[Federal Register Volume 63, Number 216 (Monday, November 9, 1998)]
[Notices]
[Pages 60431-60435]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-29970]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40627; File No. SR-NASD-97-89, Amendment No. 1]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Bond Mutual Fund Volatility Ratings

November 2, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on December 12, 1997, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') through its wholly-owned subsidiary, 
the NASD Regulation, Inc. (``NASD Regulation'' or ``NASDR'') filed with 
the Securities and Exchange Commission (``SEC'' or ``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by NASD Regulation. On October 5, 1998, NASDR 
filed Amendment No. 1 which replaces and supersedes the initial 
proposal.\3\ The Commission is publishing this notice to solicit 
comments on the proposed rule change, as contained in Amendment No. 1, 
from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On December 12, 1997, the NASDR submitted its initial 
proposal which could have limited the effectiveness of the 
disclosure statement and prevented sales literature from containing 
relevant explanatory information concerning bond mutual fund 
volatility ratings. After discussions between NASDR and the 
Commission, the NASDR filed Amendment No. 1 on October 5, 1998. The 
revised proposal will: (1) permit ratings to be provided by non-
NRSROs; (2) permit funds to provide additional information in the 
disclosure statement if the information would help investors 
understand the rating; (3) permit funds to combine information about 
different ratings when the information is the same for each rating; 
(4) clarify the prohibition against using ratings that are based on 
subjective factors; and (5) require the use of the most recently 
issued rating.

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[[Page 60432]]

I. Self-Regulatory Organizations Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation is proposing rules that add a new interpretation to 
Rule 2210 of the Conduct Rules of the NASD to permit the use by members 
and associated persons of bond mutual fund volatility ratings in 
supplemental sales literature on an interim 18 month pilot basis. 
Proposed new language is in italics.

IM-    . Requirements for the Use of Bond Mutual Fund Volatility 
Ratings

(This rule will expire on [18 months from approval], unless extended or 
permanently approved by the Association at or before such date)

(a) Definition of Bond Mutual Fund Volatility Ratings

    For purposes of this Rule and any interpretation thereof, the term 
``bond mutual fund volatility rating'' is a description issued by an 
independent third party relating to the sensitivity of the net asset 
value of a bond mutual fund portfolio to changes in market conditions 
and the general economy, and is based on an evaluation of objective 
factors, including the credit quality of the fund's individual 
portfolio holdings, the market price volatility of the portfolio, the 
fund's performance, and specific risks, such as interest rate risk, 
prepayment risk, and currency risk.

(b) Prohibitions on Use

    Members and persons associated with a member may use a bond mutual 
fund volatility rating only in supplemental sales literature and only 
when the following requirements are satisfied:
    (1) The rating does not identify or describe volatility by use of a 
single symbol, number or letter, and the rating is not described as a 
``risk'' rating.
    (2) The supplemental sales literature incorporates the most 
recently available rating and reflects information that, at a minimum, 
is current to the most recently completed calendar quarter ended prior 
to use.
    (3) The criteria and methodology used to determine the rating must 
be based exclusively on objective, quantifiable factors. Any other 
factors, such as an analysis of investment philosophy or quality of the 
fund's management, may be considered solely for purposes of determining 
whether to issue the rating. The rating and the Disclosure Statement 
that accompanies the rating must be clear, concise, and understandable.
    (4) The supplemental sales literature conforms to the disclosure 
requirements described in paragraph (c).
    (5) The entity that issued the rating provides detailed disclosure 
on its rating methodology to investors through a toll-free telephone 
number, a web site, or both.

(c) Disclosure Requirements

    (1) Supplemental sales literature containing a bond mutual fund 
volatility rating shall include a Disclosure Statement containing all 
the information required by this Rule. The Disclosure Statement may 
also contain any additional information that is relevant to an 
investor's understanding of the rating.
    (2) Supplemental sales literature containing a bond mutual fund 
volatility rating shall contain all current bond mutual fund volatility 
ratings that have been issued with respect to the fund. Information 
concerning multiple ratings may be combined in the Disclosure 
Statement, provided that the applicability of the information to each 
rating is clear.
    (3) All bond mutual fund volatility ratings shall be contained 
within the text of the Disclosure Statement. The following disclosures 
shall be provided with respect to each such rating:
    (A) the name of the entity that issued the rating;
    (B) the most current rating and date of the current rating, with an 
explanation of the reason for any change in the current rating from the 
most recent prior rating;
    (C) a description of the rating in narrative form, containing the 
following disclosures:
    (i) a statement that there is no standard method for assigning 
ratings;
    (ii) a description of the criteria and methodologies used to 
determine the rating;
    (iii) a statement that not all bond funds have volatility ratings;
    (iv) whether consideration was paid in connection with obtaining 
the issuance of the rating;
    (v) a description of the types of risks the rating measures (e.g., 
short-term volatility);
    (vi) a statement that the portfolio may have changed since the date 
of the rating; and
    (vii) a statement that there is no guarantee that the fund will 
continue to have the same rating or perform in the future as rated.
* * * * *
2200. Communications With Customers and the Public
2210. Communications With the Public
* * * * *
(c) Filing Requirements and Review Procedures
* * * * *
    (3) Sales literature concerning bond mutual funds that include or 
incorporate bond mutual fund volatility ratings, as defined in Rule IM-
__, shall be filed with the Department for review at least 10 days 
prior to use (or such shorter period as the Department may allow in 
particular circumstances) for approval and, if changed by the 
Association, shall be withheld from publication or circulation until 
any changes specified by the Association have been made or, if 
expressly disapproved, until the sales literature has been refiled for, 
and has received, Association approval. Members are not required to 
file advertising and sales literature which have previously been filed 
and which are used without change. The member must provide with each 
filing the actual or anticipated date of first use. Any member filing 
sales literature pursuant to this paragraph shall provide any 
supplemental information requested by the Department pertaining to the 
rating that is possessed by the member.\4\
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    \4\ NASDR proposes to add this language to the existing test of 
Rule 2210(c). The existing sections of this rule will remain 
unchanged and will be renumbered, beginning with Rule 2210(c)(3)(A). 
Telephone conversation between Robert J. Smith, Office of General 
Counsel, NASD Regulation, Inc., and Mignon McLemore, Division of 
Market Regulation, Commission, on October 30, 1998.
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* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASDR included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. NASDR has prepared summaries, set forth in Sections A, 
B, and C below, of the most significant aspects of such statements.

A. Regulatory Organization's Statement of the Purpose of, and Statutory 
Basis for, the Proposed Rule Change

Background
    Bond mutual fund volatility ratings are descriptions of the 
sensitivity of bond mutual fund portfolios to changing market 
conditions. The rating agencies and information vendors that issue such 
ratings are not NASD member firms, and mutual fund groups that purchase 
the ratings use them for promotional and

[[Page 60433]]

marketing purposes. NASD rules do not apply to the use and 
dissemination of bond mutual fund volatility ratings by non-members.
    Currently, NASD Regulation interprets its rules to prohibit the use 
by members and associated persons of bond mutual volatility ratings in 
supplemental sales literature. The prohibition is based on the analysis 
that judgments of how a bond mutual fund may react to changes in 
various market conditions may be predictive of fund performance or 
misleading and, therefore, prohibited for use by members and associated 
persons in sales literature.\5\
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    \5\ NASD Conduct Rule 2210 prohibits the use by members and 
associated persons of information that is misleading, that contains 
exaggerated, unwarranted or misleading statements or claims, or that 
predicts or projects investment results.
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    In Notice to Members 96-84 (December 1996) (``NTM 96-84''), NASD 
Regulation requested comment on the appropriations of its current 
prohibition. A majority of the commenters supported making the ratings 
available, and all of the commenters representing investor groups 
supported the goal of making accurate information regarding risk and 
volatility characteristics of bond funds available to investors.
    On April 30, 1997, the Legal Advisory Board of the NASD (``LAB'') 
reviewed and discussed bond fund volatility ratings. NASD Regulation 
staff proposed to the LAB that an alternative to the current 
prohibition would be permitting the use of bond fund volatility ratings 
subject to appropriate guidelines. After extended discussion, the LAB 
favored allowing volatility ratings to be used subject to guidelines 
containing sufficient prohibitions and disclosure requirements.
    At its September 1997 Board meeting, NASD Regulation considered 
issues regarding bond mutual fund volatility ratings and adopted 
resolutions: (i) Affirming that investors can benefit from the 
availability of such information, (ii) directing the staff to draft 
bond fund volatility rating regulatory proposals to best serve the 
public interest and address the differences among interested parties, 
for presentation at the November Board meeting, and (iii) appointing 
Directors Theodore A. Levine and A.A. Sommer, Jr. (``Subcommittee'') to 
assist the staff in this effort. After the September Board meeting, 
NASD Regulation staff and the Subcommittee met and worked to reach a 
solution that was sensitive to and reflective of the concerns and 
differences of all interested parties.
    At its November 1997 Board meeting, NASD Regulation approved: (i) A 
modification to NASD Regulation's current prohibition on the use of 
bond mutual fund volatility ratings in supplemental sales literature to 
permit such use by members and associated persons according to proposed 
rules designed to prevent such ratings from being misleading, 
predictive, or otherwise inappropriate, and (ii) the submission of the 
proposed rules to the SEC for approval.
    At its December 1997 Board meeting, the NASD ratified the NASD 
Regulation Board's approval of the proposed rules, without change, and 
their submission to the SEC for approval.
    At its August 1998 Board Meeting, NASD Regulation approved 
amendments to the proposed rule change as originally filed with the 
SEC, and the submission of the amendments to the SEC for approval. The 
amendments, incorporated in this submission: (i) Delete the requirement 
that ratings be issued exclusively by nationally recognized statistical 
rating organizations; (ii) add the requirement that the rating and the 
Disclosure Statement be clear, concise, and understandable; (iii) 
permit the Disclosure Statement to contain any additional information 
that is relevant to an investor's understanding of the rating; (iv) 
permit repetitive information in multiple ratings for the same fund to 
be combined in the Disclosure Statement, provided the applicability of 
the information to each rating is clear; and (v) delete the requirement 
to use a ``Required Disclosure Statement.''
Description
    Trial Period. The proposed rule change would permit, on an 18-month 
pilot basis, the use of the ratings in conformance to rules that 
prohibit the use of ratings unless certain requirements and disclosures 
are met. After the 18-month trial term, the rules would be evaluated to 
determine their efficacy in ensuring that comprehensible and useful 
information is provided to investors, and in preventing the 
dissemination of inappropriate or misleading information by members and 
associated persons. After the evaluation, the staff will consider all 
options, including prohibiting the use of ratings, permitting their use 
or permitting their use with modifications to the rule.
    Definition of Bond Mutual Fund Volatility Rating. Paragraph (a) of 
the proposed rule change defines the term ``bond mutual fund volatility 
rating'' to mean, in part, a description issued by an independent third 
party relating to the sensitivity of a bond mutual fund's net asset 
value to changes in market conditions and the general economy, based on 
an evaluation of objective factors regarding the fund's current 
characteristics and its past performance. The definition recognizes 
that the rating is an opinion of a fund's potential share price 
movement in response to various economic conditions or market 
situations, and not a prediction of the actual movement of a fund's 
share price. The definition applies only to bond mutual fund volatility 
ratings provided by an independent third party. However, NASD 
Regulation understands that many mutual fund complexes currently 
provide various descriptions of risk and volatility for their own 
funds. These descriptions may involve some of the same processes and 
considerations that are used by independent rating agencies. NASD 
Regulation specifically solicits comment on whether such descriptions 
are similar in derivation and purpose to ratings that are issued by 
independent agencies, and whether their use in supplemental sales 
literature by members and their associated persons should also be 
subject to the provisions of the proposed rule change.
    Prohibitions. Subparagraph (b) of the proposed rule change permits 
members and associated persons to use a bond mutual fund volatility 
rating only in supplemental sale literature and only when certain 
requirements are satisfied.
    Subparagraph (b)(1) of the proposed rule change prohibits the use 
of a bond mutual fund volatility rating that identifies or describes 
volatility by use of a single symbol, number or letter. At the same 
time, the proposed rules refrain from imposing a specific standard on 
descriptions or calculations in recognition of the fact that there is 
no specified or uniform range of information used by all rating 
entities, and that rating entities should be free to develop completing 
methods and models of assessing volatility. Subparagraph (b)(1) also 
prohibits the use of a bond mutual fund volatility rating that uses the 
word ``risk'' to describe the rating. Because the word ``risk'' is 
capable of multiple meanings and interpretations, NASD Regulation 
believes that it is more accurate to refer to such ratings as 
``volatility'' rather than ``risk'' ratings.
    Subparagraph (b)(2) of the proposed rule change prohibits the use 
of a bond mutual fund volatility rating that does not incorporate the 
most recently available rating and is not current to the most recent 
calendar quarter ended prior to use. This prohibition is intended to 
ensure that stale or dated

[[Page 60434]]

ratings are not provided to investors and reflects a common denominator 
time frame that can be used by rating entities currently to update 
their ratings.
    Subparagraph (b)(3) of the proposed rule change prohibits the use 
of a bond mutual fund volatility rating that is not based exclusively 
on objective, quantifiable factors. Non-quantifiable, subjective 
factors, such as an analysis of investment philosophy and quality of 
the fund's management \6\ could be considered solely for purposes of 
determining whether to issue the rating. Eliminating subjectivity from 
the volatility calculation reduces the potential variability of 
ratings, and thus helps eliminate the ability of funds to ``shop 
around'' for the most favorable rating.
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    \6\ Volatility or risk rating analysis has been described as 
being comprised of three elements: (i) an analysis of the effective 
duration of the fund's current portfolio--i.e., the sensitivity of 
the current portfolio to interest rate changes, (ii) a comparison of 
the historical risk profile of the bond fund with the risk of its 
current portfolio, and (iii) an assessment of the fund manager's 
policies and management style, including whether management has 
established policies and systems that comport with stated objectives 
for the fund, including levels of risk.
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    Subparagraph (b)(3) of the proposed rule change also requires that 
the rating and the Disclosure Statement that accompanies it be clear, 
concise, and understandable. This addresses the need to deliver the 
rating information in a way that is accessible and informative.
    Subparagraph (b)(4) of the proposed rule change prohibits the use 
of bond mutual fund volatility rating unless the supplemental sales 
literature containing the rating conforms to the disclosure 
requirements.
    Subparagraph (b)(5) of the proposed rule change prohibits the use 
of a bond mutual fund volatility rating unless the entity that issued 
the ratings provides detailed disclosure on its rating methodology to 
investors through a toll-free telephone number, a web site, or both. 
NASD Regulation believes that access to such supplemental information 
will enable investors to obtain answers to question regarding the 
meaning of the rating or how it is calculated or derived.
    Disclosure Requirements. Paragraph (c) of the proposed rule change 
requires that certain disclosures accompany any bond mutual fund 
volatility rating used in supplemental sales literature by members or 
associated persons of members.
    Subparagraph (c)(1) requires that supplemental sales literature 
containing a bond mutual fund volatility rating include a Disclosure 
Statement containing all the information required by the rule, but also 
permits the Disclosure Statement to contain any additional information 
that is relevant to an investor's understanding of the rating. 
Permitting the Disclosure Statement to contain additional relevant 
information could help explain the meaning of the rating. In 
particular, supplemental sales literature that contains multiple 
ratings could benefit from additional information that could 
distinguish and clarify different methodologies and measurements of 
volatility.
    Subparagraph (c)(2) requires that supplemental sales literature 
containing a bond fund volatility rating contain all other current 
volatility ratings that have been issued with respect to the same fund. 
Subparagraph (c)(2), however, permits information concerning multiple 
ratings to be combined in the Disclosure Statement, provided that the 
applicability of the information to each rating is clear. This serves 
the purpose of avoiding redundant and potentially confusing 
information, and reduces the possibility that the rating could be 
buried or hidden in excess information.
    Subparagraph (c)(3) requires that all bond mutual fund volatility 
ratings be contained within the text of the Disclosure Statement. NASD 
Regulation believes it is important that the rating not be located 
separately from the Disclosure Statement to avoid the danger that 
either could be read separately, or not at all, which would increase 
the possibility that the rating would not be understood in the context 
of the required disclosures.
    Subparagraphs (c)(3)(A)-(B) of the proposed rule change require 
that supplemental sales literature containing a bond mutual fund 
volatility rating disclose the name of the rating entity, the most 
current rating accompanied by the date of the rating and, if there is 
any change in the current rating from the most recent prior rating, an 
explanation of the change. NASD Regulation believes it is important for 
investors to see how a fund's rating may have changed and understand 
the reasons for the change.
    Subparagraph (c)(3)(C) of the proposed rule change requires that 
supplemental sales literature containing a bond mutual fund volatility 
rating describe the rating in narrative form. Under subparagraphs 
(c)(3)(C)(i)-(vii), the narrative description must also include: (i) a 
statement that there is no standard method for assigning ratings; (ii) 
a description of the criteria and methodologies used to determine the 
rating; (iii) a statement that not all bond funds have volatility 
ratings; (iv) whether consideration was paid in connection with 
obtaining the issuance of the rating; (v) a description of the types of 
risks the rating measures, such as short-term volatility, for example; 
(vi) a statement that there is no guarantee that the fund will continue 
to have the same rating or perform in the future as rated.
    The disclosures required by subparagraphs (c)(3)(C)(i)-(vii) help 
inform investors of certain potential limitations of a rating (i.e., 
that a rating may have been paid for, may measure only a certain type 
of risk or volatility, may not reflect a comparison with all funds of a 
given class or peer group, and may not be current).
    NASDR intends to include in the NTM that will accompany publication 
of the final rule the following Disclosure Statement as a sample to 
assist members in drafting Disclosure Statements that comply with the 
requirements of the rule:

    The volatility rating for this fund issued by [XYZ rating 
entity] (``XYZ'') is [insert narrative rating]. The rating seeks to 
measure [description of what risks the rating measures, e.g., ``how 
the value of the fund's current portfolio might respond to changing 
market conditions'']. XYZ arrived at his rating in the following 
way: [insert description of methodology]. There is no standard 
method for determining volatility ratings. The rating is current as 
of [date]. The fund's portfolio may have changed since this date and 
there is no guarantee that the fund will continue to have the same 
rating or perform in the future as rated. Not all bond mutual funds 
have volatility ratings and those that do may have paid for them. 
The fund [paid for][did not pay for] the volatility rating issued by 
XYZ. The fact that a fund has a rating is not an indication that it 
is more or less risky or volatile than a fund that does not. If you 
would like more specific information on the rating or the 
methodology used to determine the rating, call XYZ at 1-800-000-000 
or visit XYZ's web site address at www.[address].

    Filing Requirement. The proposed rule change amends NASD Rule 2210 
regarding communications with the public by adding new subparagraph 
(c)(3) to require sales literature containing bond mutual fund 
volatility ratings to be filed with the Advertising Regulation 
Department for review and approval at least 10 days prior to use. 
Members would not be required to file advertising and sales literature 
which had previously been filed and approved, and used without change. 
Members filing sales literature containing bond mutual fund sales 
literature also must provide any supplemental information requested by 
the Department pertaining to the rating that is possessed by the 
member.
    NASD Regulation believes that the proposed rule change is 
consistent with

[[Page 60435]]

the provisions of Section 15A(b)(6) \7\ of the Act, which require that 
the Association adopt and amend its rules to promote just and equitable 
principles of trade, and generally provide for the protection of 
investors and the public interest. The proposed rule change, by 
imposing certain prohibitions, disclosure and filing requirements, is 
designed to permit members and associated persons of a member to 
disseminate bond mutual fund volatility ratings in supplemental sales 
literature according to standards designed to prevent such ratings from 
being misleading, predictive, or otherwise inappropriate.
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    \7\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received. However, NTM 
96-84 requested comment on the appropriateness of the NASDR's current 
prohibition on the use by members and persons associated with a member 
of bond mutual fund volatility ratings in supplemental sales 
literature. A copy of NTM 96-84 and a summary of the comments received 
in response to NTM 96-84 are available for inspection and copying in 
the Commission's Public Reference Room.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposal is 
consistent with the Act. Persons making written submissions should file 
six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, D.C. 20549. Copies of the 
submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the file number in the caption above and 
should be submitted by November 30, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\8\
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    \8\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-29970 Filed 11-6-98; 8:45 am]
BILLING CODE 8010-01-M