[Federal Register Volume 62, Number 48 (Wednesday, March 12, 1997)]
[Notices]
[Pages 11510-11511]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-6197]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38369; File No. SR-NASD-96-39]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change Amending the 
Requirements for the Use in Advertisements and Sales Literature of 
Investment Company Rankings

March 5, 1997.

I. Introduction

    On October 17, 1996,\1\ the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association'') submitted to the Securities 
and Exchange Commission (``Commission''), pursuant to Section 19(b)(1) 
of the Securities Exchange Act of 1934 (``Act'') \2\ and Rule 19b-4 
thereunder,\3\ a proposed rule change to amend the requirements for the 
use in advertisements and sales literature of investment company 
rankings.
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    \1\ On November 21, 1996, the NASD filed Amendment No. 1 with 
the Commission. The amendment clarified that rankings based on yield 
may be based on periods of less than one year. The amendment also 
made technical amendments to the text of the rule. See Letter from 
John Ramsay, Deputy General Counsel, NASD Regulation, Inc. to 
Katherine A. England, Assistant Director, Division of Market 
Regulation, Commission, dated November 20, 1996.
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
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    Notice of the proposed rule change as amended, together with the 
substance of the proposal, was published for comment in Securities 
Exchange Act Release No. 37987 (November 25, 1996), 61 FR 64185 
(December 3, 1996) (``Notice''). Four comment letters were received on 
the proposal. This order approves the proposed rule change.

II. Description

    In 1994, the Commission approved what is now IM-2210-3 of the NASD 
Conduct Rules, which provides guidelines for the use of rankings in 
investment companies' advertisements and sales literature 
(``Guidelines'').\4\ Among other things, the Guidelines require that 
all rankings used in advertising and sales literature by member firms 
to promote non-money market mutual fund performance include rankings 
over one, and, if available, five and ten year periods. Prior to the 
guidelines, there were no specific standards for the use of rankings. 
Members generally had selected rankings for whatever time period 
produced the most favorable rankings for an investment company.
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    \4\ Securities Exchange Act Release No. 34354 (July 12, 1994), 
59 FR 36461 (July 18, 1994).
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    Since the approval of the Rankings Guidelines, the staff of NASD 
Regulation, Inc. (``NASDR'') has considered whether to allow for 
greater flexibility in the use of time periods other than those 
prescribed by the Guidelines. The staff noted that some rankings, which 
are based on adjusted total return to reflect criteria and 
methodologies established and imposed by the ranking entities, use time 
periods that do not meet the three specifically prescribed time periods 
contained within the Guidelines.\5\ NASDR staff determined that the 
Guidelines, as originally approved, should be revised consistent with 
the original goal that would prevent selectivity of time periods. The 
NASD filed a proposed rule change to IM-2210-3 \6\ of the NASD's 
Conduct Rules to allow for the use in advertisements and sales 
literature of investment company rankings that represent short, medium 
and long term performance.
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    \5\ For example, one ranking entity has developed a ranking 
system that summarizes an investment company's risk/reward profile 
for three, five, and ten year periods. This system provides a 
composite ranking that seeks to measure how well an investment 
company has balanced return and risk in the past.
    \6\ NASD Manual, Conduct Rules, Interpretative Material of the 
Rules of the Association (CCH), IM-2210-3.
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    The rule change revises subparagraphs (2) (B) and (C) to paragraph 
(d) of IM-2210-3. The rule change clarifies that the use of one, five 
and ten year time periods is required if such time periods are 
published by the ranking entity.\7\ If rankings for the required time 
periods are not published by the ranking entity, the rule change 
provides that rankings representing short, medium and long term 
performance must be provided in place of rankings for the required time 
periods.\8\
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    \7\ The Guidelines define ``Ranking Entity'' as ``* * * any 
entity that provides general information about investment companies 
to the public, that is independent of the investment company and its 
affiliates, and whose services are not procured by the investment 
company or any of its affiliates to assign the investment company a 
ranking.''
    \8\ In its discussions of how the terms ``short,'' ``medium'' 
and ``long term'' might be interpreted, NASDR staff considered time 
frames of 1-4 years, 5-9 years and 10 years or more, respectively, 
as an acceptable interpretation.
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    The rule change also replaces the phrase ``in the category'' in 
subparagraphs (2) (B) and (C) with the phrase ``relating to the same 
investment category,'' to clarify that when members provide rankings 
for advertisements and sales literature, rankings for the prescribed 
time periods must be for the same investment category or subcategory as 
the total return ranking that is being accompanied by the prescribed 
ranking.

III. Summary of Comments

    The Commission received four comment letters, three of which 
supported the proposed rule change, and one that did not, and a 
response to the comment letters.\9\ The comment letter from Lipper 
Analytical Services, Incorporated (``Lipper'') divides its criticisms 
into several different areas. Lipper stresses the importance of having 
one, five and ten year performance periods as a way to stop ranking 
companies from ``cherry picking'' performance periods in order to 
maximize attractiveness of the funds. Lipper believes that the fact 
that some funds do not have one, five or ten year histories is 
sometimes very important to investors and that lowering the 
``barriers'' will not alert the investor to the potential of an 
unseasoned mutual fund.
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    \9\ See letters to Jonathan G. Katz, Secretary, SEC, from Banc 
One Corporation, Investment Company Institute, and Morningstar, 
Incorporated, dated December 24, 1996, December 24,1996, and 
December 20, 1996 respectively; letter to Margaret H. McFarland, 
Deputy Secretary, SEC, from Lipper Analytical Services, 
Incorporated, dated December 23, 1996; and letter to Katherine A. 
England, Assistant Director, Market Regulation, SEC, from John 
Ramsay, Deputy General Counsel, NASDR, dated January 23, 1997 
(``NASDR letter'').
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    Lipper next addresses the validity of the categories of funds that 
are ranked. Lipper says that funds with similar investment 
characteristics should be compared to each other but that comparing 
dissimilar funds could be misleading. In addition, Lipper argues that 
the one year measure is important to investors who may want to know the 
short term performance of a fund and to different mutual fund 
participants who may have different time requirements. Lipper adds that 
all performance based advertising, including returns, rankings and 
ratings, should be on the same basis. Lipper also argues against the 
use of a single number that represents risk for an investment company, 
saying that investors do not believe there can be a useful single 
measure of risk. Any measure that involves the use of the word ``risk'' 
should have an explanation of the calculation procedures. Lipper says 
that any measure that compares funds with securities indices and other 
indices risks comparing unlike entities. Last, Lipper agrees that there 
should be some improvement in the disclosure of fund advertising to 
investors, and suggests that performance of funds should be measured in 
rising and falling market conditions.
    The comment letter from the Investment Company Institute (``ICI''),

[[Page 11511]]

although in support of the proposed rule change, has two comments on 
the content of the filing. The ICI states that is does not believe that 
the NASDR's suggestions of 1-4 years, 5-9 years and 10 years or more 
\10\ are intended as definitions of short, medium and long, but rather 
as an interpretation by the NASDR staff of the relative lengths of time 
for each period. In addition, ICI states that the rule change does not 
explicitly address whether a NASD member could use a short or medium 
term ranking for a fund that has been in existence for at least one or 
at least five years and for which rankings for the specified time 
periods are not published by the ranking entity, but it supports that 
result.
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    \10\ The Commission notes that the correct time period suggested 
by the NASD was 5-9 years for he medium time period and that a 
mistake was made in the Notice, which reads ``5-5 years.''
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IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with Section 15A(b) of the Act and the rules and regulations 
thereunder, and, in particular, with the requirements of Section 
15A(b)(6)\11\ that the rules of an association be designed to promote 
just and equitable principles of trade, to prevent fraudulent and 
manipulative acts, and, in general, to protect investors and the 
public. The rule change provides a flexible framework within which 
ranking entities using different methodologies can provide useful 
information to investors in a way that is not harmful or misleading and 
that still prevents selectivity of time periods. The Commission 
believes that performance-adjusted rankings which use different time 
periods than those prescribed by the Guidelines can help investment 
company investors make informed investment decisions if presented in a 
way that is not misleading.
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    \11\ 15 U.S.C. 78o-3
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    The Commission believes that a concern about selectivity of time 
periods is adequately addressed by the rule change. The Commission 
notes that under the proposed rule change, short, medium and long-term 
rankings can only be used if one, five and ten year rankings are not 
available. The Commission also notes that short, medium and long term 
rankings are still uniform in nature and do not allow Ranking Entities 
to randomly choose any time periods they want.
    Lipper raises a valid concern about only comparing similar funds, 
but the Commission believes that concern is addressed by the proposed 
rule change. The rule change clarifies language in the rule by stating 
that rankings for prescribed time periods must be ``* * * by the same 
Ranking Entity, relating to the same investment category, and based on 
the same time period.'' The NASD, further clarifying the ``relating to 
the same investment category'' language, stated that rankings for the 
prescribed time period must be for the same investment category or 
subcategory as the total return ranking that is being accompanied by 
the prescribed ranking.\12\
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    \12\ See Notice and NASDR letter.
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    The Commission notes Lipper's concern that a one year performance 
ranking is important to investors who want to know the short-term 
performance of a fund. The Commission believes that this concern is 
adequately addressed by the requirement that one, five and ten year 
time periods must be used if they are published by the ranking 
entity.\13\ The Commission also believes that Lipper's concern that 
different mutual fund participants have different time requirements is 
addressed by the proposed rule change in that it now permits the use of 
time periods other than one, five and ten years in certain 
instances.\14\
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    \13\ See NASDR letter.
    \14\ The Commission believes that the concern about risk-based 
rankings is not relevant to this proposed rule change because this 
filing does not deal with the method of calculating the performance-
based rankings themselves, other than the length of time over which 
the rankings must be calculated. The Commission also believes that 
the suggestion that performance should be measured over rising and 
falling market conditions is not relevant to this proposed rule 
filing because this filing is concerned with the length of the time 
period for measuring performance.
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    The Commission also realizes that there may be instances where non-
disclosure of certain factors could cause the use of a ranking to be 
misleading, notwithstanding that the ranking is in technical compliance 
with the Ranking Guidelines.\15\ NASD recognized these concerns and 
stressed that NASD rules governing communications with the public 
require that all advertising and sales literature submitted for review 
not be misleading,\16\ and that those rules give the NASDR broad 
authority to prohibit the use of the misleading ranking.\17\
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    \15\ For example, if a one-year ranking is used that coincides 
with the tenure at the firm of a particular fund manager, the fact 
that the fund manager has changed could be relevant. Similarly, if a 
three-year ranking is used that encompasses a change in fund 
managers at the firm, the fact that the ranking covers a period with 
more than one fund manager could be relevant.
    \16\ NASD Conduct Rule 2210(d)(1)(A) states that ``[a]ll member 
communications with the public should provide a sound basis for 
evaluating the facts in regard to any particular security * * *. No 
material fact or qualification may be omitted if the omission * * * 
would cause the advertising or sales literature to be misleading.'' 
NASD Conduct Rule 2210(d)(1)(B) further states that ``[e]xaggerated, 
unwarranted or misleading statements or claims are prohibited in all 
public communications of members.''
    \17\ See Amendment #1, filed November 21, 1996 and NASDR letter.
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V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (SR-NASD-96-39) is approved.

    \18\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-6197 Filed 3-11-97; 8:45 am]
BILLING CODE 8010-01-M