NASD Rule 2510 - Discretionary Accounts

Use of a negative response process under NASD Rule 2510(d)(2)(D) to designate an alternative money market sweep fund when existing sweep fund closes with inadequate notice.

Staff Interpretive Memo
May 15, 2008

FINRA staff is issuing this memorandum to respond to questions regarding the application of NASD Rule 2510(d)(2)(D) to the transfer, by a firm, of customer funds from one or more designated money market sweep fund(s) in customers' accounts to alternative money market sweep funds under certain circumstances. In many instances, un-invested cash in a customer's account is swept into money market funds, made available by the firm, when the sweep option is selected by the customer. Absent the use of sweep accounts, free cash balances that await reinvestment, or which the customer wishes to keep liquid, would be held by the customer's carrying broker as a free credit balance and might not earn any interest or other form of a return. The purchase of shares in a sweep fund with what would otherwise remain as un-invested cash provides returns in the form of dividends and generally functions in such a manner that subsequent reinvestment transactions (investments other than further purchases of shares of the designated money market fund) automatically cause a liquidation of the sweep fund for available settlement funds (i.e., the customer does not have to initiate a sale of a position in the sweep fund). Certain sweep funds allow customers to elect additional features, such as check-writing or electronic bill payment, that automatically use the sweep fund account balance.

FINRA has been informed by certain member firms that, due to recent market conditions, designated money market sweep funds have indicated they may refuse or limit additional share purchases for the reasons discussed in greater detail below. Normally, in such cases, in accordance with NASD Rule 2510(d)(2)(D), firms may seek to do a bulk transfer from one money market fund to another and would be required to provide written notice (in addition to such other disclosure items required by the Rule) at least 30 days prior to effecting the transfer. FINRA has received requests from firms seeking interpretive guidance that firms would not be deemed to be in violation of NASD Rule 2510(d)(2)(D), by virtue of activating alternative money market sweep funds for customers, without providing the 30-day prior notice to customers, in the event an existing designated money market sweep fund decided to close or limit additional fund share purchases without sufficient notice.

NASD Rule 2510(b) generally requires member firms to obtain written authorization from a customer prior to exercising discretionary power in the customer's account. As discussed above, NASD Rule 2510(d)(2) provides an exception to this general requirement, which allows a firm to effectuate a bulk exchange of money market mutual funds using negative response letters, provided the exchanges are effected at net asset value and are limited to situations involving mergers and acquisitions of money market mutual funds, a change of clearing members, or an exchange of money market mutual funds used in sweep accounts. Negative response letters must contain a tabular comparison of the nature and amount of fees charged by each fund as well as a comparative description of the investment objectives of each fund and a prospectus of the fund to be purchased. The negative response feature may not be activated until at least 30 days after the date on which the letter was mailed.

Firms have reported to FINRA that, due to recent extraordinary events in the financial markets, money market funds and, in particular, money market funds that describe themselves as "Treasury" money market funds, which are required under Rule 35d-1 of the Investment Company Act of 1940 to maintain at least 80 percent of their assets in U.S. Treasury securities, have found it difficult to obtain sufficient quantities of those securities. As a result of concerns with satisfying a fund's funding requirements, firms report that their designated money market sweep fund(s) are considering closing or limiting new fund share purchases without any prior notice or with less than 30-days prior notice. Firms have stated that, because they typically aggregate orders from all customers into a single order each day to their designated money market sweep fund(s), a refusal to accept all or some new fund share purchases could result in an inability to invest some or all of their customers' free cash balances. In such cases, firms would have to carry such cash in the affected customer accounts as free credit balances. These free credit balances might not earn interest until the firm had the opportunity to either comply with NASD Rule 2510(d)(2)(D) or seek orders for an alternative investment from each affected account. FINRA is informed by its members that significantly large numbers of accounts would be potentially affected by the closing or limitation of new fund share purchases in their designated money market sweep funds.

FINRA staff believes that due to the significant number of customer accounts potentially affected by the closing of money market sweep funds without adequate notice, it would be in the best interest of investors/customers to permit firms to select a new money market sweep fund for customers without having to wait for the 30-day negative consent period in accordance with NASD Rule 2510(d)(2)(D). In the event a designated money market sweep fund announces, with inadequate notice to permit the firm to provide the 30-day prior notice required under NASD Rule 2510(d)(2)(D), that it intends to close or limit new fund share purchases, the firm may select and activate an alternative sweep fund without waiting for the 30-day negative consent period subject to the following requirements and conditions. In such instances, the firm may stop attempting to sweep customer cash balances into the current designated money market sweep fund and must:

 

  • use best efforts to seek a new sweep money market mutual fund that is an appropriate money market mutual fund for customers, considering such factors as yield, fees, investment objectives, risks and current market conditions;
  • establish instructions to sweep customer cash balances into newly designated money market mutual funds;
  • promptly notify customers using negative response letters of the change in sweep funds and include in such written notification the disclosures to customers as required by NASD Rule 2510(d)(2)(B) and (C); and
  • state in the written notification that customers may give instructions to invest in available alternatives to a newly designated money market sweep fund (for example, another money market fund that may not be part of the member's sweep program).

 

FINRA staff reminds firms that use of negative response letters should be limited to permissible circumstances. Consequently, if a money market fund provides notice more than 30-days prior to the date the money market fund expects to close or limit the purchase of fund shares, a firm's reliance on this interpretive guidance would be subject to greater scrutiny to determine if such reliance was reasonable based on several factors, including, but not limited to, the number of customer accounts affected, the number of sweep funds involved and the reasonable time period necessary to prepare and mail notices to customers. Firms must have a good-faith basis for relying on this interpretive guidance and are cautioned that they may not rely on it where a reasonable and diligent effort would have allowed them to receive the affirmative consent of their customers, or, where circumstances warrant, comply with NASD Rule 2510(d)(2)(D). Members are cautioned that this interpretive guidance does not address the application of NASD Rule 2510(d) to the transfer of customers' funds from money market funds to bank sweep accounts by the use of negative response letters.

 

Please note that the opinions expressed in this memorandum are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. This staff memorandum responds only to the issues raised based on the facts as described herein, and does not address any other rule or interpretation of FINRA, or all the possible regulatory and legal issues involved.

If you have any questions regarding this memorandum, please contact Kosha K. Dalal, Associate Vice President and Associate General Counsel, Office of General Counsel, FINRA, at (202) 728-6903.