Notice To Members 95-56

NASD Files With The SEC Proposals Related To Non-Cash Incentive Programs, Disclosure Of Cash Compensation, And Direct Payments To Associated Persons

Published Date:

July 01, 1995

SUGGESTED ROUTING

Senior Management
Corporate Finance
Institutional
Legal & Compliance
Mutual Fund

Executive Summary

The NASD has filed with the Securities and Exchange Commission (SEC) a proposal to amend Article III, Sections 26 and 29 of the NASD Rules of Fair Practice to revise existing rules applicable to the sale of investment company securities and establish new rules applicable to the sale of variable contract securities. Following this Notice is the text of amendments to Sections 26 and 29 (Investment Companies Rule and Variable Contracts Rule, respectively), of Article III of the Rules of Fair Practice, as approved by the Board of Governors of the NASD and filed with the SEC. The rule amendments will not be effective until approved by the SEC.

Proposed New Rules

On March 24, 1995, the NASD filed with the SEC a proposed rule change in SR-NASD-95-10, to amend Sections 26 and 29 to Article III of the Rules of Fair Practice to revise existing rules applicable to the sale of investment company securities (Investment Company Rule) and establish new rules applicable to the sale of variable contract securities (Variable Contracts Rule). Notice to Members 94-67 solicited member comment on proposed amendments to Article III, Sections 26 and 29. In response to comments received, the NASD amended the rules originally published for comment.

The proposed rule change would:

specifically define "affiliated member," "cash compensation," "non-cash compensation," and "offeror";
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;
require that members maintain records of compensation received by the member or its associated persons from offerors;
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;
retain the prohibition, only with respect to the Investment Company Rule, against a member receiving compensation in the form of securities; and
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.

The exceptions from the non-cash compensation prohibition would permit:

gifts of up to $100 per associated person annually;
an occasional meal, ticket to a sporting event or theater, or entertainment for associated persons and their guests;
payment or reimbursement for training and educational 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;
in-house sales incentive programs of broker/dealers for their own associated persons;
sales incentive programs of mutual funds and insurance companies for the associated persons of an affiliated broker/dealer; and
contributions by any non-member company or other member to a broker/dealer's permissible in-house sales incentive program.

Focus On Point-Of-Sale Non-Cash Incentives

The NASD believes that the proposed rule change distinguishes between non-cash incentives that act at the point-of-sale to the investor and non-cash incentives which are earned on a delayed basis. Point-of-sale non-cash incentive programs reward an associated person only if they sell a certain number of shares of a specific mutual fund or variable contract. Such programs are more likely to influence (or at the least give the perception of influencing) the salesperson to sell a specific mutual fund or variable contract or the products of only one offeror and have the potential to undermine the supervisory control of the member over the sales practices of its associated persons.

In comparison, a non-cash incentive earned on a delayed basis rewards an associated person for the sale of any mutual fund or variable contract and only looks at total production—not production with respect to any specific mutual fund or mutual fund family, or variable contract security. Such delayed basis non-cash incentives do not influence the salesperson to recommend a specific mutual fund or variable contract or the products of only one offeror, permitting the associated person to focus on the best interests of the customer. The NASD's proposed rule change, therefore, limits non-cash sales incentives to situations where such non-cash incentives are earned on a delayed basis, because such situations 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 persons. Thus, the proposal results in the interests of the sales person being allied to that of the investor.

Disclosure Of Cash Compensation

The NASD is proposing to adopt as new Subsection 26(l)(4) in the Investment Company Rule the requirement currently in Subsection 26(l)(1)(C) that prohibits the acceptance of cash compensation by a member from an offeror unless such compensation is disclosed in the 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 will include the name of the recipient member and the details of the special arrangements.

The NASD is not proposing to amend the Variable Contracts Rule to adopt a similar prospectus disclosure requirement at this time. Unlike the Investment Company Rule, there is currently no provision in the Variable Contracts Rule requiring disclosure of compensation received by NASD members in connection with the distribution of variable contracts. 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. Further, the Investment Company Act of 1940 does not require such disclosure in the prospectus for variable life and annuity products. As a result, there is no practice for disclosure of any item of compensation in connection with variable life and annuity products, such as commissions and expense reallowances. The NASD believes that insurance companies would be required to make significant modifications to their automated systems to separate, in some manner, compensation for sales of securities products from total compensation for all insurance products.

The NASD has determined, therefore, that before requiring disclosure of all cash compensation for the sale of variable contract securities, more information should be gathered regarding the different kinds of compensation that are paid to broker/dealers for the sale of variable contract securities and the form of any required disclosure. The NASD intends to gather such information in the course of conducting its general study of cash compensation practices in connection with investment company and variable contract securities. It is anticipated that the NASD will develop rule proposals related to the treatment of cash compensation that will be filed with the SEC for approval prior to implementation.

Ministerial Exception Permitting Direct Payments

The NASD proposed rule changes also retain the current prohibition in the Investment Company Rule and adopt as a new requirement in the Variable Contracts Rule that a person associated with a member may not accept any compensation from any person other than the member with which the person is associated, except as permitted elsewhere in the proposed rules.

An exception from this general prohibition is proposed that would allow the receipt of commissions by an associated person directly from a non-member company if the arrangement is agreed to by the member, the receipt is treated as compensation received by the member for purposes of NASD rules, the recordkeeping requirement in the proposed rules is satisfied, and, the member relies on any appropriate rule, regulation, interpretive release or applicable "no-action" position issued by the SEC that applies to the specific fact situation of the arrangements. Also, the proposed rule change clarifies that the member must treat such direct payments to associated persons as compensation 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.

Operation Of Proposed Non-Cash Sales Incentive Prohibition

To provide guidance as to the operation of the non-cash sales incentive provisions of the proposed rules, following are examples of different non-cash incentive arrangements. A matrix is also attached that describes the relationship of the non-cash incentive provisions.

Example 1:

A member broker/dealer conducts a meeting for its associated persons. A non-cash sales incentive contest is used to determine the attendance.

Requirements: This arrangement would be permitted if it complies with the requirements of proposed Section 26(1)(5)(d) of the Investment Company Rule and Section 29(h)(3)(d) of the Variable Contracts Rule. The contest must be based on total sales of all investment company/variable contract products offered by the member broker/dealer and on total production for each associated person. Credit (points) toward the contest must be equally weighted for each security in the contest. Other entities (non-members or other members) may make contributions to the member broker/dealer for this inhouse incentive program, provided that the outside entity does not participate, directly or indirectly, in the member's organization of its noncash program. The outside entity would have no input into the conditions, qualifications, or restrictions placed on those attending. However, the outside entity would not be prohibited from providing a speaker for the meeting. Any cash contribution to the non-cash sales incentive program that is received by the dealer from an outside firm must be recorded on the dealer's books and records.

Example 2:

A non-member affiliate of a broker/dealer firm conducts a meeting attended by the associated persons of its affiliated broker/dealer. A non-cash sales incentive contest is used to determine attendance.

Requirements: Similar to the arrangement addressed in Example 1, the requirements of proposed Section 26(l)(5)(d) of the Investment Company Rule and Section 29(h)(3)(d) of the Variable Contracts Rule must be met. That is, the contest must include sales of all investment/variable contract products offered by the member broker/dealer. The contest must be based on total production for each associated person and credit (points) toward the contest must be equally weighted for each security included in the contest. However, other firms (non-members and other unaffiliated members) may not make contributions to or participate in the organization of the non-member affiliate's non-cash sales incentive program. This would not prevent such other firms from providing a speaker at the meeting. The receipt of the non-cash sales incentive by the associated persons of the affiliated broker/dealer must be recorded on the books and records of the affiliated member broker/dealer.

Example 3:

A member broker/dealer conducts a meeting solely for its associated persons. A non-cash sales incentive contest is not used to determine attendance.

Requirements: If no contributions are made by an outside firm toward a member broker/dealer's meeting costs, the member broker/dealer has no obligations to satisfy under the rule. Outside entities are permitted to participate in any manner, so long as there are no contributions or payments for any costs associated with the meeting by such outside entity. If an outside entity makes a contribution toward or reimburses costs of the meeting, the meeting must satisfy the conditions for a training or educational meeting, addressed in proposed Section 26(l)(5)(c) of the Investment Company Rule and Section 29(h)(3)(c) of the Variable Contracts Rule. That is, records must be kept of the names of the participating outside firms, the names of the associated persons attending the meeting, and the amount or nature of compensation. Only those associated persons with prior approval of the member broker/dealer may attend and attendance may not be conditioned by the member broker/dealer upon the achievement of a previously specified sales target or any other form of contest. The location of the meeting must be "appropriate" to the purpose of the meeting. Finally, only expenses of the member (or its associated persons) are eligible for payment. Expenses for guests of associated persons may not be reimbursed and payment may not be conditioned by the outside entity on sales or the promise of sales by the dealer or its associated persons.

Example 4:

A non-member affiliate of a member broker/dealer conducts a meeting solely for the associated persons of its affiliated broker/dealer. A noncash sales incentive contest is not used to determine attendance.

Requirements: As per proposed Section 26(l)(5) of the Investment Company Rule and Section 29(h)(3) of the Variable Contracts Rule, an outside entity may not make a contribution toward or reimburse costs of the meeting. The meeting must satisfy the conditions for a training or educational meeting as noted in proposed Section 26(l)(5)(c) of the Investment Company Rule and Section 29 (h)(3)(c) of the Variable Contracts Rule.

Example 5:

A member broker/dealer conducts a meeting for the associated persons of another broker/dealer.

Requirements: A non-cash sales incentive contest is prohibited. The conditions for a training or educational meeting must be satisfied as per proposed Section (l)(5)(c) of the Investment Company Rule and Section (h)(3)(c) of the Variable Contracts Rule.

This Notice provides the text of the proposed rules as filed with the SEC. It is anticipated that changes to the rule language may be made in response to comments of SEC staff and the public. This Notice does not, therefore, represent a definitive discussion of the NASD's proposed rule change. A copy of SR-NASD-95-10 is available from the SEC's Public Reference Room. Members should also note that the SEC will be publishing this proposal for comment.

Questions concerning this Notice should be directed to Clark Hooper, Vice President, Advertising/ Investment Companies Regulation Department, at (202) 728-8325; Suzanne E. Rothwell, Associate General Counsel, Office of General Counsel, at (202) 728-8247; and Robert J. Smith, Attorney, Office of General Counsel, at (202) 728-8167.

Text Of Proposed Amendments To The Investment Company Rules And Variable Contract Rules

Article III

Rules of Fair Practice

(Note: New text is underlined; deletions are bracketed.)

Investment Companies

Sec. 26.

Application

(a) No change.

Definitions

(b)

(1) through (6) No change.

[(7) "Associated person of an underwriter," as used in subsection (1) of this section, 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", "cash compensation", "non–cash compensation", and "offeror" as used in Subsection (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.

"Cash compensation" shall mean any discount, concession, fee, commission, asset–based sales charge, loan, or override 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, and payment of 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.

(8) through (10) No change.

[Dealer concessions]

[(l)(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 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 (1)(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.]

Member Compensation

(l) 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, cash or non–cash, from anyone other than the member with which the person is associated. This requirement will not prohibit arrangements where a 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 Subsection (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 Subsections (l)(5)(a) and (b), a member shall maintain records of all compensation, cash and non–cash, 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, and the amount of cash, and the value or nature 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 any non–cash compensation offered or provided to such member or its associated persons, except as provided in this provision. Notwithstanding the provisions of Subsection (l)(1), the following items of non–cash compensation may be accepted:

(a) Gifts to associated persons of members that do not exceed an annual amount per person fixed periodically by the Board of Governors¹ and are not preconditioned on achievement of a previously specified sales target.

(b) 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 and is not preconditioned on achievement of a previously specified 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 Subsection (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 based by the member on the achievement of a previously specified sales target or any other non–cash compensation arrangement permitted by paragraph (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 conditioned by the offeror on the achievement of a previously specified sales target or any other non–cash compensation arrangement permitted by paragraph (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 Subsection (l)(3) is satisfied.

(e) Contributions by a non–membercompany or other member to a non– cash compensation arrangement between a member and its associated persons, provided that the arrangement meets the criteria in paragraph (d).

Variable Contracts of an Insurance Company

Sec. 29.

Application

(a) No change.

Definitions

(b)

(1) through (2) No change.

(3) The terms "affiliated member", "cash compensation", "non–cash compensation" and "offeror as used in Subsection (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.

"Cash compensation" shall mean any discount, concession, fee, commission, loan or override 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, and payment of travel expenses, meals and lodging.

"Offeror" shall mean a separate account of an insurance company, an adviser to a separate account of an insurance company, an underwriter and any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such entities.

Member Compensation

(h) In connection with the sale and distribution of variable contracts:

(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 commission checks is treated as compensation received by the member for purposes of NASD rules; and

(d) the recordkeeping requirement in Subsection (l)(2) is satisfied.

(2) Except for items as described in Subsections (h)(3)(a) and (b), a member shall maintain records of all compensation, cash and non–cash, 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, and the amount of cash, and the value or nature of non–cash compensation received.

(3) No member or person associated with a member shall directly or indirectly accept any non–cash compensation offered or provided to such member or its associated persons, except as provided in this provision. Notwithstanding the provisions of Subsection (h)(1), the following items of non–cash compensation may be accepted:

(a) Gifts to associated persons of members that do not exceed an annual amount per person fixed periodically by the Board of Governors² and are not preconditioned on achievement of a previously specified 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 Subsection (h)(2) is satisfied;

(iv) the payment or reimbursement is not applied to the expenses of guests of the associated person; and

(i) the member's or non–member's non–cash compensation arrangement, if it includes variable contract securities, is based on the total production of associated persons with respect to all variable contract securities distributed by the member; (ii) the non–cash compensation arrangement requires that the credit received for each variable contract security is equally weighted;

(iv) the recordkeeping requirement in Subsection (h)(2) is satisfied.

¹ The current annual amount fixed by the Board of Governors is $100.

² The current annual amount fixed by the Board of Governors is $100.

REQUIREMENTS FOR NON-CASH SALES INCENTIVE PROGRAMS

						TRAINING/EDUCATIONAL MEETING REQUIREMENTS
EXAMPLE	CONTEST Include sales of All IC/VC Products Based on Total Production Credits are Equally Weighted Consistently Across Vendors	OUTSIDE CONTRIBUTIONS ALLOWED Must be booked and recorded	OUTSIDE PARTICIPATION IN STRUCTURE OF MEETING REQUIREMENTS	OUTSIDE SPEAKER ALLOWED	RECORD-KEEPING	ATTENDANCE CONTROLLED BY MEMBER AND NOT CONDITIONED ON SALES TARGET	LOCATION APPROPRIATE	PAYMENTS BY OUTSIDE FIRM ONLY FOR ASSOCIATED PERSONS AND NOT CONDITIONED ON SALES TARGET
#1 – In-house meeting held by dealer with non-cash sales incentive program	YES	YES	PROHIBITED	YES	YES	N/A	N/A	N/A
#2 – In-house meeting held by non-member affiliate with non-cash sales incentive program	YES	PROHIBITED	PROHIBITED	YES	YES	N/A	N/A	N/A
#3 – In-house meeting held by dealer without non-cash sales incentive program
(a) if outside contributions accepted	N/A	YES	NO	YES	YES	YES	YES	YES
(b) if outside contributions NOT accepted	N/A	N/A	N/A	YES	NO	N/A	N/A	N/A
#4 – In-house meeting held by non-member affiliate without non-cash sales incentive program	N/A	PROHIBITED	PROHIBITED	YES	YES	YES	YES	YES
#5 – Training or educational meeting held by outside firm for associated persons of another member	PROHIBITED	YES	YES	YES	YES	YES	YES	YES