[Federal Register Volume 69, Number 247 (Monday, December 27, 2004)]
[Notices]
[Pages 77286-77287]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E4-3806]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50883; File No. SR-NASD-2004-027]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by NASD, Inc., Relating to Investment Company Portfolio 
Transactions

December 20, 2004.

I. Introduction

    On February 10, 2004, the National Association of Securities 
Dealers, Inc. (``NASD'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change relating to investment company 
portfolio transactions. On September 17, 2004, NASD filed Amendment No. 
1 to the proposed rule change.\3\ The proposed rule change, as amended, 
was published for comment in the Federal Register on November 5, 
2004.\4\ The Commission received one comment letter in response to the 
proposed rule change.\5\ For the reasons discussed below, the 
Commission is approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Patrice Gliniecki, Senior Vice President and 
Deputy General Counsel, NASD, to Katherine England, Assistant 
Director, Division of Market Regulation, Commission, dated September 
16, 2004.
    \4\ Securities Exchange Act Release No. 50611 (Oct. 29, 2004 ), 
69 FR 64609 (Nov. 5, 2004) (``Notice'').
    \5\ See letter to Jonathan G. Katz, Secretary, Commission from 
Amy B.R. Lancellotta, Senior Counsel, Investment Company Institute, 
dated November 24, 2004 (``ICI letter''). The comment letter is 
available online at http://www.sec.gov/rules/sro/nasd/nasd2004027.shtml.
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II. Description of the Proposed Rule Change

A. Description of the Proposal

    NASD Rule 2830(k) governs NASD members' execution of investment 
company portfolio transactions. In general, the rule prohibits NASD 
members from favoring the sale of shares of any investment company on 
the basis of brokerage commissions received or expected to be received 
from any source, including the investment company.\6\ However, 
subparagraph (7)(B) of the rule allows an NASD member, subject to the 
requirements of best execution, to sell the shares of, or act as an 
underwriter for, an investment company where that investment company 
``follows a policy, disclosed in its prospectus, of considering sales 
of shares of the investment company as a factor in the selection of 
broker/dealers to execute portfolio transactions * * *.''
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    \6\ See NASD Rule 2830(k)(1).
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    NASD now proposes to strike subparagraph (k)(7)(B) from Rule 2830 
and add a new subparagraph, designated (k)(2), that would prohibit NASD 
members from selling the shares of, or acting as underwriter for, any 
investment company:

if the member knows or has reason to know that such investment 
company, or an investment adviser or principal underwriter of the 
company, has a written or oral agreement or understanding under 
which the company directs or is expected to direct portfolio 
securities transactions (or any commission, markup or other 
remuneration resulting from any such transaction) to a broker or a 
dealer in consideration for the promotion or sale of shares issued 
by the company or any other registered investment company.\7\
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    \7\ See Notice 69 FR at 64609.

    As NASD noted in its description of the proposed rule change, 
proposed new subparagraph (k)(2) ``would add an objective proscription, 
in that the broker-dealer's intent to favor or disfavor a particular 
fund would not be relevant to that prohibition. The existing 
proscription of paragraph (k)(1), in contrast, turns upon the question 
of whether a broker-dealer favors or disfavors a fund based on receipt 
or expected receipt of brokerage commissions.'' \8\ The proposed 
prohibition would apply not only to the distribution of shares of the 
fund that directs portfolio transaction commissions to the distributing 
broker, but also to the distribution of the shares of any other 
registered investment company. Further, the rule would continue to 
provide that an NASD member will not violate Rule 2830(k) solely 
because it promotes or sells the shares of an investment company that 
directs fund portfolio transactions to the member, so long as the 
member does not engage in conduct otherwise prohibited by the rule.
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    \8\ See Notice, 69 FR 64609, 64610 n. 5.
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B. Comment Summary

    The proposal was published for comment in the Federal Register on 
November 5, 2004.\9\ The SEC received one comment letter, from the 
Investment Company Institute (``ICI''), in response to the proposed 
rule change.\10\ The ICI expressed support for the proposed rule 
change, asserting that it ``would complement the Commission's recent 
amendment to Rule 12b-1 under the Investment Company Act of 1940, which 
prevents funds from paying for the distribution of their shares with 
brokerage commissions.'' \11\ The ICI stated that NASD's proposal, 
``coupled with the Commission's amendment to Rule 12b-1, would make it 
clear to both fund advisers and broker-dealers that distribution 
considerations have no appropriate role in the allocation of fund 
brokerage.'' \12\ The ICI also supported NASD's retention of Rule 
2830(k)(7)(A) (to be re-designated (8)(A)), which provides that an NASD 
member would not violate the rule solely because it sells shares of an 
investment company for which it also executes transactions, because 
NASD members might otherwise ``be improperly discouraged from 
performing both execution and sales functions for a particular fund.'' 
\13\
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    \9\ See note 4, supra.
    \10\ See note 5, supra.
    \11\ ICI letter. See Prohibition on the Use of Brokerage 
Commissions to Finance Distribution, Investment Company Act Release 
No. 26591 (Sept. 2, 2004) 69 FR 54728 (Sept. 9, 2004) (adopting 
amendments to Rule 12b-1 [17 CFR 270.12b-1] under the Investment 
Company Act of 1940 [15 U.S.C. 80a] to prohibit investment companies 
from paying for the distribution of their shares with brokerage 
commissions).
    \12\ ICI letter.
    \13\ Id.
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III. Discussion and Findings

    The Commission finds the proposed rule change is consistent with 
the Act, and in particular with Section 15A(b)(6) of the Act, which 
requires, among other things, that NASD's rules be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and, in

[[Page 77287]]

general, to protect investors and the public interest.\14\ The 
Commission believes that the proposed rule change is consistent with 
the provisions of the Act noted above because it will strengthen NASD's 
rules against quid pro quo arrangements between NASD members and 
investment companies whereby investment companies compensate broker-
dealers for promotion of their shares with brokerage commissions (or 
similar transaction-related remuneration), which are paid out of fund 
assets. The Commission has noted that such practices pose significant 
conflicts of interest and may be harmful to fund shareholders, as well 
as potential purchasers of fund shares, in that they may induce broker-
dealers ``to recommend funds that best compensate the broker rather 
than funds that meet the customer's investment needs.'' \15\
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    \14\ 15 U.S.C. 78o-3(b)(6).
    \15\ Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, note 10, supra, 69 FR 54728 at 54729-54730.
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    The addition of new subparagraph (k)(2) to Rule 2830 would clarify 
that no member may sell the shares of, or act as an underwriter for, an 
investment company if the member knows, or has reason to know, that 
such investment company, or an investment adviser or principal 
underwriter of the company, has a written or oral agreement or 
understanding whereby the investment company directs, or is expected to 
direct, portfolio securities transactions (or any commission, markup or 
other remuneration resulting from any such transaction) to a broker-
dealer in consideration for the promotion or sale of shares issued by 
the company or any other registered investment company. As NASD noted 
in its description of the proposed rule change,\16\ this requirement 
will differ from that in existing subparagraph (k)(1) of the rule 
because ``the broker-dealer's intent to favor or disfavor a particular 
fund would not be relevant.'' Rather, the new provision will require 
NASD members to refrain from distributing the shares of an investment 
company in any case where the member knows, or has reason to know, of 
the investment company's participation in such an arrangement. The 
Commission believes that this amendment of NASD's rules is consistent 
with the protection of investors because it will clarify that broker-
dealers may not enter into such quid pro quo distribution arrangements. 
One important purpose of Rule 2830(k) is to help eliminate conflicts of 
interest in the sale of investment company securities, and this rule 
change will improve NASD's ability to achieve this objective.
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    \16\ See Notice, 69 FR 64609, 64610 n. 5.
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    NASD's proposal would also strike subparagraph (7)(B) from Rule 
2830(k). This provision of NASD's rules has heretofore allowed NASD 
members to distribute shares of investment companies that, pursuant to 
a disclosed policy, consider sales of their shares by broker-dealers as 
a factor when selecting broker-dealers for the execution of 
transactions for a fund. NASD's proposal would add new subparagraph 
(k)(2) to NASD Rule 2830. This subparagraph will now explicitly state 
that members are not permitted to sell the shares of investment 
companies that the member knows or has reason to know engages in such 
practices. The Commission believes that elimination of subparagraph 
(k)(7)(B) of Rule 2830 should strengthen investor protection because it 
removes a possible incentive for brokers to recommend investments based 
on their own financial interests, rather than the best interests of 
their customers.
    Finally, the Commission notes that, under subparagraph (8)(A) of 
Rule 2830(k),\17\ NASD members may still sell the shares of an 
investment company that directs fund portfolio transactions to the 
member, so long as the other provisions of the rule are satisfied. The 
Commission believes that this existing provision of the rule makes 
clear that an NASD member may continue to distribute the shares of 
investment companies for which the member executes investment portfolio 
transactions, where the member's sales efforts are not connected to any 
arrangements for the direction of brokerage commissions in exchange for 
distribution. In this regard, the Commission notes that NASD Rule 3010 
requires NASD members to establish and maintain a supervisory system 
for registered representatives and associated persons that is 
reasonably designed to achieve compliance with applicable securities 
laws and regulations and with the NASD's rules.
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    \17\ Previously designated as Rule 2830(k)(7)(A).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act 
\18\ that the proposed rule change (SR-NASD-2004-027), as amended, be, 
and hereby is, approved.\19\
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    \18\ 15 U.S.C. 78s(b)(2).
    \19\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
Margaret H. McFarland,
Deputy Secretary.
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    \20\ 17 CFR 200.30-3(a)(12).
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 [FR Doc. E4-3806 Filed 12-23-04; 8:45 am]
BILLING CODE 8010-01-P