[Federal Register Volume 65, Number 46 (Wednesday, March 8, 2000)]
[Notices]
[Pages 12305-12310]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-5557]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42476; File No. SR-NASD-97-89]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving the Proposed Rule Change on a Temporary 
Basis and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 3 and 4 to the Proposed Rule Change on a Temporary Basis 
Relating to Bond Mutual Fund Volatility Ratings

February 29, 2000.

I. Introduction

    On October 5, 1998,\1\ the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association''), through its wholly-owned 
subsidiary, the NASD Regulation, Inc. (``NASD'' or ``Regulation'' or 
``NASDR''), filed with the Securities and Exchange Commission (``SEC'' 
or ``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 permit members and associated persons to 
include bond mutual fund volatility ratings in supplemental sales 
literature for an 18 month trial period.
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    \1\ On December 12, 1997, the NASD 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 NASD and the 
Commission, the NASD field Amendment No. 1 on October 5, 1998, which 
replaced and superseded the initial proposal.
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
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    A notice of the proposed rule change appeared in the Federal 
Register on November 5, 1998.\4\ The Commission received fourteen 
comment letters concerning the proposed rule change.\5\ On November 9, 
1998, NASDR filed Amendment No. 2 to clarify a formatting change to 
NASD Conduct Rule 2210(c).\6\ On March 26, 1999, the NASDR filed 
amendment No. 3, in which it responded to the comment letters and 
amended the definition of Bond Mutual Fund Volatility Rating to clarify 
which funds would be subject to the proposal.\7\ On August 18, 1999, 
NASDR filed Amendment No. 4, which amended subsections (b)(1) and 
(b)(3) by removing language that several commenters found misleading 
and confusing.\8\ This order approves the proposed rule change. 
Amendment Nos. 3 and 4 are also approved on an accelerated basis.
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    \4\ See Securities Exchange Act Rel. No. 40627 (November 2, 
1998), 63 FR 60431.
    \5\ See infra note 14.
    \6\ Letter from John Ramsay, Vice President and Deputy General 
Counsel, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation, Commission, dated October 
30, 1998.
    \7\ The amendment to subsection (a) removes the reference to 
``bond mutual fund'' and inserts after ``portfolio,'' the phase: 
``of an open-end management investment company that invests in debt 
securities.'' Letter from John Ramsay, Vice President and Deputy 
General Counsel, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation, Commission, dated March 25, 
1999 (``Amendment No. 3'').
    \8\ The amendment to subsection (b)(1) removes the prohibition 
against using `` a single symbol, number or letter'' to describe 
volatility. The amendment to subsection (b)(3) removes the second 
sentence that stated, in relevant part, that ``[subjective factors] 
may be used solely for purposes of determining whether to issue the 
rating.'' See letter from John Ramsay, Vice President and Deputy 
General Counsel, NASD Regulation, to Richard C. Strasser, Assistant 
Director, Division of Market Regulation and Mercer E. Bullard, 
Assistant Chief Counsel, Division of Investment Management, 
Commission, dated August 18, 1999 (``Amendment N. 4''). See also 
letter from Alden S. Adkins, Senior Vice President and General 
Counsel NASD Regulation, to Katherine A, England, Assistant 
Director, Division of Market Regulation and Mercer E. Bullard, 
Assistant Chief Counsel, Division of Investment Management, 
Commission, dated November 2, 1999.
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II. Background

    Bond mutual fund volatility ratings are descriptions of the 
sensitivity of bond mutual fund portfolios to changing market 
conditions. Currently, NASDR interprets its rules to prohibit members 
and associated persons from using bond mutual fund volatility ratings 
in supplemental sales literature. NASD rules do not apply to the use 
and dissemination of bond mutual fund volatility ratings by non-NASD 
members, including rating agencies and information vendors that issue 
the ratings, and mutual fund groups that use the ratings for 
promotional and marketing purposes.
    Specifically, NASD 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.\9\ The NASD currently 
prohibits the use of bond mutual fund volatility ratings because it 
believes that judgments of how a bond mutual fund may react to changes 
in various market conditions may be predictive of fund performance or 
misleading.
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    \9\ NASD Manual, Conduct Rules, Rule 2210.
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    In Notice to Members 96-84 (December 1996), the NASD requested 
comment on the appropriateness of its current prohibition. A majority 
of the

[[Page 12306]]

commenters supported making the ratings available, and all of the 
commenters representing investors groups supported the goal of making 
accurate information regarding risk and volatility characteristics of 
bond funds available to investors. As a result, NASDR proposed an 
interpretation to permit the use of bond fund volatility ratings 
subject to certain conditions and disclosure requirements.

III. Description of the Proposed Rule Change, including Amendment 
Nos. 3 and 4

Trial Period

    The proposed rule change would permit, for an 18 month trial 
period, the use of the mutual fund volatility ratings subject to 
certain limitations, and provided certain disclosures are made. The 
NASD believes that this trial period should be a reasonable amount of 
time for the Advertising/Regulation Department (``Department'') to 
determine whether the rules have facilitated the dissemination of 
useful, understandable information to investors and have prevented the 
dissemination of inappropriate or misleading information by members and 
associated persons.

Definition of Bond Mutual Fund Volatility Rating

    Section(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 the 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. In Amendment No. 3, the NASDR also 
proposes to amend this definition to clarify that the rule applies only 
to open end investment companies.\10\
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    \10\ See supra note 7.
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Prohibitions

    Subsection (b) of the proposed rule change permits members and 
associated persons to use a bond mutual fund volatility rating only in 
supplemental sales literature and only when certain requirements are 
satisfied.
    Subsection (b)(1) prohibits the use of a bond mutual fund 
volatility rating that uses the word ``risk'' to describe the rating. 
This prohibition is intended to remove any confusion concerning the 
word ``risk,'' which is capable of multiple meanings and 
interpretations. Thus, the NASDR believes that referring to these 
ratings as ``volatility'' rather than ``risk'' ratings is more precise. 
The proposal had also prohibited the use of a ``a single symbol, number 
or letter'' to describe the ratings. Amendment No. 4, however, removed 
this prohibition to provide rating agencies with more flexibility in 
how the ratings are presented.\11\
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    \11\ S&P notified the NASD that is planned to revise the 
symbology it uses to label its bond fund risk ratings. The current 
symbology ranges from `aaa' to `ccc,' which S&P planned to convert 
to a scale ranging from `S1+' to `S6.' Letter from R. Clark Hooper, 
Executive Vice President, Disclosure and Investor Protection, NASD 
Regulation, to Sanford B. Bragg, Managing Director, Standard & 
Poor's, dated August 3, 1999.
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    Subsection (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 that is not current.\12\
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    \12\ In this context, ``current'' describes the most recent 
calendar quarter ended.
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    Subsection (b)(3) of the proposed rule change further prohibits the 
use of a bond mutual fund volatility rating that is not based 
exclusively on objective, quantifiable factors. This subsection also 
requires that the rating and the disclosure statement that accompanies 
it be clear, concise, and understandable. This requirement is intended 
to ensure that the rating information is presented in a way that is 
accessible and informative to the investor. Originally, this subsection 
also referred to the use of other factors that could be used to 
determine whether to issue the rating. Several commenters and the 
Commission noted that the language seemed to imply that, contrary to 
the language of the rule, subjective factors could also be considered 
in determining the rating. Accordingly, the NASDR filed Amendment No. 4 
to remove this language.\13\
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    \13\ See supra note 8.
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    Subsection (b)(4) of the proposed rule change prohibits the use of 
bond mutual fund volatility ratings unless the supplemental sales 
literature containing the rating conforms to the disclosure 
requirements, which are described below.
    Subsection (b)(5) of the proposed rule change prohibits members or 
associated persons of members from using bond mutual fund volatility 
ratings unless the entity that issued the ratings provides detailed 
disclosure on its rating methodology through a toll-free telephone 
number, a web site, or both.

Disclosure Requirements

    Section (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.
    Specifically, subsection (c)(1) requires that supplemental sales 
literature containing a bond mutual fund volatility rating include a 
disclosure statement containing certain specified information required 
by the rule. It also permits the disclosure statement to contain any 
additional information that is relevant to an investor's understanding 
of the rating.
    Subsection (c)(2) requires that supplemental sales literature 
containing a bond fund volatility rating include all other current 
volatility ratings that have been issued with respect to the same fund. 
Subsection (c)(2) also 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.
    Subsection (c)(3) requires that all bond mutual fund volatility 
ratings be contained within the text of the disclosure statement. The 
rating should not be located separately from the disclosure statement 
to avoid the risk that either could be read separately, or not at all, 
thereby increasing the possibility that the rating would not be 
understood in the context of the required disclosures.
    Subsections (c)(3) (A)-(B) of the proposed rule change require that 
supplemental sales literature containing a bond mutual fund volatility 
rating disclose the names of the rating entity, the most current rating 
(accompanied by the date of that rating), and, if there is any change 
in the current rating from the most recent prior rating, an explanation 
of the change.
    Subsection (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 subsections 
(c)(3)(C) (i)-(vii), the narrative description must 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

[[Page 12307]]

of the rating; (v) a description of the types of risks the rating 
measures, such as 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.

Filing Requirement

    The proposed rule change amends NASD Rule 2210 regarding 
communications with the public by adding new subsection (c)(3) to 
require sales literature containing bond mutual fund volatility ratings 
to be filed with the Department for review and approval at least 10 
days prior to use. Members would not be required to file advertising 
and sales literature that had previously been filed and approved. 
Members filing sales literature containing bond mutual fund volatility 
ratings also must provide any supplemental information requested by the 
Department pertaining to the rating that has been assigned to the bond 
fund.

IV. Summary of Comments

    The Commission received fourteen comment letters from 13 commenters 
concerning the proposal.\14\ Of these commenters, eleven expressed 
conditional supports for the proposal,\15\ and two opposed it.\16\ One 
commenter cited a number of articles from periodicals in support of its 
position that the use of volatility ratings should only be allowed if 
appropriate safeguards are implemented.\17\ Following are the issues 
raised, the commenters' positions, and the NASDR's and the Commission's 
responses.
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    \14\ Letters to Jonathan G. Katz, Secretary, Commission from: 
Martin A. Corry, Director, Federal Affairs, AARP, dated December 14, 
1998 (``AARP Letter''); Lisa G. Hathaway, Compliance Associate, 
American Funds Distributors, Inc., dated December 9, 1998 (``AFD 
Letter''); Barbara L.N. Roper, Director of Investor Protection, 
Consumer Federation of America, dated November 30, 1998 (``CFA 
Letter''); John B. Hammalian, Associate General Counsel, The Dreyfus 
Corporation, dated November 24, 1998 (``Dreyfus Letter''); Stephen 
A. Keen, General Counsel, Federated Investors, Inc., dated November 
30, 1998 (``Federated Letter''); David H. Potel, Vice President and 
Deputy General Counsel, Fidelity Investments, dated November 27, 
1998 (``Fidelity Letter''); Betsy Dotson, Director, Federal Liaison 
Center, Government Finance Officers Association, dated November 30, 
1998 (``GFOA Letter''); Craig S. Tyle, General Counsel, Investment 
Company Institute, dated November 30, 1998 (``ICI Letter No. 1'') 
and dated September 2, 1999 (``ICI Letter No. 2''); A. Michael 
Lipper, President, Lipper Advisory Services Inc., dated November 20, 
1998 (``Lipper Letter''); James F. Des Mais, Assistant General 
Counsel, Legal, MFS Investment Management, dated November 30, 1998 
(``MFS Letter''); Leo C. O'Neill, President and Chief Rating 
Officer, Standard & Poor's, dated November 30, 1998 (``S&P 
Letter''); Susan E. Woodward, dated November 25, 1997 (``Woodward 
Letter''); Henry H. Hopkins, Managing Director and Chief Legal 
Counsel, T. Rowe Price Associates, Inc., dated November 30, 1998 
(``TRP Letter'').
    \15\ AARP Letter, AFD Letter, CFA Letter, Federated Letter, 
Fidelity Letter, GFOA Letter, ICI Letter Nos. 1 and 2, Lipper 
Letter, MFS Letter, S&P Letter, and Woodward Letter.
    \16\ Dreyfus Letter and TRP Letter.
    \17\ ICI Letter No. 2.
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Trial Period

    Most commenters suggested that once the 18 month trial period ends 
the NASDR conduct a thorough assessment of the proposal to determine 
whether it should be amended, eliminated, or approved.\18\ Federated 
believes the current ban on volatility rating disclosure is unnecessary 
and hopes that once the trial period concludes, the results will 
establish a basis for more reasonable, lenient guidelines.\19\ The 
Commission believes that the trial period will provide the Department 
with a reasonable amount of time to consider all feedback concerning 
the use of these ratings, so that a fair and accurate assessment of the 
proposal's effectiveness can be made. The Commission expects that the 
Department will keep the Commission appraised of any problems that may 
arise in the rating process so that they may be promptly addressed.
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    \18\ See, e.g., AFD Letter, pp. 1-2 and ICI Letter No. 1, p.2.
    \19\ Federated Letter, p. 1.
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Clarification of Certain Terminology

    There was some debate among commenters on the use of certain 
terminology in the proposal. Most commenters focused on what term best 
describes risk.\20\ One commenter stated that because the proposal does 
not restrict the type of entity that can provide ratings, they can be 
obtained form any entity as long as the ratings are based on objective 
criteria.\21\ The commenter therefore suggested that, to help ensure 
the quality of the entitle issuing the ratings, the NASDR consider 
providing guidelines (including specific definitions) for entities to 
follow.\22\
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    \20\ See, e.g., AARP Letter, P. 1, Lipper Letter, p. 1, and 
Woodward Letter, pp. 2-3 (discussing the terms risk and volatility 
and the implications of their use).
    \21\ Id. at p. 3.
    \22\ Dreyfus Letter, pp. 3-4.
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    The NASDR contends that it has provide guidance, albeit indirectly, 
to entities providing ratings.\23\ The proposed rule sets standards for 
NASD members and their associated persons by prohibiting their use of 
volatility rating sunless the ratings conform to the rule.\24\ The 
Commission agrees that the proposal provides adequate guidance for NASD 
members and associated persons that will use these ratings in their 
supplemental sales literature. The Commission suggests, however, that 
the NASDR periodically assess the effectiveness of the proposal during 
the trial period to determine whether additional guidance is needed.
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    \23\ NASDR response, pp. 3-4 (responding to a similar issue 
raised by a different commenter).
    \24\ Id. at p. 4.
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Additional Disclosure Requirements

    Several commenters suggested that additional disclosure 
requirements were necessary to further clarify the meaning of the 
ratings and their limitations.\25\ For example, MFS suggested that the 
rule require detailed disclosure on an entity's rating methodology and 
the underlying assumptions used to assess individual securities or 
types of securities in the fund's portfolio.\26\ AARP suggested that a 
fund's investment philosophy and management be included in the 
disclosure statement. In response, the NASDR notes that these factors 
are already disclosed in the fund prospectus.\27\ Another commenters 
suggested that a provision be added to require that the narrative 
description disclosure not only the type of risk being measured, but 
also how those risks relate to the stated investment goals of the 
fund.\28\ The NASDR believes such a requirement would be inconsistent 
with the requirement that these ratings be based on objective, 
verifiable information.\29\ Allowing the rating agency to provide its 
opinion on how the risks relate to a fund's investment objectives 
requires a subjective judgment that cannot be verified.\30\
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    \25\ See, e.g., AARP Letter, CFA Letter, and MFS Letter
    \26\ MFS Letter, p. 2.
    \27\ NASDR Response, p. 2.
    \28\ CFA Letter, p. 5.
    \29\ NASDR Response, p. 2.
    \30\ Id.
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    Conversely, two commenters who opposed the proposal expressed doubt 
that any amount of disclosure would remedy the volatility ratings' 
inherent deficiencies.\31\ For example, both commenters note that the 
proposal does not address the potential predictive nature of volatility 
ratings.\32\ According to the NASDR, the possible predictive nature of 
the volatility ratings had been a factor in its current prohibition 
against the use of volatility ratings.\33\ Moreover, this concern 
prompted the NASDR to

[[Page 12308]]

eliminate from the original proposal the provision allowing subjective 
factors to be used in the calculation of the rating.\34\
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    \31\ Dreyfus Letter, pp. 1-2 (suggesting that concerns about 
availability of additional disclosure information should be directed 
to the member firm, not the rating agency) and TRP Letter, p. 2.
    \32\ Dreyfus Letter, pp. 1-2 and TRP Letter, p. 3.
    \33\ NASDR Response, p. 3.
    \34\ Id.
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    The Commission has consistently supported requirements that attempt 
to make meaningful information available to the investor. In this case, 
however, if more information were added to the disclosure statement, it 
is possible that the investor could be or overwhelmed with information 
that he fails to read any of the literature, or fails to focus on the 
key disclosures. The Commission is satisfied with the proposed 
disclosure requirements and the quality of information being made 
available to the investor.

Payment for Ratings

    Some commenters contended that ratings prepared by independent 
third parties will be subject to conflicts of interest and potential 
misuse because the fund companies will pay for these ratings.\35\ Two 
commenters strongly advocated a prohibition on the practice of buying 
ratings to ensure that the interests of the rating entity are 
independent of the interests of the fund being rated.\36\ Lipper noted 
that the requirement that the fund disclose whether any payments were 
made for ratings should reduce, but will not completely eliminate, the 
incentive to shop for favorable ratings.\37\ TRP noted that because 
funds will now have to pay for ratings, only those that are assured of 
the highest rating will attempt to procure one.\38\ Conversely, Dreyfus 
contended that these ratings will not be generated if the rating 
agencies can not charge for them.\39\
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    \35\ See, e.g., AFD Letter, CFA Letter, and ICI Letter No. 1.
    \36\ AFD Letter, pp. 1-2 and ICI Letter No. 1, p. 5.
    \37\ Lipper Letter, p. 1.
    \38\ TRP Letter, p. 2.
    \39\ Dreyfus Letter, p. 5 (noting that payment would only be a 
material issue if subjectivity were an element in the process).
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    The NASDR believes the proposal's prohibitions and substantial 
disclosure requirements are more than adequate to address potential 
conflicts of interest that may arise from the fact that the ratings are 
procured for a fee.\40\ The Commission is concerned that rating 
agencies may be influenced by compensation received in providing fund 
volatility ratings. This concern is alleviated, however, by the 
requirement that the narrative description state whether consideration 
was paid in connection with the issuance of the ratings. Thus, the 
Commission is satisfied that the rule addresses potential conflicts of 
interest.
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    \40\ NASDR Response, p. 2.
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Presentation of Volatility Rating

    Some commenters stated that the volatility rating should not be 
buried or hidden in the text of the required disclosure statement.\41\ 
Two commenters believed that burying the rating in the disclosure 
statement increases the chances that it will not be found, as few 
investors thoroughly examine disclosure statements.\42\ Thus, they 
suggested displaying the rating in a conspicuous location, with a 
prominent reference to the disclosure statement for particulars, to 
increase the chances of it being examined by investors.\43\
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    \41\ GFOA Letter, p. 3, S&P Letter, pp. 2-3, and Woodward 
Letter, p. 3.
    \42\ GFOA Letter and S&P Letter, supra note 41.
    \43\ GFOA Letter and S&P Letter, supra note 41.
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    The NASDR believes that the appropriate point of disclosure for the 
rating is within the text of the disclosure statement.\44\ They note 
that the proposal requires any rating to be filed with the Department 
for pre-use review.\45\ The Department will, therefore, have an 
opportunity to review whether the rating is prominently displayed or 
inconspicuous and determine whether to recommend changes to the 
disclosure statement prior to use.\46\ The Commission notes that the 
NASDR has not outlined the standards for pre-use review. However, the 
Commission expects that the NASDR will conduct a thorough review of all 
submitted sales literature containing volatility ratings to ensure 
compliance with the disclosure requirements.
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    \44\ NASDR Response, p. 4.
    \45\ Proposed Rule 2210(c)(3) would require that sales 
literature containing these volatility ratings by filed with the 
Department for review and approval at least 10 days prior to use.
    \46\ NASDR Response, p. 4.
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Applicability of proposal to ``in-house'' ratings

    The NASDR requested comment on whether the descriptions of risk and 
volatility that mutual fund complexes currently provide for their own 
funds i.e., in-house ratings) should be subject to the provisions of 
the proposed rule change.\47\ Two commenters suggested that risk or 
volatility ratings currently developed in-house resemble those provided 
by independent parties.\48\ Because of the similarities between these 
ratings and the fact that funds often fail to disclose the 
methodologies used to determine their in-house ratings, both commenters 
suggested that volatility ratings developed in-house should be subject 
to the disclosure requirements of the proposal.\49\ Moreover, CFA 
believed that fund companies should not be allowed to use in-house risk 
or volatility ratings without also disclosing those ratings issued by 
independent third parties that conflict with the in-house rating.\50\
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    \47\ See Securities Exchange Act Rel. No. 40627, supra note 4, 
at 60433.
    \48\ CFA Letter, p. 3 and S&P Letter, p. 3. CFA also noted that 
because in-house ratings and those of ratings agencies can be 
similar, fund companies could use in-house ratings in lieu of 
independent ratings with which they disagree.
    \49\ CFA Letter and S&P Letter, supra note 48.
    \50\ CFA Letter, p. 3.
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    Conversely, several commenters opposed subjecting current in-house 
risk disclosures to the requirements of the proposal.\51\ These 
commenters believed that in-house ratings are used primarily as an 
educational tool for investors to compare the different types of funds 
within a fund family.\52\ Volatility ratings, they content, are used by 
funds as a marketing tool to distinguish their fund from similar fund 
families.\53\ Thus, according to ICI, in-house ratings do not present 
the same potential for abuse as volatility ratings and therefore should 
not be subject to the proposal.\54\
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    \51\ Dreyfus Letter, p. 5, ICI Letter No. 1, p. 7, and TRP 
Letter, p. 3.
    \52\ ICI Letter No. 1, p. 7 and TRP Letter, p. 3.
    \53\ ICI Letter and TRP Letter, supra note 52.
    \54\ ICI Letter and TRP Letter, supra note 52. TRP notes that 
these ratings have been filed with and reviewed by the NASD with no 
previously known objections.
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    NASDR does not intend to apply the proposed rule to fund companies' 
in-house risk rating.\55\ According to NASDR, these ratings are not 
procured for a fee, are used primarily by fund investors as an aid in 
distinguishing between risk levels within a family of funds, and may be 
calculated using different methods from those used in calculating 
volatility ratings.\56\ The Commission preliminarily agrees with the 
NASDR that in-house risk ratings need not be subject to the proposed 
rule because they are primarily used by investors to distinguish 
between funds in a family of funds, but notes that the NASDR will 
reconsider at the conclusion of the trial period whether to apply the 
proposed rule to in-house ratings.\57\
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    \55\ NASD Response, p. 2.
    \56\ Id.
    \57\ Id.
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    One commenter also wanted the NASDR to clarify that the proposal 
only applied to open-end investment companies (i.e., mutual funds) and 
not to other types of investment companies (e.g., unit investment 
trusts).\58\ For the trial period, the NASDR intends for the

[[Page 12309]]

proposed rule to apply only to open-end investment companies.\59\ The 
NASDR will decide at the conclusion of the trial period whether to 
apply the rule to all investment companies.\60\ However, until then, 
the NASDR proposes to amend the definition of Bond Mutual Fund 
Volatility Rating to clarify that the proposed rule change only applies 
to open-end investment companies.\61\ The Commission is satisfied with 
the NASDR's determination that, for the duration of the trial period, 
the proposal will apply only to open-end investment companies.
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    \58\ ICI Letter No. 1, p. 6.
    \59\ NASDR Response, p. 4.
    \60\ Id.
    \61\ See supra note 7.
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Prohibitions

    Several commenters offered their conditional support for the 
proposal, provided that all or substantially all of the prohibitions 
remained intact.\62\ After discussions with the Commission, however, 
the NASDR, has amended the proposal to remove text from two of the 
prohibitions that several commenters supported.\63\ Amendment No. 4 
removes the prohibition from subsection (b)(1) against using a single 
symbol, number, or letter to describe a rating. This amendment 
clarifies the intended application of this section and provides greater 
flexibility to members in the use of appropriate symbols for their 
ratings.\64\ The amendment also removes text from subsection (b)(3) 
that might cause confusion regarding the requirement in subsection 
(b)(3) that the rating be based on objective, quantifiable factors.
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    \62\ AFD Letter, pp. 1-2, ICI Letter No. 1, p. 4 and MFS Letter, 
p.2.
    \63\ Amendment No. 4, supra note 8.
    \64\ Id. at p. 1.
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    The Commission believes that amended subsection (b)(1) provides the 
rating agencies with appropriate flexibility. Several commenters 
suggested that investors were more likely to rely on ratings conveyed 
in the form of a number or symbol without fully understanding their 
meaning or significance.\65\ The Commission notes, however, that the 
proposal still requires that the sales literature include a description 
of the rating in narrative form. The description must include certain 
disclosures, which should decrease the likelihood of investor confusion 
concerning a rating's meaning.
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    \65\ AFD Letter, p. 2, CFA Letter, p. 4, and ICI Letter No. 1, 
pp. 2-3.
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    Concerning amended subsection(b)(3), the Commission believes the 
language is now clear that subjective factors should not be used to 
determine a rating.\66\ The NASD stated that it eliminated subjective 
factors to ensure that any ratings issued during the trial period could 
be verified and replicated.\67\ While most commenters agreed that only 
objective, quantifiable factors should be used to determine a rating, 
one commenter noted that this requirement would still allow fund 
entities to base their ratings on different, objective criteria.\68\ 
Another commenter also suggested that the NASD address how it will 
monitor compliance with subsection (b)(3) and define what an 
``objective'' factor is.'' \69\
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    \66\ But see GFOA Letter, p. 2 and Woodward Letter, p. 3 
(stating that agencies should be allowed to use the tools they deem 
appropriate in assessing risk).
    \67\ NASDR Response, p. 5.
    \68\ TRP Letter, p. 2. TRP believes this lack of uniformity will 
ultimately lead to investor confusion, if similar bond funds receive 
different ratings.
    \69\ Dreyfus Letter, p. 4.
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    NASDR believes it would be inappropriately constrictive to define 
what an ``objective'' factor is, other than to say that such factors 
should relate to information that is objectively determinable and 
should permit replication of ratings by third parties.\70\ NASDR states 
that it will monitor compliance by requiring that all volatility 
ratings be submitted to its Department for pre-use review.\71\
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    \70\ NASDR Response, p. 3.
    \71\ Id.
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    The Commission believes that, during the trial period, rating 
agencies should be allowed to determine what qualifies as objective 
criteria, consistent with the NASDR's guidelines, and which objective 
criteria they should use to calculate the rating.\72\ The proposal 
eliminates the use of subjective, qualitative factors, but does not 
prevent rating agencies from using their reasonable discretion in 
selecting which objective criteria to use to calculate a rating. The 
Commission reiterates that the onus is on the NASD member or associated 
person to make certain that all required information outlined in the 
proposal is disclosed so that the rating can be replicated and that the 
basis for any inconsistencies is readily apparent. The trial period 
should provide enough time to determine whether additional standards or 
guidelines are needed to prevent investor confusion or minimize 
excessive variability among ratings of similar portfolios.
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    \72\ The Commission recognizes that without providing an 
exhaustive list of objective criteria for the agencies to use, 
similarly-situated bond funds may receive different ratings. 
However, the Commission is satisfied that the disclosure statement, 
which should include a description of the criteria and methodologies 
used, will provide the Department and investors with the requisite 
information to replicate the rating. Thus, the potential lack of 
uniformity in ratings and potential investor confusion should be 
mitigated by the proposal's required disclosures.
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V. Discussion

    As discussed above, the Commission finds the proposed rule change 
is consistent with the Act and the rules and regulations 
thereunder.\73\ Specifically, the Commission believes that the proposed 
rule change is consistent with Section 15A(b)(6) \74\ of the Act, which 
requires that the NASD adopt rules that are designed to remove 
impediments to and perfect the mechanism of a free and open market and 
national market system, and, in general, to protect investors and the 
public interest. The Commission believes that the proposed rule change 
will remove impediments to a free and open market by allowing 
independent third parties to issue ratings of bond mutual funds based 
on an evaluation of objective criteria regarding a fund's performance 
and characteristics. The Commission also believes the various 
disclosure requirements outlined in the proposal will protect investors 
and the public interest by providing the information necessary to make 
an informed decision about a particular bond fund.
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    \73\ The Commission has considered the proposed rule's impact on 
efficiency, competition and capital formation. 15 U.S.C. 78c(f).
    \74\ 15 U.S.C. 78o-3(b)(6)
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    The proposed rule change, by imposing certain prohibitions, 
disclosure, and filing requirements, is designed to permit members and 
associated persons of members to disseminate bond mutual fund 
volatility ratings is supplemental sales literature according to 
standards designed to prevent such ratings from being misleading, 
predictive, or otherwise inappropriate. The Commission finds that the 
18 month trial period is sufficient time to implement the proposed rule 
change and to determine, based on participation and subsequent 
feedback, whether the process should continue unchanged or whether 
modifications are necessary.
    The Commission finds that the amended definition of bond mutual 
fund volatility ratings provides appropriate guidance concerning the 
type of funds to which the interpretation would apply during the trial 
period. Given the array of investment vehicles falling within the term 
``bond mutual fund,'' Amendment No. 3 provides the necessary clarity on 
the scope of investments to which this rule applies.

[[Page 12310]]

    The Commission also finds that the prohibitions and Amendment No. 4 
strike an appropriate balance. The proposed rule change and the 
amendment refrain from imposing a specific standard on descriptions 
(i.e., removing the prohibition against use of a single symbol, number, 
or letter) or calculations of ratings 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 allowed to develop 
competing methods and models of assessing volatility. The amendment 
also eliminates the use of subject factors from the volatility 
calculation, thereby reducing the potential variability of ratings, and 
limiting the ability of funds to ``shop around'' for the most favorable 
rating.
    The proposal, however, also imposes certain disclosure requirements 
that should assist investors in determining whether a fund is 
appropriate for them based on their investment objectives. The 
disclosure required by subsections (c)(3)(C)(i)-(vii) of the rule will 
help inform investors of certain potential limitations of a rating 
(e.g., 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 reflect a fund's current 
portfolio). The Commission believes that the requirement that any 
change in the rating and the reasons for the change be disclosed is 
important for investors in making informed investment decisions. Thus, 
the Commission finds that the proposed rule change, in providing access 
to this supplemental information, should enable investors to obtain 
answers to questions regarding the meaning of the rating or how it is 
calculated or derived.\75\
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    \75\ The Commission emphasizes that sales literature is no 
substitute for a fund's prospectus and, if investors have not 
received one, they should request a current prospectus to review in 
conjunction with the sales materials.
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    The Commission also finds that the requirement that sales 
literature containing volatility ratings be filed at least 10 days 
prior to use should provide the Department with sufficient time to 
review the sales material for compliance with the proposal's 
requirements. The Commission expects a thorough review of all sales 
literature to be conducted and accurate records to be maintained by the 
NASDR to facilitate the possible assessment of the rating process.
    Finally, the Commission believes this proposal represents the best 
mechanism for disseminating information about bond mutual funds risk to 
investors. Risk ratings are an important source of information for 
investors because they can potentially determine the likelihood of 
gains or losses in the market value of a particular fund. As such, the 
Commission believes they can be useful tools for investors to aid in 
making informed investment decisions. Thus, the Commission finds that 
it is in the public interest to facilitate the dissemination of this 
information in an environment that encourages disclosure and enhances 
competition.
    The Commission also finds good cause for approving proposed 
Amendment Nos. 3 and 4 prior to the thirtieth day after the date of the 
publication of notice of filing thereof in the Federal Register. The 
amendments remove ambiguous language that could hinder understanding of 
the proposal's applicability by clarifying which types of funds can be 
subject to the ratings process. The amendments also specify what types 
of criteria can be used to determine the ratings, while simultaneously 
providing some flexibility in how the rating agencies provide their 
services. The Commission believes that these amendments should help 
make the ratings provided more objective and enhance the disclosures 
made in the sales literature. Furthermore, the Commission finds that 
these amendments should enhance competition among those entities 
issuing the ratings. Thus, the Commission believes the approval of the 
amendments should not be delayed. For theses reasons, the Commission 
finds good cause for accelerating approval of the proposed rule change, 
as amended.
    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 3 and 4, including whether the 
amendments are 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. 20549-0609. Copies of the submission, all subsequent amendments, 
all written statements with respect tot he 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 offices of the NASD. All submissions should refer to the file 
number in the caption above and should be submitted by March 29, 2000.

VI. Conclusion

    For the above reasons, the Commission finds that the proposed rule 
change is consistent with the provisions of the Act, and in particular 
with Section 15A(b)(6).
    It is Therefore Ordered, pursuant to Section 19(b)(2) \76\ of the 
Act, that the proposed rule change (SR-NASD-97-89), be, and hereby is, 
approved for an 18 month trial period, which ends on August 31, 2001. 
Amendment Nos. 3 and 4 are also approved on an accelerated basis for an 
18 month trial period, which also ends on August 31, 2001.
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    \76\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\77\
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    \77\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-5557 Filed 3-7-00; 8:45 am]
BILLING CODE 8010-01-M