stated
that, unlike direct participation program markets in the 1980s, members
are effectively managing the supervisory issues associated with the
sale of investment company securities and variable contracts, and
therefore the proposed rules will have a negative impact on these
industries without concomitant benefit. The commenter stated that the
Commission should return the proposed rule to the NASD with the
suggestion that it be revised to eliminate most of the specific
limitations on conduct, and instead emphasize (a) reliance on members
to properly control perceived conflicts of interest, and (b) changes
(if any) necessary to enable the NASD to supervise the performance of
members in exercising such control (Comment 8).
Unlevel Playing Field/Discriminatory Impact
Variable Versus Fixed Insurance Products
Some commenters stated that the proposed rules create an unlevel
playing field between sellers of variable contracts and sellers of
traditional fixed life insurance products. (Comments 4, 14, 17). One
commenter stated that since companies which only sell traditional fixed
insurance products are free to provide whatever non-cash compensation
they wish, the unintended result of the proposed rules may be that
insurance companies with affiliated broker-dealers will request that
variable contracts offered by non-affiliated companies be removed from
broker-dealers' list of approved products (Comment 4). Another
commenter stated that if the proposed rules are adopted, many insurance
companies will limit their cash and non-cash incentive compensation
programs to sales of non-variable insurance products and registered
reps interested in the incentives offered by a particular compensation
program may encourage the investor to purchase the non-variable product
irrespective of whether that product is the most suitable (Comment 14).
Another commenter stated that this unintended skewing does not occur in
investment company securities since investment companies do not have
any unregistered funds (Comment 17).
Discrimination Against Smaller Issuers and Independent Insurance
Agencies
One commenter stated that the proposed rules will place small fund
groups which distribute through their own in-house sales forces at a
serious economic disadvantage since they will be required to give
unaffiliated groups equal access to their distribution systems without
having to share the high costs or maintaining such systems (Comment
11). Small fund groups with captive sales forces will clearly suffer
because they will probably not have the clout to demand fees for shelf
space, and their only alternative may be to take unaffiliated funds off
their shelves altogether (Comment 11). If such fund groups could not
recover the costs of training in-house sales representatives by
``encouraging'' them to sell house-brand products, they would have
little incentive to invest in such training in the first instance
(Comment 11).
Another commenter stated that as the rules are presently written,
insurance companies that have affiliated broker-dealer may implement
and use non-cash compensation incentives to reward their captive
brokerage agents while non-cash compensation for independent agents is
prohibited, which unfairly discriminates against the independent agent,
the independent broker-dealer, and issuers who distribute their
products through independent broker-dealers (Comment 17). Thus, captive
agents have opportunities with regard to compensation that independent
agents do not, which skews the marketplace toward a limited line of
products from a single issuer, which may not be in the client's best
interest (Comment 17).
Proprietary Versus Non-Proprietary Products
Many commenters stated that the proposed rules, by requiring
insurance-affiliated firms to ``equally credit'' sales of all third
party products, will force insurance-affiliated firms selling primarily
proprietary products to either deny its registered reps access to
third-party products, sell such products at a loss, or pay lower
commissions for proprietary products (Comments 10, 13, 19, 20, 21, 22,
23, 24, 25, 26, 27, 28). Following are selected excerpts from
commenters.
(a) ``Preconditioned on achieving a sales target'' and ``equal
credit.''
One commenter stated that virtually all broker-dealer commission
schedules provide for banded commissions, i.e., for all sales between
$0 and $X, the commission is 40%; for all sales between $X and $Y the
commission is 45%. Thus, all commissions are ``preconditioned on a
person achieving a sales target'' (Comment 20). The commenter argues
that therefore, proposed subparagraph (h)(4) to Rule 2820, which
provides that ``no person
[[Page 47093]]
associated with a member shall accept any cash compensation that is
preconditioned on such person achieving a sales target,'' literally
prohibits registered representatives from accepting commissions for
their sales unless the commission schedule falls within a specified
exception of the rule. The same commenter further argued that
subparagraph (h)(4) would mandate that an insurer include within its
overall compensation plan not only compensation from sales of the
variable contracts which it issues but also compensation from the sales
of all the variable contracts which may be distributed by its
registered representatives in its affiliated broker-dealer. The
commenter concluded that firms with proprietary products will be unable
to comply with the ``equal treatment'' mandate of the proposed rules
and be forced to limit products to only their proprietary products,
which would eliminate the incentive that issuers now have to improve
their product design and/or administration so as to allow them to pay
out higher total compensation. Thus, any superior profit margins that
an issuer may achieve would be used not to provide incentives for
further sales of that product but to supplement compensation on non-
proprietary products or inferior proprietary products. The commenter
stated that the proposed rules, if adopted without further
clarification, would be inconsistent with long-standing insurance
regulatory practices, and give an unfair competitive advantage to
broker-dealers that do not manufacture their own products (Comment 20).
Another commenter stated that the proposed rules require a member
firm which offers incentive-compensation on proprietary products to
provide comparable incentives in connection with the sale of non-
proprietary products, and the most likely means to do so will be to
reduce the base commissions (i.e., the non-incentive compensation) paid
to registered representatives for the sale of non-proprietary products.
These savings in base commission costs (i.e., the additional portion of
the dealer concession retained by the member firm) will then be used to
provide incentive compensation on non-proprietary products at the same
level as on proprietary products. Registered representatives would
therefore have an even greater incentive to offer proprietary products
given the even greater disparity in base compensation payable between
proprietary and non-proprietary products. Such an outcome is also
inconsistent with the stated intention of the proposal. The simplest
means by which a member firm may comply with the proposed rules is to
eliminate all non-proprietary products from its list of products
(Comment 19).
Another commenter stated that if a captive dealer could no longer
provide incentive programs to its own reps which focused on proprietary
products, it would be faced with the unfortunate choice of becoming
strictly captive or being less able to earn a return on the
traditionally greater investment they have made in their reps, as the
benefit of that investment unintentionally accrues partly to outside
product providers (Comment 21).
Another commenter stated that if the rules are adopted sales
contests will be held only to promote those products whose issuers have
the resources to finance multiple contests or who sell through captive
agents. This situation creates an advantage for large issuers with the
ability to finance the contest of multiple broker-dealers (Comment 24).
Another commenter stated that the proposed rules will have the
opposite effect than what is contemplated. The proposed rules will
require many companies to make wholesale changes in their compensation
plans and in the systems that support these plans, which will cost
millions of dollars. Instead, many companies may decide to disallow the
sale of ``non-proprietary'' products, in effect limiting the registered
rep to one fund family and one variable annuity contract (Comment 25).
(b) Anti-competitive effect.
One commenter stated that because some members might only offer
proprietary products, clients of such member firms would have a limited
number of products from which to choose unless those clients were
willing to shop around among various brokers, which would have a
negative effect on competition (Comment 13).
Another commenter stated that because the resulting response by
many insurance company broker-dealers with proprietary mutual funds,
variable annuities, and variable life insurance will be to reduce or
eliminate availability of non-proprietary products, investors will be
subject to fewer objective investment recommendations, less portfolio
diversification, and recommendations of other possible non suitable
products not affected by the proposal, e.g., fixed annuities and and/or
permanent insurance policies (Comment 23).
Another commenter stated if the proposed rules take effect, a
number of firms will out of necessity be forced to only offer so-called
proprietary products. This would severely limit the choice of products
being offered to the prospective purchaser by a particular registered
representative and necessitate the potential purchaser of a product to
go through the time consuming process of having to visit a number of
registered representatives (Comment 28).
(c) Effect on ``statutory employee'' compensation and ``career
agent'' system.
One commenter stated that although the proposed subparagraphs
sections (h)(4) and (1)(6) would appear to mandate the equal treatment
of both proprietary and non-proprietary commission payments for
variable products and investment companies, the Internal Revenue Code
makes this virtually impossible for insurance-affiliated companies
utilizing the career agency system. For such companies, the commission
and recognition programs for their proprietary variable insurance and
annuity products are integrated into the overall compensation plans for
its career agents. In accordance with Section 3121(d)(3) of the
Internal Revenue Code, payment of commissions of these proprietary
variable insurance products to full-time career agents is treated as W-
2 income to statutory employees. Typically, such commissions also
generate contributions from the parent insurance company to the career
agent's pension plan, health insurance plan, 401(k) plan, and similar
fringe benefits. Payments made to career agents for sales of non-
proprietary products are, however, treated as 1099 income paid to
independent contractors. Accordingly, non-proprietary products
commissions are not, and cannot be, incorporated into overall
compensation plans (Comment 20).
The same commenter further stated that even if commissions from the
sales of non-proprietary variable products could somehow be received by
the parent insurance company, it would still be impractical to
recognize them in the parent's compensation plans because such products
are not manufactured by the proprietary issuer and there has been no
opportunity to build appropriate margins into the products to cover
certain distribution costs, particularly fringe benefit costs (Comment
20).
Another commenter further stated that the profit margins on third-
party products are insufficient to fund the cost of providing ``equal
credit'' toward all benefits having production eligibility criteria. As
a result, if forced to provide equal credit for the sale of non-
proprietary variable products, insurance-affiliated firms will be faced
[[Page 47094]]
with the Hobson's choice of either denying its registered
representatives access to third-party products (to the ultimate
detriment of its customers), or selling such products at a loss
(Comment 10).
The same commenter stated that to the extent that the proposed
rules bring within the definition of ``non-cash compensation'' (or
otherwise purport to regulate as incentive-based cash compensation)
items that traditionally have been viewed as point-of-sale incentives
but instead as benefits customarily afforded in the context of an
employer-employee relationship (e.g., health and disability income
coverage, tuition reimbursement programs, etc.), the result will be
regulation that is disruptive and unduly burdensome, again without
meaningfully contributing to the protection of investors (Comment 10).
Another commenter stated that agent compensation is covered in
collective bargaining agreements between insurance companies and career
agents. If certain forms of compensation are no longer permitted with
respect to variable products under the terms of the proposed rules,
then collective bargaining agreements may have to be renegotiated
(Comment 13).
Training and Education Limitations
Some commenters objected to the limitations imposed on training and
education meetings (Comments 8, 20, 23, 24).
One commenter argued that, contrary to the requirements of the
proposed rule, it is entirely appropriate to assess eligibility for
training and education meetings based on achievement of sales targets.
Offerors have a legitimate interest in limiting participation in such
meetings to representatives whose sales activities reflects some
minimal level of interest in the offeror's product. It is unreasonable
without substantial justification to preclude offerors from targeting
representatives who have exhibited an ability to market the offeror's
product (Comment 8).
The same commenter also stated that the proposed rules should not
impose artificial limits on ``appropriate locations'' for training and
education meetings organized by offerors. Limiting ``appropriate'' to
mean ``an office of the offeror or the member, or a facility located in
the vicinity of such office, or a regional location with respect to
regional meetings'' is unnecessary and too rigid (Comment 8).
Another commenter similarly stated that the limitations in the
proposed rules concerning the locations of education/training meetings
should be relaxed, not increased. The proposed rules mistakenly attempt
to draw a link between the purpose of a meeting (i.e. education/
training) and the location at which such meeting is conducted (i.e.
office of the offeror or member). The commenter suggested that the
largely irrelevant location requirements for education/training
meetings be eliminated and replaced with a simple requirement that the
broker-dealer be required to maintain documents (e.g. agendas,
attendance lists, etc.) confirming the educational nature of the
meeting (Comment 20).
Another commenter stated that, if the proposed rules are adopted,
product issuers will have no control over the content of presentations
made at training and education conferences. This shift in control of
the sales conference from the issuer to the broker will result in the
loss of an important forum for issuers to educate independent agents
about the products they sell (Comment 24).
Implementation
Some commenters requested that the implementation period for the
proposed rules be extended (Comments 11, 13, 15, 27, 28).
One commenter stated that the six-month grace period for
implementing the rules is not long enough since many sales contests
cover a full year or more than one year, and recommended grandfathering
all contests commenced before the effective date of the rule (Comment
11).
Other commenters stated that proper implementation requires that
contracts between offerors and member firms will have to be amended to
include provisions assuring compliance with the new rules, systems will
have to be updated to track compensation of total production, and, if
repricing is involved, approval by state insurance departments may be
necessary prior to implementation. Such issues could require up to 24
months to fully comply with the proposed rules (Comments 13, 15, 27,
28).
Recommendations
A few commenters suggested changes to the non-cash and cash
incentive provisions of the proposed rules (Comments 2, 10, 16, 20,
22).
One commenter stated that the inclusion of subparagraph (h)(4),
dealing with cash compensation matters, was confusing because the
proposal and its release largely address non-cash compensation rule
amendments (Comment 2). The commenter stated that it did not interpret
subparagraph (h)(4) as an attempt to establish new procedures governing
the receipt of cash compensation by associated persons of a broker-
dealer, but as an effort to prevent circumvention of non-cash
compensation practices by ``monetizing'' the compensation. The
commenter stated that subparagraph (h)(4) could be construed to simply
state that broker-dealers may not do indirectly what they are
prohibited directly from doing in Rule 2820, and recommended the
substitution of this concept for subparagraph (h)(4) (Comment 2).
Another commenter stated that the problems resulting from the equal
weighting requirement can be addressed through the adoption of a de
minimis exception to the provisions of subparagraphs (h)(3)(d) and
(h)(4)(a) and through modifications to the definition of non-cash
compensation (Comment 10). The commenter stated that the de minimis
exception could be included as new subparagraph (h)(5) and would state
in substance:
The provisions of subparagraph (ii) of paragraphs (h)(3)(d) and
(h)(4)(a) shall not apply to the production of associated persons
with respect to variable contracts issued by a non-affiliate of the
member to the extent that such variable contracts, in the aggregate,
account for [an insubstantial percentage] of the total production of
associated persons with respect to variable contracts; and further
provided that the member does not actively promote such variable
contracts to its associated persons nor permit the offeror of such
variable contracts to do so. However, the member shall be required
to provide such weight to the production in variable contracts
issued by a non-affiliate as it determines, in good faith, best
reflects the relative contribution of such production to the
profitability of the member, taking into account the desirability of
promoting, to the maximum extent practicable, parity in commissions
between such product(s) and comparable products, if any, issued by
an affiliate (Comment 10).
The commenter also recommended that the definition of non-cash
compensation be revised to read as follows: ``Non-cash compensation''
shall mean any merchandise, gifts, prizes, payment of travel expenses,
meals and lodging and all other similar items, including cash payments
in lieu of any of the foregoing, received in connection with the sale
and distribution of variable contracts.'' The commenter stated that, as
so revised, the definition would be sufficiently broad so as to
encompass those items of non-cash compensation that have traditionally
been viewed as having the greatest potential for abuse. By including
the phrase ``including cash payments in lieu of any of the foregoing,''
the definition
[[Page 47095]]
also would be sufficiently encompassing so as to prevent the abuse that
subparagraph (h)(4) of the proposed rules was seemingly designed to
address; namely that offerors might seek to ``monetize'' non-cash
incentives to circumvent the provisions of the rule. However, the
definition would not be so broad so as to unintentionally include
items, like health insurance benefits, tuition reimbursement programs,
etc., which traditionally have not been viewed as point-of-sale
incentives (Comment 10).
One commenter strongly recommended that the proposed rules be
amended by deleting Sections (h)(4) and (1)(6) in their entirety
(Comment 20).
Another commenter suggested that: (1) the proposed incentive
compensation requirements as they relate to proprietary/non-proprietary
products be eliminated or revised; specifically, that the total
production and equal weighting requirements might be applied separately
to all proprietary products together; and, in any case, (2) an
exemption be provided for companies for whom the amount of non-
proprietary product sales is not material, i.e., a test of materially,
or for whom the proprietary and non-proprietary products do not compete
(Comment 22).
One commenter stated that the language relating to the inclusion of
all investment company securities in incentive arrangements is over-
broad and unduly restrictive (Comment 16). The commenter stated that an
incentive arrangement which includes both a broad base of funds and
funds of each fund family sold by the broker-dealer to an equal extent
would meet the objectives of the proposed rules and recommended that
the relevant language of proposed Rules 2830(I)(5)(d)(i) and
2830(I)(6)(a)(i) be changed to read as follows:
The member's or non-member's [non-cash compensation]
arrangement, if it includes investment company securities, must (a)
include a broad range of investment company securities, (b) not
discriminate within the range among investment companies included in
the arrangement and (c) give equal weighting to the sale of all
investment company securities included in the arrangement by the
member (Comment 16).
The same commenter disagrees with the manner in which the NASD
proposes to accomplish prospectus disclosure of cash compensation. The
commenter states that full service firms which neither act as
underwriter for mutual funds sold to its clients nor control the issuer
or underwriter of such funds, and thus have very limited ability, if
any, to influence the contents of prospectuses, bear the burden
adequate prospectus disclosure. Moreover, the proposed rules would
place an extraordinary administrative burden on such firms by requiring
continuous review of each funds prospectus to evaluate whether the cash
compensation disclosure requirements of the proposed rules have been
satisfied (Comment 16).
The commenter recommends, therefore, that the proposed amendments
be modified to prohibit the ``underwriter'' from paying any cash
compensation that is not disclosed in the fund prospectus, and would
define the term ``underwriter'' to include ``any person which, directly
or indirectly controls, in controlled by or is under common control
with the underwriter.'' The commenter stated that this recommended
change should accomplish the NASD's purpose of holding a person under
its jurisdiction responsible for prospectus disclosure. In addition,
because underwriters of investment company securities are generally
under common control with the issuer of the investment company
securities, it is much more likely that they can control or influence
the disclosure contained in the fund's prospectus. Such an approach is
consistent with Federal securities laws, which subjects underwriters to
``prospectus liability,'' but not broker-dealers acting as agent in the
sale of securities (Comment 16).
Specific Commission Requests for Comments
The Commission Release contained requests for comment on four
specific issues. The requests are restated below with a summation of
the commenters' responses.
1. The proposed rule change would continue to permit an associated
person to accept gifts if the total value does not exceed $100 and an
occasional meal, a ticket to a sporting event or the theater, or
comparable entertainment. Should members be required to keep records of
such gifts or entertainment to enable the NASD to surveil effectively
for abuse? The unanimous response of those commenters who answered this
question was that, since such de minimis activity does not undermine a
broker-dealer's supervisory control over registered representatives or
create the appearance of impropriety, imposing recordkeeping
requirements concerning these activities is not warranted (Comments 2,
3, 4, 5, 7, 8, 12, 16, 20, 23, 26, 27, 28).
2. The proposed rule change would permit a member or an associated
person to accept payment or reimbursement from an offeror for expenses
incurred in connection with meetings held by the offeror for the
purpose of training or educating associated persons of a member. Are
the recordkeeping requirements proposed by the NASD sufficient to
support determinations of whether such meetings will be bona fide? Most
commenters who responded felt that additional recordkeeping in this
area was not needed (Comments 2, 3, 4, 7, 26, 27, 28).
Other commenters stated that the requirements were not sufficient
(Comments 5, 8, 14). One commenter stated that such records should also
include the identification of the nearest office of the member and
should contain information relating to the agenda of the meeting in
order to document the determination of a bona fide meeting (Comment 5).
Another commenter stated that the recordkeeping requirement with
respect to education and training meetings should be sufficient to
indicate the substance of the meeting and to demonstrate that the
location and related activities were appropriate (Comment 8). The
commenter suggested that the following information, in addition to that
required by the proposed rules, should be sufficient for these
purposes: a description of the purpose of the meeting, a statement of
the basis on which the member approved attendance at the meeting by the
associated person (which would also evidence member approval), and a
copy of the agenda of the education and training portion of the
meetings (Comment 8). Finally, another commenter suggested that
proposed rules are inadequate because they do not require records to be
kept with respect to the location of such meetings (Comment 16).
3. The NASD states in its filing that a member holding a training
or education meeting for its associated persons would not be required
to comply with the conditions imposed with respect to training and
education meetings held by offerors or unaffiliated members ``if the
member does not receive a payment or reimbursement from an offeror for
the expenses of the meeting.'' In any event, the member would not be
prohibited from permitting offerors to make a presentation at the
meeting. Commenters are asked to address whether a training and
education meeting should constitute non-cash compensation subject to
the proposed rule change if an offeror participates in organizing the
meeting even though an identical meeting would not be subject to the
proposed rule
[[Page 47096]]
change if organized by the member for its own associated persons. Some
commenters who responded felt that when a broker-dealer conducts
training and educational seminars with offeror participation it should
not constitute non-cash compensation, because the broker-dealer is
fully aware of the offeror's participation, because the broker-dealer's
supervisory control is not diminished or undermined, because this is
not typically an area of abuse, or because flexibility is needed to
arrange meetings at locations convenient to attendees and within the
budgets available (Comments 2, 7, 20, 23, 26, 27, 28).
Other commenters stated that mere offeror participation, as long as
the offeror does not provide any monetary contributions, should not
result in the meeting being treated as non-cash compensation (Comments
3, 4, 5, 8).
4. The Tully Committee identified the practice of payment of higher
commission to registered representatives for proprietary products than
for non-proprietary products as an arrangement that can create
conflicts of interest. The proposed rule change would not prohibit or
regulate this practice. The proposed rule change would, however,
prohibit a contest granting cash awards if the contest gives greater
weight to certain securities than others. Commenters are invited to
address whether the proposed rule change should be extended to cover
ordinary compensation practices in addition to incentive compensation
practices. Most commenters who responded stated that the proposed rule
change should not cover ordinary compensation practices because the
regulatory objectives cited in the proposed amendments are unrelated to
the payment of commissions, such an approach would have anti-
competitive implications, such an approach would delay the date of
effectiveness of the proposed rules, or it would result in duplicative,
overlapping regulation (Comments 2, 3, 6, 7, 8, 12, 13, 16, 23, 26,
27).
One commenter, however, stated that he could see barring
differentials in cash compensation, since cash compensation is the
strongest possible incentive (Comment 4). Another commenter stated that
The Tully Committee's report on compensation practices voiced concern
over possible conflicts of interest created by both higher commission
payments for proprietary products and narrowly focused incentive sales
contests. If such practices genuinely create conflicts of interest, the
effect of the proposed rule change is to allow higher commissions to be
paid year round under a general period. We fail to see the distinction.
The ultimate issue for regulatory consideration should be suitability.
Regulatory authorities should determine whether or not a conflict of
interest is created by higher payments, regardless of the duration of
the program and provide consistent proposals for rule changes
accordingly (Comment 5).
[FR Doc. 97-23540 Filed 9-4-97; 8:45 am]
BILLING CODE 8010-01-M
