On April 19, 2011, the Financial Industry Regulatory Authority filed with the Securities and Exchange Commission a proposed rule change that would replace NASD Rule 2830 with proposed FINRA Rule 2341. The proposal makes significant changes to NASD Rule 2830 and to FINRA’s initial proposal released in 2009. The changes include:
(i) new disclosure requirements regarding arrangements for receipt of cash compensation;
(ii) a change to the recordkeeping requirement for non-cash compensation;
(iii) the elimination of a condition regarding discounted sales of investment securities to dealers; and
(iv) the codification of past FINRA staff interpretations regarding the purchases and sales of exchange-traded funds (ETFs).
The proposal also includes “supplementary material” further describing what constitutes “cash compensation” and makes technical changes to conform terms used in the rule to definitions in the Investment Company Act of 1940.
I. Disclosure of Compensation Arrangements
NASD Rule 2830 currently prohibits FINRA members from accepting cash compensation from an “offeror” (defined to include an investment company, an adviser to an investment company, a fund administrator, an underwriter and their affiliates) unless the compensation is described in the fund’s current prospectus. In addition, the names of members who have “special cash compensation” arrangements must be disclosed in the prospectus or statement of additional information (“SAI”) along with the details of the arrangement if the arrangement is not made available to other member firms on the same terms. Proposed FINRA Rule 2341 would broaden the definition of cash compensation and remove the requirement for disclosure of the cash compensation arrangements in the prospectus or SAI.1 In its place, proposed FINRA Rule 2341 would place the disclosure obligation on the FINRA member,2 and would require a broker-dealer to “prominently disclose”:
(i) if applicable, that in the previous calendar year it has received or entered into3 an arrangement to receive cash compensation from an offeror in addition to the sales charges and service fees disclosed in the prospectus fee tables (“additional cash compensation”); and
(ii) that “this additional cash compensation may influence the selection of investment company securities that the member and its associated persons offer or recommend to investors.”
In addition, broker-dealers would be required to provide a “prominent reference,” or in the case of electronically delivered documents, a hyperlink, to the webpage or toll-free number where investors could obtain more information concerning these arrangements.4
Furthermore, the webpage or information available when calling the toll-free number must include the following information:
(i) “a narrative description of the additional cash compensation received . . . , or to be received pursuant to an arrangement entered into . . . , and any services provided or to be provided by the member . . . for this additional cash compensation”;
(ii) “if applicable, a narrative description of any preferred list of investment companies to be recommended to customers that the member has adopted as a result of the receipt of additional cash compensation, including the names of the investment companies on this list”; and
(iii) “the names of the offerors who have paid, or entered into an arrangement with the member to pay, this additional cash compensation to the member.”5
The proposed rule does not require disclosure of the total or per-offeror amount of such compensation received, noting concerns by commenters to the 2009 proposed rule that disclosure of dollar amounts received by a broker-dealer absent further explanation would not provide meaningful disclosure.
Broker-dealers would be required to update this information annually within 90 days after the calendar year end. If the information becomes materially inaccurate between annual updates, the broker-dealer would have to update the information “promptly.”6
The above disclosures would be required to be provided either electronically or in paper form (i) to new customers before the customer first purchases shares of an investment company through the broker-dealer, or 90 days after the effective date of the proposed rule, whichever is later; and (ii) to existing customers before the customer next purchases shares of an investment company through the member, or 90 days after the effective date of the proposed rule, whichever is later.7 These disclosures must be made even if the member firm does not recommend the purchase or sale of mutual funds, and even if the member firm offers a mutual fund supermarket (i.e., makes a wide range of mutual funds available through its platform). Although the proposed rule requires “prominent disclosure,” it does not define what that is; presumably, member firms can look to the advertising rules as to what constitutes prominent disclosure.
The proposed rule and supplementary material broaden the definition of “cash compensation” subject to these disclosure requirements to include revenue sharing payments made in connection with the sale and distribution of investment company securities. The proposed rule clarifies that revenue sharing payments are included in this definition regardless of whether they are based upon the amount of investment company assets that a member’s customers hold, the amount of investment company securities that the member has sold, or any other amount if the payment is related to the sale and distribution of the investment company’s securities. In addition, payment for services such as sub-administration or sub-transfer agent fees are included in the definition of cash compensation. Cash compensation also includes payments received from an offeror for a member’s annual sales meeting even though the receipt of such compensation is permitted under the non-cash compensation rules. Where a member is uncertain as to the character of any payments it is or will be receiving, FINRA says it should “err on the side of disclosing receipt or expected receipt of these payments.”
II. Recordkeeping Requirement
NASD Rule 2830 requires broker-dealers to maintain records of compensation it or its affiliates receive from offerors. Among the items to be recorded is the value of the non-cash compensation received, if the value of the non-cash compensation is “known.” The proposed rule removes the phrase “if known” from the recordkeeping requirements of Rule 2830(l)(3) and adds in “supplementary material” that provides that where documentation of the value of any non-cash compensation received is unavailable, a member must estimate in good faith the value of the non-cash compensation received.
III. Discounts to Dealers
NASD Rule 2830 currently prohibits investment company underwriters from selling a fund’s shares to a broker-dealer at a price other than the public offering price unless: (i) the sale is in conformance with NASD Rule 2420 and (ii) a sales agreement is in effect at the date of the transaction, and the sales agreement sets forth the concessions to be received by the broker-dealer. According to the 2011 proposing release, the requirement that these sales be in conformance with NASD Rule 2420 is based on historical concerns that both underwriters and dealers of investment company securities be FINRA members. FINRA proposed rule 2341 would eliminate the requirement that the sale be in conformance with NASD Rule 2420 as unnecessary because, now, virtually all broker-dealers doing business with the public are required to be members of FINRA.
IV. Exchange-Traded Funds
FINRA Proposed Rule 2341 permits the trading of an exchange-traded fund on a secondary market or securities exchange at other than the exchange-traded fund’s current net asset value, as long as such transactions are consistent with applicable SEC rules and orders. This provision codifies exemptive relief previously provided by FINRA staff interpretive letters.
Comments on the proposed rule are due 21 days from the date of publication in the Federal Register. Within 45 days of the date of publication in the Federal Register, the SEC may approve the proposed rule, institute proceedings to determine whether to disapprove the proposed rule‚ or extend the period for a total of 90 days from the publication date. FINRA proposes giving member firms no more than 365 days after the SEC approves the rule to implement the rule.
Please direct any questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters.
1Form N-1A still requires investment companies to include in their disclosure a statement that the investment company and its related companies may pay financial intermediaries for the sale of shares and other services and disclosure of brokerage commissions and brokerage selection procedures. See Form N-1A, Items 8 and 21.
2The 2009 proposed rule would have prohibited the broker-dealer from selling securities of investment companies if any arrangements for additional cash compensation with the broker-dealer were not disclosed in the prospectus or SAI.
3Under the 2009 proposed rule, only arrangements pursuant to which the FINRA member actually received additional cash compensation within the past 12 months had to be disclosed. The 2011 proposal also requires disclosure of all arrangements for additional cash compensation entered into within the past 12 months.
4The 2009 proposed rule did not require that a broker-dealer maintain either a webpage or a toll-free number. It required that broker-dealers disclose that updated information would be sent to the customer on a semi-annual basis.
5The 2009 proposed rule would have required a disclosure providing a list of offerors from whom the broker-dealer received cash payments over the course of the previous 12 months in descending order based on dollar amounts received. The 2011 proposed rule dispenses with the requirement to report this list in descending order based on dollar amounts received. It does, however, require that a list be maintained of investment companies and their affiliates with whom the broker-dealer has arrangements for receipt of additional cash compensation, and from whom the broker-dealer has received additional cash compensation, within the last 12 months. That list would be required to be maintained on the webpage or available via a toll-free number.
6The 2009 proposed rule would have required broker-dealers to update their disclosures on a semi-annual basis.
7The 2009 proposed rule would have required broker-dealers to provide disclosure of additional cash compensation arrangements at the time of first purchase in the case of new customers, or at the time of next purchase in the case of existing customers.